Cash pooling: UK company as the cash pool header
In theory, if the “business” of the cash pool header is to take in short term deposits and lend money out short term, the spread between the interest rates is the return that they make, from which they deduct the expenses incurred in administering the cash pool (assuming an exact match of deposits and borrowings). However, the reality is that the cash pool header may also take the risk of:
- Holding excess deposits, such that it needs to put money on overnight deposit externally. The return on these external deposits may be less than the return which needs to be paid to the cash pool depositor, and there may also be counterparty risk.
- Having a net funding balance owed by borrowers, which means that the cash pool header needs to fund the amounts borrowed in excess of the amounts deposited, via external borrowing, such as a revolving credit facility, commercial paper etc. Depending on the external borrowing rate, this could erode the margin of the cash pool header. Alternatively, the header could consider demanding repayment from borrowers.
- Not being able to return the deposited money “on demand” if borrowers are unable to repay their debts on demand or funds have been invested over a range of maturities. If the cash pool is being used for longer term borrowing in substance, the reality may be that the cash pool header would not be able to return funds to the depositors by requesting repayment on demand from the borrowers. Given this liquidity risk, consider to what extent the cash pool header is capitalised - if it has an equity capital buffer or has access to other liquidity on demand, this risk is obviously reduced, although the cash pool header still requires compensation for managing and funding this risk. The risk may also be reduced by the existence of cross-guarantees in place, depending on the specific terms and conditions of these guarantees.
The cash pool header’s margin therefore needs to ensure that its assumption of any risks, including those listed above, is being rewarded on an arm’s length basis, as opposed to automatically seeing its role as solely administrative. A full functional analysis of the cash pooling arrangement should be prepared and reviewed, to consider whether the cash pool header is receiving an arm’s length return, given the particular facts and circumstances of the arrangements.