This article appears as part of Private Equity International‘s December/January Emerging Markets special supplement.
It’s close to impossible to have a conversation with a limited partner about investing into emerging markets without the subject of currency volatility coming up.
In EMPEA’s latest LP survey, currency risk was the second most-cited factor likely to deter LPs from investing in emerging markets within the next two years, second only to political risk – and the two often go hand in hand.
Of those LPs that do invest in emerging markets, most ride out the currency risk unhedged on the understanding that the fund will move in different directions over its life, hoping that, on balance, the movement won’t be too material, says Michelle Davidson, managing partner at investment consultant TorreyCove.
But there are some steps investors can take to better manage the forex risk.
Pay the GP a little extra
Generally, unless the opportunity is very compelling, US LPs will only co-invest in US and European portfolio companies because they bear the currency risk.
GPs are not going to provide a currency hedge because they are not getting paid to do that, so the risk transfers to the LP, according to a partner at a law firm that works on emerging market fund documents.
Increasingly, however, some LPs are paying their GPs a nominal fee for hedging, even in no-fee no-carry co-investment structures. “GPs are better-positioned to time the hedges, since they are close to the cashflow and know when they are going to draw capital and when the company is ready for exit,” Davidson said.
Account for currency depreciation at the portfolio level
Siguler Guff, a fund of funds manager that has long operated in emerging markets, underwrites each transaction in local currency and typically assumes a 5-10 percent depreciation over the hold period, according to principal and portfolio manager of emerging market co-investments Shaun Khubchandani.
“GPs are better positioned to time the hedges, since they are close to the cashflow and know when they are going to draw capital and when the company is ready for exit”
The calculation is based on average historical depreciation rates and its sensitivity varies by country. For instance, for Brazil, the firm could assume a currency depreciation of between 15 and 20 percent, given that the economy is just emerging from one of its worst recessions, which severely impacted the Brazilian real. For India, the Indian rupee has typically depreciated by 3 percent annually; one of Siguler’s largest investments in the country was modelled at an entry price of 72 rupees to the dollar and an exit price of 80 rupees. If the rupee depreciates by less than the 11 percent built into the underwriting over the investment’s hold period, it would be an incremental upside to the base case return, Khubchandani says.
Consider diversification of the whole PE portfolio
If the GP’s portfolio is largely made up of companies that export their goods and services in dollars, the local currency risk is naturally hedged. However, if the LP’s overall private equity portfolio has a large exposure to the dollar, investing in funds whose portfolios comprise companies focused on local consumption – for instance in China and India – can be beneficial from a diversification standpoint. European and Middle Eastern LPs usually prefer investing in such funds, the law firm partner says.
Consider local currency distributions
While most emerging market funds are dollar-denominated and return distributions are in dollars, some managers are offering local currency distributions on dollar-denominated funds with a higher hurdle rate of between 12 and 14 percent to account for currency risk, according to the law firm partner.
Push for clever use of credit lines
Despite outperforming Brazilian public markets by at least 9 percentage points on an IRR basis, Brazil specialist Vinci Partners’ second fund lost double-digit IRR over the cycle because of currency exchange headwinds, partner and head of private equity Bruno Zaremba tells PEI. To address this, deals in Vinci Capital Partners III have been structured to reduce currency exchange impacts: cashflows are deferred so dollar-based investors deploy their capital closer to the exit.
“This gives comfort to our LPs,” Zaremba says.