“Why didn’t you hedge?” Private equity managers are often asked this question following unfavorable foreign exchange movements resulting in realized or unrealized losses and markdowns. (Curiously, no one seems to ask this question following a period of favorable currency movements.)
The answer: for most illiquid investments, be they private equity, infrastructure, agriculture or other real assets, the frictional costs and premiums to hedge long term principal exposure via forwards, options and other derivative contracts will inevitably erode investment returns over time.
At the same time, it is very difficult for US investors to outrun large and persistent currency declines against the USD such as those in Brazil where the BRL remains 40% below 2014 levels and Australia where the AUD has never fully recovered from a 25% selloff in 2014-2015. We need to find ways to mitigate these idiosyncratic risks.
What then are some practical strategies to manage exposure?
Discipline and disclosure around timing of entry and exit with an eye on currency cycles. Investment committee members should have a thorough understanding of local currency markets, volatility and cycles during the investment review process.
Sensitivity analysis based on the impact of currency movements. As previous examples have shown, currency movements of 25-40% can be expected during the course of a long term investment particularly in developing and commodity-based economies.
Utilize vanilla instruments such as committed forward purchases and sales to hedge known investments and capital repatriations. These are inexpensive low risk hedges which can be executed weeks or months in advance to protect investors. Complex derivative strategies to manage currency risk are expensive and require focused management.
Use of debt denominated in the investment’s functional currency can offset FX fluctuations by matching revenues and liabilities. Investors will need to weigh these considerations against the effects of local terms and loan pricing.
Maintain cash balances in the fund’s reporting currency rather than local currency whenever possible and develop a practice of frequent distributions of free cash.
Educate the investment and finance teams at all levels about the importance of FX and risk management. Investment results will ultimately be judged in the fund’s currency.
Understand the underlying currency exposure of both the portfolio company and its customers’ businesses. You may be able to reduce currency risk through creative sales terms that are favorable for both parties.
Always drive for best execution from your partner financial institutions including banks and brokers. Spend time cultivating these relationships. Plan your FX strategies well in advance. Trading FX under stress and time pressure may lead to suboptimal outcomes for investors.
Price movements of currencies and commodities are highly unpredictable. But you can tilt the odds in your favor by taking some simple steps to manage risk.