What is trs in business?

Total return swap, or TRS (especially in Europe), or total rate of return swap, or TRORS, or Cash Settled Equity Swap is a financial contract that transfers both the credit risk and market risk of an underlying asset.

A swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. In total return swaps, the underlying asset, referred to as the reference asset, is usually an equity index, loans, or bonds. This is owned by the party receiving the set rate payment.

Total return swaps allow the party receiving the total return to gain exposure and benefit from a reference asset without actually having to own it. These swaps are popular with hedge funds because they get the benefit of a large exposure with a minimal cash outlay.[1]

In a total return swap, an investment bank could buy assets for a hedge fund, which is paid returns from the assets.[2] The hedge fund can thereby remain anonymous insofar as the investment bank is the owner.[2] If the value of the assets drop considerably, and the hedge fund is unable to provide more collateral on a margin call from the investment bank, the investment bank can sell the assets.[2]

High-cost borrowers who seek financing and leverage, such as hedge funds, are natural receivers in Total Return Swaps. Lower cost borrowers, with large balance sheets, are natural payers.

Less common, but related, are the partial return swap and the partial return reverse swap agreements, which usually involve 50% of the return, or some other specified amount. Reverse swaps involve the sale of the asset with the seller then buying the returns, usually on equities.

The TRORS allows one party (bank B) to derive the economic benefit of owning an asset without putting that asset on its balance sheet, and allows the other (bank A, which does retain that asset on its balance sheet) to buy protection against loss in its value.[3]

TRORS can be categorised as a type of credit derivative, although the product combines both market risk and credit risk, and so is not a pure credit derivative.

Hedge funds use total return swaps to obtain leverage on the reference assets: they can receive the return of the asset, typically from a bank (which has a funding cost advantage), without having to put out the cash to buy the asset. They usually post a smaller amount of collateral upfront, thus obtaining leverage.

Hedge funds (such as The Children's Investment Fund (TCI)) have attempted to use total return swaps to side-step public disclosure requirements enacted under the Williams Act. As discussed in CSX Corp. v. The Children's Investment Fund Management, TCI argued that it was not the beneficial owner of the shares referenced by its total return swaps and therefore the swaps did not require TCI to publicly disclose that it had acquired a stake of more than 5% in CSX. The United States District Court rejected this argument and enjoined TCI from further violations of Section 13(d) Securities Exchange Act and the SEC-Rule promulgated thereunder.[4]

Total return swaps are also very common in many structured finance transactions such as collateralized debt obligations (CDOs). CDO Issuers often enter TRS agreements as protection seller in order to leverage the returns for the structure's debt investors. By selling protection, the CDO gains exposure to the underlying asset(s) without having to put up capital to purchase the assets outright. The CDO gains the interest receivable on the reference asset(s) over the period while the counterparty mitigates their credit risk.

Executives, board members, the press, and investors regularly look at total returns to shareholders (TRS) as an important metric of value creation. Yet TRS, like any performance metric, is instructive only when users understand its components. Actual corporate performance, for example, is only part of the mix, as TRS is also heavily influenced by changes in investors’ expectations of future performance. Sophisticated managers know that a failure to grasp how the various components work together can generate unrealistic expectations among companies or their investors and even steer companies to pursue more growth or take on more risk—without any value creation.

Sadly, most traditional ways of understanding TRS are flawed. Many of them, for example, define TRS as the sum of the percentage change in earnings plus the percentage change in market expectations—as measured by the price-earnings ratio (P/E)—plus the dividend yield. This simplistically connects TRS with changes in earnings, as if all forms of earnings growth created value equally. Not so. Earnings growth creates more value when it is rooted in activities that generate high returns on capital—such as the discovery of new customer segments for a company’s products—than in activities with low returns on capital, such as many acquisitions when the goodwill paid is taken into account.

Traditional approaches also err when they relate TRS to dividend payments. Dividends do not create value. For example, if a company pays a higher dividend today by taking on more debt, that simply means that future dividends must be lower. If a company pays a higher dividend by forgoing attractive investment opportunities, that also reduces future dividends. Finally, the usual approaches fail to account for the impact of financial leverage: two companies that created underlying value equally well could generate very different TRS, simply because of the difference in debt-equity ratio and the resulting differences in risk.

A better approach to understanding TRS breaks up the metric into four fundamental parts: a company’s operating performance, its stock market valuation at the beginning of the measurement period, changes in stock market expectations about its performance, and its financial leverage. The analysis can further divide a company’s operating performance into the value from revenue growth net of the capital required to grow, from margin improvements, and from improved capital productivity.

Consider a hypothetical example using a traditional approach to gauging TRS (Exhibit 1). Company A has a 14.4 percent TRS based on 7 percent earnings growth, a 3 percent change in the company’s P/E (as a proxy for changed expectations), and a 4.4 percent dividend yield. When we apply a more fundamental breakdown of the elements of TRS into the parts described above, however, we see that the reinvestment required to achieve the 7 percent earnings growth consumed most of the earnings growth; the TRS stemming from it is actually only 1.4 percent.1 1. Required investments = 5.6 percent total returns to shareholders (TRS), ie, (107–100)/125. With 3 percent coming from a change in expectations, the remain-ing 10 percent is the TRS that results from the company’s value at the start of the period—its “zero growth” return, which represents the company’s TRS if it had no earnings growth and investors had no change in expectations.2 2. More precisely, the “zero growth” return equals the earnings yield—that is, the inverse of the earnings multiple.

Let’s now consider Company B, which is identical to Company A except for its debt financing (Exhibit 2). As a result, Company B generated higher TRS but did not create more value after adjusting for higher financial risk. The traditional decomposition approach fails to reflect this and suggests that Company B’s shareholders benefited from a higher dividend yield and a stronger increase in expectations. The fundamental decomposition clearly shows that at the business level, companies A and B have an identical TRS from zero-growth returns, growth, and changed expectations, when measured by the unlevered P/E multiple (enterprise value/earnings). The additional 3.6 percent TRS for Company B now shows up under TRS from capital structure, indicating that it is leverage-induced and not value creating.

Examples from various industries show how a more detailed, fundamental analysis can be illuminating. Let’s compare the TRS performance of the Dutch brewer Heineken and its Belgian–Brazilian competitor InBev. A traditional TRS decomposition suggests that InBev generated significantly higher annual shareholder returns over five years mainly because of its superior earnings growth (Exhibit 3). A deeper look with the new approach reveals more accurately where InBev made the difference.

Compared to Heineken, Interbrew (now InBev) was facing a bigger challenge in 2002 to generate strong TRS. Its valuation multiple already reflected higher investor expectations for future value creation, resulting in a zero-growth return three percentage points below that of Heineken.3 3. We call this the treadmill effect; see Richard F. C. Dobbs and Timothy M. Koller, “The expectations treadmill,” mckinseyquarterly.com, August 1998.

Over the subsequent five years, revenue growth was not an important factor for shareholder returns: InBev’s top-line annual growth of almost 24 percent did not create positive shareholder returns once capital expenditures and good-will paid were taken into consideration. Heineken actually generated higher shareholder returns from much lower revenue growth.4 4. Keeping all other factors constant, such as returns on capital, investor expectations, and capital structure.

InBev’s outperformance of Heineken in terms of TRS was driven by its superior improvements in return on capital over the period. It generated an impressive 34.6 percent shareholder return per annum by pushing its return on invested capital5 5. Return on invested capital (ROIC) adjusted for operating leases and excluding goodwill. (ROIC) from 14 percent in 2002 to an industry-leading 47 percent in 2007. Heineken, by contrast, saw its ROIC decline over the same period to 17 percent, from 24 percent, thereby losing around 5 percent in TRS.6 6. Again, keeping all other factors constant.

Finally, InBev’s TRS was negatively impacted by 14.4 percent as its valuation multiple declined from 2002 to 2007, reflecting lower stock market expectations that InBev would further improve its value creation. By contrast, the market increased its expectations for Heineken to improve its performance and growth after 2007, driving up TRS by 5.3 percent.

The analysis shows that InBev generated its shareholder returns through very strong operating improvements, not top-line growth. In contrast, most of Heineken’s TRS was due to a high zero-growth return and increased investor expectations. The company’s business growth and operating performance had little impact.

A more detailed decomposition of TRS can also offer insights into the drivers of shareholder returns in a sector as a whole. Take, for example, the stock market performance of the largest 25 European banks by market capitalization from 2002 to 2007 (Exhibit 4). These institutions are a good proxy for the entire European banking sector, as they represent around 80 percent of its assets. In aggregate, they have delivered a 15 percent TRS per annum over the last five years. A traditional TRS decomposition indicates that these returns largely reflect growth, suggesting that it is critical and that banks should focus on growth strategies.

Once the analysis takes investment requirements and acquisition goodwill into account, however, it turns out that for the sample as a whole, growth didn’t drive shareholder returns. In reality, since 2002 better returns on capital have driven the creation of value in European banks, whose aggregate return on equity (ROE) increased to 23 percent, from 16 percent. This insight has several implications for managers. Going forward, value creation in the sector probably won’t come again from performance improvements, given the record profit levels of recent years. In fact, falling expectations show that investors believe that profitability will decline. Yet finding value-creating growth might be as big a challenge, since banks on average did not manage to generate TRS from growth in the recent past, when profitability was peaking. This leaves banks with a difficult problem: where to find attractive returns for their shareholders in the future.

A total return swap is a swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains.