This article is sponsored by Monex Europe.
Why is forex management moving up the agenda for private equity fund managers?
Tom Farrow: We have seen record levels of private equity M&A activity in the past few years while experiencing significant levels of currency volatility during this period. That combination draws forex management into the spotlight for managers that have ever-increasing exposure to international funds at the LP level and generally more exposure to emerging markets’ currencies.
Daniel Jack: Volatility is the biggest issue for managers, and they are being pushed harder by LPs to manage that volatility and the risks associated with it more effectively. We have seen so many black swan events over the last decade or so, causing dramatic swings in currencies to the point that investors have had returns eroded or, worse, ended up making losses. That has forced managers to look at forex volatility in a new light.
Where do firms tend to be most exposed to FX risk, and why?
TF: I would generally consider four elements to private equity FX exposure. First would be the initial exposure in the form of a commitment and the subsequent currency element of an investment; second is the translational value of the underlying investment; third is the yield generated by the investment; and fourth is the exit and the distributions that could occur as a result. There are multiple points where these four exposures may arise depending on which asset class the fund is investing in.
DJ: At portfolio level, a firm that is investing in assets outside the base currency of the fund creates a forex exposure for the fund itself from the moment it enters into those investments. Funds that run share classes in different currencies to the base currency of the fund are also exposed to risk. 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 would you describe GPs’ current approach to FX management?
TF: Due to the recent volatility we have experienced, ensuring that forex does not become a drag on performance and liquidity has become a hot topic. We continue to see the more traditional hedging of capital calls, exits, balance sheets and management fees. Additionally, in certain asset classes, we also see yield hedging, and more opportunistic trades that can present themselves when we see moves like we have recently seen in the sterling-dollar exchange rate.
DJ: GPs are looking to manage this much more proactively. Managers are looking for the most cost-effective and economic way of removing currency risk and are typically doing passive hedging rather than opportunistic hedging. They are looking to remove downside risk at the lowest possible cost. In most cases, that means looking for a partner who will provide facilities that do not require them to tie up punitive amounts of capital, and trading strategies that do not create huge numbers of cash events over the life cycle of the investment.
What is the attitude of LPs to this issue?
TF: LPs are paying much more attention to this. At a time of significant volatility among currencies, LPs generally wish to alleviate currency risk as part of their investment thesis. They have become more sensitive to the forex policy of funds and have become acutely aware of the potential impact of FX moves on the underlying performance of funds.
DJ: If any part of a manager’s investment strategy is to invest outside of the base currency of the fund, as a minimum they are being asked by LPs to demonstrate that they have thought about FX strategy and, in some cases, manage FX risk over the life of the fund. Many LPs have been burnt by volatility in the past, and are quite rightly asking questions to make sure their returns are not going to be affected by factors outside the GP’s control. Ultimately, it comes down to whether macroeconomic exposure is a factor in the investment decision, both for the GP and LPs.
What does a sophisticated hedging strategy look like?
TF: Just because a strategy is sophisticated does not necessarily translate to the optimal solution. A hedging strategy should include a blend of products that are dynamic in a volatile market, therefore reducing the risk of forex having a negative impact on the underlying investment.
A strategy should give a manager protection by reducing the risk of forex negatively impacting the fund or having a drag on performance. What upside a fund wishes to see thereafter will depend on the manager’s attitude to risk and its ability to implement both protection and solutions to capture potential upside, which will be dictated by the visibility it has over underlying investments and performance.
DJ: You can have a very dynamic hedging strategy, recalculating the NAV or the change in the share classes multiple times daily and adjusting the hedge accordingly. Clearly, the more transactions you enter into, the higher the cost. This is because of transactional costs incurred, and the greater administrative burden. Alternatively, you can take a more passive approach. It’s our job to work out the best fit for the manager and its LPs, and what is going to be the most cost-effective way of hedging risk to get the best outcome.
What are the key considerations around the use of interest rate swaps and international bank accounts?
TF: With interest rate swaps, as with the consideration around any form of hedging, it is about creating a level of certainty in factors that have traditionally been uncertain and can impact the underlying performance of an investment. There is currently considerable uncertainty around interest rates and that is the main reason we are seeing elevated focus in this area.
DJ: International bank accounts are seeing a lot of growth and demand from our client base, primarily because banks are becoming less willing to provide those services. Even if managers are just collecting funds from LPs, making acquisitions and then distributions, they need an account to do that. 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.
How do you expect FX management to evolve in PE, and how can outsourcing help managers address FX challenges?
TF: We anticipate a substantial increase in proactive forex management in private equity in the coming years. I expect to see an increase in the outsourcing of this function as the industry focuses on more bespoke solutions built by companies with proven track records.
DJ: Private equity has always been run as leanly as possible because any additional costs incurred drag on yield and performance. Partnering with specialists can allow managers to meet the expectations of LPs from a regulatory perspective, a prudential capital perspective and a reputational perspective. The best managers understand where their weaknesses are and partner with people who can plug those gaps.