Treasury Advisory. Quarterly Fall Liquidity Management Services. Treasury and Trade Solutions

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1 Treasury Advisory Quarterly Fall 2014 Liquidity Management Services Treasury and Trade Solutions

2 2 Treasury and Trade Solutions Credits Authors: Michael Botek New York +1 (212) Anita Suen New York +1 (212) Cindy Yung Singapore +1 (212) Treasury transformation, global liquidity management, and managing trapped cash have been recurring themes in our client discussions over the course of this year. In this edition we summarize research by INSEAD, conducted in collaboration with Citi, on the shareholder value of treasury transformation; provide an update on trends in global liquidity management based on what our clients are doing today; and propose a framework for dealing with trapped cash. Please contact your Citi representative for more information on any of these topics. The editors invite your comments and feedback, including what you would like to see in future editions of this quarterly. Acknowledgments: We thank all our clients and our colleagues who shared their insights without which this would not have been possible. Editors: Ron Chakravarti New York ron.chakravarti@citi.com Jennifer Sariano New York jennifer.sariano@citi.com

3 Treasury Advisory Quarterly Fall 2014 Edition 3 Table of Contents Treasury Transformation: Does It Create Shareholder Value? 4 To pool or not to pool?, that is not the question. 7 Trapped Cash: Not To Forget the Other Side of Liquidity Management 12 Must Read 16

4 4 Treasury and Trade Solutions Treasury Transformation: Does It Create Shareholder Value? By Ron Chakravarti and Cindy Yung Corporates often undergo treasury restructuring out of necessity. Such was the case for Tyco International, Lenovo and Roche, for each of which treasury transformation was considered a success. But does effective treasury centralization result in shareholder value creation? An INSEAD study, in collaboration with Citi, set out to find the answer a matter of relevance to CFOs and Treasurers. Following a decade-long acquisition spree, Tyco s large debts came due in 2002 but its cash was locked in subsidiaries, inaccessible by headquarters. Following a landmark bond offering that solved the company s urgent liquidity needs, Tyco swiftly set up a global cash management structure to ensure that most of the subsidiary cash is available centrally in its Swiss in-house bank (IHB). In doing so, Tyco also achieved efficiency by reducing partner banks and number of bank accounts. An immediate challenge post Lenovo s acquisition of IBM s PC business in 2004 was to establish financial processes and cash pools for its international business when Lenovo had no experience in managing global treasury. Lenovo, with the help of IBM, eventually established a combined treasury center and re-invoicing center that allowed automated, daily concentration of cash from all its international subsidiaries into Singapore. Funds were then used to settle outstanding trade balances, alleviating the need for intercompany lending, which is costly and often complex. This setup lowered operating cash required, eliminated withholding tax on interest, and reduced cost of capital by ~US$23-48 million annually. Roche posted a consolidated net loss of CHF4 billion in 2002 due to changes in international accounting practices and a plunge in the value of its equity holdings. Realizing the need to overhaul its financial processes, Roche created an award-winning IHB that made treasury services cheaper and more relevant to business. Even before full completion, Roche s IHB had already saved the company CHF10MM in net interest, bank fees and FX fees. In each case, centralization clearly brought rewards. INSEAD s study went further, looking at data from Citi s Treasury Diagnostics global benchmarking survey to identify linkages with corporate performance metrics that matter to shareholders. The research revealed three benefits of sophisticated treasury centralization: 1. Reduced cost cash is costly, and companies with centralized treasury typically run at 5% less cash 1 2. Higher stock valuation: Market-to-book 2 value improves by 10% 3. Enhanced operational efficiency return on assets is 1.44% higher Centralized treasury management clearly has substantial impact on a company s valuation and financial results. The takeaway: management teams of large companies can enhance shareholder value through effective treasury transformation. 1 As measured by a firm s cash-to-market value ratio (e.g. from 20% to 15%) 2 As measured by Tobin s Q, defined as the market value of a firm s existing assets divided by its book value

5 Treasury Advisory Quarterly Fall 2014 Edition 5 Centralized treasury management clearly has substantial impact on a company s valuation and financial results.

6 6 Treasury and Trade Solutions Multinationals continue to amplify the use of cash pooling around the globe to reduce funding and FX costs, enhance visibility and control over liquidity, and increase operational efficiency.

7 Treasury Advisory Quarterly Fall 2014 Edition 7 To pool or not to pool?, that is not the question. By Michael Botek and Anita Suen Hats off to the latest list of multinational corporates being recognized for their innovations in global liquidity and risk management. At Citi, we are very happy to have had a part to play in their successes. As many companies restructure their global liquidity and currency management, we are often asked about corporate trends and practices. In this article, we summarize some of the most frequent questions. Global Corporate Trends While cash pooling has become prevalent in many markets, the scope and automation of pooling structures varies greatly, leaving plenty of opportunities for improvement in organizations that have not reassessed global liquidity management for a year or more. Corporate benchmarking data from our Citi Treasury Diagnostics (CTD) survey suggests that companies are acting on this. CTD results reveal that, where pooling is allowed by regulations, 78% of our survey respondents report daily cash aggregation in a centralized pool. For larger corporates, the percentage increases to 83% the bigger the company, the more actively it uses cash pooling. Frequency of Cash Concentration While the majority of survey participants (78%) reported daily concentration of cash into a central pool Daily Cash Concentration by Revenue large firms were significantly more likely than their smaller counterparts to concentrate cash on a daily basis 9% 5% 47% 8% 68% 78% 82% 83% Daily Weekly Periodically Monthly <$2bn $2-10bn $10-25bn >$25bn

8 8 Treasury and Trade Solutions and automation is highly preferred. Pooling Automation Most companies (77%) reported either fully or partially automated pooling processes For a more detailed discussion, please refer to our prior publication Cash Pooling & Netting: Best Practices. 1 The key point is that physical or notional pooling can be used independently or combined in a customized solution to enhance cash management across multiple accounts, entities, countries, currencies and banks. 23% Fully or Partially Automated 77% Manual Structures Used While Citi offers physical or notional pooling (or both) in many centers across the world, we find most large multinationals center their global liquidity management around a few locales. Historically, this has been London. More recently, we see the emergence of new regional (as opposed to purely local) centers. Among the new regional centers Singapore clearly leads at present, although we see emerging regional activity in other locales in Asia Pacific, EMEA and Latin America. Given the sheer volume of structures in London today, to provide further perspectives on global trends, we reviewed client liquidity structures with header accounts of physical pools or participating accounts in notional pools there. We focused on non-financial corporates, excluding financials (e.g. asset managers and insurance companies) as they are often regulated and behave in specialized ways. Types of Cash Pooling There are two main types of pooling physical and notional. Physical Pooling, also referred to as target balancing or cash concentration, occurs when funds are physically moved into one bank account, with a single entity taking ownership of the funds. Since cash from multiple entities are commingled into one entity, this results in intercompany loans. Notional Pooling occurs when funds are notionally aggregated by the bank, into one net position, to achieve interest efficiencies. In simple terms, the bank looks through the individual account positive and negative balances (which remain as they are) to the overall net position across all accounts in the pool to determine interest charges. A Multi-entity Notional Pool allows a company to achieve that single net position without commingling funds across entities, alleviating the need for intercompany loans. A Multi-currency Notional Pool allows a company to simplify management of positions held across different currencies; these pools may be multi-entity or single-entity. The data shows that only 12% of liquidity structures are multi-entity notional pooling structures, where funds are not commingled. The balance are physical pools; this includes structures that have single-entity multi-currency notional pools on top of the physical pools. Top Jurisdiction of Incorporation for Single-Entity Structures in Citibank NA London Branch 1. England 2. Netherlands 3. Switzerland 4. Ireland 5. Luxembourg 1 Michael Botek, Eva Carey. (January 2013) Cash Pooling & Netting: Best Practices. Treasury and Trade Solutions

9 Treasury Advisory Quarterly Fall 2014 Edition 9 Notional Pooling Mix Broadening Currency Mix MCP 41% SCP 59% Non-G10 26% Other G10 26% USD, EUR, GBP 48% Non-G10 30% Other G10 32% USD, EUR, GBP 38% SCP=Single-currency Notional Pool MCP=Multi-currency Notional Pool The high preference for physical pooling appears to be driven by the greater transparency and efficiency from clear transfer of cash ownership between entities. This is despite that, when entity A lends money to entity B, the considerations often include transfer pricing, withholding tax, and thin-capitalization. Not coincidentally, we find the entities where cash gets concentrated tend to be domiciled in tax-favorable jurisdictions. This table displays the top jurisdictions of the entities (often designated as In-House Banks) to which cash is concentrated. Whatever the reasons companies are selecting these, it is worth noting that England has one of the widest double tax treaty networks, while the Netherlands and Luxembourg have zero percent withholding tax for interest and royalties paid. Additionally these two countries have extensive treaties to support zero or reduced withholding tax when paid to these countries. Tax specialists have suggested that we may see future changes in the top jurisdictions of incorporation, as initiatives such as the OECD s Base Erosion and Profit Shifting (BEPS) become catalysts for shifts in tax considerations. Multi-entity notional pooling structures remain alive and well, even if less common. The principal reasons cited for preferring multi-entity notional pools include that they allow treasury departments to capture the benefit of organic liquidity with less internal change. Participating legal entities retain ownership of their cash, making it easier for treasury to gain business buy-in when the corporate culture favors less centralization. And, there is less to deal with in administrative and tax considerations of intercompany lending that necessarily arise with physical pooling. Multi-currency notional pooling structures are on the rise. Since 2007, Citi has observed a 77% compounded annual growth in the number of its multi-currency notional pools. Today, nearly 41% of notional pools are multi-currency (MCP in the diagram). Often these are single-entity structures, used with physical pools. A single-entity multicurrency notional pool is set up after concentrating cash into a series of currency header accounts owned by the In-House Bank. Here, the principal reason cited by clients is the value of easing management of liquidity across long and short balances across currencies without needing to perform frequent FX swaps. The currency mix of multi-currency notional pools has also broadened since 2007, from a time where a majority included USD, EUR and GBP to now including a much larger range of currencies. And this broadening is not limited to developed market G10 currencies. Today, a frequent request is to incorporate Chinese Renminbi.

10 10 Treasury and Trade Solutions Case Study The diagram below illustrates a typical sophisticated structure. In this example, the company has Regional Treasury Centers in Singapore and Europe to manage treasury functions, including liquidity management. However, it also wished to optimize liquidity at a global level. With the Singapore structure (#1), all poolable cash is concentrated in the name of one entity across various currencies, with a single-entity multi-currency pool on top. For the Europe-based structure (#2), cash is held in the name of each legal entity incorporated in various jurisdictions, with a multi-entity multi-currency pool on top. Periodically, the financial coordination center transfers liquidity from one regional cash pool to another, based on cash forecasts, to optimize global positions. There is also non-poolable cash in highly regulated markets and, using what is called an Interest Optimization structure, the bank improves interest benefits for the company on this cash as well. Multi-regional Cash Pooling Structure 2 Multi-currency Notional Pool (London) NL EUR NL GBP NL USD 1 Multi-currency Notional Pool (Singapore) Legal Entity EUR Legal Entity GBP Legal Entity USD SG USD SG SGD SG NZD SG HKD 1 Single-entity NP HK USD SG USD JP USD TW USD MY USD AU USD Multiple options to concentrate cash from 3 rd -party banks 2 Multi-entity NP PH FCY VN FCY VN LCY CHN LCY CHN FCY TW LCY MY LCY IN LCY SGD NZD HKD Citi Citi Non-Resident Account Auto Cash Concentration FX Notional Pool Citi Citi Resident Account 3rd 3rd-Party Bank Manual Cash Concentration Interest Optimization

11 Treasury Advisory Quarterly Fall 2014 Edition 11 When Does It Make Sense To Pool? The benefits of pooling are a function of governance, complexity and return. The optimal structure maximizes governance and returns while minimizing complexity. Improve Governance Reduce Complexity Maximize Return Align liquidity management with Treasury strategy and organization structure, while: Centralizing control over cash positions Increasing automation Pooling cash to the highest level possible allowed by regulations Considerations in adopting a centralized legal entity for the in-house bank Change management (usually across treasury, business units and Shared Services) Connectivity and integration with banks and treasury systems Incremental accounting, tax or regulatory requirements Quantifying the value: Reducing External Financing: Debt: Notional (Cost of funds foregone returns) Bid/Ask Spreads on FX Improving Investments Returns Opportunity costs of onshore local currency investments Tax leakages Incremental pooling costs = Total returns from pooling DID YOU KNOW? On a cross-border basis, it may not always be advantageous to move funds offshore. Apart from trapped currencies in highly regulated markets that must be managed onshore, even liberal market currencies may have access to better rates in the (home market) currency center, apart from better cutoff times. Defining the optimal solution for a company requires analysis of the costs and benefits of the change. The Future Multinationals continue to amplify the use of cash pooling around the globe to reduce funding and FX costs, enhance visibility and control over liquidity, and increase operational efficiency. In the process, companies have greatly expanded the range of legal entities, countries and currencies, and new pooling centers have emerged in Asia, EMEA and Latin America. What has not changed is that effective solutions are based on a sound analysis of the economic and ergonomic impacts, in concert with a bank account rationalization strategy. A good strategy will allow the structure to evolve over time as corporate needs change, markets liberalize, and banks advance their capabilities for clients.

12 12 Treasury and Trade Solutions Trapped Cash: Not To Forget the Other Side of Liquidity Management By Ron Chakravarti Globalization has dramatically changed the economic landscape. New markets have opened up and new capital has been made available for expansion in emerging markets. Many that were initially largely manufacturing sites have begun to transform into consumer markets, increasing their attractiveness for multinationals. Emerging economies also learned from the currency crisis of the 1990s and more easily weathered the most recent global financial crisis than many developed markets. Despite challenges, they seem likely to continue to manage their exchange rates and protect their tax bases to preserve competitiveness, even as they scale the ladder in building economies based on higher value-add than low-cost manufacturing. Ultimately, with more favorable demographics than developed markets, emerging markets should be able to consolidate their growing economic power. The trapped cash burden The shift in the global economy towards emerging markets has tangible consequences for treasury departments. The change in the geographical distribution of cash flows has made optimization of internal liquidity a challenge because of regulatory and tax constraints and the increased breadth of companies operations. These mismatches can result in a company facing unnecessary working capital funding needs. Similarly, capex or acquisitions could prove more expensive because of an inability to use internal liquidity effectively. Trapped cash represents an asset that is underutilized and potentially creates a need for unnecessary liquidity. As a result, it is a burden on the balance sheet of a company. For purposes of this article, we define trapped cash as both: Lazy cash, i.e. idle non-earning local cash balances in excess of day-to-day operating requirements; Constrained cash, i.e. cash that can be moved but at a cost and with time constraints.

13 Treasury Advisory Quarterly Fall 2014 Edition 13 Trapped cash represents an asset that is underutilized and potentially creates a need for unnecessary liquidity. As a result, it is a burden on the balance sheet of a company.

14 14 Treasury and Trade Solutions Decision time: When to free trapped cash When regulations restrict the convertibility and offshore movement of funds, companies are forced to redeploy and, preferably, invest the cash locally as effectively as possible to retain value until repatriation. The spectrum of regulation, ranging from FX controls to central bank reporting, may directly affect the amount or the frequency of cross-border movements. These constraints set the boundary of what may be possible to extract from a particular market. However, the options may be further reduced by other considerations. Tax leakages, for example, often prevent companies from using trapped cash. The primary distinction between regulatory and tax considerations is that while regulations enforce operating policies on cash movements, tax considerations do not restrict cash movements but instead result in a financial cost. Each transaction must undergo a cost/benefit analysis to determine whether it is in the best interest of the company. Just a few of the tax considerations to be taken into account when evaluating a liquidity strategy include: Withholding taxes: sometimes mitigated by foreign tax credit Thin capitalization: maintaining tax shields Stamp duty tax Deemed dividend issues The cost/benefit analysis should also incorporate internal factors such as the cost of funds. The following depicts a deliberately over-simplified formula to gauge the benefits of using freed cash as an alternative to third-party financing, assuming no access constraints: Execution: Strategic and tactical approaches Extracting trapped cash usually requires consideration of both structural and tactical approaches. Structural, or more strategic approaches, may involve the deployment of legal vehicles that allow companies to stretch trade payables and shorten trade receivables terms. One solution is to lead (pay early) on payables out of a restricted jurisdiction releasing cash from the subsidiary and lag (pay late) on receivables into that country. This strategy delays payment into a trapped cash environment and optimizes the company s working capital. However, local regulatory and tax oversight, as well as market FX movements, must be taken into account. One of the best ways of eliminating trapped cash is to avoid trapping it in the first place. A potential solution is to use an internal intermediary located in a free market to buy from restricted jurisdictions and sell to the rest of the world. Given the intercompany nature of the underlying trades, transfer prices should be on an arm s length basis and trade terms set in a way to avoid possible characterization of receivables as loans. Through similar intermediaries, management fees can be paid to the parent company as compensation for management support and knowledge. Some of the frequently used structures include: Procurement center Re-invoicing center Netting center Investment fund linked to internal securitization arrangements Cost/Benefit 1 = {[Notional Amount x (Cost of funds Foregone returns)] [Tax Leakages] [Other Incremental Transaction Costs]} Where: Notional Amount = freed cash Cost of funds = marginal cost of borrowing assuming constant capital structure Foregone returns = Opportunity costs of local currency onshore investments Other Incremental Transaction Costs = FX Bid/Ask Spreads, bank transaction fees, etc. 1 Every component of the formula will be expressed in monetary terms; a positive final outcome indicates that using internal cash is preferable to third-party financing. Note that this is not exhaustive and may omit factors that could materially impact its final outcome including FX gains and losses, among other considerations.

15 Treasury Advisory Quarterly Fall 2014 Edition 15 These structures are multi-purpose as they can facilitate other objectives, such as increasing the company s procurement bargaining power, FX management and tax optimization. Other episodic options could include local capital reinvestment, M&A, business expansion and local sourcing. More tactical options include: Cash Forecasting: an obvious, but effective, way to avoid pumping liquidity into a country where it will be trapped is to have an accurate cash forecasting process in place Optimization: domestic pooling structures across local entities should be used wherever allowed and feasible to help offset local cash requirements Yield enhancement: relationship interest enhancement from bank deposit balances in restricted jurisdictions may help subsidize borrowing elsewhere; other investment options may include vehicles such as local currency money market funds, commercial paper, government bills, etc. Funding: Funding local businesses with intercompany loans from the parent company (or In-House Bank) instead of capital injections Holistic liquidity management Internally generated funds will always be more competitive than external credit lines. Effective liquidity management can activate a virtuous cycle in which net financial changes decrease and credit strength, ratings and valuation improve (further improving credit spreads). Furthermore, by tapping internal liquidity, a company gives itself greater flexibility either to respond to external shocks or to adopt more opportunistic strategies. Strengthening oversight of funding to subsidiaries in restrictive jurisdictions, leveraging cross-border strategies to manage working capital and funding, and effective cash forecasting systems are essential components to the approach. Advanced financial structures such as intercompany netting, re-invoicing centers, in-house banks, and financially efficient trading company models are the next step to help companies overcome the problem of trapped cash. It is essential for companies, especially those that have a mismatch between where they generate and need liquidity, which may be most companies these days, to have holistic liquidity management strategies to prevent or release trapped cash. Repatriation: Ensuring timely regular capital and dividend repatriation within the limits allowed by each jurisdiction Finding the right solution Whatever the approaches employed, all options should be vetted and compared with alternative solutions to determine which produce the most value for the entire company on a consolidated basis. Citi s Treasury Advisory team often works with clients to help determine the best course of action for trapped cash. We have found that using a decision-tree framework makes it simpler to maneuver through different markets and levels of restrictions in place. Using the decision-tree framework, particular types of constraints may lead to particular actions. By going through a series of ever-narrower filters, the likely most appropriate solution can be found. Where local restrictions make an immediate solution near-impossible, alternative structural approaches aimed at changing the underlying nature of targeted cash flows may be the best approach. Using this sort of decision-tree approach can be an effective way for a company to determine an optimal approach for adoption.

16 16 Treasury and Trade Solutions Must Read Please contact your Citi Representative for copies of the Treasury by the Numbers: A Closer Look as well as Cash Pooling & Netting: Best Practices. Treasury by the Numbers: A Closer Look In recent years, corporate treasury has experienced a unique period of transformation. Broadening geographic footprints, changing regulations, and advancements in technology are changing treasury management. At the same time, the bar is constantly rising today s treasurer must respond to the challenge of doing more with less. To help navigate this landscape, we provide some trends and themes gathered from Citi Treasury Diagnostics, our benchmarking tool designed to help companies assess treasury and working capital management practices. Cash Pooling & Netting: Best Practices With continued focus on liquidity management among clients, we re-issue an old favorite. This primer on the fundamentals of cash pooling and intercompany netting explains how these solutions can provide effective pathways to improve cash access, reduce financial risks, and rationalize bank account structures. We review business drivers, explain solution approaches, and highlight some of the key considerations.

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