- For global funds investing internationally, FX rates may move materially during the sign-to-close period.
- FX rate uncertainty arises from the time an international fund investment is contracted to the time the deal is funded.
- The potential impact on the amount of US dollars (USD) that must be called can be significant.
- Short-dated forwards can be used to help mitigate the impact of currency fluctuations during this period.
Short-dated foreign exchange (FX) forwards can be used to help minimize the FX rate uncertainty that arises between the time a global fund investment is contracted and the time the deal is funded.
The situation
A US-based global fund (“Fund”) has raised USD capital and submits a bid for an overseas asset priced in euros (EUR). The bid is accepted and will be funded three to four weeks later. Simultaneously with the acceptance of the bid, the Fund may look to make a capital call for the USD needed or instead opt to draw down from the capital call borrowing facility closer to the funding date. Either way, the amount of USD needed will change between the bid acceptance date and the date the transaction is funded.
If the EUR appreciates, more USD will be needed as the price is fixed in EUR. As a result, the Fund would need to call for more USD capital to close the transaction. This is an undesirable situation, as investors will have paid more for the asset than originally negotiated, eating into internal rate of return (IRR) and other investment performance metrics.
On the other hand, if the EUR depreciates and a capital was made on the bid acceptance date, capital will need to be returned, as fewer USD will be needed for the acquisition. Economics aside, giving capital back presents and administrative and operational burden which many times renders the windfall more trouble than it’s worth.
Why hedge?
The longer the time between deal signing and close, the more the USDs required to close the transaction will fluctuate due to FX volatility. Funds may call more USD capital than needed resulting in overfunding, or insufficient capital leading to the need to call additional funds. Both scenarios present operational challenges which can be easily addressed by hedging with short-term FX forwards.
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Solution An FX forward is a contractual obligation to exchange one currency for another at a pre-determined fixed rate and specific date in the future. Purchase contract The Fund agrees to pay €50.0M to acquire a European-domiciled asset priced in euro, which translates to $52.65M according to the spot rate on the day the bid is accepted and the deal is signed. Funds will be remitted in 3 to 4 weeks. Trade details
Notes: Conservative (longer) tenors are advisable as it better to draw down the trade early than having to roll it forward, as the latter involves a cash event. |
Scenario analysis
The total USD needed to close an overseas purchase can change materially over a 4-week period, from bid acceptance to deal funding. According to historical data, there is a 10 percent chance that on a €50.0M price tag, the price can change by more than $3.5M in either direction.
However, regardless of where the EUR / USD exchange rate is trading on the settlement date, according to the terms of the forward contract, the Fund will be selling $52.65M in exchange for €50.0M to make the investment.
Additional considerations
What if the deal fails to materialize?
A forward contract represents an obligation to buy or sell currency at a predetermined price. Should the deal fail to materialize, the Fund would need to cash-settle the forward hedge to fulfill the obligation, resulting in a gain or loss depending on spot movements during the hedge period.
What if the fund is ready to deploy capital earlier than forward settlement date?
We can accommodate early unwind of the FX forward hedge.
What if there is a delay in the expected deal close date?
There are two alternatives: 1) Settle the forward and hold euro in a multi-currency account or 2) Roll the forward for an additional week, month, etc. as required. A “roll” is a standard FX contract which requires a cash settlement.
If you’d like to discuss your specific situation or for information regarding SVB’s tailored FX risk management services, reach out to your SVB FX contact or send an email to GroupFXSalesGFB@svb.com
