Buyout firms have increasingly sought to initiate FX hedging strategies amid the covid-19 pandemic, according to Investec bankers.
The high return multiples on private equity buyout investments have traditionally insulated those funds with foreign currency investments from much of the volatility they’re exposed to, said Investec’s Michael Slane and Jonathan Smith. Many firms have historically taken the view that longer-term reversion to the mean in currency values makes FX hedging more or less irrelevant to PE.
FX providers have said that is slowly changing, as geopolitical uncertainty in historically tame markets like the UK and Europe (stemming from Brexit and the euro crisis, respectively) has resulted in persistent currency volatility there.
But the intense movements in March, as the spread of covid-19 roiled markets, caused a sudden surge in interest from clients unused to hedging, looking to mitigate FX risk and lock in gains where they can. “If you’re returning a little less, and volatility is a bit more, it becomes more meaningful to see those big swings,” said Slane of Investec’s Fund Solutions group in the UK.
Locking in gains
“We were sort of expecting PE clients to move on to what opportunities this creates,” said Smith of Investec’s Treasury Risk Solutions group in the UK. “But what surprised us was how equally alive and alert clients have been to opportunities this presents in terms of the way markets have moved and how they may take advantage of that in ways they may not previously have done.”
Smith says clients who haven’t looked at FX hedging before have been calling to find ways to lock in gains on assets resulting from currency moves. Those clients include a listed alternative asset fund with a remit to make dollar-denominated investments, but without FX hedges. Then, from March 9 to 18, sterling slid against the dollar from $1.32 to $1.15.
“That effectively delivered a 10 percent uplift in valuation of the assets,” Smith said. “That client came back to us quickly and said, ‘We’re going to look at this in some detail now.’” The fund has since reached out to LPs to see if it can get an amendment to its documents to enable FX hedging.
Some firms with hedging already on the books found themselves significantly in-the-money in March, and looked to Investec to close out or restructure the hedges to crystallize mark-to-market gains and recoup some liquidity, Smith said. At the start of the sterling slide against the euro, private equity firms with UK arms were even looking to FX solutions to lock in gains on expected management fees. That activity has since calmed along with sterling’s volatility, but “the moves certainly create awareness of this risk in their income streams,” Smith said.
Credit funds feeling the stress
Many credit funds, which are typical users of FX solutions, have been under significant stress, which has only been exacerbated by FX movements in foreign currency investments.
“My experience is that people haven’t been looking to take trades off or unhedge for negative marks,” said Slane. “But the adverse of that has been that it either has created a liquidity crunch because they’re getting margin calls, or the marks are pushing covenants through limits.”
He added that in April, Investec was looking to restructure and refinance some hedges for credit fund clients breaching or about to breach loan-to-value covenants.
Investec does provide uncollateralized FX hedging facilities, a bonus for firms that don’t want to tie up cash in collateral agreements as the outlook on liquidity and IRRs remains uncertain. Slane said the number of banks offering uncollateralized, unmargined hedging has increased in recent years, making hedging more attractive for private equity, real estate, infrastructure and other funds that don’t typically look to FX markets.