The global financial crisis has changed the way the world looks at risk, and the twists and turns in the currency market have certainly brought foreign exchange (FX) risk management higher up the agenda for many funds and businesses alike. Historically, private equity firms may have viewed FX moves as rounding errors. But major swings in the crisis, and the continued high volatility since, have fundamentally changed their mindsets.
Increased FX volatility is one of the reasons behind the large swings in fund returns lately – and, perhaps even more importantly, one of the reasons we have started to see large disparities in performance. For example, in 2007/08, with the sterling/ US dollar exchange rate (GBP/USD) at 27-year highs, and 20 percent above purchasing power parity (PPP), some USD funds decided to hedge their exit risk on UK assets, locking in rates above 2.00. In the six months post-September 2008, GBP/USD then fell 32.5 percent to 1.35; it has subsequently averaged 1.57 across 2009-12. (Graph 1)
How would this affect returns? Well, to give an example: if two USD funds had held GBP1 billion in identical UK assets over that period, but only one had hedged, the ultimate USD returns to the fund and its limited partners on exit would have been USD2.00 billion vs. USD1.57 billion.
Depending on the proportion of UK assets as a percentage of the fund, this could result in sizeable differences in the manager’s internal rate of return (IRR). Indeed, in some cases, FX hedging will have been the difference between a positive and negative return across this period.
Such disparities have naturally focused both fund managers and investors’ attention – as they not only impact managers’ immediate performance returns, but also potential prospects for raising future funds.
What to hedge, and how to do it
With this sharpened focus, clients are increasingly looking at how they can better manage FX risk and what products to use. Indeed, 2011 was Barclays’ most active year to date, with hedging activity more than doubling.
Some funds increased their FX cover; but perhaps more interestingly, many funds that had never previously hedged introduced new hedging programmes.
These hedges included a myriad of different currency pairs, although hedging AUD, CHF and JPY assets was particularly prevalent in the first half of the year, given these currencies were trading at extremes versus long term averages and PPP (i.e. the theoretic fair value where one would expect the currency to trade over the long term).
Indeed, at certain points these currencies were trading up to 40 percent above fair value. This meant USD, EUR and GBP denominated funds that had invested in assets in these currencies were often sitting on significant FX gains versus when the assets were acquired – and therefore chose to lock those gains in by hedging. This made economic sense, since over the long term currencies typically trend back towards their PPP.
In the latter part of the year, the EUR understandably became the hot hedging topic, as the European debt storm intensified.
Given the diversity of funds, the chosen hedging solution will vary from fund to fund, but a few standard conversations typically arise. In framing the policy, it is first of all necessary to quantify how much risk is inherent in a business, and how much of this the business wants to hedge. Typically, clients use value-at-risk (‘VaR’) analysis to work out a probability-weighted estimate of how much cash is at risk over a given timeframe, and therefore how much hedging to undertake.
The selected structural solution might then be driven by:
• Market levels/ conditions – e.g. current rates relative to PPP
• Volatility/ the relative cost of using option strategies
• Hedge tenor (i.e. the length of hedge)
• Preference for solutions that will achieve hedge accounting
• Ability of the fund to sustain mark-to-market movements/ to post collateral – e.g. infrastructure or real estate funds may have interim dividends or rental flows to meet cash calls, whereas a pure buyout fund typically will not
• Availability of sufficient credit lines for preferred hedging solution – e.g. longer-dated hedges are generally more credit intensive
In order to speed up the decision-making process, we have seen a number of clients create FX/treasury committees – whose role is to react to market events, and take advantage of opportunities outside of any regular hedging review process. These committees often have the authority to commit to hedges, within agreed parameters, without the need to seek further approvals.
With the sovereign debt crisis still ongoing in Europe, funds that constantly evaluate the risks they face – in the widest sense – and seek access to a range of solutions and strategies to combat these risks, will be better placed to navigate the current economic environment.
Resolving the crisis will not be straightforward, of course, and that will continue to have an impact on the EUR over the coming year. In a recent report, Barclays Capital forecast the EUR to trade towards 1.2000 over the coming year, with the EUR/USD having formed a classic ‘head and shoulders’ pattern, which would suggest an initial target of 1.2530 and potential longer term target of 1.1250.
A ‘head and shoulders’ takes its name from the pattern that it graphically forms, with a left shoulder, head and right shoulder, as shown by the three circles on the (Figure 2). When the neck of this structure is broken, as it was at the end of last year, this is seen as a strong technical bearish signal. To neutralise this bearish sentiment, EUR/USD would need to move back above 1.3400 territory.
Beyond the EUR, given the divergent world economic data and increasingly mixed central bank policy responses, FX volatility looks set to remain high across all currencies in 2012. So it will become an increasingly hot topic for private equity managers.
Indeed, such an outlook provides a conundrum for funds. For example, with new EUR-denominated fundraisings, some USD limited partners are now actively asking: “What is the hedging policy”. They like the strategy of the fund and they like the general partners –but often, they will only commit if they are offered some protection against returns being impacted by currency effects. For instance, funds may offer overlay FX hedging programmes, which aim to neutralise any currency impact and therefore return the same IRR to both EUR- and USD-denominated investors.
Given this sea change in investors’ expectations and the continuing volatility in global FX markets, finding the right risk management strategy is crucial. But managing FX need not be complicated – and, once identified and understood, it can even give funds a competitive edge.
Philip Bowkley is managing director, Funds and Asset Managers, and Andrew Brock vice president, Risk Solutions, at Barclays