The past few weeks have seen plenty of speculation that China might be about to devalue the yuan. Although private equity firms don’t typically need to worry about currency fluctuation and volatility, the prospect of devaluation could potentially cut of profit margins for many of the worlds PE funds. So how serious is the impact of currency volatility and what can PE fund managers do to protect against it?
How Does Currency Volatility Impacts PE Firms?
John Kinnell, an associate at the UK-based financial risk consultancy group HiFM, wrote in 2013 that private equity firms have to deal with currency volatility risks in three different areas. First, they are exposed to risk in the area of expenses. For example, a firm based in the UK might need to deal with dollar-denominated management fees. Secondly, there is a risk within the operational transactions such as IPOs and exits in non-reporting currencies. Finally, currency volatility poses a risk to private equity firms through “the impact of NAV of holding foreign assets”.
The impact of the above can be just a minor problem or it could pose a much larger risk to profits and performance. In regards of the current risk of yuan devaluation, Kevin O’Mara, a partner at law firm Morgan Lewis & Bockius, told the Wall Street Journal that, “Lack of stability could knock 10% to 15% off the return. It could knock something below the hurdle rate.”
Furthermore, currency exchange rates are constantly changing and funds must understand by just how much this can impact the fund’s value in the long term. For example, a study by TorreyCove Capital Partners showed that in the previous 12 years, the USD/EUR exchange rate has fluctuated from a mere 84 cents to $1.60. Currency volatility therefore is a challenge for PE firms.
At the same time, it is crucial to note that the long-term nature of private equity funds makes changes in currency’s value more difficult to manage. For a PE firm, the sensible approach is to understand that currency values change over time, as the above shows, and it isn’t possible or even viable to take note of every single change.
Hedging Against Currency Volatility
Private equity firms, as other institutional investors, can opt to hedge against the issues with currency volatility. The problem for fund managers comes from trying to find an approach that is acceptable within the objectives of the fund. It can also be difficult to ensure investors see eye to eye with the hedging approach.
But perhaps more importantly, it isn’t sure whether hedging for private equity firms works in a desirable manner. The ToreyCovey study shows that “hedging works best with a discrete cash flow that is of a known quantity and is expected to be received within a relatively narrow time frame in the future”. But for private equity investments, this is harder to achieve as the nature of PE investments make the cash flow analysis ‘less predictable’.
There are other options available for fund managers as well. In fact, many experts believe currency hedging is potentially very costly practice and hard to achieve successfully. The industry experts believe manager selection is much more influential in guaranteeing proper returns in the face of currency volatility. Commenting on the current situation with China, Baird Capital partner, Aaron Rudberg, told the Wall Street Journal, “GPs will need to decide if they are willing to walk away from the sale due to the current dollar-yuan rate”. Mr O’Mara continued the sentiment by saying, “Theoretically, one deal hit by depreciating currency should be balanced by other investments in a portfolio”.
The Current Situation with China
Much of this debate has resurfaced now the Chinese government is considering a possible devaluation of the yuan, according to experts. Yuan-denominated funds became a lucrative opportunity for private equity firms after the financial crash in 2008, as the funds found more opportunities to invest in Chinese companies.
According to Preqin data, in 2011 and 2012, private equity firms raised around $35.5 billion for the yuan-denominated funds. During the same time, non-yuan denominated funds managed to attract a little less, roughly $33.7 billion. Despite the early outpouring of interest, investors quickly realised that the funds offered much less transparency and uncertainty. Chinese government’s treatment of these yuan-denominated funds wasn’t clear and the mighty dragon saw its economic growth beginning to slow down.
In 2014, investment for the yuan-denominated private equity funds had declined to $5.6 billion, whereas the non-yuan denominated China-focused funds continued to gather $16.9 billion.
The fear is many of these Asia-focused funds are now sitting on a lot of dry powder, as PE funds have been slow to invest or return capital to investors in recent months. Yuan-denominated funds could thus be hit hard in the event of devaluation.
So far, the Chinese government has been trying other methods. It recently cut interest rates in a hope to increase lending and stall devaluation. But it remains to be seen how well the current reforms are able to impact the economy. Many analysts are still relaxed about the prospect. In a recent Wall Street Journal post on the matter, Joe Brusuelas, chief economist at advisory and accounting firm McGladrey said, “Should they (Chinese) choose to devalue, one can assume it will be modest in scale, and well-telegraphed so as not to disrupt sensitive domestic financial markets as well as global markets.
Importance of Proper Management
Overall, currency volatility can pose a threat to PE funds and it is something managers and investors need to think about. Although there are no clear signals that a big shock is on the way, managers need to be prepared for the possibility. Proper deal flow analysis and possible hedging against currency volatility is something PE firms should think about. Private equity fund managers have a big role in deciding how well their portfolios perform and it is important to keep a cool head when considering currency risks.