Human nature often leads many managers to consider their currency exposures only when there is a significant market move against them; many are aware that risk is present yet choose not to consider actively hedging them until that risk crystallizes on the bottom line.
There are two principal reasons why looking at currency risk when its effects are less obvious makes sense – firstly, consideration of hedging policy in times of low volatility allows for more coherent and less pressured decision making, free from the emotion associated with a loss-making position. Secondly, the costs of hedging in periods of elevated volatility are substantially higher, as banks have to factor this increased risk into their pricing. To give an analogy, buying home insurance on a house that has recently flooded is going to prove far more costly than getting the same cover before the river bursts.
There are three main areas in which private equity firms are exposed to currency risk; expenses (e.g. a London-based firm with Euro-denominated management fees), operational transactions (overseas calls/distributions, IPOs/exits in non-reporting currencies) and the impact on NAV of holding foreign assets.
In uncertain times investors are increasingly keen to see firm policy in place for the mitigation of currency risk
Whilst the hedging of salaries and office rental can be relatively straightforward, correctly mitigating the transactional and translational risks associated with NAV protection and high-value acquisitions or disposals can have so many facets as to encourage fund managers to choose blissful ignorance over informed decision. In uncertain times investors are increasingly keen to see firm policy in place for the mitigation of currency risk; even if the decision not to hedge is reached, it is beneficial to understand exactly the costs and implications of hedging vs. not doing so, as it provides justification should an investor ever question the currency risk of a fund.
In light of these considerations, what would be perceived as best practice for managers looking to implement a hedging policy? It is important to adopt a systematic approach; a chief financial officer must understand and identify exactly where his risk lies, and what his appetite for that risk is before any decisions can be made on which approach to take. A robust strategy does not involve any form of prediction in regard to how the currency markets will perform; rather it involves careful consideration and modelling of potential scenarios, developing a system that offers protection (and potentially gains from favorable market moves) regardless of market direction. Put simply, it should exactly meet the agreed objectives of the fund.
There are implications associated with hedging that must be considered. For example, the manager of a fund specializing in illiquid investments may have a very low risk appetite, and as such may look to fix rates on a 12-month basis using outright forwards; whilst this offers absolute protection, the mark-to-market valuations on forwards can severely impact cash flow. Poorly-adopted policy could effectively replace currency risk with liquidity risk; if the fund is fully invested when it receives a 10 percent margin call from the bank to cover these forwards, the aforementioned manager could find himself in a position where he is forced to prematurely dispose of assets at a considerable discount to market value in order to satisfy his banking covenants. Due consideration to the strategy of hedging is therefore of high importance.
In contrast, a properly-considered policy can add huge value to any firm facing such risks. Use of structured products allows for 100 percent protection against adverse market moves, whilst enabling the firm to benefit from favorable shifts; they also offer enhanced flexibility in situations where the projected exposures are subject to change. More often than not these strategies can be zero-premium, when packaged and negotiated correctly within your banking group. The timing of execution can also be considered, with firm levels put in place at which to add to/roll back existing cover.
Having a robust strategy in place allows funds to focus on their primary objective, namely to generate profit from investments in their chosen field. After all, an investor who places money with a buyout firm wants their P&L to depend on that fund’s ability to identify value within their acquisitions, not on how the currency markets behave that year; if an investor wants exposure to the FX markets, they will place money with a currency fund. Whilst a poor year saved by a favorable FX move may be looked upon with questionable relief, a year in which profits made through wise investments are eradicated is often seen as unforgivable.
John Kinnell is an associate at UK-based financial risk consultancy group HiFM.