Risk Management Implications of International Acquisitions - Part 1

Background

For most companies, expanding their business globally is a near-term corporate objective, and foreign acquisition is certainly one path toward accomplishing that goal. But with international acquisitions, rare is the case when the acquisition price is set in the acquirer’s currency. Pre-acquisition, an analysis must be conducted to determine what the currency price is. The acquirer must also decide whether it is economically viable or important to hedge the foreign currency acquisition price. Hedging foreign acquisitions has differing, and at times, confusing points of view. This article discusses the issues surrounding the foreign acquisition process and clarifies what the appropriate risk management steps are.

Determining The Price

The first step is to determine whether the analysis will be conducted from a domestic or foreign currency perspective. While this seems obvious, there are subtle differences in the NPV methodology depending on the currency perspective¹. If the acquisition is evaluated from a domestic perspective, exchange rates must be forecast to convert the foreign currency cash flows into domestic values. The company then applies a domestic cost of capital (“DCOC”) discount rate; although depending on the situation, management may increase the DCOC by including an incremental risk premium.

Alternatively, the acquirer can use a local currency approach, which involves discounting the currency cash flows at a local discount rate. The NPV is then converted into domestic currency by applying the spot exchange rate. At first glance, this may seem to be a superior approach because it does not require one to forecast exchange rates. The challenge, however, is to determine an appropriate foreign discount rate.

In the end, whether the acquisition is evaluated from a domestic or local currency perspective, the NPV’s must be identical². This has implications in sensitivity analyses. When examining the impact of differing exchange rate assumptions, the cash flows vary in a domestic currency analysis. But, if a local currency approach is chosen, the discount rate adjusts when exchange rates change.

Tables One and Two illustrate this point. We assume that the euro cash flows are known. The domestic cost of capital is 11.0%. Given the exchange rates in Table One, and using the domestic currency (USD) approach, this yields an NPV of $559 (EUR462). Using a local currency analysis, a discount rate of 9.4% must be applied to yield the same NPV (i.e., EUR462 or $559).

In Table Two, we change the exchange rate assumptions. This changes the dollar cash flows but the euro values are not affected. For example in Year 1, the USD cash flow has changed to $110 from its previous value of $125. Using the same DCOC (i.e., 11%), the new NPV is $509 (EUR421). However, to obtain the same EUR (and USD) NPV using a local currency analysis, the local discount rate must adjust to 12.9% from its prior value of 9.4%. Contrary to conventional wisdom, when a local currency approach is used, the discount rate changes to reflect exchange rate risk. Depending on the exchange rate scenario examined, the cost of capital differential can be either positive or negative. This finding may be a sound reason to conduct the analysis in the domestic currency. It is much easier to explain the results of an exchange rate sensitivity analysis if cash flows are changing rather than the discount rate.

Hedge The Acquisition?

Following the pricing stage, the acquirer must also decide whether it is economically viable or important to hedge the foreign currency acquisition price. There are numerous theories on this matter that could lead one toward not hedging. We examine some of these and hopefully clarify the appropriate risk management steps. Among the theories that we examine are:

• The Fair Market Value theory. Changes in the closing cost related to foreign currency moves are mirrored by changes in the value of the purchased asset. Therefore, don’t hedge.
• The We’re So Big theory. The market value of the acquisition is small relative to the acquirer’s total market capitalization. Therefore, don’t hedge.
• The Informed Investor and Global Expansion theory. The investor base knows that the company is expanding globally and understands that foreign currency risk is part of that business dynamic. Therefore, don’t hedge.
• The No-Reward theory. The investor community does not reward companies for hedging risk.

The Fair Market Value (“FMV”) Theory

At the close of the acquisition period, the market value of the acquisition is the local currency price converted into the acquirer’s home currency. If the foreign currency has appreciated during the acquisition period and the position is unhedged, the cost is higher than expected. Offsetting this cost increase is the fact that the acquired asset is now more valuable than originally projected. Under the FMV theory, hedging the interim foreign currency risk is unnecessary, as the price paid is always “fair”.

From a treasury perspective, we need to consider what “fair value” is. Is “fair value” the actual price paid or the expected cost? We believe that “fair value” is what the company expects to pay, as this is what the investment analysis is predicated on. An acquisition can be thought of as an allocation of a company’s investment portfolio. From the perspective of a portfolio manager, allocations are always percentages of the overall portfolio when evaluated in domestic, not local, currency.

For example, suppose a US based company has a $100M investment portfolio. It has entered into an agreement to acquire a European-based company for EUR100M. The current exchange rate is $1.00/EUR. This represents a 100% cash deal, as well as a 100% allocation of the investment portfolio. The company does not hedge the exposure, however, and the exchange rate moves to $1.25/EUR. Due to the exchange rate move, the cost is $125M, which is now a 125% allocation of the investment portfolio. The company must leverage to consummate the deal because it has no additional cash resources even though the acquisition is at FMV.

Another way of thinking about the FMV theory is to consider a domestic stock purchase. Theoretically, the price of any stock, at any time, is always at the FMV. If it were not at the FMV, then an arbitrage opportunity would exist. During the day, the price of the stock fluctuates in an unpredictable manner, but it is always at FMV. The difference between the theory and practice is this: a portfolio manager feels differently if he owns a stock at $100 and its fair market value is $100, compared to when he owns it at $80 and the FMV is $100.

Foreign exchange volatility however, is very real in economic terms. If at the close, the cost paid is high but the forward-looking flows are not hedged, the “increased value of the asset” is temporary and phantom. If the acquisition price is unhedged, the potential cost to the shareholders is also the widest (see Chart One). A basic tenet that we subscribe to is that risk management reduces the variability of potential outcomes, especially bad outcomes. Reducing the variability of bad outcomes adds value.

Chart One: Probable Cost Increase of EUR100M Acquisition Over a 6-Month Horizon

Source: Banc of America Securities

Purchasing assets at fair value is not the issue. We believe that every acquisition strategy’s goal is to purchase assets with an eye toward adding shareholder value. To that end, the actual cost paid as measured in domestic currency is most important.

The We’re So Big Theory

Another argument for not hedging is based on relative size. When the market value of the foreign acquisition is small compared to the acquirer’s total market capitalization, one argues that there is no need to hedge because the incremental cost is marginal in the aggregate. Under the “We’re So Big” theory, the company elects not to hedge.

By not hedging the acquisition price, the acquirer is effectively self-insuring against a potential cost increase. We note that companies often self-insure risks, but the motivation to do so, is typically cost driven.

Who bears the cost of self-insurance? Without question, it is the shareholders. Their cost is the cost of equity. Shareholders expect their capital to be invested in activities that yield a return superior to the cost of equity. Therefore, unless the cost of equity is less than the cost of hedging, self-insuring acquisition costs is a poor allocation of corporate capital. In most cases and particularly in major currencies, self-insurance results in negative carry to the shareholder.

The Informed Investor and Global Expansion Theory

Under this theory, the assumption is that the investor base accepts foreign currency risk as part of the company’s global expansion strategy. As such, by hedging foreign currency risk, the company is actually reversing a key motivation for stock ownership.

If the market understands that global expansion also means currency risk and was indifferent to it, then there should be no relationship between foreign exchange losses, earnings announcements and changes in market capitalization. However, observable evidence clearly shows that the market is not indifferent, implying that currency and its impact on a company’s performance matters.

For example, going back to September 2000, many US-based companies announced that they would experience a shortfall in sales or earnings due to the strong dollar³. The earnings announcements of 200 US companies were examined, and of these, thirty-eight specifically mentioned adverse foreign currency moves as partially responsible for either a decrease in the US dollar value of sales or a shortfall in expected earnings. The market reaction was clear. Sixtyone percent (of the thirty-eight) experienced double-digit percentage erosion in their market value at the open following the announcement, and the equity erosion continued over the next trading month. The declines were five to ten times the percentage move in the broad market.

Based on our analysis, we cannot conclude that changes in terms of lower USD values of foreign sales and resultant lower USD earnings were the only, or even the primary, factor that drove down the share prices of the companies studied. The greatly varied wordings of the earnings and sales announcements did not allow that kind of a summary statement to be made. However, we can say that the impact of currencies was great enough to merit mention by a significant number of companies, and that those companies represented a wide range of market capitalization. Chart Two shows the portfolio of stocks (equally weighted portfolio of the thirty-eight names) and the relative change in price as compared to the S&P 500.

There is a significant difference between a company expanding globally and exposing investors to unmanaged currency risk. Shareholders have a tacit expectation that the risk management process allows a company to grow internationally, but in a manner that also controls financial market risks. A possible exception to this general risk management mantra is that in certain commodity-based industries (e.g., oil, gold, etc.), it is believed that an equity purchase is equivalent to gaining commodity exposure.

Chart Two: The Impact of Earnings Losses Due to Currency (September 2000)

Source: Banc of America Securities

Specific to currency exposure however, sophisticated investors do not buy companies for their currency portfolio. First, it is impossible to determine what a company’s actual currency exposure is based on financial reports. Second, a company’s currency exposure is dynamic and particularly unknown when an acquisition occurs. Sophisticated investors understand that currency exposure is more efficiently gained by buying currency, rather than indirectly through the purchase of a stock. Buying a stock incurs broad equity market risk, as well as, currency risk. Hence, if an investor is searching for currency exposure, it is much more efficient to buy currency directly.

The No-Reward Theory

This perspective suggests that the investment community does not reward companies for hedging risk. If a company’s stock price is not positively influenced by managing risk, then why should they manage it? In addition to the analysis above, we cite two academic research papers written by Allayannis and Weston. The first, entitled, “Earnings Volatility, Cash Flow Volatility, and Firm Value” ⁴ examined the relationship between financial volatility and value. Allayannis and Weston concluded, “that both earnings and cash flow volatility are negatively valued by investors”. In fact, a one-standard deviation in earnings volatility was associated with a six to twenty-one percent decline in firm value. This is very similar to the results we observed in our study above. Managing risk (i.e., hedging) reduces the variability of financial outcomes and produces more predictable and smoother results. Allayannis and Weston concluded that producing smoother financial results adds measurable value to the firm.

A second research paper written by Allayannis and Weston, entitled, “The Use of Foreign Currency Derivatives and Firm Market Value” ⁵ reviewed seven hundred twenty non-financial firms to investigate whether those that managed currency risk were more valued, as measured by Tobin’s q⁶. Tobin’s q ratio is the market value of the firm to its replacement cost. A Tobin’s q ratio greater than 1.0 indicates that investors have a positive outlook for the firm’s growth opportunities. Allayannis and Weston found a positive and robust relationship between firm value and foreign currency hedging: “the hedging premium is statistically and economically significant for firms with exposure to exchange rates and is on average 4.87% of firm value”. In other words, all other things being equal, companies that hedge foreign exchange risk are nearly 5% more valuable in market capitalization relative to those that do nothing. Based on our experience, we are also in the Allayannis and Weston camp, and reject the No-Reward theory.

Closing Comments

This paper examined several theories that are often used as economic justification for not hedging acquisition exposure. These are: the “Fair Market Value” theory, “We’re So Big”, the “Informed Investor and Global Expansion”, and the “No-Reward” theory. We believe that foreign exchange risk in acquisitions is material to the economic performance of the acquired asset. As such, hedging the acquisition price should not be a topic for debate. Hedging the acquisition price is financially prudent, value-added, and should be mandatory, as it clearly delivers material economic and shareholder value.

In Part I, we examined the NPV analysis process, and whether to hedge the acquisition price. In a future article, we will discuss two additional and important steps. First, what one needs to consider when executing. Second, once the merger has been consummated, what the implications are looking forward.

¹See Miyamoto, “Linking Foreign and Domestic Costs of Capital”; Bank of America Monograph Number 50, Winter 1996.
²Ibid.
³See Bird and Yee, “Currency Fluctuations, Earnings Announcements, and Market Capitalization”; Bank of America Monograph Number 162, Spring 2001.
⁴See “Earnings volatility, cash flow volatility, and firm value”, Allayannis and Weston, https://faculty.darden.virginia.edu/allayannisy/EARNVOL0727.pdf
⁵See “The Use of Foreign Currency Derivatives and Firm Market Value”, Allayannis and Weston, Review of Financial Studies, vol. 14, no. 1 (Spring 2001): 243-276
⁶Tobin’s q is the market value of the firm to its replacement cost. The ratio is named after Nobel Economics Laureate James Tobin.

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