Foreign direct investment from the United States to other countries averaged almost $6 trillion from 2017 through 2020, partly due to the large amount of capital invested by U.S-based private equity (PE) funds in international companies. The desirability of international PE investments stems from the ability to merge overseas companies with U.S.-based portfolio companies, expand product markets and enable vertical integration. In addition, attractive valuations of companies outside the United States have provided a compelling reason for U.S.-based firms to develop international investment strategies.
One key component of investing outside the United States is assessing the risk of currency fluctuations. This issue of the Private Equity Quarterly explains why many PE firms are strategically incorporating detailed foreign exchange (FX) hedging procedures into their overall investment policy, highlighting the value this integration can provide.
International Investments Take Off
For most U.S.-based PE firms, investments in international markets have become an increasingly material component of their portfolios. New records for both deal count and total capital raised were set in 2021, with an almost 50% increase on each measure compared to previous five-year averages. This increased focus and allocation will likely continue as global market dynamics shift in the years ahead.
Figure 1: International Deals by U.S.-Based Private Equity Firms
International investments by U.S.-based firms can offer a means to diversify, provide access to lower valuations and higher return potential, or expose opportunities that are simply not present in the U.S. market. The diversification benefits of these investments can provide more stability to the returns of the entire fund, but they can also bring new by-product risks, including political, economic and foreign currency risk. These by-product risks are generally reflected in the overall volatility of local securities markets along with the other capital market risks of the underlying investment. However, the FX risk can be isolated, and by isolating the FX aspect, the investor can attempt to quantify and manage this risk separately.
Although some PE finance and deal teams welcome the diversification from international investments, most view currency uncertainty and volatility as having the potential to negatively impact the total return of the underlying investment. Figure 2 below shows that Europe and Asia received the bulk of investment capital from U.S.-based PE firms from 2017 through 2021. The need to quantify and manage these inherent risks remains a constant in these regions and the underlying countries.
Figure 2: U.S.-Based Private Equity Investment Into International Regions, $M (2017–2021)
To Hedge or Not to Hedge
Whether the investment is in a fund manager’s home country or abroad, their primary job is to take investment risks to derive returns. Protecting these returns against unnecessary volatility is also part of this responsibility. Unlike the corporate world where hedging FX risk is almost universally necessary and thought through, it isn’t always the case in PE.
Some PE firms may take a dynamic (opportunistic) approach to currency exposure management, while others may follow a passive (always or never) approach; many choose a hybrid of the two. In some cases, a decision not to hedge is simply a decision to remain passive. In other cases, the decision to hedge FX risk is specific to the underlying investment, cash flow or investment tenor, and it isn’t consistent across the fund’s investments or mandates. At a minimum, firms should be consistent with their hedging approach, by including language about FX risk in investment policies or a separate FX hedging policy.
What Does Managing FX Risk Look Like?
While many see the creation of a hedging policy as a linear process that ends the day the hedge is booked, others view it as a cycle in which management of exposures is adjusted when fund or investment dynamics change. Ideally, this process involves a detailed approach to FX hedging policy creation, execution and, most importantly, monitoring. Creation of an FX strategy and execution of a dedicated FX policy are important first steps. After implementation, having a trusted FX advisor monitor the efficacy of the firm’s FX strategy as market dynamics shift is the key to the long-term consistency most PE firms and investors seek.
The four steps in the pie chart below demonstrate the flow of managing FX risks in parallel with the fund investment cycle. First Republic’s experienced team of FX advisors will partner with PE firms throughout this process to understand risk tolerance and goals; identify and quantify risks; and implement, execute and monitor these plans.
Figure 3: The Four Phases of FX Management in Private Equity
- Defining FX policies and procedures as you raise and structure. During the process of raising and structuring a fund is when a firm would typically identify its approach to FX risk and get the necessary infrastructure in place, so it’s ready to trade when that time comes. This exercise aids a firm in developing its overall philosophy, policies, procedures and objectives related to international investments and FX risk management. For instance, an FX policy would consider a firm’s desired risk tolerance, identify the types of risk that are tolerable and calibrate how much risk is acceptable. The firm would then set policy and review it with internal personnel. The firm would also establish an ongoing review and reporting structure in this phase.
- Identifying and quantifying risks as you find investments and deploy assets. As the firm starts to research investments and deploy assets, it will need to identify and quantify a wide range of risks and exposures, including any inherent FX risk. Partnering with an expert FX team can help firms identify relevant market dynamics and resulting strategies they may have overlooked. The first step to identifying and quantifying risks includes estimating the budget for the initial investment and when the funds will be deployed. In addition, the firm will need to quantify the FX exposures if the deal has already closed or at the time it closes. This process may include defining how the firm is forecasting its expected foreign currency denominated returns and determining if the associated cash flow risks are short-term or long-term. Finally, the firm will need to identify any contingent exposures, including acceptance of bids and contract changes.
In advance of executing hedges, the firm and its FX partners will work to identify and compare potential strategies to manage FX risks. These strategies can include common currency trade tools, such as spot, deliverable and non-deliverable forward contracts; currency swaps and vanilla options; and option structures. The selection of the appropriate hedging tool(s) will be based on the stated philosophy of the firm or fund but can also be customized to fit the goals of the exact investment.
- Investment monitoring and measuring hedge effectiveness. As the firm monitors the results of its investments, seeks new opportunities and eventually starts to exit investments, it will also work with its FX partners to evaluate exposures and hedge performance and effectiveness. Monitoring includes reviewing internal reporting mechanisms and ensuring the accuracy of figures and the sufficiency of data to gauge the investment and hedging performance. In addition, the firm in this phase would compare the efficacy and performance against stated goals to see if the U.S. dollar returns are smoothed out. The firm would also determine whether the FX risk management program failed to account for any cash flows resulting in FX gains or losses. It would make these assessments to decide if the firm should investigate the potential use of other tools as well as changes to the tenor, size or structure of its existing hedges.
- Harvesting and exiting investments along with hedge settlement and reassessing firm or fund level risks. During the harvest and exit stage, the firm may exit some or all of its international investments and begins the process of either returning funds to limited partners or redeploying the proceeds. As select investment exit opportunities are harvested and hedge settlements occur, it’s important to look at the total exposures and makeup of the funds to see if any adjustments are needed to the remaining positions.
The Benefits of Managing FX Risk
As U.S.-based PE firms continue to search globally for new investment opportunities, the need for increased awareness of FX risk management processes and tools will also rise. Formalizing an FX risk management program is a multistage process that’s typically measured in years and doesn’t end until the investment has been fully converted to U.S. dollars and returned to investors. For some PE firms, FX risk can be an afterthought, a risk they mitigate on a deal-by-deal basis. However, this article outlines the benefits of crafting an FX policy at the fund formation stage to best implement consistent and well-considered hedging mechanisms that can flex with any investment opportunity during volatile market conditions.
The First Republic Foreign Exchange team works with firms that choose to formalize a firm- or fund-level FX hedging policy as well as firms that approach each investment individually.
A U.S.- based PE firm’s implemented FX policies and procedures can also be restructured to accommodate future international investments and new funds, as adjustments are often required when selecting hedge tools, based on market dynamics and due to the underlying nature of the new funds. Although the unique characteristics of each new fund will determine whether the hedge tools are uniform or if they vary across international investments, the need for documenting the process of identifying and quantifying FX risks remains a constant if a fund maintains material exposures to international investments.