Hedging with Derivatives; Part 2 of 3: Interest Rate Risk

If variable interest rates leave your company exposed, you should consider an interest rate hedging strategy.  The most common method is a ‘vanilla’ interest rate swap which can be used to effectively convert all or part of a variable (LIBOR + X) rate loan into a fixed rate loan, thereby mitigating the risk of fluctuating exchange rates.  Simple example:  You have a $2 million loan that pays a variable interest rate.  You can enter into a swap agreement whereby you will borrow $1 million at a fixed rate and invest it in a security that earns a variable rate.  This will reduce your exposure to fluctuations in the variable LIBOR rate.

Another situation that may necessitate an interest rate hedging strategy is when you are anticipating a significant inflow or outflow of cash to take place in the future, perhaps one year from now.  The viability of the strategy may depend to some degree on the interest rate at that time, and you do not know what that interest rate will be.  By purchasing a Treasury futures contract, you could effectively ‘lock-in’ the interest rate now.  This will take one important variable out of the equation and make it easier to focus on the other aspects of the deal.

As with other types of hedging, remember the purpose of a hedge program is to mitigate risk.

Next up:  Hedging with Derivatives; Part 3 of 3:  Commodity or Product Input Risk

Hedging with derivatives Part 1 of 3; Foreign Exchange Risk

When a middle market company engages in exporting its products or importing raw materials, it may want to consider hedging the risks related to fluctuations in the currency.  For example, let’s assume your company takes a sales order from a French customer that will be filled in 6 months and you agree on a price in Euro’s.  You know exactly how many Dollars those Euro’s will convert into at today’s exchange rate.  The problem is you don’t know what the exchange rate will be 6 months from now when you get paid.  If the Dollar appreciates versus the Euro, you will end up with fewer dollars than you anticipated when you booked the sale.  To mitigate this risk, you can purchase foreign-exchange futures contracts.  I will not get into the details of how those work, but I will offer these additional tips:

  • If you agree to terms with a customer or vendor involving foreign currency, define the currency and stick with it.  Do not allow the customer/vendor to have their choice between a price in Dollars or the foreign currency.  Doing so would allow them to complete the transaction in whichever currency is favorable to them at the time of payment, which means your company is shouldering all the risk and will likely lose either way.  Make sure your salespeople, AR and AP staff’s understand this and monitor it.
  • As an alternative to hedging, you can structure the sale or purchase contract in a way that shares the risk between the customer and the vendor by locking the current exchange rate on a portion of the total contract.
  • Some companies have a natural hedge, meaning they purchase raw materials in a foreign currency and then sell finished goods in the same currency.  The idea is fluctuations in the currency that drive raw material prices up will also result in higher sales and vice-versa so there is less need for a hedging strategy.  However, due to timing differences, you might think you have a natural hedge but what you really have is twice the exposure and you could actually lose on both ends!
  • Isolate your gains/losses on foreign currency exchange from your other revenue and material costs.  Make it one of the KPI’s you include in your reporting package.
  • Remember, you are not a speculator.  You are a risk mitigator.  If your “hedging” strategy actually makes a lot of money for the company, you are not doing it right.

Next up:  Hedging with Derivatives Part 2 of 3; Interest Rate Risk

Hedging risk with derivatives

Warren Buffet called derivatives “financial weapons of mass destruction”.  Warren is right, as always, but he also understands their purpose.  Derivatives can be extremely risky investments, but when used properly, they are tools to reduce risk.  It is very important when implementing a hedging strategy to build in sufficient oversight & accountability and follow the policy closely.  This not only protects the interests of the company, for the CFO it is about CYA – covering your ass-ets.  When done right, a hedge strategy is like insurance.  It costs the company money and you hope you never need to use it.  It’s about cutting your losses, not making money. The idea is the cost of the hedge is far less than the potential loss had you not hedged.  CEO’s and owners will sometimes forget this point and question why you spent money on derivatives that expired with no value.  If the strategy was clearly presented to them, they participated in the decision and signed off on it, it will help them remember the blurry uncertainty you were hedging against at the time the strategy was implemented, which can be difficult to see when hindsight is 20-20.

To help you evaluate a company’s use of derivatives for hedging risk, in this 3 part series, we’ll look at the three most common ways to use derivatives for hedging.

HR1105 to deregulate #middlemarket #PE

H.R. 1105, the Small Business Capital Access and Job Preservation Act of 2013, would allow middle market investors access to capital and exempt investment advisers from having to register with the Securities and Exchange Commission (SEC). Currently under the Dodd-Frank Act, private equity fund managers are subject to time-intensive and capital-constraining registration requirements.

The Association for Corporate Growth (ACG) is in support of this bill.  Their press release is attached here.

Middle Market driving job growth

Per Bureau of Labor Statistics data, businesses with between 50 to 1,000 employees generated the biggest job gains between March 2011 and March 2012. In fact, the 1.8 million jobs these firms added over that period accounted for more than half of all new jobs and more than five times the number of jobs created by companies with 1,000-plus employees.

Deloitte’s Tom McGee praises the middle market in article for Forbes

Deloitte’s Tom McGee praises the middle market in article for Forbes

Deloitte’s Tom McGee talks about the middle market in an article for Forbes.  The success of middle market companies stems from their ability to be nimble, McGee states. Operational costs tend to be lower, and smaller companies have greater flexibility and hands-on management. McGee said many mid-market companies also tend to be entrepreneurial, a positive point highlighted by another Deloitte survey that showed that entrepreneurial mid-market companies experience greater worker productivity and generate higher profit margins. “All of this evidence, in my view, points to a cross-section of the economy that is most likely to explode once our nation’s economy starts to shift to its potential growth rate,” McGee argues.

Middle Market CFO @cfopub giving away free beer

…related advice. That’s right, free beer related advice about how middle market companies can go toe-to-toe with giant corporations and win.  Consider the case of craft beers.  The number of breweries in the U.S. has more than quadrupled in recent years.  Restaurants that once offered the choice of either American mega-brews or ‘imports’ are increasingly turning to a line-up of craft beers, many of them made in America by middle market breweries.  How are they able to compete with the big companies?

  • Make a better product.  The bland American-style pilsners may appeal to the masses but they leave room for competition.
  • Embrace your underdog status.  Turn their strengths (economies of scale, mass appeal) into weaknesses.  “They spill more than we produce” and what not.
  • Work like hell.  Many successful craft brewers will tell you it was a lot harder than they thought it would be, but it was worth it.
  • Be cool.  Get involved in your community.  Host fun events.  Associate with fun-loving adventurous types, musicians and the like.
  • Use clever marketing tactics, something this blogger knows absolutely nothing about.

Most, if not all, of this free beer related advice applies to middle market companies in industries other than beer.

New section 336(e) regulations could simplify #PEG investments

On May 10, 2013 the SEC and IRS passed final regulations under section 336(e) that provide basis step-up opportunities for non-corporate acquirers.  The new regulations provide an opportunity for a Private Equity Fund (PE) to acquire a target and receive a basis step-up and tax shield, without creating a purchasing corporation or otherwise restructuring the target prior to the acquisition. Further, a PE now has the flexibility to restructure the target such that the ongoing activity is conducted through an LLC taxed as a partnership, which would allow the fund to pass on a full basis step-up upon exit and eliminate future corporate taxation on the target’s activities. In addition, the new regulations may provide the ability to separate multiple businesses post-acquisition in a much more tax-efficient manner than previously existed, thereby allowing a PE to better align its investments.

The full article from McGladrey can be found here.