BREXIT and the Treasurer – an update after three weeks
14 July 2016
Uncertainty. Shock. Opportunity. Confusion. Hope. The impact of the EU Referendum result may have evoked some or all of these emotions across the UK Corporate Treasury community.
We are now in a period where uncertainty is the only certainty and this is likely to continue to be a feature of the business and financial landscapes for the coming months.
Our conversations with Treasurers have highlighted four key issues that they will be keeping a close focus on to help their business better navigate this uncertainty.
Foreign Exchange volatility and the weakness of the British Pound (GBP) is the biggest concern of the Treasurers we have spoken with post-Brexit. In the period 23 June 2016 to 11 July 2016 the GBP fell nearly 13% against the US Dollar and 11% against the Euro. Of course the economic implications for corporates vary in line with their business models – negative for net importers such as retailers and consumer goods businesses, notwithstanding they are likely to be hedged in the short term, but positive for UK exporters and those companies based in the UK with overseas operations.
However, whatever their FX exposures, corporates are finding that their forecasting, analysis, reporting, control and hedging processes are being tested and stretched by both the constant demand for information from senior management and external stakeholders, and the need to work in an ever changing environment with multiple internal and external parties. Without remedial action – particularly in relation to systems, policies and controls – this process ‘stress’ could well increase as the practicalities of Brexit play out in the coming months and years, hedging put on prior to 23 June 2016 unwinds, new accounting rules begin to bite and businesses make strategic decisions that force further changes to treasury activities.
A second challenge for UK Treasurers is how to fund corporate strategic initiatives and find liquidity.
Since the referendum result, our Debt & Capital Advisory team has been collating market sentiment, both in the larger liquid debt markets and the less liquid mid-market. Overall sentiment in both markets is positive but still cautious, with most banks and funds professing “business as usual”.
However, the High Yield bond market and GBP underwrite markets are essentially closed – and we expect there to be little activity in either during the usual summer hiatus. Whilst Sisal has successfully priced its dual-tranche high yield bonds this week, also inside pricing guidance, the lead arrangers on this issue would have wanted to ensure that they weren't sitting on a bridge loan over the summer. It does nevertheless illustrate that the market isn't completely closed. Whilst yields will no doubt increase, the high yield market was delivering record low yields to borrowers in Q2 2016 supported by activity from the ECB, in particular the extension of QE into investment grade corporate bonds, which has also helped benefit both crossover and BB-rated issuers.
Whilst we also expect the Euro loan underwrite market to be quieter over the summer, unlike the financial crisis of 2008-2009, banks are well capitalised and there is an abundance of liquidity in the form of CLOs and alternative lenders that can support new transactions. With lenders still keen to deploy liquidity, a flight to quality is predicted. Cyclical companies, those with mismatched foreign exchange exposure or any challenging credits, may find it more difficult to raise debt.
We expect the UK mid-market to be more insulated given the abundance of liquidity available to borrowers, but we anticipate an element of repricing (likely to be higher) in the coming months and a focus on higher quality credits. The lending environment is constantly evolving and, although navigating these pockets of liquidity can be challenging, there is definitely appetite from banks and funds to continue lending due to the positive but cautious sentiment throughout the market.
The effects on corporate cash management activity are likely to be divided between the short term response to uncertainty and the medium term effect on structures, banking arrangements and the tax thereon which will become clearer as the likely terms of Brexit begin to emerge.
Short term. In the short term, the corporate focus is on greater visibility of cash and improved forecasting of cash to protect and make best use of this key corporate asset in uncertain times. This is a trend that has been evident throughout 2016 and the EU referendum result has reinforced this – business should expect further focus in this space.
Cash structures. In the medium term, the UK leaving the EU could change (either upwards or downwards) the effectiveness of certain cash concentration and loan structures set up by corporates, particularly where the header is in the UK, and the attractiveness of managing such cash and treasury operations from the UK.
The level of impact will depend upon a number of factors around the nature of the ongoing relationship between the UK and the EU, which are still to be determined. In particular, the ability of UK based banks to provide cash management and banking services across the EU; the change in legal requirements and regulations on those banks and corporates, and the tax considerations on those activities; and potentially any restrictions on the free movement of EU citizens to work in the UK.
Withholding taxes. The UK has a large network of bilateral treaties with other territories, and in many cases these treaties reduce or eliminate withholding taxes on cross border payments in relation to interest dividends and royalties. This will not change just because the UK leaves the EU. However, EU member states are also bound by the Parent-Subsidiary Directive, and the Interest and Royalties Directive, which eliminate withholding taxes on payments between subsidiaries in different member states if certain criteria are met. Where the bilateral treaty between two territories allows a withholding tax, these directives provide an override to eliminate the tax. Once the UK is no longer a member of the EU, the ability to rely on the directives will be lost and withholding taxes may apply.
Last but not least is the counterparty risk on the banks and other financial counterparties who work with corporate treasurers. In the past few years, the key indicators of the health of the UK and European banking sector have generally improved up until 2016, and Brexit further added to the recent negative trend. As with foreign exchange, volatility is putting stress on monitoring, management and valuation practices given the need for instant analysis and agility. A flight to counterparty quality, the increased use of collateral and security to cover positions are the likely outcomes if the current position prevails.
The list above it not exhaustive and given the uncertainty may change over time, but keeping on top of them over the next months will be the key challenge for the Treasurer. Organisations should put in place effective processes and systems to enable them to plan and manage their treasury risks within the context of this uncertainty, while acknowledging that plans may change as the situation becomes clearer. Focus, flexibility, control, process efficiency and easily available quality information and analysis will be critical throughout.
If you’d like to speak to one of our subject matter experts on the topics mentioned above feel free to contact us. You can also visit our website or sign up to our Treasury Talk blog to make sure you receive the latest updates and articles.