Treasury and Finance managers: How to manage cash pools when long-term borrowing costs increase?

For group treasury and finance teams, the past two years were complex to manage due to the great volatility within financial markets resulting from the Covid-19 pandemic. Due to supply chain disruptions and governmental restrictions, some industries faced great financial stress and had to restructure their operations funding. How did group treasurers manage to face these difficulties and maintain access to funding, and what was the impact on cash pooling arrangements? 

For group treasury and finance teams, the past two years were complex to manage due to the great volatility within financial markets resulting from the Covid-19 pandemic. Due to supply chain disruptions and governmental restrictions, some industries faced great financial stress and had to restructure their operations funding. How did group treasurers manage to face these difficulties and maintain access to funding, and what was the impact on cash pooling arrangements? 

Two years ago, the Organization for Economic Co-operation and Development (OECD) published its final report on transfer pricing guidance for financial transactions¹ (hereafter “the Report”). The Report clarifies how the general guidelines on transfer pricing should apply to intragroup financial transactions. In particular, the guidance emphasizes the need to accurately delineate the financial transactions under review. Finally, the Report provides a framework for treasury companies that perform cash pooling activities and manage long term funding activities. 

Cash pools are arrangements mostly seen within multinational groups and are used to optimize cash and liquidity management and reduce reliance on external funding and associated funding costs. 

There are two basic types of cash pooling arrangements:

• Physical cash pooling: in a physical cash pool, all accounts of cash pool participants are managed on a daily basis. Positive balances are transferred to a central concentration account (or master account), and negative accounts are brought to a target balance, using positive balances or cash available at the level of the cash pool leader. Cash pool leaders will often rely on external funding in case excess of cash is not sufficient to cover the negative balances. 
• Notional cash pooling: under a notional cash pooling system, the bank (or the cash pool leader) will assess the individual balances of each participant and will pay (or charge) interest depending on the net balance. There is no physical transfer of funds in a notional cash pool, thus transaction costs are lower. However, cross-guarantees from pool participants are likely to be required. 

There may also be variations between notional and physical cash pools. 

What are the different types of cash pool leaders? 

The remuneration of the cash pool leader will depend on its functional profile, the assets used, and the risks assumed. Two main types of cash pool leaders may be identified: 

• Treasury service company: cash pool leaders operating as limited risk companies will perform limited functions when managing the cash pooling, and bear limited risks. Their functions will be more of administrative nature. 
• Full risk treasury company: full risk treasury companies will have a more intensive functional profile and will be acting as internal banks. They will negotiate funding with external lenders and operate the cash pooling with a view to efficiently manage internal liquidity. They will also bear some risks. 

The OECD indicates that benefits arising from cash pooling should be thoroughly analyzed, especially when they are due to deliberate, concerted actions. It is thus necessary to determine the nature of the economic benefit or costs, their amount, and how those benefits or cost should be allocated among the cash pool participants. Main benefits are related to the internalization of the bank spread, and reduction of transactions costs. 

Global uncertainties reshuffle the access to liquidity

Over the past two years, many industries were heavily impacted by the Coronavirus pandemic, and continue to be impacted. Due to the measures implemented to limit the spread of the pandemic, industries faced strict limitations on their operations and experienced supply chain disruptions. As a result, they saw their revenues and profitability decrease significantly. Governments had to intervene to support most affected companies and sectors.  

In parallel, when groups tried to refinance their debt, or raise funds from financial markets, they experienced great difficulty to negotiate financial terms and conditions, with banks and investors reluctant to grant funding. Thus, several groups had to rely on governmental support in the form of loans, or government guarantees, to obtain funding. Consequently, borrowing costs of Treasury companies significantly increased. Even industries less affected by restrictions faced similar difficulties, with long-term borrowing costs increasing on the markets as investors required higher risk premium, due to global uncertainties.  

Groups that needed to raise funding during peak of volatility thus saw their borrowing cost increase, due to reliance on long term funding, and Treasury companies faced several issues in relation to short term funding: how to ensure access to liquidity for subsidiaries, especially when they have no other source of funding? What financing strategy to apply when only long-term debt is available to finance a cash pooling? How to allocate high borrowing costs among cash pool participants, and at the same time remunerate the Treasury company? 

How to set interest rates on the cash pooling? 

Depending on how the cash pool operates, and the accurate delineation of the cash pooling transactions, a thorough analysis would lead to identify the most appropriate way of remunerating the cash pool leaders and participants. In most cases, the cash pool leader will set interest rates on the cash pooling in order to cover its own operating costs and achieve a profit margin consistent with its functional profile. In some cases, when the leader assumes high risks, a compensation for the equity at risk would also be included. This analysis can be performed under a three-step approach: 

• Step 1: Groups should consider the different sources of funding available: third party facilities or bank funding, equity funding (if any), but also deposits available from cash pool participants. Deposit balances, for which a low remuneration is usually applied, allow to reduce the cost of funding for cash pools.  
• Step 2: the cash pool leader will determine its remuneration, which will be either a cost-plus compensation for limited risk profiles, or remuneration of equity at risk for risk bearing cash pool leaders. 
• Step 3: the arm’s length nature of the cash pooling borrowing, and deposit rates should be assessed. Generally, borrowing and deposit rates can be benchmarked against short term market rates. For instance, short term yield curve rates or lending rates published by central banks provide indicative market rates. Money market instruments or deposit rates published by central banks also provide data points for deposit rates. 

As a final check, groups should assess the overall margin of the Treasury company, and check whether interest income from lending positions allow to cover the interest expense paid on deposit positions, and achieve the net margin determined in Step 2. 

This analysis may create some risks in the case that the cash pooling is financed with long term debt, or when the cost of funding tends to be higher. Here, groups would have the choice between allocating the full cost of funding to cash pool participants, and thus pushing the risk towards the borrowing entities, or keeping a higher portion of the borrowing costs, and maintaining the risk at the level of the cash pool leader. 

There are theoretical and economic arguments that could justify both approaches, and the analysis would depend on the specific facts and circumstances of each group. The main questions to consider are the following:  

• What is the level of risk assumed by the cash pool leader? 
• What are the contributions of the cash pool leader and participants to the cash pooling? 
• What are the options realistically available to the cash pool participants? Do they have access to other sources of funding? 
• Are the cash pool participants better off than in the absence of the cash pool arrangement? 

A thorough functional analysis and delineation of the cash pooling transactions will help to determine the most appropriate approach in each case. It will be important to identify the key risks assumed in the Treasury companies and the entities supporting them. In this respect, the OECD considers that the two main risks of a cash pooling are credit risk and liquidity risk. The effect of any guarantee or cross-guarantee should also be taken into consideration. In addition, the OECD also notes that for participants, the access to funding through cash pooling, when liquidity is not available otherwise, might be a benefit in itself. Finally, multinational groups should also consider the OECD guidance on the transfer pricing implications of the Covid-19 pandemic. 

In any case, groups will need to appropriately document their cash pool arrangements, and also how they set up the interest rates. This will be even more important in case of increased borrowing costs at the level of the Treasury companies. Preparing this documentation beforehand will help groups be ready in case of enquiries from tax authorities, especially since guidance on financial transactions has only been published recently, and as with any recent regulations, its application remains unclear.  

[1] OECD (2020), Transfer Pricing Guidance on Financial Transactions: Inclusive Framework on BEPS Actions 4, 8-10, OECD