In the high-stakes world of Private Equity (PE), where exceptional returns are non-negotiable, value creation strategies have evolved far beyond financial engineering. Today, operational improvements, including in treasury and financial risk management, are required to yield high-quality returns. Among these, FX risk management often flies under the radar but holds significant untapped potential to protect and drive value for portfolio companies (PCs). In this article, we explore the importance of identifying and managing FX risks and suggest various quick wins to unlock value for portfolio companies.

The Untapped Potential of FX Risk Management in Value Creation 

PCs operating across multiple countries frequently lack a cohesive treasury and financial risk management approach. For example, bolt-on acquisitions often lead to fragmented teams, processes, systems and banking structures, while exposure to an increasing number of currencies creates financial risk that often remains invisible to central teams. This complexity is exacerbated by ad hoc and localized FX hedging practices, where PCs may not have access to competitive FX rates from their banking partners or access to a multi-bank FX dealing platform. 

For PE firms, FX risk often represents a hidden drain on EBITDA and cash flow. FX mismanagement can erode margins and impact portfolio company value. Hence the importance of uncovering financial and operational inefficiencies and building streamlined processes to manage FX exposures effectively. Proper FX risk management, which goes beyond hedging by means of financial instruments, not only mitigates financial risk but directly contributes to value creation by reducing cash flow volatility, reducing costs, increasing control, and increasing transparency. 

In this simplified example, a private equity-owned manufacturing firm, focused on expansion into emerging markets, was losing millions annually due to unmanaged foreign exchange (FX) exposures. The culprit? Decentralized treasury processes, idle bank balances in multiple currencies, and hidden FX risks within operational flows. The firm can address and manage these inefficiencies by using FX forward contracts to lock in exchange rates for future transactions and employing centralized treasury technology to monitor and control FX exposures across all operations. By addressing the inefficiencies, the firm reduced financial losses, stabilized its margins, and reinvested savings from FX gains into growth initiatives.

Quick Wins in FX Risk Management 

In your search of value creation, we suggest two potential quick wins to unlock PC value.  

Enhance Exposure Visibility 

Check whether your PCs operate with a clear understanding of their FX exposure landscape. Conducting a quick scan early in the investment lifecycle should identify, amongst others: 

• Where exposures are originated (e.g., revenues, costs, intercompany transactions) and if there are natural hedging possibilities. 

• Idle cash balances or loans in nonfunctional currencies, which create FX volatility. 

• The potential impact of these exposures on financial results through FX risk quantification. 

Private equity sponsors can facilitate the creation of a centralized treasury function that i) establishes a policy and process for FX risk management, ii) implements an FX dealing platform for efficient and competitive FX trading with banks, iii) monitors balances to reduce cash balances in non-functional currencies, and iv) implements netting arrangements to streamline intercompany payments and minimize cross-border transactions. 

Hidden FX Risk Discovery 

Business practices, such as allowing customers to pay in multiple currencies or a pricing agreement based on currency conversions, often lead to hidden FX risks and are a common pain point which is overlooked. For instance, a PC may receive customer payments in USD but agree to link the actual payable amount to the EUR/USD exchange rate, creating an implicit EUR exposure that impacts margins and cash flow.  

To address hidden FX risks, a private equity sponsor can help portfolio companies achieve a quick win by conducting a thorough analysis of their pricing models and operational agreements to identify implicit currency exposures, then implementing (soft) hedging techniques, such as adjusting pricing strategies to match revenue and cost currencies, renegotiating contracts with suppliers and customers to align payment terms, and utilizing natural hedging opportunities like balancing currency inflows and outflows, thereby minimizing net exposure before deciding to resort to financial instruments. 

In summary, as illustrated by the above quick wins, streamlining treasury processes can yield: 

• Hard dollar savings: Reduced FX costs by accessing competitive spreads. 

• Soft dollar savings: Enhanced decision-making through better visibility on exposures and reduced operational complexity. 

Consider this: A PE-owned retail chain expanded into international markets and faced profit erosion due to unmanaged FX risks and fragmented treasury processes. The sponsor conducted a quick scan to map exposures, uncovering mismatched revenue and expense currencies, a scattered landscape of bank accounts with idle balances, and operational inefficiencies. Hidden FX risks, such as supplier pricing tied to EUR/USD rates and uncoordinated customer payment options in multiple currencies, were also identified. Leveraging these insights, the sponsor centralized FX management by consolidating bank accounts, aligning supplier contracts with revenue streams to create natural hedges, and introducing competitive trading for FX transactions. They also established internal multilateral netting to streamline intercompany settlements, reducing FX costs by 20%.  

Measurable Results 

Integrating exposure identification and quantification, hidden risk discovery, and treasury process optimization into a single strategy enables PE firms to achieve more stable margins, cost savings, improved cash flow predictability and liberates capital for reinvestment. Furthermore, a proactive approach to FX risk management provides improved transparency for decision-making and LP reporting and strengthens financial resilience against market volatility. By embedding these robust treasury and financial risk management practices, PE sponsors can unlock hidden potential, ensuring their portfolio companies are not only protected but also positioned for sustainable growth and profitable exits.

Conclusion 

In the dynamic world of private equity, optimizing FX risk management for internationally operating PCs is a crucial strategy for safeguarding and enhancing portfolio value. Reflect on your current FX risk strategies and identify potential areas for improvement. Are there invisible exposures or inefficiencies limiting your portfolio’s growth? Take the initiative today - evaluate your FX risk management practices and make the necessary refinements to unlock substantial value for your portfolio companies. Embrace the opportunity to drive significant improvements in their financial resilience and overall performance. 

If you're interested in delving deeper into the benefits of strategic treasury management for private equity firms, please contact Job Wolters. 

Accurately attributing changes in counterparty credit exposures is essential for understanding risk profiles and making informed decisions. However, traditional approaches for exposure attribution often pose significant challenges, including labor-intensive manual processes, calculation uncertainties, and incomplete analyses.  

In this article, we discuss the issues with existing exposure attribution techniques and explore Zanders’ automated approach, which reduces workloads and enhances the accuracy and comprehensiveness of the attribution. 

Our approach to attributing changes in counterparty credit exposures 

The attribution of daily exposure changes in counterparty credit risk often presents challenges that strain the resources of credit risk managers and quantitative analysts. To tackle this issue, Zanders has developed an attribution methodology that efficiently automates the attribution process, improving the efficiency, reactivity and coverage of exposure attribution. 

Challenges in Exposure Attribution 

Credit risk managers monitor the evolution of exposures over time to manage counterparty credit risk exposures against the bank’s risk appetite and limits. This frequently requires rapid analysis to attribute the changes to exposures, which presents several challenges: 

Zanders’ approach: an automated approach to exposure attribution 

Our methodology resolves these problems with an analytics layer that interfaces with the risk engine to accelerate and automate the daily exposure attribution process. The results can also be accessed and explored via an interactive web portal, providing risk managers and senior management with the tools they need to rapidly analyze and understand their risk. 

Key features and benefits of our approach 

Zanders’ approach provides multiple improvements to the exposure attribution process. This reduces the workloads of key risk teams and increases risk coverage without additional overheads. Below, we describe the benefits of each of the main features of our approach. 

Zanders Recommends 

An automated attribution of exposures empowers banks teams to better understand and handle their counterparty credit risk. To make the best use of automated attribution techniques, Zanders recommends that banks: 

• Increase risk scope: The increased efficiency of attribution should be used to provide a more comprehensive and granular coverage of the exposures of counterparties, sectors and regions. 

• Reduce quant utilization: Risk managers should use automated dashboards and analytics to perform their own exposure investigations, reducing the workload of quantitative risk teams. 

• Augment decision making: Risk managers should utilize dashboards and analytics to ensure they make more timely and informed decisions. 

• Proactive monitoring: Automated reports and monitoring should be reviewed regularly to ensure risks are tackled in a proactive manner. 

• Increase information transfer: Dashboards should be made available across teams to ensure that information is shared in a transparent, consistent and more timely manner. 

Conclusion

The effective management of counterparty credit risk is a critical task for banks and financial institutions. However, the traditional approach of manual exposure attribution often results in inefficient processes, calculation uncertainties, and incomplete analyses. Zanders' innovative methodology for automating exposure attribution offers a comprehensive solution to these challenges and provides banks with a robust framework to navigate the complexities of exposure attribution. The approach is highly effective at improving the speed, coverage, and accuracy of exposure attribution, supporting risk managers and senior management to make informed and timely decisions. 

For more information about how Zanders can support you with exposure attribution, please contact Dilbagh Kalsi (Partner) or Mark Baber (Senior Manager).

The observation period for the average rate calculation is usually long and can be defined flexibly with daily, weekly or monthly periodicity. Though this type of contract is always settled as non-delivery forward in cash, it is a suitable hedging instrument in certain business scenarios, especially when the underlying FX exposure amount cannot be attributed to a single agreed payment date. In case of currencies and periods with high volatility, ARF reduces the risk of hitting an extreme reading of a spot rate.

One of the walls in its Amsterdam headquarters shows the evolution of the Philips business. Philips’ roots lie in Eindhoven, where, in 1891 Gerard Philips started producing light bulbs in an empty factory building. When he was later joined by his research-oriented brother Anton, the firm enjoyed its first major business stimulus. Through vertical operation, with their own factories and dependent suppliers, they took their first big steps towards success.

Continuing to develop through the production of radios and TVs, followed by Philishave electrical razors and inventions such as the Compact Cassette and the Compact Disc as new audio media, the company then expanded into professional products, such as medical equipment, studio mixers and computers. Today, Royal Philips is a diversified technology company that focuses on innovation in the healthcare sector.

Currency risks

The internal structure of this multinational comprises two axes, the business groups and the markets. The business groups are organized into product types: medical equipment, lighting and domestic appliances – along with variations on these themes. The business groups develop and produce the products and distribute them to their international markets where the products are sold. Together, in a matrix, these two form what’s known as the business-markets combination. Commercial employees (‘the business’) and financial managers (‘finance business partners’) are active in both axes and it’s their joint responsibility to ensure that a healthy and successful business can develop and thrive.

We are active in over 100 countries and we process EUR 100 billion in internal payments every year, so, clearly, we are highly exposed to currency risks.

Gabriel van de Luitgaarden, Senior VP, Head of Financial Risk & Pensions Management at Philips.

In the logistics, financial stream from factories to markets, all manner of invoices are sent back and forth and, eventually, money from customers flows through the market to the Treasury. Hedging currency risks is expensive and prevention is always better than cure, he muses: “If you don’t properly understand what the risk is and what effect it will have, there’s not a lot you can effectively do about it. But by quantifying risks you can get a handle on them and decide whether you want to take any action. You have to consider aspects such as what will happen to EBITA if you do nothing, how much lower will it be if you hedge, and how much will it all cost? It’s all about how much risk you are prepared to accept.”

Currencies fluctuate in relation to one another and this strongly influences a multinational’s earnings and financial reporting. “We deal with risk management every day,” says Van de Luitgaarden. “But the people who work in the business very rarely do so. They see it as a specialism, but that’s not really the case. People in the business should be much more involved with it, asking themselves what is acceptable and what should I do about it?”

Argentinian toothbrushes

Philips initiated a project to define a new FX policy and hedging strategy for currency risks. Above all, it had to give the people in the business much more insight into the impact that fluctuations in exchange rates have on their performance, and show them how important it is for them to understand and manage currency risks.

“In many multinationals the business part thinks that the Treasury will just hedge currency risks, despite the fact that these currency fluctuations cannot simply be neutralized,” says Zanders consultant Lisette Overmars, who was involved in the project. “You can manage it all, but eventually you’ll need to come up with other solutions.”

Van de Luitgaarden adds: “That’s why we explained to the business that we can provide more insight into the risks and buy them time through hedging, but we cannot completely protect them. There’s no magic formula that can shield you from the effects of currency fluctuations.”

This bespoke form of hedging is primarily directed at countries whose currencies typically lose value, sometimes suddenly performing really well, but eventually losing value relative to harder currencies like the euro and the dollar. “That’s because emerging market economies are less solid,” says Van de Luitgaarden. “There is often high inflation and less political stability. If you don’t do anything about the prices in the respective countries, than the fact that their currencies lose value against the euro will progressively erode your income. There are extreme cases where we can lose 30 to 40 per cent in value in a year, which cannot be remedied by hedging. In such cases you have no option but to constantly increase your product prices.” It means, for example, that the price of a toothbrush in Argentina can suddenly rise by 10 per cent from one month to the next. “But not everyone in the business does this, which is why education plays such an important role in the project; it has to be visible. For many people the effect that currencies have on results was far from clear. We therefore developed an FX model to make the currency footprint visible. It shows us which currencies our EBITA is derived from and the extent of our various exposures. Thanks to this new policy we can make EBITA more predictable and less volatile, although we still cannot completely cover the risks.”

The real risk management is mainly to be found in the market; for example, where can you best procure in order to reduce your susceptibility to currency risks? Van de Luitgaarden says: “Take Japan, for example, where we are huge in medical equipment, representing substantial income in Japanese yen. But we don’t spend anything there because we don’t buy there. Three years ago the Bank of Japan began to devaluate the yen to stimulate the country’s economy, and this had huge repercussions for us. A 20 per cent drop in the value of such a currency results in our sales and profit also falling by 20 per cent – that’s just how it works. And if you don’t do anything about it, the situation won’t change. In addition to short-term hedging, to reduce your vulnerability to such currency fluctuations you need to consider procuring more in yen, or even opening a factory in Japan.”

More consistency and efficiency

The old way of working, centered on a policy set up about 18 years ago, was based on a Philips that was both organized very differently and was much bigger than it is today. Van de Luitgaarden continues: “Back then we had 12 product divisions but our performance, in particular, was managed differently. Every factory had its own P&L account and budget. If a factory was exposed to currency risks it had to reduce them itself and if any hedging was necessary that too had to be done by the factory in question. Now we measure our performance at a higher level, via the business-markets combinations. The factory’s P&L is now less important – it’s about the result of the group as a whole. The exposures that you hedge are therefore the ones that affect the result of the group. It’s much more efficient. If you're in a ‘long position’ in a particular currency, you sell it, in a single transaction. In the past this was done factory-by-factory, in several transactions. Given the tens of thousands of transactions that we used to do, this now represents a huge efficiency boost. The spread is no longer paid multiple times by buying and selling the same currency. We hedge currencies in the same way. We’re looking for risk reduction, so it makes little sense if everyone follows their own policy – it has to be done consistently. That’s actually more important than the net group exposure.

It's a combination of the two: hedging at group level and the highly consistent application of our hedging policy. That has an enormous  impact on the risk reduction that’s achievable.”

Headwinds and tailwinds

The project was launched in September 2014 and the new FX policy went live in November 2015. Given that it involved the whole organization, which was used to doing things the way they’d been done for the past 18 years, it was a formidable challenge to make the necessary changes. Moreover, three weeks after the start of the project it was announced that the company was to be split into the lighting division (Lighting Solutions) and a combination of the Healthcare and Consumer Lifestyle divisions (Royal Philips). The organization’s focus, particularly at the IT and Treasury departments, was then obviously on the impending split. It affected much more than just the business; it also had repercussions for Tax – which had to be paid in 100 countries – and Accounting and how it would all be technically processed in the books with the use of hedge accounting. All-in-all, it was a sea change.

“Its implementation was indeed quite overwhelming,” concedes Van de Luitgaarden. “It was complex material for which there were no ready-made solutions. We were dealing with people in the business who did not fully understand the situation; they only took into account what they did themselves and didn’t look at the bigger picture. This sometimes made it difficult to explain. Take, for example, a factory in the UK making mother & child-care products.

A high exchange rate of the pound against the euro at the time decimated profitability because procurement and manufacturing costs just kept on rising. But looking at Philips as a whole, the rise in the value of the pound was a good thing; we earned more pounds than we spent. We didn’t have to buy pounds to cover costs; we sold pounds to cover our sales. But try explaining that to the UK factory – at the end of the day currencies influence bonus targets. Sometimes you have a tailwind and at other times a headwind.” Last year was a good year for those who sold in dollars; which rose against the euro. “Thanks to the dollar being so much stronger, our sales in 2015 were EUR 2 billion higher, which is an awful lot on a total of 24 billion. That’s something to take into account, because it was certainly a windfall. This new way of looking at things needs time.”

What else has Zanders done for Philips?

• Treasury management: the extrication of treasury operations and the setting up of new treasury functions for Philips’ former television business (TP Vision) and the lifestyle entertainment business (WOOX Innovations).
• Risk management: the development of a new commodity price risk management framework.

Do you want to know more about risk management for corporations? Contact us.