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F X S T R AT E G Y M A R K E T I N S I G H T
The merits of building an effective FX strategy
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hese last few weeks have seen global equity markets tumble over fears of the impact of COVID-19, which has now been declared a global pandemic. On 17th March, the Dow Jones fell 12.9 per cent, its most severe decline since 1987; even after the US Federal Reserve committed USD700 billion to support the US economy. These are understandably uncertain times for all market participants, including the global private equity industry, as the impact on supply chains and business revenues across all sectors begins to take effect. According to McKinsey’s Global Private Markets Review 2020, PE deal multiples rose from about 11x in 2018 to nearly 12x in 2019. With hundreds of billions now wiped off the markets, those valuations are likely to be noticeably lower in 2020. And while most PE firms factor in cyclical risk, McKinsey’s report suggests that only one third of them have adjusted their strategy to prepare for a potential recession. Against this backdrop, and with market valuations at their potential apogee, it has arguably never been more important for PE managers to think about how they build value into their portfolio companies. FX STRATEGY REPORT | April 2020
One way to achieve this, which is gaining more prominence, is to construct a flexible FX risk framework, to help managers protect their funds’ assets against currency volatility, which, if left unchecked, could potentially impact valuations: both at the acquisition stage, and at exit. This report examines some of the key considerations to building such a programme and explains how FX hedging can protect the long-term performance of a fund. There are numerous reasons why PE groups should seek to mitigate FX risk in their portfolios, in just the same way as global corporations do. Investors are beginning to think more carefully themselves about FX risks but for the GP, who has ultimate control over investment decision-making, applying an FX risk strategy at the fund level also makes sense. Second, by demonstrating that the manager has an FX risk management solution which they have used in earlier funds, it can allow them to show investors how they have been able to generate attractive risk-adjusted returns, without exposing the fund to negative FX price movements. www.privateequitywire.co.uk | 2
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Now, with Brexit and the uncertainty it has created, over the next five years FX risks are likely to be more pronounced. This is something all asset managers and investors are becoming more mindful of. Alex Lawson, Western Union
Given the headlines that FX has been making, with some significant swings in the markets in recent years, and the nature of PE investments – which can be anything from five to 12 years in length – it is not something that should be underestimated. If one looks at the last couple of years, the ongoing uncertainty over Brexit negotiations saw sterling fall from 1.42 against the US dollar in April 2018 to 1.20 by August 2019. Anyone in the process of selling UK assets, during that period of volatility, could have incurred substantial losses without an FX hedge in place. Alex Lawson is Director of Hedging Products for the UK and Europe at Western Union, where he advises clients on FX risk strategy structuring and implementation and FX risk management, to achieve their hedging objectives. In his view, the private equity world has become more aware of the impact of FX risk. “It wasn’t that long ago that sterling traded in a very narrow range against the euro and you probably didn’t need to worry too much about FX risk, apart from on acquisition cost basis. “Now, with Brexit and the uncertainty it has created, over the next five years FX risks are likely to be more pronounced. This is something all asset managers and investors are becoming more mindful of. Investors will want to know, ‘what impact will GBP/EUR price fluctuations have on my PE investment?’ They will want reassurances they are going to get a return on the companies the GP is investing in, in the Fund,” comments Lawson. Constructing an FX risk solution 1. Make it clear to investors The importance of any FX hedging strategy will vary from manager to manager. It depends on the Fund’s Limited Partners and what their expectations are for the
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strategy, in relation to where the Fund is investing. If the PE manager is solely buying companies in Europe, it might be possible that investors want the currency exposure as a result, “but assuming it is in the investors’ best interests to protect the Fund against FX volatility, the approach taken by a PE client really ought not to be any different to that taken by our corporate clients”, advises Lawson. Having an FX strategy in place that one can explain to key stakeholders can help the manager to differentiate from its competitors and demonstrate that they’ve given serious consideration as to how FX might impact the value of investments. “It can serve as a good story to tell potential investors,” says Lawson. “Moreover, it also allows the GP to focus on what they should be doing, which is sourcing and managing assets in the Fund.” So for anyone thinking about FX risk, the first consideration should be to work with an FX counterpart who understands the investment strategy’s objectives, and who can devise a solution that can be easily communicated to investors. Given the depth and breadth of opportunities across Europe’s middle markets, beyond the Eurozone, FX rate moves are a bigger consideration than when one is buying and selling assets in a single jurisdiction such as the US. It is a patchwork of currencies and regulatory frameworks, adding a layer of complexity (and risk) to European mid-market players. Lawson and his team work on developing new FX hedging products for clients across Europe. “Aside from the UK, we operate in other countries across Europe including France, Austria, Germany, Poland, Italy and the Czech Republic. We can provide advisory services, supporting our corporate clients’ business activities as well as fund management groups including private equity,” says Lawson. www.privateequitywire.co.uk | 3
F X S T R AT E G Y M A R K E T I N S I G H T 2. Be aware of regulatory implications When the European Union’s Directive, the Markets In Financial Instruments II (MiFID II), was formally introduced on 3rd January, 2018, one of the key tenets was to increase price transparency and for investment firms to demonstrate best execution to end investors. EU regulatory standards RTS 27 and 28 lay down obligations on all execution venues to publish data relating to the quality of execution of transactions (i.e. venue, average price, volume traded). This regulatory shift has ushered in a suite of tools, analytics and information to evaluate whether best execution has actually taken place. As such, any PE group looking to appoint an FX counterpart should factor best execution capabilities into its selection process. Western Union has counterparty relationships with eight to 10 investment banks in order to get best price on spot FX, forwards and options. In some respects, PE has it easier than other asset classes under MiFID II. Spot FX doesn’t fall under the MiFID II rules, for example, while the price for forward contracts is already very transparent. There is, therefore, less likely to be opaque pricing going on for the FX products that PE managers will typically be buying. Lawson says that PE managers should not, however, only be looking at best execution and fair price when selecting an FX broker. There is also speed and likelihood of execution to consider, for example, as well as other factors, he says. “If a PE firm is dealing with a currency with an FX broker they may well have a credit line in place. If so, how valuable are the credit terms being offered to the Fund or the investment company? They don’t want cash tied up in margin calls. Price is important but so is the ability to tie up less cash in margin. Also, a smaller broker might be able to offer better credit terms, compared to dealing with a larger, more expensive counterparty,” outlines Lawson. FX STRATEGY REPORT | April 2020
3. Scale opportunities Another consideration is that smaller managers don’t necessarily have access to the big tier one banks. In this instance, using an FX broker can bring economies of scale benefits, where the broker acts as a leveraging partner to help the manager gain access to competitive pricing. “Our tagline is ‘Serving the underserved’,” adds Lawson. “There is a need among smaller managers that we meet to provide not only access to pricing but access to a range of products and structures: trading against a brand with an investment grade credit rating and a long pedigree in the stock markets.” Bjorn Gravsholt is Managing Director of Hereford Capital, a UK turnaround-focused firm whose special situations fund can best be described as a hybrid PE fund principally making debt investments, but with an equity component and a private equity style of investing – operationally involved and focused on business improvement. “At the core of our currency approach is the use of a number of FX providers. It’s important for us to always ensure our LPs have options any given moment,” explains Gravsholt. “When it comes to debt and currency risk, hedging debt is definitely becoming more relevant for us. Many of our investors prefer allocating US dollars into the fund, which invests in UK-based sterling assets. As a hybrid fund, the currency transaction which is most relevant to us (and the need for hedging) is at the point a loan is advanced when our loan company (an Irish entity denominated in GBP) requests funds from our Master Fund, a Cayman-based entity also denominated in GBP, with a hedged USD-denominated feeder for USD investors.” 4. Speed and flexibility Over the years, the costs of FX hedging have narrowed as alluded to above. At the initial acquisition stage, once a PE group has agreed to purchase a company, they may www.privateequitywire.co.uk | 4
F X S T R AT E G Y M A R K E T I N S I G H T want to put a hedge in place to protect against the deal potentially falling through. Baking in flexibility to the FX strategy should be the aim. In the hedge fund world, which uses prime brokers and actively maintains margin accounts, it’s very easy to run an FX hedging strategy. With PE managers, it is less straightforward. They don’t have traditional banking relationships to lean on, because the banks don’t want to get involved in cash accounts – and as a result need non-bank FX providers to give them that support where they are providing cash account facilities. Consequently, one of the benefits to using an FX broker as opposed to a traditional bank is speed: it only takes days to set up an account with a broker as opposed to weeks, provided they have streamlined processes in place. Pre-acquisition risk considerations A suite of solutions is available for hedging FX risk, ranging from forwards to swaps and options. For the most part, private equity managers tend to place relatively vanilla trades. Because they are reporting to so many investors they require something quite neat, clean and easily digested. In terms of initially thinking about FX hedging at the pre-acquisition stage, one of the tools to consider may be a deferred premium option. “Deferred premium options are products that allows you to pay the premium at the end of the contract. In an acquisition phase, this might make sense as it means you are only paying the option premium at the time of completing the acquisition. You still have to pay the premium if the deal falls through, but these type of products can help from a cash flow perspective,” explains Lawson. Prevailing market volatility at the time of acquisition would be another consideration. Volatility in Q4 2019 was lower than in the same period in 2018 and as a result the cost of hedging would have been lower. The threat of significant swings in market volatility is something a PE manager has to be mindful of during the acquisition phase. Interest rate risk Before buying a European asset, at the pre-deal stage, another factor to consider is neutralising the interest rate risk for the target company being acquired – especially if this is a leveraged buyout strategy. The internal rate of return (IRR) that the PE firm achieves when it comes to exit will depend on the interest rates at which it takes on debt. Therefore, hedging interest rates can help the manager to guard against breaking any covenants and help to ensure they are fulfilling the debt obligations of individual portfolio companies. Also, modelling interest rates will help the manager determine what FX STRATEGY REPORT | April 2020
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economic impact higher rates might have on the fund (in terms of dividends, amount of leverage), before they pull the trigger and finalise the acquisition. The type of IR hedging strategy will depend on the size of the deal and the country; rates will be higher in Turkey, or Romania, compared to the UK or Germany. Managing FX risk during the investment cycle Some PE managers hedge a portion of their portfolios and increase the amount as time goes by and the value of the assets increase. As private equity investments can be anywhere from 5- to 10-year investments, how one manages ongoing FX risk, at the Fund level, can be somewhat subjective. For a particular asset, it might depend on the P&L, and the certainty of cashflows being generated, so that the manager is able to determine how to ‘right size’ the FX hedge – i.e. not to over- or under-hedge the position. “As far as our fund structure goes, we have two currency needs,” says Graham Nicholson, General Counsel and COO at Hereford Capital. “Firstly, a spot rate FX STRATEGY REPORT | April 2020
conversion – USD to GBP when a loan is made – and then back again when it comes to paying investors back. In practice, this need can be met by entering into rolling FX hedge contracts during the life of the loan.” Speaking anonymously, one London-based PE manager who invests across Europe on a fund and on a co-investment platform basis, explains that they do engage on FX hedging “on a limited basis at this stage”, but will continue to have ongoing discussions moving forward. “It tends to be needed at the time when we receive and finalise a capital commitment from an investor,” they say. “Usually this will be a commitment that we draw down over a period of time, so that tends to be how we consider whether to use an FX hedge…as we monitor those capital commitments in anticipation of future drawdowns.” Throughout a multi-year investment cycle, a PE manager might wish to avail of a number of FX tools including FX forwards, vanilla options, and deferred premium vanilla options referred to earlier. It is worth noting that derivatives may not fit for every entity and there are specific downside risks associated
with these products which should affect any decision to purchase one. FX forwards Forward contracts involve fixing a rate of exchange today for a date in the future. A PE manager might use such a contract to try to reduce impact on investor asset classes from FX fluctuations. “In a dollar-denominated fund, for a sterling investor the manager may want to remove FX risk from that investor’s investments by using a rolling forward hedge with the aim being to mitigate any FX losses in the investment. “Typically, the average duration of a forward contract is six to nine months but we have seen instances of up to five years, which we can facilitate. Not all FX providers are willing to offer FX forwards for that length of time; some may only support up to 12 or 24 months’ duration,” explains Lawson. “If you’re in a lossmaking situation when the hedge crystallises, somebody has to fund that loss; either you have a revolving credit facility that enables you to cover www.privateequitywire.co.uk | 6
F X S T R AT E G Y M A R K E T I N S I G H T that loss temporarily, or the investors have to pay for it on request, through an additional capital call. This can be cumbersome and time consuming for all parties involved – and shows why a revolving credit facility specifically for currency contract needs can have real value for a fund,” says Nicholson. “Typically the rolling currency contract would be for a one- or three-month period. Beyond that hedging becomes less straightforward and exponentially more expensive.” Given the complexity and long-term nature of private equity investing, the extent to which FX hedging is deployed will vary tremendously. Broadly speaking, those who use more leverage may be more likely to use an FX hedging solution because they have less capacity to accommodate a fall in asset value.
Our general experience is that our LPs are sophisticated and therefore have extensive experience managing currency risk on their own as part of their overall portfolio asset management strategy. Robert Spittler, Silverfern Group
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Vanilla options Vanilla option contracts provide the right (not the obligation) to buy or sell a currency at an agreed rate, at a date in the future. This requires the option buyer to pay a premium for that right, and it can best be thought of as an insurance contract. The cost of using an option premium will tend, subject to more variable circumstances, to be 1 to 3 per cent of the notional amount the manager is looking to hedge. Then, when the option contract is due to expire, they have the right to choose whether to roll it for another period of time. If it is in your interest to exercise the option, you will do so and know that you have that rate locked in, if the FX rate has moved against you. If it has moved favourably, however, and the asset is worth more – or perhaps the cost of the acquisition has fallen at the pre-deal stage – one may choose to let the option lapse and trade at the prevailing market price. The London-based manager referred to earlier points out that part of the complexity of using FX hedging effectively comes from not knowing what anticipated cashflows
in an underlying asset will be; making it tricky to know exactly when to implement a hedge. “If you have a clearly defined cashflow projection then it might make sense, but that’s not always the case,” they say. “We want to avoid the risk of eroding any value creation and it is part of our internal discussion at the investment committee level. Often, we find there is no effective way to manage FX risk other than to monitor the asset(s) and hedge over short time periods when cashflows are more predictable.” Again, PE managers may not want, need or have the risk management strategy fit for options and there are, of course, specific downside risks associated with these products which should affect any decision to purchase one. Zero cost options “In terms of ongoing FX risk management we have a large suite of FX options and zero cost options structures,” says Lawson. “These are combinations of underlying options where you are protecting your downside risk and gaining some degree of upside participation, but that upside is capped; the benefit of this is there is no premium involved. Zero cost options may be suitable for the ongoing management of assets in the portfolio.” From a PE standpoint, one commonly used FX options product is a protective collar – also known in the market as a ‘risk reversal’ where one option is bought and another sold. The premise of this is to protect against a worst-case rate if the market moves against you, and a best-case rate if it moves favourably. A protective collar is designed to limit, rather than eliminate, FX volatility and can be an effective way to protect the value of an asset: certainly as the manager moves closer towards selling the asset to a corporate or PE fund sponsor. Again, with FX volatility impossible to predict, having some level of FX protection in place, can go a long way towards preserving a good internal rate of return in the fund. www.privateequitywire.co.uk | 7
F X S T R AT E G Y M A R K E T I N S I G H T “We take this seriously – most of our USD investors ask us about it,” asserts Gravsholt. “We spoke to one currency provider who showed us analysis that over a five-year period, the volatility on the GBP/USD currency pair could lead to a 50 percent deviation in price. At some point – not all the time and nobody knows when – it will happen. Some of our investors choose to do their own FX hedging, or choose to do none at all and are willing to take the risk; others want to know what solutions can be provided. “Sometimes investors will ask us what we think will happen to the USD/GBP currency exchange pair. We don’t profess to know. We aren’t looking to second-guess whether the price of sterling is going to weaken or strengthen against the dollar over time; we try instead to avoid having to worry about it, by using hedging intelligently.” The point Gravsholt makes about LPs choosing to do their own FX hedging (or not) illustrates an ongoing trait within the private equity space. Robert Spittler is Managing Director at the Silverfern Group, a global mid-market private equity group, which over the years has built an investment platform to offer institutional investors selective co-investment opportunities. He explains: “We have an active dialogue with our LPs (and banking partners) and have addressed currency exposure questions on a case by case basis, but our general experience is that our LPs are sophisticated and therefore have extensive experience managing currency risk on their own as part of their overall portfolio asset management strategy.” Flexibility to evolve Regardless of the approach taken, any PE group who seeks out to build an effective FX risk solution should allow it to be flexible enough to evolve over time. That way, the manager can help guard against incurring unnecessary costs in the Fund. Lawson says this is precisely where he feels Western FX STRATEGY REPORT | April 2020
Union can add value: “It’s should be important for PE managers to give sufficient consideration to their FX hedging strategy; the primary purpose of this may be to free themselves from currency risk to focus on sourcing deals and improving the fortunes of portfolio companies, and if they have companies within the portfolio managing their own FX risks they can give them an overall FX structure, which we can create for them, to operate within. “A key aspect of such a risk structure is to set KPIs that the manager can assess and gauge on a periodic basis and if there is a breach of one of those KPIs, that they have an action plan in place: i.e. taking necessary steps to adjust FX hedging if market volatility significantly jumps.” There are four steps one can think about towards a flexible risk management framework: • Step 1: Define your exposures, including things such as Value at Risk (VaR) • Step 2: What are your hedging objectives? Are you trying to eliminate FX risk or contain it within a certain range? • Step 3: Put an execution plan in place: who is responsible for doing what, when, and under what circumstances? • Step 4: Continuous monitoring of KPIs within the FX risk strategy, including an annual periodic review to assess its efficacy and whether it needs to be adjusted Depending on the particular strategy, these KPIs will vary. “Once agreed upon with the manager, we would be able to report those in a variety of ways: some managers prefer Excel, some might prefer Bloomberg,” adds Lawson. As PE groups begin to focus more on this, there is still a degree of education needed. Gavan McGuire is Head of Business Development at Centaur Fund Services and as he points out: “Over the years, I’ve seen instances where managers have put FX hedges on backwards: instead of buying the currency they sold it. We always say to PE managers that any hedging activities should be performed by their operations team.
Over the years, I’ve seen instances where managers have put FX hedges on backwards: instead of buying the currency, they sold it. We always say to PE managers that any hedging activities should be performed by their operations team. Gavan McGuire, Centaur Fund Services
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Some of our investors choose to do their own FX hedging, or choose to do none at all and are willing to take the risk; others want to know what solutions can be provided. Bjorn Gravsholt, Hereford Capital
“Be systematic when doing the hedge. Buy the spot and the forward contract at the same time and at the same rate: even if you do the spot contract in the morning and the forward contract in the afternoon, there will be a spread and it can be substantial; and that, in the long term, could hinder the fund’s overall performance. Poor execution and poor policy can be costly. It could be the difference between being up 10 per cent on the year as opposed to nine per cent.” Working with management teams A final point on the mechanics of ongoing FX risk management relates to the management teams within portfolio companies themselves. To support its PE clients, Western Union may go in and speak with management where it can leverage the experience it has working with global import/export companies. “Some PE firms are more hands-on than others. They may acquire an asset and leave the existing management team in place but others might suggest that whatever they are doing with their existing FX strategy, to talk to Western Union. At this point, we would present the FX strategy framework that the manager wants them to operate under and to trade under based on the manager’s pre-agreed credit line and pricing terms with us,” confirms Lawson. FX STRATEGY REPORT | April 2020
Risks of FX hedging There is no silver bullet for FX hedging within PE portfolios, such is the scope and variety of strategies employed by GPs. As such, one should be mindful that hedging is not suitable in all circumstances. Transaction reporting under MiFID II on all derivative contracts would be necessary and as such Lawson says that FX products would only be offered based on an assessment of the GP’s “appropriateness and suitability”. Aside from the regulatory reporting aspect, which if not handled properly could lead a PE manager to unwittingly introduce regulatory risk for non-compliance, there is also the fact that active hedging may require them to pay margin. This could potentially lead to additional cash being tied up to manage margin calls, if the derivatives contract exceeds certain loss thresholds. A third risk consideration is termination. Lawson states that if a derivatives contract needs to be terminated prior to maturity date, it could result in the GP paying additional costs. Exit considerations To conclude, when approaching the time to exit a position, the manager will likely have a clearer idea as to what the asset value will be and tailor the FX hedge a bit more precisely. “I would say that the discussion becomes more substantial the more the visibility of cashflows becomes,” confirms the London-based PE group. “If you are approaching the end of an investment, based on the discussions you have on the size of cashflow and on the proposed time to sell, that is when it becomes a more material consideration.” In this instance, the use of non-deliverable forwards might be used. This can allow the PE manager to hedge the asset value of its overseas investment(s) and pay to hold the contract by renewing it at expiry e.g. every six months or 12 months. This means the manager will know what his exit cost is at any given point in time. Through the ongoing portfolio review process, they might look to wind down the hedged position in place for an asset once they’ve determined it is the right time to exit. An intention to sell doesn’t mean you will know the exact date it will happen so again, having flexibility in one’s use of FX hedging products should be paramount. “This can help produce better risk-adjusted returns for the fund and help reduce uncertainty around performance of the portfolio. Reducing FX risk should help the manager to more clearly demonstrate value creation in the fund, to investors,” concludes Lawson. At a time when markets are going through a period of pronounced volatility, with the risk of recession growing stronger by the day, having a clearly defined and flexible FX hedging solution in place could be the difference between demonstrating to investors that your fund is top decile, as opposed to top quartile. And in so doing, justify the cost of having such a programme in place. www.privateequitywire.co.uk | 9