A Comprehensive Approach to Managing Trapped Cash

Multinationals with a growing international footprint and subsidiaries worldwide eventually face the challenge of how to treat their trapped cash. The problem became more acute with the onset of the global financial crisis in 2008, with major economies facing a significant liquidity crunch as counterparties try to guard their cash while striving to minimise counterparty risk.

At the same time, companies have examined their structures for any levers to free cash – for example through working capital management and tighter cost controls – and attempted to transform identified amounts of trapped cash into cash available for the daily cash cycle. So companies have paid greater attention to cash and liquidity risk, with cash built up to strengthen their independence from external financing and increasing capital exports to finance foreign direct investments (FDIs), which might have been financed at least partially with cash. Figure 1 below shows recent FDI activity for German corporates.

Figure 1: German Net Foreign Direct Investments Abroad – Cumulated Transaction Values 2008-11.
PwC Trapped Cash Figure 1
Source: Deutsche Bundesbank, Direktinvestitionen laut Zahlungsbilanzstatistik, April 2012, p. 6.

Defining Trapped Cash

The phrase ‘trapped cash’ generally describes all cash not available for a corporate’s daily cash cycle, but has traditionally been known in the market as referring to the following two main categories:

  • The first category can be described as restricted cash, which is not available for the daily cash cycle due to, for example, the fulfilment of covenants in financing/factoring or collateralisation. Restricted cash is induced through the daily business and reflects the company’s negotiating power. It does not originate from a fixed external requirement, so will not be reviewed further for the purpose of this article.
  • The second category – the focus of this article – is that of trapped cash as characterised by cash amounts that are not accessible from a geographical and legal point of view as they are they are in countries where local legislation applies. These restrictions obstruct total or partial repatriation. These are dubbed ‘regulated countries’, although the specific legal obstacles may vary widely from one country to another. Repatriating trapped cash from a regulated country can involve significant effort for the company, without any guarantee of success.

This problem is widespread among large multinational companies (MNCs) where the sum of all trapped cash in several regulated countries (assuming that subsidiaries are widely spread) can reach a sizeable percentage of overall group cash. The problem is not limited to major MNCs, often being faced by sizeable middle market companies with a limited number of foreign subsidiaries. However, the impact of trapped cash at a mid-sized company might quickly become significant in comparison to the amount of free cash out of non-regulated countries, as highly specialised companies may attain significant revenues there.

Consequently, the unavailability of trapped cash for the daily cash cycle, liquidity optimisation and internal financing is a constant challenge for companies with subsidiaries in regulated countries such as Brazil, China, India and Russia (BRICs). Such challenges exist both when economic times are good and in downturns, as the speed of the economic swings operate as a catalyser and can impact on unprepared companies more heavily than others. Therefore, companies with planned FDIs in regulated countries should consider the measures outlined below.

How Companies Can Approach the Challenge

Companies benefit from managing the challenge of trapped cash and avoiding its potential negative consequences by following a comprehensive approach. This is even more so for companies that have included managing liquidity risk and business best practice into their overall strategy. 

Business Strategy: The company should agree on objectives, core principles and responsibilities regarding its FDIs and confirm them in a written investment policy. Management will need to ensure that all employees, particularly those with the power to trigger and perform merger and acquisition (M&A) processes, have completely understood such a policy and are aware of their responsibilities. In addition, a clear strategy/business plan should be devised to support decisions for all departments likely to be involved in the future process of cash repatriation, especially finance, treasury, tax and legal.

Investment Setup: Before proceeding with initial investment in any regulated country, the investing company should aim to gain clear visibility on capital requirements and related legislation such as foreign exchange (FX) rules, corporate law on foreign-invested companies, tax law and transfer pricing. This might prove to be a difficult task, with some regulated countries prone to continuous or sudden changes to their legislative landscape. Additionally, any external financing options should be explored as they could present opportunities for avoiding substantial amounts of trapped cash. 
However, to ensure control over the initial investment and future application of repatriation strategies, tracking developments in local legislation should be delegated to local legal advisors, either internal or external.

Working Capital Financing: Financing working capital is also of strategic importance as it presents an opportunity either to avoid trapped cash in the short and long term, or become one of headquarters’ future vehicles for cash repatriation, such as via tailored intercompany financing structures.

Bank Partner: The choice of the company’s bank partner in the regulated country is important as banking models differ from country to country. When combined with local legislation it results in a range of different regulatory and product/service environments. As a result some banks may not be permitted, or able, to perform certain services such as cash concentration; financing, transfers and transactions in local or foreign currency; and acceptance of deposits. Also, many regulated countries will differentiate between local banks and branches of foreign banks.
Consequently, a company performing FDIs might not be able to restrict its choice to the preferred bank partner in non-regulated countries but may also need to establish business relationships with additional local banks to ensure it has access to the necessary services and products.

Bank Account Reporting: Once the subsidiary is incorporated and operating, the company-wide treasury policy – including the responsibilities and core principles of management and control of subsidiaries’ bank accounts – should be communicated and implemented. As both cross-border and local cash concentration structures are rarely allowed in regulated countries, central treasury should at least achieve an acceptable level of information; otherwise cash information on subsidiaries in regulated countries stays hidden.
Central treasury should therefore have full transparency for all bank accounts through regular reporting of account statements; for example by setting up contracts with the respective bank(s) for automatic posting of account statements via SWIFT in MT940 format. This activity is a way to control subsidiaries’ bank account usage and supports analysis on the degree of compliance in local business.

Forecasting: Visibility through bank account statements should be used to validate subsidiaries’ forecasted cash levels by central treasury. Such activities allow identification of potential systematic variances and forecast errors and, ultimately, historical cash forecast accuracy. Levelling out identified forecast variances and errors can help the subsidiary improve forecast accuracy.
Central treasury can therefore estimate the accuracy of forecast cash and related numbers for the year-end relatively early on in the business year. It can also decide whether the planned strategy on cash repatriation can be realised, and being preparing for the repatriation process to avoid adverse effects and undesirable attention from local administration in the regulated country. This activity also supports the calculation of the subsidiaries’ forecasted liquidity profile and creates visibility on necessary local funding.

Repatriation: Finding a way to extract trapped cash from a subsidiary into the company’s daily cash cycle is a challenge in each regulated country. Respective legislations are different both in breadth and in depth. Knowledge on repatriation should be an integral part of the above-mentioned investment policy. This will enable the company to optimise the application of repatriation alternatives; some of which are listed below. It should be stressed that such alternatives will require adjustment for any practical case to reflect the individual legislation of a regulated country.

  • Intercompany Financing: Depending on the regulated country, central treasury should set up a tailored structure for intercompany financing; for example through the parent company, an affiliate subsidiary or even an affiliate subsidiary that holds a banking license. Available structures in the company will help determine the amount of effort required in setting up such financing processes. At least a cost-benefit study should be performed before setting up such processes, to achieve visibility for all stakeholders.
  • Service Fees: Services provided by the company to the subsidiary can be fixed in writing and carry regular service fees to be paid by the subsidiary.
  • Royalties: Royalty payments are a popular instrument, for example due to usage of the parent company’s trademark or copyrights.
  • Dividends: Repatriating cash via dividend payments to the shareholder is the most apparent, being the ‘most natural’ instrument available. Such payments may be subject to time constraints in the regulated country. In addition, requirements on justification and documentation can be significant and should be prepared well in advance, to avoid jeopardising the dividend payment by the local administration. The company’s treasury policy should include specific wording on dividends to avoid yearly repeated discussions on the same subjects, such as local opportunities to hedge dividend payments versus treasury policy on foreign exchange (FX) risk management.

For all cash repatriation instruments available, the underlying tax legislation both for the parent company and subsidiary play an important role and should be reviewed individually.

Reinvestment: Where repatriation is neither possible nor the objective, cash that has to remain in the regulated country might be used for other activities, including local investments in other businesses or in the local financial market. However, starting any such activities creates more complex local processes so they should be supported by setting up local risk management under the treasury policy.

A well laid-out approach under a company’s strategy, together with the inclusion of subsidiaries in regulated countries into the above combined with efficient control processes, should result in better control of the daily cash cycle and increase the cycled amounts of cash even under conditions set in regulated countries. 

Companies operating internationally face a continuously-evolving world, with more countries attracting FDIs as they develop their national economies, but often prove more cautious in liberalising their legislative regimes. As it is hardly possible to estimate if and when a regulated country will loosen its grip on international capital transfer, companies with a comprehensive approach to trapped cash and a well-managed cash cycle will be better positioned for the challenges triggered by international economic developments.  
 

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