A series of major geopolitical shocks ranging from Brexit to the election of Donald Trump have placed currency risk in the spotlight over the past few years. The reality is that currency volatility is a perennial challenge - one that many private equity firms have historically chosen to ignore.
But in a returns-constrained environment, IRR-driven managers can be hit hard by even moderate currency movement, let alone major swings caused by unexpected global events.
As a result of this heightened interest, the 2018 Investec Hedging and Risk Management Masterclass focused on exploring the intricacies of how private equity can and should manage FX exposure.
“Even when private equity returns were at their highest in the early nineties, a shift of 20 or 30 per cent that we routinely see in the most traded currency pair, EUR/USD, would have a material impact on IRRs,” said Joe McKenna of Investec. “With returns coming down, coupled with heightened volatility, it is time to give currency risk management the focus it deserves.”
“Two per cent of managers claim that FX risk is of no importance”
Indeed, when considering the alternative investment industry as a whole, according to a survey conducted by risk management adviser Validus last year, only two per cent of managers claimed that FX risk is of no importance, down from 26 per cent 12 months earlier. 75 per cent are hedging currency exposure in some form, meanwhile, 50 per cent have developed policy-driven FX programmes at a fund level, according to Validus partner Haakon Blakstad.
“That is a big change we are seeing,” he said. “Instead of deal guys managing risk, ad hoc, it is becoming more centralised.”
Private equity firms hedge, fundamentally, to manage risk. In most cases, they are hedging out of a risk they don’t want. “It is incredibly rare that a private equity firm invests in a currency because that currency is attractive. It’s the market they are interested in,” Blakstad added. “If you don’t expect a return from the risk you are taking, you don’t want that risk.”
The hedging edge
Limited partners (LPs) are driving hedging activity too, with growing interest in hedged currency feeder funds. However, private equity managers are also increasingly hedging in order to gain a competitive advantage. “Prices are high and return profiles are compressed,” said Blakstad.
‘Managers are viewing a robust risk management programme as a way to gain an edge.’
Private equity managers are primarily hedging funding risk by locking in the amount of funding required to buy an asset. They are also hedging investment risk.
“That investment risk can either be direct, when a firm is buying an asset in a different currency,” Blakstad explained, “or it can be indirect. A Euro-denominated fund may buy a UK asset, but that asset may have 90 per cent of its revenues in dollars. The manager needs to ask what that risk means for the valuation of the company.”
Private equity managers also have a think carefully about where in the fund structure they should hedge, according to Thomas Smith of law firm Debevoise & Plimpton. The first option, is to effect FX hedging within the fund’s capital call financing facility.
The hedging counterparty benefits by being able to share security with the subscription line lender. From the fund’s perspective, this may afford them better pricing. It does, however, prevent the manager from working with other counterparties. “That lender may also want to cap the amount of FX hedging exposure within the subscription line,” Smith explained.
Alternatively, hedging can take place at the fund level, but outside the capital call facility. This gives managers access to the full market but can still have an impact on fund finance as the lender will take into account any hedging exposure within the financial covenant in the fund’s capital call facility.
Finally, some managers structure hedging below the fund, in a special purpose vehicle. This raises questions over where credit support comes from and the counterparty may require a guarantee from the fund.
Pressure on returns is so high that any capital being pulled away from investments is not being used efficiently
Avoiding cash drag
The majority of private equity firms that hedge use forward contracts or swaps. But, the requirement to have cash available to meet margin calls, sometimes at short notice, has often proved too onerous for many.
“Pressure on returns is so high that any capital being pulled away from investments is not being used efficiently,” said McKenna. “We work a lot on uncollateralised hedging, where we establish a credit threshold up to which the manager doesn’t have to place margin. That means there is a reduced or even no drain on capital.”
It is also possible that a fund will have to roll hedges and change the settlement date. Rolling positions can create additional complexity and create further cash drag. Subject to the market rate at the time of rolling, the manager would typically have to pay out additional capital before the maturity date can be changed if the contract has a negative mark-to-market.
“In certain circumstances, when deemed appropriate, Investec may be able to amend the maturity dates on hedges without these cash flow implications” McKenna explained. “if the situation is right we can do this by consolidating the original hedge into the new hedge rate, rolling the deal to the new maturity date.”