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Hedging Expert Says Middle-Market Firms Must Look Inward to Navigate Currency Fault Lines

With more middle-market firms expanding overseas at an early age, currency hedging best practices are becoming a menu item for companies that are still many years away from achieving even a national footprint.

Middle-Market Executive recently caught up with hedging expert Amol Dhargalkar of Chatham Financial and asked him to offer some hedging pointers to firms thinking about sticking their toes into the currency-hedging waters.

download (1)MME: What’s the telltale signal that it’s time for a middle-market firm to adopt a hedging program?

Dhargalkar: From a currency standpoint, the greater the mismatch between your revenues and expenses, the more a firm has to be worried. If you have started to go international and you have moved your production to Europe and you’re selling in euros, there will be some residual risk there, but if you are producing in the U.S. and you’re exporting into Europe, you have a fundamental mismatch — your cost of production is in dollars and your sales are in dollars and euros. Then you start selling into Japan and your sales are in yen, and when added up, you have a fundamental mismatch. It’s here at this moment that a firm must start thinking about how much this matters as an organization, because you can spend millions of dollars in services and systems to address the mismatch. We believe that firms must first ask the questions: How much risk do I have, and am I comfortable with that risk? If you’re not comfortable, then the question becomes, How do I get to a place where I am comfortable?

MME: How significant is IT today when it comes to addressing the mismatch?

Dhargalkar: IT is particularly important once a firm gets to the issue of scale. It’s very challenging to scale a program without technology. The most popular technology is of course still Excel — everyone has copy of it on their desktop, and it comes in handy for managing everything from cash to derivatives. Scale is what really causes firms to push toward a technology solution of some sort. When a firm is starting off with a program, we believe that the first thing that a firm usually needs is not a piece of technology, but instead to know how much risk they actually have. We’d rather have firms answer this question and then bootstrap into a more effective program over time.

MME: What are some of the common pain points that may signal to a firm’s management that it’s time to take their hedging program to the next level?

Dhargalkar: If you’re a firm that has designs on going public, you may be concerned about demonstrating strong, consistent earnings growth. If you’re a private equity–owned firm, it might be EBITA. If you’re family-owned, it might be dividend capacity or cash flow. Different types of objectives will lead to different starting points. When you ask the question of how much earnings are at risk due to currency and commodity movement, there are very few middle-market firms that would be able to answer this with solid numbers. There may be some level of intuition, but if you intuitively know, it’s still very useful to quantify so that you know how much you should be spending on it. It might be that your business could go under, but it might also be that your risk is only a few pennies a share, which is a situation we found with one of the middle-market firms with which we work, a global manufacturing firm that is publicly listed. We were asked to help them with a hedging program, but what we found was that the firm had between 2 and 4 percent of EBITA at risk. From this, the CFO was able to prioritize where a hedging program fell on a list of 10 pressing issues. The CFO opted to put the money somewhere else.

MME: Do manufacturers require more elaborate hedging programs?

Dhargalkar: If a firm is a manufacturing company, they will likely have some level of currency exposure as well as commodity exposure, and this brings to bear a set of questions around whether a firm has looked at the interaction between its currency and commodity risk. Is it additive, or do they actually neutralize one another? Are you in a situation where as fuel prices go up, which is generally correlated with currency prices moving in your favor, you want to hedge both? Or just one? Or neither? Commodity exposure complicates matters.

MME: How does a firm determine what type of hedging program is a good fit?

Dhargalkar: A management team really needs to correctly identify the types of metrics that drive its business. What are the metrics you talk about the most? Take it one level down and understand which metric executives look to. This will help a firm to better understand the type of program it should be considering. A company that cares about earnings per share should really be thinking about running a balance sheet hedging program. This is where receivables and payables are in different currencies than the functional entity in which they occur. If you don’t care so much about earnings, but do care about gross margin percent or EBITA, a balance sheet hedging program would not be well suited. It might indicate that there’s been a disconnect between what really drives the company and the program that’s been put in place. Sometimes there’s an assumption that a program matches an organization, and when we dig in, we find out that it may be helping somewhat, but not really helping to achieve what they had set out to achieve.

MME: Is there a point where the complexity of measuring risk exposure neutralizes?

Dhargalkar: Opening the first office abroad can be very complicated for a U.S. firm, and opening a second office abroad in yet another country can be equally complicated, because the regulatory regime is different. From a currency standpoint, every currency has its nuances. The complexity grows as your portfolio of exposure grows, and when a company is in 12 different locations globally, to some degree you have diversified your risk, but the question is, How much has it been diversified? And then we come back to our original question: How much risk do I have?

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