The Finance Function in a Global Corporation by Mihir A. Desai
Historically, the finance functions in large U.S. and European firms have focused on cost control, operating budgets, and internal auditing. But as corporations go global, a world of finance opens up within them, presenting new opportunities and challenges for CFOs. Rather than simply make aggregate capital-structure and dividend decisions, for example, they also have to wrestle with the capital structure and profit repatriation policies of their companies’ subsidiaries. Capital budgeting decisions and valuation must reflect not only divisional differences but also the complications introduced by currency, tax, and country risks. Incentive systems need to measure and reward managers operating in various economic and financial settings.
The Globally Competent Finance Function
As companies globalize, they face new financial challenges. The first set of questions summarizes the work of the traditional finance function with respect to external providers of capital. Because a global firm is itself a capital market, the finance function must consider a second set of questions, which addresses the internal capital market, in addition to the first.
Traditional questions for the local finance function:
• How should we finance ourselves?
• How should we return cash to shareholders?
• How should we analyze investment opportunities?
• How should we communicate information to shareholders and lenders?
• How should our ownership structure influence operations?
New questions for the global finance function:
• How should we finance our subsidiaries?
• How should we get money out of our subsidiaries?
• How should we analyze the same investment opportunities in different countries?
• How should we communicate financial information inside the firm?
• How should we decide what to own and with whom?
The existence of what amounts to internal markets for capital gives global corporations a powerful mechanism for arbitrage across national financial markets. But in managing their internal markets to create a competitive advantage, finance executives must delicately balance the financial opportunities they offer with the strategic opportunities and challenges presented by operating in multiple institutional environments, each of which has it own legal regime and political risks. There is also a critical managerial component: What looks like savvy financial management can ruin individual and organizational motivation. As we’ll see in the following pages, some of the financial opportunities available to global firms are affected by institutional and managerial forces in three critical functions: financing, risk management, and capital budgeting.
Financing in the Internal Capital Market
Institutional differences across a company’s operations allow plenty of scope for creating value through wise financing decisions. Because interest is typically deductible, a CFO can significantly reduce a group’s overall tax bill by borrowing disproportionately in countries with high tax rates and lending the excess cash to operations in countries with lower rates. CFOs can also exploit tax differences by carefully timing and sizing the flows of profits from subsidiaries to the parent. However, tax is not the only relevant variable: Disparities in creditors’ rights around the world result in differences in borrowing costs. As a consequence, many global firms borrow in certain foreign jurisdictions or at home and then lend to their subsidiaries.
Multinational firms can also exploit their internal capital markets in order to gain a competitive advantage in countries when financing for local firms becomes very expensive. When the Far East experienced a currency crisis in the 1990s, for example, and companies in the region were struggling to raise capital, a number of U.S. and European multinationals decided to increase financing to their local subsidiaries. This move allowed them to win both market share and political capital with local governments, who interpreted the increased financing as a gesture of solidarity.
But the global CFO needs to be aware of the downside of getting strategic about financing in these ways. Saddling the managers of subsidiaries with debt can cloud their profit performance, affecting how they are perceived within the larger organization and thereby limiting their professional opportunities. Similar considerations should temper companies’ policies about the repatriation of profits. For U.S. companies,
tax incentives dictate lumpy and irregular profit transfers to the parent. But many firms choose to maintain smooth flows of profits from subsidiaries to the parent because the requirement to disgorge cash makes it harder for managers to inflate their performance through fancy accounting. Finally, letting managers rely too much on easy financing from home saps their autonomy and spirit of enterprise, which is why many firms require subsidiaries to borrow locally, often at disadvantageous rates.
Managing Risk Globally
The existence of an internal capital market also broadens a firm’s risk-management options. For example,
instead of managing all currency exposures through the financial market, global firms can offset natural currency exposures through their worldwide operations. Let’s say a European subsidiary purchases local components and sells a finished product to the Japanese market. Such operations create a long position in the yen or a short position in the euro. That is, those operations will become stronger if the yen appreciates and weaker if the euro appreciates. This exposure could be managed, in part, by offsetting exposures elsewhere in the group or by having the parent borrow in yen so that movements in the yen asset would be cancelled by movements in the yen liability.
Given this potential for minimizing risk, it might seem perverse that many multinationals let local subsidiaries and regions manage their risks separately. General Motors is a case in point. Even though its treasury function is widely regarded as one of the strongest pools of talent within the company—and
one of the best corporate treasury functions worldwide—GM’s hedging policy requires each geographic
region to hedge its exposures independently, thereby vitiating the benefits of a strong, centralized treasury. Why duplicate so many hedging decisions? Because forcing a business’s hedging decisions to
correspond to its geographic footprint gives GM more-accurate measurements of the performance of the individual business unit and of the managers running it.
In a related vein, companies often limit—in arbitrary and puzzling ways—their considerable expertise in
managing currency exposures. Many firms require finance managers to follow “passive” policies, which they apply in a rote manner. For example, GM actively measures various exposures but then requires 50% of them to be hedged with a prescribed ratio of futures and options. Firms adhere to these passive strategies because they limit the degree to which financial managers can undertake positions for accounting or speculative reasons. So although functioning in the global environment calls for considerable financial expertise, organizational strategy requires that expertise to be constrained so that financial incentives don’t overwhelm operating ones.
Global Capital Budgeting
In addition to exploiting the de facto internal financial market to mediate between their operations and the external financial markets, CFOs can add a lot of value by getting smarter about valuing investment opportunities. When energy giant AES began to develop global operations, in the early 1990s, managers applied the same hurdle rate to dividends from around the world that they used for domestic power projects, despite the different business and country risks they faced. That approach made risky international investments look a lot more attractive than they really were.
The company’s subsequent attempts to improve its capital-investment decision process illustrate the
organizational challenges CFOs face as they move from domestic to foreign markets. In order to improve the quality of valuations, AES required managers to incorporate sovereign spreads into their discount rates. Sovereign spreads measure the difference between the rates at which two countries can borrow in the same currency, and they are widely tacked on to discount rates in order to adjust for country risk. Although this method created the semblance of tremendous precision, it came with some curious incentives, particularly for managers charged with securing deals in emerging markets. Knowing that their projects would face very high discount rates, managers forecasted inflated cash flows to compensate. For managers keen to complete transactions, as some at AES were, excessive penalties and precision can result in a less robust process.
In extreme cases, the gaming that takes place in a formalized process can undermine the company’s strategy. Consider Asahi Glass, one of the first Japanese corporations to rigorously implement Economic Value Added systems worldwide in order to increase capital efficiency. Asahi set country-specific discount rates based on typical risk measures, including sovereign spreads. The result, however, was that managers overinvested in Japan (because of very low discount rates) and underinvested in emerging markets (because of very high ones). Once again, adopting a narrowly financial approach led to an outcome directly at odds with the company’s strategic objectives. In response, Asahi made a series of adjustments to reconcile its initial, purely financial approach to discount rates with its broader organizational goals.
The moral of these stories is that formal methods of valuation and capital budgeting—which work quite
well in a domestic context, where the variables are well understood—must be refined as companies
globalize. Firms need to make sure that their finance professionals actively discuss potential risks with the country managers who best understand them.
Creating a Global Finance Function
How can CFOs ensure that their global finance operations make the most of the opportunities at their disposal? At a minimum, they must inventory their financial capabilities and ensure their adaptation to institutional variation and their alignment with organizational goals. To achieve this, a global finance function must do three things well:
Establish the appropriate geographic locus of decision making.
The example of GM’s approach to hedging makes clear that a finance function must locate decision making at a geographic level where other strategic decisions are made. Even if centralizing decisions can generate substantial savings, these might need to be sacrificed to ensure that the finance function reflects the degree of centralization appropriate for the firm overall. Highly centralized firms can have a large finance function at headquarters that effectively dictates decision making for all subsidiaries; such an arrangement can capitalize on many financial arbitrage opportunities without sacrificing organizational goals substantially. Decentralized organizations, in which country managers are paramount, must replicate some financial decision making at the country level.
Create a professional finance staff that rotates globally.
Leading companies recruit and rotate financial managers in the same way that they do marketing and operational talent. If companies groom a network of finance professionals who are comfortable in various environments—and have rotated through positions at the country, region, and corporate levels—the
dynamic between the financial headquarters, where most expertise resides, and the subsidiary can be a powerful resource in difficult times. Drug giant Novartis is an example. In 2001, the company had to decide whether to continue financing its Turkish subsidiary, which had repeatedly delayed payment to Novartis during periods of crisis. On the numbers alone, the decision would have been straightforward: Force the managers to fund locally or deny shipments of life-saving drugs to the subsidiary. Complicated negotiations ensured that the subsidiary would continue to operate, capitalize on the weakness of its competitors, and ultimately pay back the parent. A successful outcome was achieved only because of the trust built up over many years between finance managers at headquarters and those in Turkey, many of whom had spent time at Novartis subsidiaries around the world.
Codify priorities and practices that can be adapted to local conditions.
It is tempting to stipulate that cash repatriation policies or investment criteria be applied universally. Such a requirement, however, can sacrifice opportunities that arise locally. Similarly, strategic objectives, as in the Asahi example, may demand flexibility in investment analyses. Smart companies, therefore,
formulate policies centrally with an understanding that local idiosyncrasies and strategic imperatives may require exceptions. Specifying the process for making exceptions, such as instituting a standing committee of finance professionals to review possibilities, is critical to ensuring that deviations from the norm are properly managed.
• • •
Forty years ago, most firms didn’t have CFOs, and the finance function was usually staffed by controllers. As external markets have become more demanding in terms of performance and their requirements for disclosure, the finance function has become more prominent. Now that multinational companies have their own internal capital markets, the finance function must graduate to a more strategically engaged level. A globally competent finance department is one that understands how to reconcile the firm’s
financial, managerial, and institutional priorities across its business units. Does yours?