Currency Engineering For an Extra Edge In Buying Overseas: Foreign exchange rate changes can produce more favorable prices and hasten payoffs in cross-border transactions.

At a point in the growth of companies the management starts to look beyond the borders of their home market and weigh the effects of an acquisition in a foreign country. Often the driving force is the strategic needs or opportunistic events that dictate the choice of country and the situation chosen for the overseas acquisition. Along with the decision to make the overseas acquisition comes the effect the earnings will have on the parent company and in particular the risks of exchange fluctuations that will affect the way earnings are accounted for and assets are valued. Often a company establishes debt in a foreign currency equal to the asset value exposure or the purchase price in order to purchase the currency used for the acquisition. Therefore, any fluctuation in the currency would zero out against the value of the purchase. A good rule of thumb is that the currency used in the transaction should be the same currency in which the debt would be paid. An interesting effect of exchange rate fluctuations is the ability of the acquirer to have a net gain in earnings from year to year if the currency of the target is strong when you buy, and then weakens. Consider the case in which a U.S. firm buys a U.K. company for five times earnings. We will assume that the U.K. company is earning 5 million pounds in EBIT-DA and has 40 million pounds of sales. When the purchase is made, the pound is trading at $1.40 to the pound. (Note that the pound is the only international currency quoted in dollars to the pound as opposed to all of the other currencies, which are quoted in foreign currency to the dollar.) In conducting transatlantic deals at American Corporate Services over the past 26 years, we do not believe that exchange rates have a major effect on the desire to expand internationally. Companies make cross-border acquisitions for strategic business reasons, such as following their customers or maintaining growth. Exchange rate concerns do come into play in deal pricing and structuring, but do not typically make or break a deal. In our example of a U.S. company buying in the U.K., when the pound is strong against the dollar, the U.K. company can appear expensive relative to comparable U.S. acquisitions. During the past year, the pound has fluctuated between $1.40 and $1.65. At $1.60 (a strong pound), an American company would buy a U.K. company with 5 million pounds in EBIT-DA for $40 million. Assuming that the U.S. company has been watching the U.K. company for some time, as is often the case, the U.S. company has seen the U.K. company’s earnings climb from $7 million to $8 million. This climb in apparent earnings took place because of the currency fluctuation. It does not represent any real growth at the U.K. company. An example of how this can affect an acquisition price is shown in Figure 1. Cross-border transactions, especially if they are the first move into a new country or in-ternationally for the acquirer, often take time. When reviewing the financials of the target company, it is important to consider how rates have changed during the “courting” period, and management must make some determination of how these rate changes might affect them in the future. The cross-rate between the two currencies tends to move like a pendulum over short periods of time, typically measured in several quarters before reversing. Cur-rency traders speak of a “floor” and a “ceiling” to the range, as well as identifying psychological barriers (such as one euro to the dollar) and levels at which the central governments of the countries will be expected to intervene to support their currency. Over the long term, measured in many years, the currencies of most developed nations have had a single long-term trend against the dollar. The pound tends to fluctuate in a 12% to 16% range against the dollar with a long-term trend of weakening against the dollar. Long-term trends are readily explained by looking at the underlying growth rates of the economies. Interest rates have a short-term effect on the pendulum, but ultimately it is the strength of the underlying economy that drives long-term currency moves. Changing rates have an impact on world trade, an area deserving of an article in itself. Suffice it to say that a strong dollar makes U.S. products expensive to foreign consumers, hurting our exports, and a weak dollar makes international products, such as luxury German automobiles, more expensive. Major swings in the pendulum have a delayed reaction on trade of approximately 18 months, since major exports/imports have long lead times between ordering and delivering. The euro, as a new currency, has fared much worse than expected against the dollar. Much press has been devoted to the fact that Euro-pean commerce, both within the European Union (EU) and between the EU and the United States, continues to be strangled by national inefficiencies, tariffs, and trade barriers, which stubbornly remain in Europe. The euro, and the central European Bank, was expected to bring the major European economies in line. In practice, Europe still does not have a single tax policy for business or individuals, and tax revenues have had a direct effect on the deficit/surplus run by the individual countries within the EU. This has been controlled by tweaking the interest rates in European countries and by central bank intervention, affecting the overall performance of the euro against the dollar. Social and labor costs within Europe remain high. We believe it is an excellent time for American companies to buy in Europe. Consolida-tion is taking place in many industries as tariff and trade barriers are starting to come down within the EU. Com-panies that were protected in their local markets can no longer compete effectively within Europe. They are being sold and consolidated. Stronger players are seeking strategic partners and financing to complete roll up strategies. Good Timing on Deal Returns Currency fluctuations also impact the returns to an acquirer in a cross-border transaction, as demonstrated by this example of a U.S. company’s acquisition of a U.K. firm: Year One Acquisition Price (in dollars): $35 million Exchange Rate: $1.40 to the pound Target Company EBIT-DA (in pounds): 5 million Multiple of EBIT-DA: 5 Effect on Acquirer’s Financials (in dollars): $7 million of EBIT-DA is consolidated Year Two Exchange Rate: Dollar drops; rate is $1.80 to the pound. Target Company EBIT-DA (in pounds): Holds at 5 million Effect on Acquirer’s Financials (in dollars): $9 million of EBIT-DA is consolidated Result: A 28.6% year-over-year gain even without an actual net gain or growth in EBIT-DA at the new U.K. subsidiary. Figure 1: How Exchange Rates Drive Pricing Purchase Price Pound vs. EBIT-DA EBIT-DA In Dollars Dollar (Pounds) (Dollars) At 5 x EBIT-DAWeak Pound $1.40 5 million $7 million $35 million 1.50 5 million 7.5 million 37.5 millionStrong Pound 1.60 5 million 8 million 40 million<\TBL>