FX Risk Management and Corporate Valuation: A Key Driver for Private Equity Investors
FX Risk Management and Corporate Valuation:
A Key Driver for Private Equity Investors
Business valuation is as much an art as it is a science. But anyone who has done a discounted cash forecast, or evaluated a business based on an EBITDA multiple model, is aware of the centrality of cash management, operating margins and capital efficiency to corporate valuations.
Thus even Private Equity (PE) investors who are not doing cross border deals, but whose portfolio companies have FX exposure, can benefit from understanding the implications of FX risk on financial performance and how effective FX hedging can help drive material value creation.
In the notes to this piece, you will find links to research conducted by the Bank of Canada and others that outline evidence for a steelman case for FX hedging as a value driver.
FX Risk Management Outcomes: Stability, Planning, and Efficiency
Proactive, prudent FX risk management can help deliver three key outcomes that can enhance corporate valuation:
Reduced Cash Flow Volatility
Improved Planning & Higher Margins
Optimized Working Capital
As some readers may already know, the 3- and 5-stage Dupont models break out the financial ratios that can drive return on assets and return on equity. These same ratios also get pulled into EBITDA and Enterprise Value, which are the yardsticks of most transaction comps.
Taken together, much of the academic research, and our experience in practice, highlight specific areas where proactive FX risk management can drive value creation.
Prudent FX risk management practices can directly improve each of these components in these ways:
Profitability: Hedging can be a tool to help minimize the negative impact of currency fluctuations, leading to more stable earnings and improved profit margins. This increase in predictability can enhance a company’s attractiveness to investors.
Efficiency: By improving working capital management and releasing cash held as reserves, active FX risk management can boost return on assets (ROA). More efficient use of capital can translate into higher asset turnover and improved valuation.
Leverage: Lower cash flow volatility makes a company (and thus an investment) less risky, enabling it to support higher levels of debt. Since taking on and servicing debt is typically cheaper than offering equity, using more debt can enhance returns on equity, a key factor for PE firms and the health of their portfolio companies.
FX Risk – Not Just a Deal Consideration
I spent an earlier phase of my career working with Canadian mid-market PE firms and their portfolio companies, so I know these facts aren’t lost on PE investors.
Further, private credit investment and cross border M&A has exploded in the last decade, with much of the capital originating in North America and heading outbound.
US operators and investors tend to be less familiar with FX hedging than some others, due to the centrality of the USD as a global reserve currency. That said, they would be remiss if they were to overlook the role FX hedging can play as a strategic lever in value creation.
I intend to show how in my next piece in this series.
See also:
Investing for beginners: Extended Dupont Analysis:
Read the previous article in the series: Netting and Working Capital Management
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