Using debt as a natural FX hedge by matching it to the company’s EBITDA currency split, is a commonly deployed solution in private equity. For example, a EUR-reporting business, generating half its EBITDA in EUR and half in USD, would draw debt in these same proportions.
Both banks and debt fund lenders will in many cases offer the borrower the choice to redenominate term loans in whole, or in part, into a different currency with no margin differential. This makes redenomination quite attractive as it neatly addresses FX exposures – and back in 2014 or 2015, when interest rates were not too dissimilar in EUR, USD and GBP, there was little difference in funding cost across these currencies. However, this has changed significantly as interest rates across the major currencies have materially diverged: three-year USD swap rates are close to 3% but for EUR they are only 0%. Assuming a lender charges a margin of 6% over the three-month LIBOR in both USD and EUR, redenominating from EUR into USD increases the annual interest rate bill by 50%.
An additional drawback of having foreign currency debt on the balance sheet, is its impact on the company’s P&L, as it needs to be re-measured into the reporting currency at the spot rate on each reporting date. That introduces P&L volatility, albeit below EBITDA. Before deciding to denominate debt in a foreign currency, it is important for any company to have thought about how address this issue – whether by applying hedge accounting (if possible); neutralising the P&L volatility by hedging with derivatives; or simply accepting the impact.
Does this mean that redenominating debt should not be considered if the interest rate differential is too wide between the currencies in question? Matching EBITDA and debt from a currency perspective can also stabilise leverage ratio and, more importantly, equity value. These benefits may outweigh the increase in funding costs and potential P&L volatility. This assessment, however, hinges significantly on the company’s exact currency position, which drives how volatile leverage ratio and equity value would be if one didn’t match debt and EBITDA.
To complicate matters further, it is also possible for a company to manage its currency exposure using a derivative-based strategy, for instance in the form of a cross-currency swap or other FX hedge. Depending on the business objective, this may be a more or less attractive alternative. Considerations in pursuing this solution include credit line availability, the pricing offered by derivative providers and potential P&L impact.
So what should borrowers do? It is hard to generalise, as the answer is dependent on so many different variables. Provided that the objectives are well defined and the right questions are asked, one can explore the various alternatives and make an informed decision. Unfortunately, heuristics may not cut it anymore.
To discuss any of the issues raised in this article, or to find out how we can help with your hedging requirements, please contacton +44 (0)207 493 3310.