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What, when and how private equity can hedge FX to protect fees and returns

Recent volatility in the forex market looks set to remain as geopolitical shocks become almost commonplace, and with this, private equity firms are increasingly choosing to hedge currency risk as a means of protecting fees and returns.

However, the industry’s relative inexperience when it comes to FX hedging, means many CFOs and operational professionals are unsure as to what should be hedged, when to execute and how to appropriately cover the associated costs.

But, as the industry matures and funds attract an increasingly multi-national profile of investors, as well as execute cross boarder deals, FX strategies are creeping up the agenda. Kieran Cleere, Director of SVB’s Market Risk Solutions team noted, “The focus on FX strategy has a lot to do with the increased headwinds over the last three years. Events such as Brexit and the ongoing US trade wars have really put FX on the map. This rise in volatility has forced private equity firms to take FX seriously into consideration.”

Geopolitical events of recent years have seen intraday FX volatility of up to 10%. According to Preqin’s latest 2019 Q3 performance report. The average 10 year internal rate of return for private equity is less than 15% - meaning in just one day, a negative currency swing has the potential to wipe out almost the entirety of a fund’s returns. “Increasingly, firms are looking at what those large swings mean to them, and the what is the cost of securing against it,” explains Cleere.

Clearly the tables are turning when it comes to FX hedging in today’s environment. “If a fund has a sound investment thesis, being agnostic in FX means removing the FX component from the fund’s returns. Agnostic doesn’t mean inactivity; it needs to be managed and taken off the book,” says Cleere.

Fee keeper

Hedging management fees are the most common FX hedge for PE firms. With a large number of houses operating out of London but raising funds in euros and in some cases dollars, it is necessary to protect income. “Managers immediately get a good sense of what their fee streams look like; they know their operating costs over the next couple of years and as the fund as contractual obligations, they’ll want to bottom that out,” explains Cleere.

“We see different approaches on this, it’s more like corporate hedging. At a base level it’s about security and peace of mind to keep the lights on, without worrying too much about what FX movements mean to you,” adds Cleere.

Some managers, however, look to hedge their entire fee stream, with partners taking a view on the market.

Rock and rolling

Another potential place to hedge is of course investments and exits. The first cash movement often hedged is the drawdown. Within the time it takes to call down capital, which can be from two weeks to two months, a currency fluctuation could mean more capital needs to be called, therefore a hedge is a sensible protection mechanism. “But you have to be certain the deal is going ahead,” warns Cleere.

Then there’s balance sheet hedging for single assets or the whole portfolio. This is done to essentially neutralise currency swings over the lifetime of the investment(s). “It’s impossible to time for the lifetime of an asset, and the hedge would be very expensive because of increased credit risk. But a quarterly approach keeps charges down and allows for regular reappraisal of the businesses – to see if it matches the hedge. And typically, GPs are looking to do that alongside the reporting period,” explains Cleere.

Class act

When it comes to receiving fund commitments in a different currency, one way to manage this is through currency feeders. “At the fund or feeder level, we typically see this if the fund is denominated in euro and perhaps the cornerstone is investing in dollar. This scenario is becoming more common, with US investors who haven’t typically allocated abroad steadily upping participation in European funds,” says Cleere.

Clearly, being able to absorb allocations in a different currency is excellent from a fundraising and LP diversification perspective, but administratively, it’s far more complex. “You want to ensure all LPs are being treated equally and that you can accurately report your performance. If the share class hedging isn’t looked at, it can get tricky over life of the fund in terms of how you report the differing terms to differing investors. Currency feeders can make this more straight-forward,” says Cleere.

Indeed, the challenge with onboarding multi-currency investors is ending up with a range of IRRs. Currency feeders provide a neat mechanism for the disparity and provide an element of rigour to a manager’s overall governance.

Drag race

“Execution is the fundamental problem when it comes to FX hedging. It normally needs margins, but where do you get margins from? That’s not obvious in a PE fund structure,” says one private equity operational professional.

Unlike other providers, SVB incorporates FX lines into overarching facilities. “Within regulatory scope, this also removes aspects of the administrative burden of servicing the margin, where typically contracts need to be reviewed on a daily basis to make sure the right amount is being posted,” explains Cleere.

The bottom line when it comes to developing an FX strategy is that even the decision to do nothing must come from an informed basis. In today’s market, managers must take a position when it comes to protecting income and returns.

But, as is often the way in private equity, it all comes down to a manager’s ability to attract capital. In-demand funds will be able to set their own terms, or have the operational capacity to manage multi-currency commitments and investments. For less established managers that have found investors willing to commit big enough tickets, it’s highly likely they’ll find the LP’s preferred solution.

About the Author

Gavin Rees heads Silicon Valley Bank’s Global Funds Banking Team in the UK.

The team serves private equity and venture capital funds with banking services and customised financing. Gavin has more than 25 years of specialist commercial banking experience, of which 14 years have been focused on funds finance and 7 in structured finance. Gavin joined Silicon Valley Bank from Barclays, where he led the European private equity funds team. Before that, Gavin was a founder member of WestLB’s funds finance group in New York.

Gavin has a BA degree in PPE from Oxford University and an MBA from Columbia Business School, New York.
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