The most influential variable for optimal decision making is not based upon accurately utilizing and pricing all available information; rather, it is the inability to place any acceptable degree of confidence on the variable for uncertainty over future potential outcomes. Managing such uncertainty is precisely the challenge the corporate finance community faces after Britain’s recent referendum to withdrawal from the EU, writes Bob Callahan, Director at Redbridge DTA.
In BREXIT: A Guide for Treasurers to Manage the Uncertainty, Redbridge DTA offers thought leadership to senior corporate finance executives on managing the challenges, risks, and opportunities in reaction to the impending changes to the landscape for global trade. Our objective is to provide the requisite tools and relevant information to enable corporate treasurers to efficiently manage the initial shocks and the impending secondary, tertiary, and quaternary disruptions.
The Certainties – What we know
Before outlining the challenges for the corporate finance community arising out of Brexit, it would be helpful to address the few certainties available. The three most important are:
- The oft alluded to 2 year countdown clock does not actually begin until Britain’s Prime Minister goes to the European Commission (EC) to formally state the government’s desire to exit.
- The period can be extended through a mutually agreed upon new time frame.
- Any renegotiation requires a “qualified majority” of member states.
The Uncertainties – Considerations for Corporate Treasurers
Sterling weakness was the first shock, followed by a lower Euro, and a flight to quality as stable currencies saw large inflows. The pound will continue to weaken while the Euro could strengthen as the Union may rally together. Either way, global trade is being redefined and corporate treasurers face challenges in every area of their operations.
The overriding objective for treasurers, therefore, is to manage currency exposures and to determine the best means by which to protect profit margins from the volatility.
Within a comprehensive analysis, treasurers must do the following:
- Systematically recalculate all exposures to Britain and to the EU, both currently and for their long-term growth plans.
- Understand that the value of protecting profit margin from volatility through hedging is relative to costs & revenues that are affected by foreign currency exposures. Generally speaking, creating a stable environment by eliminating volatility is the optimal option since it allows treasurers to more effectively plan for the future.
- Focus on the effects to the balance sheet by identifying new translation risks. Be mindful of translation exposures affects on credit ratios and cash flow measurements, which may be relevant to debt covenants. One option is to consider switching to local suppliers to better manage foreign currency risks by matching revenues and costs.
- Evaluate the value of changing the functional currency.
- Determine new hedging costs and, given growth plans, where expectations for future hedging costs may be.
- Explore the value of implementing currency adjustment clauses into customer and supplier contracts. Such a strategy can be a cost effective means to managing currency risk and minimizing hedging costs.
An environment with higher funding costs in the UK is nearly certain. Why? Because markets dislike uncertainty and we are in an uncertain environment. Likely triggers are cited in I – III. Areas upon which treasurers should focus are:
- As sterling debt will likely be considered riskier, banks could face higher borrowing costs from the Bank of England (BoE) which, in turn, would mean higher rates for corporations.
- If the pound continues to fall, the BoE may have to raise rates to defend the currency.
- All three major rating agencies indicated that a UK exit would be credit negative. Britain is therefore facing a downgrade. If Britain were downgraded, corporations face lower credit ratings and higher funding costs.
- As a UK based business, do you borrow from the European Investment Bank (EIB)? If so, do you have contingency plans? If not, do the businesses with which you transact have such exposure?
- To what extent will your debt financing be impacted by the exit? Scenario analysis will provide results from a variety of changes to variables and coefficients.
- To implement strategic reviews for a company’s funding sources is essential to managing outcomes.
Credit ratings are a common tool used to select counterparties for banking relationships, which assists in meeting internal policies for managing exposure limits. On the backdrop of recent events, a review of current and potential increases to counterparty risk is essential. Essential considerations for treasurers are:
- To communicate with corporate banking relationship managers to obtain early guidance for any bank withdrawing from any specific line of business OR if the counterparty will become a different entity within the organization. Doing so may change the credit rating of the counterparty.
- To redefine credit limits with British companies, reflective of new environment.
- To examine value of taking out credit insurance against suppliers/customers.
- To limit not only individual credit exposures but also operational exposures to British banks.
- To review contracts for changes to terms and conditions that could have trigger events.
Banking Relationship Management
Arguably the most important consideration on which treasurers must gain control is in BRM. Banks are at the forefront of changes and will define the longer-term landscape. Communicate with your banker concerning the following issues:
- How will current banking relationships change and will they remain appropriate for your needs?
- To understand the changes in bank abilities, particularly UK-based banks which will face uncertainty surrounding their ability to offer services in the EU. Verify what you are told.
- Review existing facilities and the applicable currency to the RCF, paying particularly close attention to off-balance sheet funding, which is often overlooked in normal reporting.
- What will be the effect on Passporting rights, particularly for UK regulated entities? Big US banks that have set up large regulative business operations in the UK and then used their right to passport into the EU are not immune, although many have EU operations to which they can transfer operations.
The most complex of a treasurer’s challenges, since it incorporates all other areas, including funding, foreign currency exposures, and overall banking relationships is cash management. Among areas to explore for potential problems are:
- Determine what the UK’s participation in the Single Euro Payments Area (SEPA) means for companies. Will, for example, additional charges be implemented and passed on to companies? This is particularly bad news for companies with centralized accounts in the UK for the purpose of cash pooling to optimize liquidity.
- Reviewing all cash pooling arrangements, particularly as negative rates in the EU drive central banks to stop current accounts from being used to park cash. Prepare contingency plans since a change to continental Europe may be the best option, at least until laws, regulations, taxes, and trade agreements are fully known.
- Potential system changes need to be implemented.
- Whether sufficient ST liquidity needs are met. Incoming and outgoing flows will be volatile and working capital needs must be managed forward under worst case scenarios. Explore option to extend working capital cycle.
- To act very early on any sterling refinancing needs.
- Whether new trading companies or off-shore account structures need to be created.
- To explore challenges with intercompany lending and run scenario analysis to determine optimal structure.
- Whether treasurers should review all financial contracts with different counterparties, including suppliers, banks, and clients to ensure continuity and to mitigate risks.
- To determine the level of reliance on UK banks from a cash management POV. There might be a need to switch banking partners, or at least secure access to alternative banks that are based in the Eurozone.
General Risk Management
It is essential to review and revamp your organizations current risk management framework. To do so, it is best to develop a comprehensive scenario analysis for contingency planning. Issues to explore are:
- How your organization’s profile will change, particularly if your business location was specifically chosen to optimize cross-border trade.
- Whether creating a committee with representatives from different areas makes sense. The objective would be to ensure all company exposures are managed in sync.
- To consider an alternative treasury and trading model, or at least a module to adjust for changes.
- How reporting may change, specifically related to risk management.
- How data protection, data transfer, and data sovereignty may be effected.
- How to prepare for a total revamp of treasury policies to comply with new agreements.
- Whether the concept of “equivalence” will remain.
First, new trade agreements with countries and regions will take years to formalize, creating complete uncertainty for the business community for an extended period. Periods of uncertainty are always bad for business. After all, who would want to invest in new projects, expand operations & hiring, renew leases, and launch new businesses or projects without knowing the rules, taxes, and regulations that will exist in the future? Secondly, it is highly improbable that Britain will negotiate a more favorable trade agreement with the EU. In fact, the incentive for member states is to offer much less favorable terms. If more optimal terms were offered, remaining members would question the value of the Union and increase the chances of a total collapse.
To further demonstrate Britain’s poor negotiating position, according to Britain’s Treasury Department, only 3.1% of EU GDP depends on trade with Britain whereas 12.6% of British GDP depends on trade with the EU. Moreover, according to Britain’s Office of National Statistics, over 44% of Britain’s total exports go to the EU and 53% of all goods and services imported to the UK come from the EU. One wonders what leverage Britain really has and why would remaining members agree to provide the UK significant access to the single market without requiring acceptance of EU regulations or require Britain to make contributions to Brussels to support the Union?
Clearly, Brexit will create unanticipated dislocations due to the long period of before stability returns and, without pro-active and comprehensive management of the operational, structural, and performance related effects treasurers will face, significant risks lay ahead. The challenge to successfully manage through Brexit lies in efficiently managing uncertainties. To do so, Treasurers must confront all the potential organizational risks, systematically establish a plan of action for each detrimental effect to current operations, and continually adjust the internal strategy as the probabilities of such outcomes increase or decrease.
Bob Callahan, Director at Redbridge Debt & Treasury Advisory North America, holds almost 20 years of global finance experience. In the 1990’s, he made equity markets for Fidelity Investments. By 2005, he had moved to a Frontier/EM debt hedge fund, focusing on performing & distressed/recovery credits. In 2010, Bob launched and later ran Banco Bradesco’s NY fixed income dealer desk. Since 2013, Bob has been a global consultant to corporate finance executives, joining Redbridge DTA in 2015. He has a B.A. from UT, Austin in Economics & English Literature, and a Master’s degree from Columbia University’s School of International and Public Affairs, with a concentration on International Finance and Business.