By Tom Farrow, Group Director of Trading, Monex Europe
With ongoing volatility posing an ever-substantial threat to returns – and potentially even leaving investors facing losses – currency risk is concentrating minds across the private equity market.
LPs are increasingly pushing GPs to mitigate currency risk as part of their investment thesis, with many asking the latter to show they have a considered forex strategy in place, and in some cases, how they are planning to manage it over the lifetime of the fund.
GPs for their part are also looking to manage forex risk more proactively and seeking out the most cost-effective and economic ways to do so. To some extent, it is the price of success – the more the industry hits record levels of M&A, the more the risk of exposure.
The private equity forex risk
Forex risk is embedded across the investment process – from the initial commitment and currency element of the investment, all the way through to the exit of the investment, as well as any subsequent distributions.
Furthermore, investors must consider the asset class and the currency itself. At a portfolio level, if a firm is investing in assets outside the base currency of the fund, it creates a forex risk – just as it does when it runs share classes in different currencies to the base currency of the fund. The exposure is linked to who the underlying investors are, the types of investors, the size of the fund, the strategy, and the attitude of the manager.
How private equity is addressing forex risk
We continue to see the more traditional hedging of capital calls, realisations, balance sheet/assets and management fees across the industry. In certain asset classes, we are also witnessing yield hedging and the more opportunistic trades that present themselves when there are moves such as the recent sterling-dollar exchange rate swings.
Typically, passive hedging rather than opportunistic hedging is more cost-effective, as it looks to remove downside risk at the lowest possible cost. This often means looking for a partner who can provide facilities that do not require GPs to tie up punitive amounts of capital and offer trading strategies that do not create huge numbers of cash events over the life cycle of the investment.
It is worth noting that a highly sophisticated strategy does not necessarily translate into the optimal solution. A hedging strategy should include a blend of products that can respond quickly to a volatile market to reduce the risk of forex having a negative impact on the underlying investment.
For example, a dynamic hedging strategy can be designed to recalculate the NAV or the change in the share classes multiple times daily and adjust the hedge accordingly. There are strategies such as interest rate swaps which create a level of certainty in factors that have traditionally been uncertain, and can impact the underlying performance of an investment.
Given that more transactions drive up costs, it’s foreign exchange providers’ job to determine the most cost-effective way of hedging risk to secure the best outcome for the manager and its LPs.
What does the future hold?
There is currently considerable uncertainty around interest rates, and that is driving an elevated focus in interest rate swap among GPs.
We are also seeing more demand for international bank accounts, primarily because banks have become less willing to provide those services. Even if managers are just collecting funds from LPs, making acquisitions and distributions on a cross-border basis, they need an account to do that. However, the costs of maintaining accounts are often prohibitive, so we now offer digital solutions that meet GP and LP expectations and demonstrate high levels of corporate governance.
LPs expect their GP partners to adopt a best practice approach across their entire business model. As such, we are likely to see more private equity firms adopt a proactive forex management in the coming years to reduce costs and improve efficiencies. Private equity has always been run as leanly as possible because any additional costs act as a drag on yield and performance. With many GPs increasing the size and complexity of their global footprint, the demand for expert forex advice will continue to grow.
