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Private Equity managers increase FX hedging activity to iron-out risk

By Jean-Philippe Castellani, Societe Generale – The reasons are many for the increase in the number of private equity funds seeking to mitigate foreign exchange (FX) risks through risk management solutions.  

The most obvious is the fact fund managers are more aware of the pitfalls of the past and are keen to avoid getting their fingers burned again. The structure of private equity funds means money from investors is generally locked in for 10 years. This gives fund managers a bit of breathing space to think strategically about how to manage the acquired asset and examine economic cycles. 

FX volatility is a perennial consideration. In the past, unhedged equity investments were often compensated relatively easily by strong returns. More recently, however, investors have focused their attention on mitigating medium-term FX risk to avoid torching swathes of their investment. The result is reduced risk for investors and more time for managers to focus on what they do best.

The sheer size of the market too is responsible for increased activity in this space. Private equity’s firepower increases year on year. New funds come into the market, all the while raising more capital to deploy. USD453bn were raised in 2017 by 921 private equity funds. The entire private equity market represents around USD2.8tn to be added to infrastructure, real estate Closed-End funds, globally.

A further boost to activity is the growth in the secondary market – funds of private equity funds which give investors the option of selling on their shares to third
parties. Not only does the growing emergence of this asset class provide the market with liquidity but it contributes to its growing size.

Naturally the increase in market size has increased competition for private equity funds. Managers are chasing the same investors and looking at the same deals, all of which has left them looking for ways to differentiate themselves from their peers.

Incorporating FX hedging solutions into their offering can help them do just that. It highlights to potential investors that risk management solutions are an integral part of their toolkit. It allows them to offer better risk-adjusted returns and reduce uncertainty around performance. Demonstrating a relationship with a highly rated bank with well-established derivatives expertise to structure these solutions further enhances a manager’s clout in the market.

There are many providers of FX forwards, deal contingent forwards and options in the market but few with a genuinely deep understanding of the derivatives market. Banks that lend in many of the capital call facilities have a strong understanding of the private equity market, providing funds with short-term funding to bridge the gap between investment and receipt of the capital from investors. 

Well-established relationships with corporate treasurers are invaluable in building relationships with private equity funds. Trading FX options, corporate clients generally sell implied volatility through their hedging programmes. Private equity clients on the other hand are often buyers of implied volatility. A foot in both camps can help a bank to find competitive prices for both client groups.

No-one knows what the future holds and experience has taught us to expect the unexpected. Geopolitical events of the last few years include surprises many didn’t see coming. They all had a dramatic effect on currencies, contributing in no small part to the uptick in FX hedging for private equity.

A suite of solutions is available for hedging FX risk – forwards, swaps, options or variations on a theme. For the most part, private equity clients tend to place relatively vanilla trades.  Because they are reporting to so many investors they require something quite neat, clean and easily digested. The solutions available are flexible; some managers hedge a portion of their portfolios and increase the amount as time goes by and the value of the assets tends to increase.

Having a framework for FX hedging also gives the fund manager the option of expanding into other classes. Rates, commodity or equity hedging for instance, can also be included in the suite of risks that the original FX set-up can help to accommodate.

While private equity funds invest in global markets and especially emerging markets, FX risk will continue to present challenges. The key always is to be prepared; insuring yourself against currency volatility cannot be done after the event. 

1 Source: Preqin 2018 report​
2 Source: Preqin 2018 report​

Jean-Philippe Castellani is a Managing Director in Structured Finance Hedging at Societe Generale.

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