A capital allocation confab, reviewing local vs. global banks, and treasury roles.
Members of the Treasurers’ Group of Thirty Large-Cap Edition met at the New York City offices of BNP Paribas, whose bankers noted that there will be Brexit hurdles even if a deal is inked, and gave an update on the migration away from the Libor benchmark. The day-long meeting started with members discussing their projects and priorities and their top questions for the group. Those questions included whether cash management banks are pushing members to move UK accounts to the continent; whether to centralize treasury; and peers’ current outlook on cyber insurance. Here are some key takeaways from the event:
1) Brexit Deal or Not, Divorce Will Remain Uncertain. A Brexit deal must be reached soon, but major political obstacles will remain before and after the March 29, 2019, deadline. Hedging the possibility of a no-deal outcome may be wise.
2) Term SOFR is on the Table as Libor Replacement Gains Traction. The infrastructure for the Secured Overnight Financing Rate (SOFR) slated to replace Libor is developing quickly, and much-desired term SOFR rates are in the works.
3) Capital Allocation Confab. Exploring optimal strategies for high-level capital deployment, members heard ideas ranging from the theoretical to specific efforts undertaken by their peers.
Brexit Deal or Not, Divorce Outcome Will Remain Uncertain
Despite the gloomy outlook, a Brexit deal must arrive soon or the consequences will be dire. A deal would still be tentative given that major political obstacles remain before the March 29 deadline, said BNP’s UK economist, Paul Hollingsworth. Indeed, he added, hedging the possibility of a no-deal outcome may be wise, as is prepping for the UK breakaway in whatever form it eventually takes.
KEY TAKEAWAYS
1) Irish troubles. To reach a Brexit deal, the UK and the European Union (EU) must agree on the border status between the UK’s Northern Ireland and the Republic of Ireland, which remains an EU member. An anticipated resolution at the Oct. 17 EU summit meeting never materialized.
2) Political declaration even more contentious. The nonbinding political declaration—a statement of intent setting out where the parties want the relationship to end up—may be even tougher to agree on. Mr. Hollingsworth said the issue has created a lot of “noise in the press,” since views in the UK range from an ultra-hard Brexit, essentially a complete breakaway from the EU, to a relationship such as Norway’s. The country, not an EU member, is a part of the single market and its financial services firms have “passport” rights to operate freely in the EU, but in return it contributes significantly to the EU budget.
3) Prep but don’t panic. One member noted that his company’s main cash management bank in Europe—a major US institution—has been pressuring the company to move all its accounts out of London, and he asked if peers’ banks were doing the same. “We think the bank is using it as an excuse to put more of its business in Luxembourg,” he said. No other members reported similar pressure, but BNP bankers recommended establishing “shadow accounts” in the EU to migrate cash-management structures efficiently when the time comes.
Centralized vs. Local Treasury
Multinational companies must weigh the efficiencies and control achieved by centralizing treasury against local finance staffs’ better understanding of their markets. In a session focusing on re-evaluating treasury roles and responsibilities, members drew several conclusions.
- When countries are difficult, stay local. A member from a large manufacturer said his company was highly decentralized until new technology incented treasury to centralize. “But it’s tough to centralize the really difficult countries,” he said. “Not just the highly restrictive ones, but also where language and local custom matter.” Two regional treasury centers now cover most non-US jurisdictions and report directly to corporate treasury, while treasury staff in restricted countries such as China and India are overseen by corporate but report to local finance executives.
- When the going gets tough… Local banks must stay put while the big global banks may pull up stakes. “There’s a balance to be struck between local and global bank groups,” the treasurer said. “We ask local offices not to scatter business across dozens of local banks but instead concentrate who they’re working with, and they get similar benefits to working with a global bank.” However, winnowing local banks can face resistance, especially when local CFOs “like getting their cricket tickets,” he added.
OUTLOOK
Even when a deal is reached, it must be passed by the UK and EU parliaments. Mr. Hollingsworth said that while the UK’s various political parties are miles apart, BNP calculates a 50-50 chance of passage, given that no deal would be “catastrophic.” Even if a deal is finalized by the deadline, however, uncertainty about the shape of the new relationship will remain until the final breakup, which is scheduled for 2020 although the EU and UK recently expressed support for extending it by a year to work out the details.
Term SOFR on the Table as Libor Replacement Gains Traction
After explaining the urgency to find a replacement for the Libor floating-rate benchmark and the global nature of the effort, Alex Maia, head of interest rate structuring and solutions at BNP, provided members with an update on important developments, focusing on the United States’ Secured Overnight Financing Rate (SOFR).
KEY TAKEAWAYS
1) Libor risk is building. Mr. Maia related to members the litany of warnings expressed recently by top regulators about the deterioration of Libor. In the case of USD Libor, that puts at risk $200 trillion in contracts, including derivatives, securitizations, and consumer and commercial loans. Libor is the unsecured borrowing rate between major banks, and it has become insufficiently active to provide a robust benchmark. The widely used three-month Libor averages $1.1 billion transactions daily and is often determined by expert judgment, whereas SOFR is generated from $800 billion worth of overnight repurchase-agreement transactions.
2) Term cash products on the drawing table. Given that SOFR settles overnight, borrowers wouldn’t know their interest payments on a SOFR-based loan until it matured and each daily rate was compounded. The Alternative Reference Rates Committee (ARRC) initially resisted developing “term fixings” because they may face challenges similar to Libor, such as a lack of liquidity. However, term rates are favored by corporate borrowers and other end users managing cash. Listening to constituents, Mr. Maia noted, the ARRC, which selected SOFR, recently announced plans to publish three-month and six-month SOFR rates.
3) Small volume, big problem. Cash products including floating-rate notes and commercial loans make up $8 trillion of current outstanding contracts, or only 4%. But unlike derivatives’ standard documentation, which enables amendments and protocols to facilitate migration to SOFR, cash products typically are negotiated and must be adjusted bilaterally or multilaterally. A majority of transactions should mature before Libor disappears, but it’s still a daunting task.
4) Fall back, move forward. Banks will no longer be required to contribute quotes to Libor beyond 2021, but the benchmark could end sooner for various reasons. The ARRC issued draft proposals in September seeking feedback from corporates and other market participants about appropriate fallbacks for floating-rate notes and syndicated loans, with comments due Nov. 8.
AI and Blockchain: Still in Pilot
BNP Paribas bankers described the bank’s initiatives to cater more effectively to corporate clients and develop new technologies including artificial intelligence (AI) and blockchain. Michael Krzewicki, director of ecommerce and digital at the bank’s global markets Americas division, said they ultimately should make corporate services more efficient and secure.
- AI still on the horizon. A BNP banker noted that banks are moving full throttle ahead on developing AI solutions that will likely be reconfigured for corporates later on. When T30LC group leader Craig Martin asked members about their use of AI, one described the technology “as an opportunity but not yet actionable at this stage…kind of like blockchain.” Others agreed. Key is AI’s ability to structure unstructured information to be used for decision-making; for example, learning to review different payment formats and methods, and sending problem payments to humans to resolve.
- If you can’t beat them, join them. Early on, blockchain fintechs spoke about disintermediating banks—no more. Now they are teaming up to develop useful solutions. One member requested priority be given to developing supply-chain solutions, rather than the current focus on payables and receivables. “How do I know when a supplier goes out of business tomorrow? Blockchain could be very useful,” he said.
OUTLOOK
Preparation should start now. Migrating some Libor products to overnight-index products based on fed funds—eligible for hedge accounting—or other existing rates can be done in the short term. It’s important to establish a working group with broad representation, including specialists in derivatives, loans, legal and compliance, Mr. Maia said, adding that fed funds and SOFR trade within a few basis points. “Moving to fed funds as a proxy is suitable as an intermediate or final step.”
Capital Allocation: No Easy Matter
In a session exploring optimal strategies for high-level capital deployment, members heard about how to allocate capital more effectively, ranging from theoretical ideas to specific efforts undertaken by their peers.
KEY TAKEAWAYS
1) Business drives capital. Members from companies in two very different businesses explained their capital allocation strategies, relating their hands-on experience. The treasurer of a major retailer said that a wide-ranging analysis, including internal assessments, white papers and talking with peers, concluded that more emphasis should be put on producing growth. “Comparing our reinvestment rates to best-in-class companies told us we need to invest more if we want to be a higher performer,” he said, adding those companies had committed to targets including cash flow, working capital and cash balance—not just dividends and share repurchases.
2) Not a perfect world. Greg Milano, CEO of Fortuna Advisors, said companies tend to repurchase shares when their stock prices are high, but research shows more buybacks don’t necessarily result in higher stock prices. Instead, companies should time repurchases for when their shares are on the upswing, he said, noting that if Exxon Mobil had taken that strategy, it would have bought back 35% more shares for 26% less per share. Easier said than done. “Please go talk to my activist shareholder, because he’s the reason I can’t keep cash on my balance sheet,” one member noted.
3) Buyback funding alternatives. Members’ interest was piqued by BNP Paribas bankers’ description of a client that funded share repurchases with convertible debt. It bought back the stock at spot through an accelerated share repurchase (ASR) and sold the convertible bond at a significant premium to spot. The interest rate was low because the company’s equity volatility provided for a valuable call option. “It got the attention of the activist and other shareholders, and the stock price rose immediately,” one banker said.
4) Capital allocation: Ever a work in progress. Most members of NeuGroup treasurer and assistant treasurer groups, 66%, said their companies have a process to evaluate whether spending has met the expectations originally set out, although typically in a limited way. However, a majority, 57%, said there is no clear accountability for ensuring capital spending generates the originally anticipated returns. Accountability is often fragmented rather than holistic, or the original decision-makers have left the firm. The vast majority, 78%, said tax reform had not changed their companies’ share repurchase and/or dividend strategy.
AI and Blockchain: Still in Pilot
- Maturing policies. A few years ago, cyber insurance policies covering business interruption had low limits or significant sublimits. More meaningful limits are now available, one member noted. “I told the board this makes sense now, but it’s fluid and it’s unclear if underwriters understand the risk, so something bad happening could change the market radically when we look to renew,” he said. He added that a costly previous attack prompted his group to reconsider the size of the company’s revolving credit.
- Immature governance. One member’s cybersecurity executives avoid alerting even colleagues inside the company about cyber complications because they’re afraid it will expose them to larger problems down the road. IT, legal and finance are now fighting over governance in those situations, and “who really has a need to know and how do you go about doing that.” Another noted a mindset evolution: Since there are no true fixes, defense and mitigation are the priorities.
- Insurance brings rigor. As cyber insurance matures, one member noted, it will benchmark for a company’s preparedness. Another noted that’s the case for specialized policies such as aviation insurance, where airline safety executives may meet once a year with underwriters, but not for more general property and casualty.
OUTLOOK
With volatility anticipated to increase, BNP Paribas research suggests most companies that foresee increasing volatility in their own stock should consider repurchasing shares in the open market rather than through an accelerated share repurchase program (ASR).