The dramatic growth seen in the private equity industry over the past years will no doubt with hindsight be viewed as the teenage growth spurt of a market hurtling towards maturity. The analogy is pertinent because it reminds us of the melee of previously unimportant issues that surfaced during one's teenage years. Foreign exchange risk is one of those issues that the industry is just starting to become conscious of.
Without laboring the analogy, everyone tries to deal with these issues in their own way – even if nobody really knows how. Nonetheless, the end result is always maturity – and, as we have all discovered, with maturity comes responsibility
Traditionally, acknowledgement of foreign exchange risk amongst private equity funds has been suppressed. Some funds that are aware of the risks they face pass responsibility up the line to their investors. By not hedging, they aim to give their investors a clean view of the risk, thereby leaving them free to choose whether to hedge their currency exposure or not. This approach is similar to that of a multinational corporation who decides not to hedge its balance sheet foreign exchange exposures – but, crucially, this mechanism only works if the investors acknowledge and are happy with their exposures, or are able to hedge them.
Other funds claim that the long-term nature of their investments makes hedging inappropriate. There are valuation difficulties, they say, and the mean-reverting characteristics of currency markets make medium to long-term hedging of currency exposure unnecessary. The latter argument is easily challenged if deal flow is irregular or there is any negative correlation between observable currency cycles and the investment cycle. At best these arguments are probably an acknowledgement of the complexities of hedging the exposure.
Historically, the most honest approach has been to acknowledge the currency risk and hedging complexity and then add a few percent to the expected IRR to account for that additional risk. Whilst an inexact approach, this has allowed funds to participate in the rapid globalization of the industry with at least some level of protection. The excess returns available in this rapidly growing industry have effectively allowed the risks to be subsumed without consequence.
But this is where the point about maturity comes in. The wall of money and high debt multiples that increasingly characterize the industry are driving available asset prices higher. The capitalist system is working to compete away those excess returns
Those private equity managers that have been able to identify attractive equity investment opportunities and apply strong partnership and management skills to bring these investments to fruition have seen significant success. The successful private equity funds of the future will be those that apply strong financial risk management techniques, using all the hedging skills that the financial markets have developed, with the same dedication that they have to date applied to other areas of management.
Those relying on excess returns will struggle in a more mature market. A good comparison can be drawn with multi-national corporations. There are many examples of companies whose management paid a heavy price when they booked excess returns from overseas markets and overlooked the FX risk. In the old days either they argued that they ?couldn't hedge? or ?didn't need to hedge,? but the market learned otherwise and the Corporate Treasury Function has gone from strength to strength as the market has demanded and rewarded efficient financial risk management. A similar picture can be seen in Currency Overlay Management, with asset managers looking to reduce the foreign exchange risk in substantial international portfolios.
The premise is simple. As prices rise, the expected profit potential falls and therefore the risk tolerance in the investment model decreases. The answer is clearly to reduce unnecessary risk wherever possible.
So what are the risks and what can be done about them?
The main area of concern is currency risk arising from cross-border transactions in currencies other than the base currency of the fund. FX risk intrinsic to the operations of the underlying business will hopefully be well catered for within the business model.
Traditional asset and liability matching techniques suggest that, where possible, debt to provide the leverage in cross-border deals should be raised in the currency of the target company. So we are left with the currency risk on the equity injection – still a significant piece of the puzzle.
Usually, this equity portion is converted into the currency of the target company to complete the financing of the purchase price. The currency risk has been accepted as a small portion of the overall investment risk. Investment bank financiers have done a good job of tying this FX conversion element into the overall financing package. However, this can be a significant transaction in itself and consideration should be given to completing the transaction through a third-party bank that understands the sensitivities of the business. Equally, one should be aware of any short-term currency risk that may arise if there is any time lapse between the decision to proceed and completion, when hedging through currency options may be appropriate.
Private equity funds should be looking for ways to hedge the FX risk on these foreign equity investments. This can be relatively easily done through the creation of a foreign currency liability on the fund's balance sheet to offset the asset i.e., increase the level of foreign currency debt (if any) at the fund level or hedging the currency through a forward outright or currency option.
The hedge should be adjusted in line with asset revaluations. This adds a dynamic approach to the hedging strategy that aims to incrementally approach the exit value – an amount that can be very uncertain at inception. The requirement for options to offset this uncertainty can be reduced using this approach. Any option premium outlay can therefore be targeted to create currency upside as opposed to hedging uncertainty. However, a case can certainly be made for the inclusion of optionality in the hedging portfolio in the form of structured forwards which can be used to introduce the potential for FX gains from views held, at zero premium cost.
The biggest obstacles to such hedging are operational, principally in the form of credit and funding constraints. To hedge, a fund needs bank credit lines or additional financial capacity. If clean bank credit facilities are not available, the operation of a hedging programme will entail financing margin calls or covering cash flows that might result from hedge rollovers. Further funds will be required to pay the premiums for any options purchased. As we have said, net premium outlay should be carefully considered, but zero cost structured alternatives again introduce the credit and funding constraints.
Equally, the administration and execution of the chosen hedging strategies might cause concern. Lack of expertise and financial control considerations might be good reasons to explore the options for outsourcing implementation.
These latter issues are not so easily resolved. However, now is the time to start addressing them. Increased globalization of the industry and the allure of emerging economies in the search for increased returns will only serve to accentuate the problem.
Paul Honeywood is Director, Private Equity FX/LM Sales, at the London office of Dresdner Kleinwort Wasserstein.