Aspen Case

Aspen Technology, Inc.: Currency Hedging Review 1. What are Aspen Technology’s main exchange rate exposures? How does Aspen Tech’s business strategy give rise to these exposures as well as to the firm’s financing need?

Aspen Technology Inc. is a highly international company that sells its specialized engineering software in more than 30 countries. It accounts 52% of revenues outside the United States and employs a total of 417 workers, of which 152 come from abroad. More specifically, its revenue structure is subdivided in 4 major categories: with the U.S. accounting for 48% of revenues, Europe 31%, Asia 12% and other countries for 9%.

As such, it is no surprise that a company of its sort in a highly globalized economy would be exposed to considerable amounts of exchange rate risk. To this day, AspenTech’s main currency exposures are in German Marks, British Pounds, Japanese Yens and Belgian Francs.

AspenTech gives rise to these currency exposures by generating revenues in foreign countries and by operating foreign subsidiaries. Amongst its foreign subsidiaries, there are offices in London (deriving from AspenTech’s purchase of Prosys Technology in 1991), its foreign sales subsidiaries in the UK, Japan, Hong Kong and Brussels, and its JV with China’s petroleum and petrochemical company for its operations in China. Aspentech counts 16 offices worldwide. Overall, AspenTech’s policy of selling in foreign currencies is appropriate as it tends to increase foreign sales.

More specifically, on the revenue side of its operations, AspenTech’s exposure to exchange rate risks is a consequence of the financing it grants customers when they enter licensing agreements with the company. In fact, since the annual licence for one of AspenTech’s core

products is rather expensive (in the range of $ 10,000 to $ 25,000) and conditional to 3 to 5 year fixed contracts, AspenTech’s envisaged a financing policy. As many as 90% of customers would avail themselves of such arrangements. Such financing however (susceptible to a 12% interest rate), would give rise to future cash flows in foreign currencies that would then become susceptible to currency fluctuations and the subsequent need to manage such exchange rate risks.

Furtherly, such financing did not only generate complexities in terms of exchange rate risk, but also in terms of the firm’s financing needs (liquidity risks). In fact, the firm periodically experienced operating cash shortfalls deriving from the fact that the majority of its customers preferred to finance their purchases. Such deferred cash flows led the company to find alternative solutions to provide for its operating cash flow needs, namely through selling its receivables to two well established financial institutions: GE Capital and Sanwa Bank.

In addition, the company established a seasonal line of credit with a New England Bank (up to 10 million) and a 4 million subordinated debenture from the Massachusetts Capital Resource Company.

2. Should Aspen Tech practice risk management? Why? Support your answers by using data from the case and provide an estimate for the potential impact of risk management on the firm.

Interest rate risk: Aspen provides financing for their clients, charging a credit spread over the U.S. Treasury rate, which is locked in at the time of sales. As such, the value of their accounts receivables are exposed to interest rate risk. However, one could argue that this risk would be offset in the long run, unless the market encounters an extended period of perverse rates. While

we are unable to provide an estimate of the effects of their interest rates hedging via sales of receivables, but it is safe to conclude that such strategies would align with their goal of eliminating unnecessary exposures.

Operational risk: AspenTech should practice operational risk by diversifying the location of its Research and Development sites to mitigate the effects of exchange rate movements. This is because most competitors are in the US, should diversify to other countries to reduce operational risk.

Credit risk / default risk: Aspen sells their account receivables for an upfront payment to financial intermediaries such as GE Capital and Sanwa Bank. While this limits their exposure to credit default events, it does not fully eliminate the risk. It is not certain that they are able to swap the full amount of their receivables, which results in Aspen retaining the risk of market fluctuations and the rate of conversion. Furthermore, they are liable for a portion of the losses due to credit defaults on their receivables that are sold to GE and Sanwa under a limited recourse clause. As mentioned in the case, failure to offload these receivables would have adverse effects on the company, since they would be retaining credit and interest risk.

Liquidity risk - As a result of their accounting procedures, Aspen recognises the entire amount of sales as revenue, even their client opts for the financing scheme. As such, they are plagued with cash shortfall due to discrepancies between their booked revenue and cash received. In addition, the company had in place a seasonal line of credit facility with a New England bank, which can help address the cash shortfall. However, this limits their ability to obtain more credit facilities since all assets are posted as collateral for this seasonal credit line.

Currency risk - As mentioned in earlier parts, Aspen’s operations in various countries exposes them to currency risk. The situation is exacerbated by their offerings of financing plans to clients in local currencies, therefore increasing the volatility of their future cash flows. Aspen’s current hedging strategies merely accounts for their revenue, yet neglects their expenses in foreign currency.

We believe that it is imperative for Aspen to practice risk management, as evidenced from the analysis conducted (as shown in Figure 1) on the impact of risk management on their currency risk exposure.

Figure 1 VaR of Currency Exposure

Given the increasing volatility of the currencies of which AspenTech has exposures to, it should practice risk management and hedge out currency risk. Based on 1995 data, the annualized standard deviations for each the major exposed currencies is about 10%. When translated into VaR (1%) estimated losses, this leads to an approximate one-third loss on each of AspenTech’s currency exposures. In particular, net revenues from the US, UK, Germany, and Japan will fall by about one-third during a worst-case scenario, and this may lead to going-concern problems if currency risk is not managed adequately.

3. Calculate Aspen’s exposures by currency for the past year. What currencies is it long and short?

Based on the estimated breakdown of AspenTech’s revenues and expenses by currency, AspenTech is long the USD, GBP, DM, JPY, and CAD (represented in other currencies) while it is heavily short the Belgian Franc, as seen in the table above. Its top main currency exposures are the USD (Long), and Belgian Franc (Short)

4. What goal would you recommend for the firm’s currency risk management program? Why? Based on your goal, what type of exposure should Aspen measure?

The firm’s currency risk management program should insulate the firm from exchange rate risk, ensuring certainty and predictability of future foreign cash flows. Certainty and predictability of future cash flows protects the firm from uncertainty and shields the management team from unnecessary distractions. A firm’s risk management team should in no event indulge in any form of speculative activity. The firm’s competitive advantage lies in its ability to produce superior engineering software and certainly not in predicting foreign exchange rate fluctuations.

Furthermore, certainty of future cash flows is an axiom in financial planning and, as such, is a main prerequisite for the firm’s financial apparatus in general. An effective financial department relies on the predictability of future cash flows to budget the firm’s future cash needs and ensures that all of the firm’s functions can operate effectively. As such, the risk management team is a fundamental apparatus of any efficient financial department.

Additionally, an effective financial planning apparatus is of the utmost importance for a firm like AspenTech, whose competitive advantage relies on heavy amounts of sustainable R&D spending paired with investments that have long time horizons and take even longer to produce steady cash flows. Incapability of budgeting future cash flows could indeed bring to the ruin of a company like AspenTech, whose business model is so reliant on long term value propositions and consistent R&D expenditures to meet customers’ expectations.

In essence, to achieve such goals, AspenTech should measure Net Foreign Currency Exposure and hedge it appropriately. In fact, it is intrinsically wrong to only hedge against revenues, and not expenses, as foreign expenses can likewise have adverse effects on the company’s end cash flow. Such argument is also noticeably more compelling given the information that the firm’s foreign expenses have been increasing at a faster rate than foreign revenues and that AspenTech is now a publicly traded company.

5. Should the firm maintain its policy of completely eliminating all exposure on booked sales? If not, what policy would you advocate and why?

It is not recommended for AspenTech to completely eliminate all exposure on book sales only. AspenTech also has expenses in foreign currency which is growing faster than its revenues. This could increase the amount of currency exposure attributable to expenses, which it currently leaves unhedged. Therefore, AspenTech should focus on eliminating net currency exposure after taking into account its net exposures by examining its sales revenues and expenses accordingly. Risk management should also be centralized, with the goal of lowering total risk and not just currency risk as a more holistic risk management system will benefit the company more.

To allow for a more holistic risk management system, AspenTech should centrally manage all risk exposures. This includes commercial cash flows and financial assets and liabilities. Risk exposures and hedges should be tracked in a central treasury management system. Specifically, by consolidating currency transaction flows to the portfolio level, AspenTech can reduce its currency exposure as well as Foreign Exchange transaction costs.

Figure 2 IHB risk management structure

AspenTech can implement a more holistic risk management system through the use of an InHouse-Bank. With the adoption of an In-House Bank, the management of liquidity and risk is centralised within the IHB. The subsidiaries will therefore execute all Foreign Exchange transactions with the IHB, which will then manage net exposures with banks. In addition, subsidiaries can place liquidity or obtain funding with the IHB, which will then be the sole party in managing net liquidity needs with banks. Such a system has a myriad of benefits, including maximizing global funding and risk mitigation efficiency, minimizing transaction cost and counterparty risks, as well as providing AspenTech with a global oversight on its Free Cash Flow. The aggregation of FX flows within the IHB will also allow for larger notional amounts which may allow AspenTech to find counterparties for longer dated forward contracts.

Figure 3 Cylinder Option Payoff Structure vs Vanilla Forward

In addition, given the wider availability of financial instruments available, AspenTech can consider constructing zero cost strategies to further minimize FX transaction cost. An example of such a strategy is the Cylinder which is a low risk, fully hedged, option structure with limited upside participation. It provides a minimum and a maximum realizable rate for a currency pair, and provides full protection against the depreciation of the spot rate. It involves purchasing a Put option and selling a Call option for the same amount. The premium gained from the sale of the Call option is used to offset the cost of the Put Option. As an example, a company buying a put option at a strike of 1.1 and selling a call option at a strike of 1.13 is assured of both a minimum and maximum selling price for the currency pair. When compared to a vanilla Forward Contract, the client reduces transaction cost (net premium strategy), and also participates in limited upside, while participating in some potential downside (as the client is hedged at a rate lower than if he would have used a vanilla forward).

6. How, if at all, should Aspen’s recent transition from a private to a publicly-traded firm affect its approach to risk management?

Hedging foreign currency risk and the use of derivatives in general are a very delicate subject in publicly traded firm’s financial statements.

In fact, hedging can be an effective and reliable tool in financial planning, however, it is to be done very carefully. It is of the utmost importance to state that clarity is a fundamental characteristic of any properly written financial statement. While a measured and straightforward use of derivatives as risk management tools is appreciated by investors, esoteric derivative practices are often viewed with a questionable eye by stock analysts. Warren Buffet made all sorts of headlines with his iconic quote in Berkshire Hathaway’s 2002 Financial Statement where he described derivatives as “time bombs” and denounced his scepticism towards firms overly relying on such financial instruments.

In light of such observations, given that it is a publicly traded firm, AspenTech’s approach to risk management should be duly adjusted to the given circumstances. First of all, all practices concerning any form of derivatives should be regulated by a firm policy. Secondly, such firm policy should try to streamline hedging practices as much as possible and avoid any esoteric practices. Most publicly traded companies, to this day, still rely on standard vanilla products to hedge.

AspenTech’s public financial statements are susceptible to public scrutiny, furthermore, the company needs to prove to stockholders the reliability of their investment. Investors care about security first, as such, the company’s risk management objectives should be geared towards

providing such certainty as much as possible. After all, a firm should always be held accountable to its shareholders.

TO CONTINUE

Predictability

Forecasts

Accountability

Transparency

Meet Promises

More scrutiny of its financial statements would also mean more focus on its risk management policies. Furthermore, if the company is intending to raise funds in the form of debt or equity from public markets in different countries, it might also expose itself to FX risks. Dividends are also generally paid out in local currency, and being publicly traded internationally may allow it to adopt netting for dividend payments.

Investors also want certainty therefore reducing volatility would have benefits.(reducing cost of equity), stability of CF. reducing financial risk reduces beta which lowers cost of equity.

Reducing total risk rather than just financial risk.

Being a publicly traded firm would mean that they have more accountability towards shareholder. As such, their risk management program should not only seek to hedge their positions, but also look into implementing stress-testing procedures to ensure that the continuity of operations even during adverse market conditions.