02 Apr 2019
How are funds responding to macro risk?
Private equity funds are no strangers to managing risk. However, Brexit, trade wars and the threat of an economic downturn have meant that funds are having to be increasingly alert to macro risks, and take steps to mitigate them.
In March, Investec co-hosted a breakfast roundtable event with Real Deals – we were joined by Michael Slane, head of Investec Fund Solutions, Investec economist Ryan Djajasaputra and leaders from a range of funds and advisors. The full discussion was published in the April 4 issue of Real Deals, but as a summary, here are some of our key takeouts:
Approaches to hedging vary
There is significant variation in private equity: some funds have a carefully-considered hedging policy in place while others might adopt full transparency with investors to allow them to make the call on whether to hedge. Some funds are able to time their exits with such control that they reduce the need for hedging: whatever the approach, market participants are certainly paying more attention to macro risk.
There are huge challenges to currency risk management in emerging markets – and novel approaches
We heard the example of LatAm managers for whom returns can be wiped out altogether after switching back to US dollars. Because hedging is so expensive for these currencies, some funds have spread out deployment carefully to ensure that if they are hit in a down cycle, they can at least average this out over the investment period.
We have combined our understanding of fund credit risk with our trading capabilities to offer hedging products tailored to the space. This means we don’t have to ask for cash collateral, which is the biggest cost in fund hedging.
Cookie-cutter products don’t work for funds
Funds have uncertainty around exit, and hold periods can often be longer than anticipated; for a hedging solution to work for funds it must be efficient and flexible. Investec’s Michael Slane explained: “We have combined our understanding of fund credit risk with our trading capabilities to offer hedging products tailored to the space. This means we don’t have to ask for cash collateral, which is the biggest cost in fund hedging. We can also allow managers to move delivery date without any cash settlement.”
Hedging is on the rise
Investec recently surveyed almost 300 managers as part of our latest GP Trends survey. That showed that 40 per cent of firms are now hedging and that percentage is increasing year on year.
It starts with the big funds but moves down through the market for a number of reasons.
Banks develop products in response to what the big funds want, that makes hedging easier and more flexible. LPs see that their big funds are hedging efficiently and start to talk to their other GPs about it too. Then there are factors such as Brexit, product development, changing LP sentiment, and macro events are all having an effect. We see it in our trading figures too. Our primary fund trading volumes are up 67 per cent year on year.
Pressure on returns means funds can’t take a risk on currency
The cost of a mismatched currency book on fund performance can be up to around 300bps. 300bps when funds were doing 30 per cent IRR is no big deal. But with returns sinking into the teens and low 20s, that is a significant hit.