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Strategies for smoothing the highs and lows of currency volatility exposure

I’ve been fascinated recently with “currency wars” and the ways national governments are adapting. For instance, the United Kingdom and China are entering their own currency-swap deals, and Brazil, Russia, India, China and South Africa (aka BRICS) have recently agreed to set up their own $100 billion monetary reserve and are reportedly dumping their euro reserves.

Closer to home, currency fluctuations hit U.S.-based multinational corporations in 2012 to the tune of a collective negative impact of $22.7 billion in the third quarter alone. The trend continues in 2013, and currency volatility has for the first time grabbed the attention of management at the highest levels in companies. In this volatile environment, the treasurer is working more closely than ever with the CEO, the CFO, the board and the head of M&A on associated risk management.

But how are companies adapting? For one, tech giant Hewlett-Packard, which has approximately 65 percent of its sales outside the United States, addresses the possibility of countries exiting the euro in its risk disclosures. Companies are increasingly trying to understand the potential implications of currency volatility and how to plan for them; the best advice bankers seem to be able to give is to get the paperwork in order and narrow the number of jurisdictions that hedge contracts are subject to. Restricting business to counter-party banks in a single jurisdiction is a smart move, because at least the terms would be consistent.

When, and if, exposure is clearly quantified, identifying the need for direct risk-mitigation strategies that can be controlled and reduced by operational strategies can best be accomplished by answering the following questions: Where are balances kept and in what currencies? Do FX exposures match the respective trading risks? What is the relationship between subsidiaries and the global parent? Are they financed by loans or equity?

JP Morgan, in the recent article “Managing FX Risk: The Challenge of Global Payments,” says the key is to centralize what is appropriate. In many instances, treasury activity is with business units. It is possible to leave the payments with these units (they are most in touch with vendors and suppliers), but centralize everything else. (Fortunately, several global banks now offer easy-to-use technology that allows multinationals to see their FX exposures without the cost of standardizing all their ERP systems or even requiring the systems to be on the same version.)

According to a recent Wells Fargo Foreign Exchange Risk Management Practices Survey of U.S.-based multinationals, companies are using three risk management approaches:

Systematic risk management: hedging a fixed amount of forecasted foreign currency transactions over a specific time period at regular intervals using specific hedge instruments (55 percent of survey respondents)

Active hedging: discretionary hedging of forecasted foreign currency transactions based on market conditions that allows for extending the hedge horizon, changing targeted percentage amounts or using discretion in the hedge instrument (36 percent)

Dynamic hedging: using discretion not only when initiating hedges, but also during the life of hedges (9 percent)

Given the rapidly changing environment, it’s imperative that a multinational’s particular strategy be revisited at least quarterly and openly discussed with the board.

Perhaps countries will one day figure out how to calm currency volatility, and currency wars will be a thing of the past. This month, the Bitcoin 2013 conference in San Jose drew more than 1,000 enthusiasts, developers, entrepreneurs, VCs and lawyers. (I still don’t understand how this decentralized, open-source peer-to-peer digital currency works, but I’ll keep trying.) And at the G8 Summit in July 2009, then-president of Russia Dmitry Medvedev presented a newly minted “test coin” representing a “united future world currency.” Mere mention of this in my circles creates very spirited debate between those who believe we’re eventually heading for a single global currency and those who believe entertaining such an idea is simply conspiracy theory.

One thing is for certain, the monetary policies of the mature and emerging markets will continue to keep the senior leadership of multinational companies on their toes.

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Evaluating an acquisition target: pay attention to the gray areas

What’s more shocking: HP’s $8.8 billion (yes, billion!) impairment charge recorded in its recently completed fourth quarter, or the fact that it blames the charge on the “accounting improprieties and disclosure failures” of Autonomy, a UK-based company it acquired just last year? Clearly, investors were not pleased, as evinced by the immediate drop in stock price after the announcement was made. What lingers, though, is an aching question that haunts companies contemplating an acquisition: if HP, with its significant M&A experience and multiple Big Four audit teams, failed to see through Autonomy’s misrepresentations, then what hope is there for the rest of us?

Investigations by the Securities and Exchange Commission’s Division of Enforcement and the UK’s Serious Fraud Office are under way to determine whether evidence of fraud exists. I think it’s safe to say that detecting fraud at a target company is not typically engrained in the pre-acquisition due diligence process. However, consider this: what if the “improprieties” weren’t fraud per se, but instead liberal interpretations of principles-based international financial reporting standards?

Drawing focus to areas requiring extensive judgment and assumptions should be an integral part of the due diligence process. Even where the financial statements have already been audited by a reputable firm, focusing on the gray can be exceptionally beneficial: it can highlight areas of financial risk; it can provide greater insights in vetting forecasted financial results; and it can identify areas where the target’s accounting policies differ from your own.

More often than not, the financial due diligence process is focused on quantifying the net assets of the business (aka “scrubbing the balance sheet”) and understanding the assumptions underlying the company’s financial projections. However, attention should also be given to those accounting policies for which judgment and/or material estimates are required. SEC registrants often refer to such policies as “critical accounting estimates” and include required disclosures in the Management Discussion & Analysis section of their periodic filings. Private companies are not required to provide such disclosures, and they may only touch on general accounting policies in the footnotes.

Critical accounting estimates often include areas such as rev rec, asset impairment analysis, contingent liabilities, income taxes and reserve accounting, including warranty provisions, bad debt allowance and reserves for excess and obsolete inventory. Understanding your target’s policies with regard to these areas is critical, not only to assess the judgments applied, but also because certain accounting rules (especially those that are principles based) can provide leniency in interpretation, and different companies arguably have different risk profiles.

So the moral of the story is, no deal is ever black and white. The more time you spend understanding the gray, the better your chances are for understanding and valuing what you’re buying.

For an M&A due diligence checklist, see our report, M&A: Get What You Bargained For.

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