Any large corporate doing business across borders faces the challenge of dispersed liquidity.
Done well, subsidiary capital structure optimization ensures that the corporate balance sheet is no larger than it needs to be and that that capital can be repatriated with minimal difficulty.
However, companies often pay insufficient attention to subsidiary capital structure optimization. By doing so, they jeopardize the visibility of liquid assets: too many standalone bank accounts and liquidity in multiple legal organizations without planned cash concentration obscures the overall picture.
“There may be multiple banking relationships, all with different formats, availability and ways of delivering information,” explains Patrick Peters-Bühler, principal of the treasury advisory group, treasury and trade solutions at Citi.
Many corporates … don’t know where their cash is
Patrick Peters-Bühler, Citi
Another potential advantage of subsidiary capital structure optimization is greater control of the cash in the company.
Cash can get lost or trapped, even when it is being used for legitimate purposes, and it is important that this liquidity is deployed for maximum benefit.
“It is also useful for ensuring compliance with treasury policy,” says Peters-Bühler. “Corporate treasurers must ensure that money is used for the purposes to which is it attributed within each subsidiary.”
Centralization of funds enables all the funds of an organization to be co-mingled and minimizes investment risk for subsidiaries.
Peters-Bühler recommends that once a corporate has finalized its budget, it should create a formal internal financing plan for each subsidiary or legal organization, regardless of which business unit or business group they belong to.
“Many corporates have highly regarded brands, excellent distribution structures and well-managed sales processes, but they don’t know where their cash is,” he says.
“In some cases, this is because their banking or legal structures are too complex. Any business with many hundreds or even thousands of bank accounts will find it hard to be agile.”
Decision-making around subsidiary capital structures requires a focus on maintaining appropriate leverage and ensuring return of cash to shareholders. In the case of subsidiary capital structure, the holders of debt and equity are controlled by the same organization, hence intercompany debt normally carries an implicit guarantee.
Pitfalls
Fred Schacknies is a former senior vice-president and treasurer at Hilton Worldwide and now a board member of the Association for Financial Professionals. He explains that the traditional approach is to minimize use of equity to that which is required to avoid tax and regulatory pitfalls of deemed dividends and thin-capitalization scenarios.
Debt should be prioritized over equity for two reasons…
Fred Schacknies, Association for Financial Professionals
“When assessing sources of subsidiary capital, debt should be prioritized over equity for two reasons,” he says. “First, debt capital is almost always easier, cheaper and faster to repatriate than equity capital. Second, the value of interest payments provides a baseline cash-flow stream to the parent and its shareholders.”
Conversely, when assessing uses, priority should be given to using surplus local cash flow to repay short-term debt over dividends.
The decision becomes more subjective in matters of cross-currency intercompany debt.
As a rule, a company should hedge an intercompany loan that it expects to be repaid. However, many intercompany debt investments are not clear or finite in time horizon, even if the terms of the agreement would suggest so.
“In cases of true long-term debt, a company would prefer not to hedge and to carry any FX revaluation in equity, but the tests for doing so can be onerous,” says Schacknies.
“This scenario can pose a risk-management dilemma: either hedge a loan that ends up rolling over in perpetuity, paying FX spreads, consuming credit and incurring real cash-flow volatility from the naked derivative, or avoid hedging out of fear of the above, accepting profit-and-loss risk and possibly cash-flow risk as well.”
Some companies may choose not to hedge a loan, based not on uncertainty of repayment but rather on the assertion that the hedging costs are simply too high.
Schacknies believes this response belies a flaw in capital budgeting: if the true cost of funding activity in high-yield countries is properly captured, the cost of hedging should have already been accounted for.
It is clear that a proactive and thoughtful approach to subsidiary funding is an important pillar in a global company’s working capital strategy.
With it, the company can grow overseas in a manner that is accretive to its return on capital.
Without it, the company faces trapped cash and ballooning international balance sheets, which can be expensive to remedy.
