As private equity, venture capital, real estate and debt funds increasingly look across borders for new investments, efficiently hedging currency risk is becoming more and more necessary. But many firms, especially in PE, have dutifully avoided the topic, perhaps relying on the old wisdom that currencies mean-revert over long time periods, rendering hedging long-term investments like PE a more or less irrelevant “win some, lose some” game.
But Deaglo, a cross-border advisory firm specialising in FX solutions for institutional investors, investment managers, multinational corporations and private clients, is hoping to convince private fund CFOs that not only is hedging necessary, it’s easier, more transparent and more value-add for both funds and investors than ever before.
The firm is industry and strategy agnostic, and has clients with a wide range of AUM, says Ashley Groves, Deaglo’s founder and former head of institutional clients for AFEX, a global non-bank foreign payments solutions provider. Indeed, making FX hedging cheaper and more flexible so more firms can readily access it is a big part of Deaglo’s aim. The firm offers access to 150-plus currencies, as well as bespoke baskets of currencies that can mitigate the risk of single-currency exposure – or even mimic currencies so illiquid they can’t traditionally be hedged, like the highly-volatile Argentinian peso, or only hedged expensively.
“FX is the proverbial buck. It gets passed from pillar to post,” said Groves. Some of the big players have teams dedicated to it, he says, but many smaller firms have either avoided the issue, are brand new to the idea of it as they enter new markets or place their hedges and don’t think about them again for years. CFOs of funds with decades of expertise in, for example, US residential real estate might diversify into Canadian or European real estate, Groves says. Concentrated on the similarity of asset fundamentals, they often simply don’t think of the currency risk implications as a priority.
“Many people just say, ‘We don’t hedge. We don’t need to hedge.’ But when I ask them why, they can’t actually tell me,” Groves said.
In part, the aversion to hedging is due to fear of increased complexity and operational cost. But Groves says his operation makes some fundamental adjustments to the traditional currency solutions market. “We’re providing a solution to help these firms that are growing internationally and looking at more diverse opportunities overseas, no matter where they go, to treat them like domestic transactions. FX shouldn’t complicate deals,” said Groves.
“We want to empower CFOs to manage this risk efficiently, saving them a ton of money in the process, but we also want to highlight that it’s their responsibility to investors to do just that,” he adds.
Win some, lose some mentality
The thinking that, over the long term, hedging is a crap shoot given currencies’ long-term mean reversion tendencies, causes many CFOs to take the view that, in not hedging, it all averages out over time, according to Groves. It also means that many firms that do hedge focus primarily on the exit period, often a matter of months, when suddenly asset value becomes all-important. But that’s misguided, he said.
“Adding a sound FX risk management strategy is absolutely key to stabilising profit at every level,” he said. LPs need to know that it’s the funds making the profits (or losses), not currency moves. And portfolio company foreign cashflows should be analysed heavily, as their revenues will dictate the end-value of the investment.
Stabilising profits can of course detract from them, but that’s a conversation funds should have with their FX providers, he added. And with increased strategic optionality and pricing transparency, there’s no reason not to.
“It’s been done the same way for the last 100 years,” Groves said. Managers go to their relationship bank, and the bank provides all the services they need, from subscription credit lines to leveraged loans to FX. But, firstly, banks tend to treat every transaction as a new entity, meaning a fund has to set up a new account for every transaction it hedges. And pricing can be opaque, with some banks outsourcing the job. In that case, “without adding a third counter-party to the transaction, you’re not necessarily going to know the pricing they’re getting you.”
The pricing that banks provide will reflect their risk appetite and, among other things, the cost of regulatory capital. Many bank activities perceived to be risky have been hamstrung in that regard by post-crisis regulations like Basel III and Dodd-Frank. Take a new fund, newly in debt, operating in a risky market. “Would their bank give them a $100 million facility?” Groves asks. “Yes, but at what costs? Who’s monitoring the price that bank is going to give them? If they’re taking that risk you can best believe they’re going to be making their money somewhere.”
Smaller firms, from mid-tier down, also often have to put up large deposits to place hedges with their banks. Groves says some of Deaglo’s service providers are willing to post collateral on behalf of its clients with banks, with the service provider and Deaglo doing the necessary due diligence with banks, freeing up the end client. Groves said that in some cases, Deaglo can free up to 10 to 20 percent of a client’s collateral that would be posted for hedges, rendering hedging cheaper and more widely available to different-sized firms.
“Not everyone qualifies for 0 percent collateral, we don’t give these facilities out to everyone,” he qualifies. But it’s just part of the way Deaglo plans to make hedging cheaper. “There are a number of ways to reduce cost: collateral, execution fees and just reevaluating your strategy, if you have one.”
To that end, Deaglo offers a portfolio hedge optimisation tool that uses its efficiency frontier analysis to analyse a given firm’s recent transactions to get lower hedging costs. The firm also offers hedging simulations that use a “first of its kind” Monte Carlo analysis for stress testing hedging strategies against future volatility, in order to select the best hedging products.
It also advises on overall hedging strategies. “We’ve worked with a number of firms now to hedge deployment” of capital, Groves says. “For example, if a firm is working on a waterfall deployment schedule for a big project, or buying up a piece of the debt over a period of time, they’ll have a value to deploy over that time in a given currency. What’s the value of that dollar or euro tomorrow, or six or 12 months from now, when they expect to be fully deployed?”
Deaglo can hedge that unknown, and as the firm draws down on the hedge, it will add a proportional hedge to the other side. “So you can offset the cost of those hedges by the gains you’re making on the opposite end,” Groves said. “I’ve spoken to a number of firms about this and they weren’t doing it.”