Over the past two years, the US dollar has steadily been gaining against its peers, capped with a meteoric rise in recent weeks, gaining as much as 32 percent against a basket of currencies.
This has affected private equity firms in a variety of way, including: balance sheet risk, foreign share class returns, margin calls, dividend values, portfolio company profitability and exit values.
This year is set to be the most volatile year since 2008. Markets are red across the board and the world is on lockdown. In times of uncertainty, it is important to remember that you can only control what you can control.
Understanding why we are here
This is not just because of covid-19. We’ve been in the midst of a two-year-long trade war between the two largest economies in the world, with impacts to supply chains worldwide. The EU and the UK have been roiling the markets even longer with Brexit, terms of trade and potential for Irish unification and a Scottish exit. OPEC has been in shambles, resulting in an oil price crash that has sent tremors throughout the equity markets. In many countries, consumer confidence, industrial production, PMI and other indicators show widespread weakness. Covid-19 was simply the tipping point of longer-term trends.
Equity and foreign exchange markets have reacted with ferocity, shifting to “risk-off” mode within the last few weeks. Equities are down (officially a bear market, down 20 percent in many exchanges) and gold is up. In the FX markets, Japanese yen and the Swiss franc picked up a massive initial boost but recently lost ground to the rate cutting US dollar as investors unwind their carry trades in higher-yielding countries and riskier equities to fly to safety.
What does it mean to me?
The first step in managing risk is quantifying it. Is it material? Will it harm my investor returns on my foreign investment or will our portfolio companies costs or profits be materially affected?
One of the most common measures is value-at-risk (VaR). VaR is an indication of the limitations of the worst case. For example, a VaR of $1 million means that 90 percent of the time your losses will not exceed $1 million.
How is this calculated? Assuming that market returns are normally distributed, you can use the volatility of the historical market returns to calculate your VaR. Using Excel, populate a column with daily historical spot values. In the next column, calculate the log returns (this normalizes the data). Use the Excel function stdev (log returns) to calculate the standard deviation (= volatility). Convert this daily volatility to annual by multiplying by sqrt(252). Finally, using the Excel function normsinv(90%), calculate the number of standard deviations of the desired confidence, multiply by the volatility and the size of the exposure. The result is the annual VaR.
Now that I know my risk, what’s important to me?
Most private equity firms will set a budget rate for their transaction, hold period or exit. It’s used to set prices in local currency and estimate future revenues or returns in the firm’s reporting currency. Depending on the firm’s margins or expected returns, an additional buffer may be added. The rate can be set in a variety of ways:
- Current spot
- Current forward rate
- Prior period average
- Off-market rate
- Consensus forecast
This is the rate which needs protecting – if it’s breached, then the risk manager will experience liquidity problems. This is where hedging is useful.
It is important to remember that your main responsibility is to your shareholders and that you are paid to import widgets, grow revenues or provide investment returns. Currency speculation is unlikely to be a part of your strategy.
I’ve decided on what I want to do, now what?
You’ve decided to use hedging to protect your firm or investors. There are many instruments and methodologies to choose from.
Instruments include forwards and futures, options, and for long-term debt instruments, cross currency swaps. Each has advantages and disadvantages, and the choice depends on both the firm’s risk profile and margins.
Forwards are the most common hedging instrument. They lock in an exchange rate in the future, up to 24 months is normally the max in most cases (we have seen as far out as 10 years). The rate that’s locked in is the current spot rate plus “forward points” which depend on the relative interest rates of the two countries. As central banks race to slash their rates and stimulate the economy, forward points have changed drastically over the past month, meaning, depending on your direction, the costs of hedging may have increased or decreased.
Options are another alternative. At the expense of a premium, they protect the downside whilst allowing participation in upside. Pricing is opaque and expensive; they may be a good alternative for firms with high expected returns and those who have a higher risk tolerance. Deal contingent hedging is available in some cases and can be a suitable (if not expensive) option to hedge a large currency exposure whilst lowering the cancellation costs.
The number, size and tenor of the instruments used is determined by the methodology. While there are several well-known methods, layering forwards produces the most reduction in volatility as measured period over period. Things can get even more complex, with portfolio hedging and other more advanced methods which can reduce the cost of hedging while preserving its efficacy.
It may be the case your own internal FX exposures should be handled differently. At the share class level, a passive strategy is favored to protect investors, whereas at the portfolio level, one can be a little more creative with their hedging tools.
How much will it cost me?
How long is a piece of string? How much it “costs” depends on a great many factors. Using forwards when both currencies are major (eg pound sterling, US dollar, euro, Canadian dollar, Australian dollar, New Zealand dollar, Swiss franc) is essentially free. Forward points are almost zero, and the only “cost” may be a margin deposit. If one or both of the currencies are in an emerging market (eg Brazilian real, Indian rupee, Mexican peso), then the annual cost may be as much as 5% of the notional being protected. However, as mentioned above, as central banks cut rates, forward points are falling.
Option premiums are a function of volatility. In high-volatility environments, option premiums can be quite expensive. Using combinations of long and short options can reduce the net premiums paid.
One thing for certain is that during volatile times the spreads from banks widen substantially and they have to be policed.
Not managing FX risk is speculation, pure and simple. Hope is not a strategy, and betting the firm on some Fibonacci retracement is equally unwise.
Organizing and presenting the facts in a clear and concise way can help speed up the decision-making process by removing the emotion out of a stressful situation.
During times of intense volatility, depending on the side of the market you are on, liquidity can be a huge issue. You may be able to work with your provider to reduce these collateral calls, just make sure that you are aware of any interest rate and any extra hedging costs.