Corporate Liability Management - Using FX To Make Your Debt Sweat

The importance of professional asset management is well entrenched. Everyone from the man on the street understands the importance of investing and managing assets wisely and is happy to pay for expertise. But what about the other side of the balance sheet? As debt levels and interest rates rise, the concept of debt management – with the dual aims of reducing debt and improving cash flow – is increasingly important.

Innovative investors are realising the need to make both sides of the balance sheet work for them. While asset growth remains the primary focus, as debt becomes an increasingly common form of financing, CFOs need to find ways to make their debt work harder for them. One of the best ways to do this is to manage debt in a multi-currency loan facility.

UK interest rates are rising following a long period of historically low rates, which is likely to make debt a growing concern. In recent years, leverage multiples have increased in the leveraged buyout (LBO) market and the easy availability of credit has made debt essential for corporate treasurers looking to optimise their capital structure.

Property prices continue to rise, adding to the potential loan size for any corporate expansion strategy. At the end of last year, outstanding debt on property stood at more than £143bn. The use of debt in a wide range of forms is increasing. Whilst equity markets are shrinking, recent estimates are that the corporate debt market is growing at a rapid rate. Thomson Financial estimated the FTSE 100 owed a net £1,100bn at the end of H106.

Debt as a tool to fund acquisitions is increasingly popular, particularly in the private equity sector. Funding structures are becoming increasingly sophisticated with the use of instruments such as payment in kind (PIKs), the introduction of second lien debt to Europe and a strong appetite for mezzanine debt to feed the collateralised loan obligation (CLO) market, which repackage a series of loans into bite-size chunks for investors searching for yield.

While debt has moved to centre stage in the corporate finance market, the FX market has also grown in popularity as an asset class, and is now increasingly used by pension funds and even retail investors. The FX market is already the largest market in the world and is growing faster than any other. According to financial services research consultancy TowerGroup, FX volumes, which rose from US$1.77 trillion in 2004 to US$2 trillion last year, are set to rise to US$2.6 trillion this year and to US$3.6 trillion in 2008, as foreign exchange becomes accepted as an asset class in its own right.

The highly liquid FX market provides opportunities to benefit not only from trading currencies profitably but also from lower borrowing costs. Multi-currency corporate liability management allows companies to achieve this by taking medium-term short positions, when appropriate, on major currencies against sterling.

This can provide two benefits. In the first instance, the debt is placed in currencies that are expected to fall in value relative to sterling, thereby reducing the sterling value of the debt.

Secondly, it’s also possible to reduce interest costs if the new debt currency has lower interest rates than sterling. The interest cost further reduces if the amount of debt itself is shrinking. As well as the cumulative effect of the reduction on the size of the debt, an additional incentive for corporates using this kind of liability management is an immediate cash flow benefit.

However, trading in currencies is not without risks and CFOs should be careful not to expose shareholders’ funds to unquantifiable risks. This can be achieved by the use of a capital protection instrument which is incorporated in the multi-currency debt management structure to ensure the potential downside is capped.

This performance protection option, provided by ABN AMRO, limits the borrower’s liability to an upfront or annual premium and removes any risk of being margin called or stopped out. In this scenario, the borrower has the potential for both debt reduction and interest savings without risk of loss and the lending bank has the potential to see its security improve but not deteriorate.

To give an example of how this might work, it is instructive to look at ECU’s 10-year track record of multi-currency debt management. As the currency decisions have been consistent across all sterling portfolios it is possible to see the track record and performance of sterling debt allocated to ECU at any given point since 1995. It shows that £100m-worth of debt given to ECU to manage on 1 September 1995 would now be reduced to £27,632,827 – a saving of over £72m in 11 years.

For the property market, managing debt in the currency markets makes a lot of sense. It provides investors with portfolio diversification through an asset class, which has a negative correlation to property and can help enhance returns. In recent years, the property industry has benefited from the difference between the cost of borrowing and the average property yield, but the opportunity for arbitrage has shrunk significantly.

While this free lunch has disappeared, it does not mean that property investors have no option but to sit back and pay off the debt in a traditional manner. Multi-currency liability management can offer property investors the additional attraction of loosening the ties to the banks that have been tightened through the commercial or residential mortgage-backed securities (CMBS or RMBS) markets. If the investor opts for a managed multi-currency loan facility over a CMBS or RMBS deal, they also have the ability to sell their property at any time in the conventional manner, which would not be the case if it had been securitised.

This form of debt management also makes sense for the burgeoning private equity market. The recent FSA discussion paper on the private equity market reflects increasing industry and regulatory concern about the volume of debt in the sector. Excessive leverage is cited as a significant risk not only for the private equity houses and the companies in which they invest, but for the stability of the financial markets as a whole.

Recently, an increasing number of private equity deals have been strongly contested, driving bids to a premium. As acquisition targets increase in size and value, and more debt is needed to finance deals, such companies are often the recipients of large unmanaged loans on their balance sheets, which sap their performance and reduce returns to the private equity houses and their investors.

This situation is driving private equity houses towards different debt management solutions. The industry is re-examining whether it’s possible to reduce debt and improve cash flow without having to liquidate assets. There are other sectors where this form of debt management is a natural extension of existing practices. This is most common in markets where there is a regular need for transactions in a variety of currencies, with a significant amount of debt financing. The shipping world is accustomed to dealing in both markets in size and, as a result, is ideally positioned to adopt this debt management method.

It is clear that as debt assumes a central role in the European business world, investors will seek ever more innovative ways of reducing the weight of the debt burden. As the FX market grows larger and more liquid every year, the marriage of the two would seem like a very natural form of market evolution.