Private equity must stop ignoring currency risk

23 Nov 2018

Joe McKenna

Fund Solutions

Private equity funds are leaving themselves exposed to FX risk and, despite warning signs, continue without a dedicated strategy.

Hedging currency exposure currently polarises the private equity (PE) industry. There are houses for which hedging currency is integral. These firms might have a carefully considered policy in place which they re-evaluate on an annual basis.
 
But equally we see experienced managers, with significant foreign currency exposure, who have given FX policy very little consideration at all. Oddly, in the corporate world, FX hedging is seen as essential for protecting margins if the business has international dealings, but the message hasn’t travelled up the chain.

PE funds that operate outside their functional currency could be exposed to FX risk in a number of ways.

Acquisition cost

Asset value

Management fees

Investors

Acquisition cost

Acquisition cost

When buying a foreign currency asset, funds will have to arrange an exchange upfront, which may create its own risk if FX movements change the investment amount.

 

PE Funds

Asset value

Asset value

Bigger still is the impact currency volatility can have during the hold period, with many examples of funds experiencing currency depreciation which mitigates, or totally erodes, hard-won investment gains.

PE Funds

Management fees

Management fees

Receiving management fees in a non-base currency makes income susceptible to FX movements. For example, if you were an euro-denominated fund with a cost base in sterling.

PE Funds

Investors

Investors

Funds may want to create a broader investor which could involve offering feeder funds or share class hedging to a diversified client base in multiple jurisdictions. 

PE Funds
A series of market-moving events in recent years have placed the importance of having a FX strategy firmly back in the spotlight. Sterling has been a hot topic since it lost 20% of its value in the four months following the Brexit referendum decision and it’s not uncommon to see daily swings of over 1% as we approach the March 2019 Brexit deadline.
 
And this year, the Turkish lira lost 94% of its value against the US dollar. This was after Trump doubled an existing trade tariff following Turkey’s refusal to release a US prisoner because of his apparent involvement in the attempted military coup.
 
It would be easy to think that these are one-off events, that geopolitical uncertainty and currency volatility will calm down. But, in fact, foreign exchange volatility is a constant.
 
Analysis of EUR/USD, the most commonly traded currency pair in the world, shows annual positive and negative swings of 20-30% over the past 18 years.
If you consider that between 2010 and 2015, median IRRs in the PE world remained flat at around 14%, you can see that the potential implications of being caught unhedged are significant, even if it’s only for a small percentage of your portfolio.  
 

So why is private equity not hedging?

 

Given the scale of the risk involved, it can be challenging to understand why the PE world has not embraced FX hedging more fully. However, through talking to the industry, we realised it wasn’t the process of hedging that was off-putting. It was the associated capital requirements that were providing the obstacles. 
 
Typically, placing a hedge can involve a significant drain on capital from a collateral perspective because the GP will usually have to place cash security against their position, creating a cash drag.  

Given the uncertain and illiquid nature of private equity, it’s typical that a fund will have to roll hedges and change the delivery date, either moving the contract expiry further out or bringing it in. But rolling positions traditionally has not been that straightforward.
 
There is also the potential for this exercise to create a cash drag. For example, this would happen if that contract has a negative mark-to-market – that is, if it would create a loss if sold back into the spot market. At the time of rolling the deal, the fund would have to cough up more capital to settle that paper mark to market loss, and re-hedge at the new improved rate. This is economically circular, but a very real cash drag for the fund.
 
For a fund, it’s always important to be efficient with capital. The expected returns on capital from investors mean that locking cash up in FX hedging tools, earning no return, is a cost too far. Not to mention the administrative burden of having to find spare cash if your FX counterparty suddenly makes a margin call at short notice.
 

Hedging for private equity: A flexible solution

 
Understanding the capital constraints that private equity is facing, we have sought to develop a more flexible offering, catering to the industry’s needs. 
 
  • Uncollateralised hedging lines: The first step is having the credit appetite to be able to offer uncollateralised hedging lines. The key here is that we give headroom on a hedging facility so that we don’t need to ask for capital upfront to book the contract. If those positions come out of the money and have a negative mark to market, we seek to provide adequate threshold to remove, or at least reduce, the chance of calling for variation margin. For many funds, our unsecured appetite is adequate. For others with larger requirements, this could mean a secured line, with security against LP commitments, maybe the NAV of the underlying portfolio, or future distributions from the fund.
 
  • Historic rate rolls: We understand things can change and you may need to change the settlement date of a hedge.  In certain circumstances, when deemed appropriate, Investec may be able to amend the maturity dates on hedges without the negative cash flow implications.  If the situation is right, we can achieve this by consolidating the original hedge into the new hedge rate and rolling the deal to the new maturity date.  A subtle, but crucial advantage our clients have.

A spate of seismic geopolitical events may have put currency volatility in the headlines, but FX risk will never go away. As IRRs continue to be constrained by an increasingly competitive market and high valuations, it is crucial that private equity protects its returns from unpredictable currency fluctuations. 
 
We understand that the efficient pricing, flexibility and the preservation of free capital is imperative and so we continually seek to evolve our hedging products to meet the industry’s needs. By providing uncollateralised hedges and the ability to roll those hedges in a simple and cost-effective way, we believe more managers will appreciate that the time has come to stop ignoring currency risk.

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The opinions and views expressed in this article are for information purposes only and are subject to change without notice. They should not be viewed as recommendations or investment, legal, tax, accounting or other embarking on any course of action.