Why should Private Equity managers focus on interest rates and currency risks?

The benign rate environment since the global financial crisis has compounded this: before 2022, some younger PE managers may never have experienced interest rates as high as even 1%. As a result, many managers viewed interest-rate hedging as an afterthought – if they concerned themselves with it at all. Those that did tended to do so with cheap out-of-the-money options.

With regards to foreign exchange (FX) rates, where risk presents at the corporate level it is often mitigated with a more formal hedging policy. However, at a fund level, the hedging of foreign currency assets on PE balance sheets has tended to be infrequent, owing to a greater tolerance for this ‘noise’ within expected PE returns and (by extension) greater uncertainty over future asset valuations in determining what notional value to hedge.

A changed world

Events since then have dramatically altered the interest-rate environment. After two years of sustained rate hikes by most G7 central banks, interest rates are elevated in most parts of the developed world. And the speed of that increase has been startling: in the UK and the US, interest rates went from 0.5% to 5% in just 18 months.

In this period of soaring interest rates, managers with even a light-touch but continuous approach to interest rate risk management have been massively rewarded, as several extreme tail risk events have combined to create an inflation and rates environment that would have been unimaginable at the end of the last decade.

Not surprisingly, we’ve seen much greater interest in rates hedging from PE over the past couple of years. We’ve had many conversations with financial directors and chief financial officers who have never implemented an interest rate hedge before – or at least not in their current positions.

An opportune moment?

Now, of course, investors are looking ahead to the turn of the rate cycle. With major central banks expected to start cutting rates this year, PE managers are weighing up volatile market rates, an inverted yield curve (where cash rates are higher than longer-term rates) and a typically elevated level of leverage that is moving higher as asset values are adjusted to reflect the greater cost of borrowing.

Most PE investors realise that rates are unlikely to fall back to near zero any time soon. They also face the uncertainty of what the new neutral rate will be once central banks start to cut them, and how long rates will stay there. That raises the question of whether now is a good time to hedge to ensure a degree of certainty in the years ahead. Recently, PE managers have been able to lock in rates that are up to 160 basis points below current rates for the next three years.

Also, PE managers are realising that depressed valuations mean that they need to hold their investments for longer. For that reason, interest rates have become more important – and with them, the need to hedge. For highly levered managers in particular, a longer-term hedging strategy can be a crucial precaution against volatile rates.

Foreign affairs

Along with the growing awareness of the risks implicit in leaving interest rates unhedged, a more challenging fundraising environment is leading alternative asset managers to look further afield for new investors. Here at Investec, we are seeing more enquiries from managers looking to accept commitments in other currencies to which they typically fundraise. Such foreign currency investors will often seek a hedged solution in which to invest into the fund.

As a general rule, managers of asset classes with more predictable and stable returns, such as credit, infrastructure and real estate, have a greater propensity to hedge foreign currency asset values within their portfolios. Typically, this is achieved using either a short-dated rolling contract strategy or aligning hedges to expected portfolio dispersals. That said, we are increasingly receiving requests from PE managers who are revisiting their FX policy while they review interest rate hedging, as they look to establish a more consistent approach going forward.

A fund-level focus

For reasons of efficiency, we are seeing increased enquiries about hedging interest rate risk at a parent fund level. Regulations have presented an obstacle to this due to a potential obligation on managers to cash collateralise interest-rate hedges. This can represent a headache for PE due to the administrative burden of moving money and the cost of liquidity. By contrast, hedging at the asset level has been relatively more straightforward since end-user exemptions have been provided by regulators.

But asset-based hedging can be less efficient overall, not least due to a quagmire of box-ticking and form-filling associated with anti-money laundering and ‘know your customer’ rules needed to hedge across multiple entities at asset level. This is another area where Investec provides support. We can help mitigate some of the headaches that come with hedging at a fund level by leveraging deep credit and structuring expertise in providing simple solutions. By effectively outsourcing some activities to us, funds can achieve their hedging needs without the complication that many assume is necessary.

Uncertainty ahead

As we start to navigate through 2024 conversations about the timing and extent of interest rate cuts are becoming far more prominent. Consensus is that ultra-low rates are likely behind us, but what is not clear is where the new neutral rate sits. PE utilised leverage to great effect when interest rates were close to zero. However, now that managers are accepting a more volatile forward-looking rate environment, they are also questioning their hedging policies with greater rigour. For some, this is entirely new ground, and for all it is taking on increased focus both when structuring deals and when speaking to limited partners.