Research

Andrea Minardi is a professor at Insper Institute of Education and Research and a member of the Executive Committee of the Business Association of Latin America Studies (BALAS).

Andrea has adapted this piece from a study on currency impact in Brazilian private equity and venture capital deal performance published in March 2015. The full white paper may be found here.

Many private equity (PE) and venture capital (VC) firms that invest in Brazil raise capital from international investors. Funds call capital in U.S. dollars (USD) and convert it into Brazilian reais (BRL) to invest in portfolio companies. At the time of exit, they receive the proceeds in reais and convert them back into dollars. As performance and profits are measured in dollars, and as the investments are in reais, funds run currency risk.

We analyzed how currency risk has affected performance of the Brazilian PE/VC investments over the last 20 years, basing our analysis on the Spectra-Insper database. The database was built through a partnership between Spectra Investments, a Brazilian investor in PE and VC funds and Insper Institute of Education and Research, a Brazilian business and economics school.

Key findings from the study include:

Currency risk is irrelevant for the long term performance of limited partners and PE/VC firms

From the sample of 239 deals invested between 1994 and 2014, annual BRL appreciation is 0.4 percent, that is, close to zero. As long term limited partners (LPs) and PE/VC firms invest or manage a portfolio of many deals with vintages spread out over time periods, diversification mitigates currency risk, and these investors should be more worried about performance in BRL than performance in USD.

The impact at the deal level may be substantial, impacting performance fees

Contrary to the finding above, currency impact for a single deal may be substantial. Although mean and median are close to zero, the dispersion is high: 33.5 percent of the deals had an annual BRL appreciation over +12 percent or under -12 percent.

IRR in USD may be misleading to judge track records of general partners

Currency devaluation may transform exceptional performance in BRL into mediocre returns in USD. For instance, one deal with an IRR in BRL of 37 percent had an IRR in USD of 6 percent. The opposite is also true. Currency appreciation may also convert mediocre returns into exceptional returns. One deal with an IRR in BRL of 8 percent had an IRR in USD equal to 29 percent. Accordingly, LPs should require performance data in local currency for assessing the real picture about a GP’s track record and making good judgment about the GP’s ability to generate high performance deals.

 

Although there is diversification across deals, depending on the vintage, some funds may not be able to diversify across cycles, and foreign exchange risk may affect fund performance

Currency impact is cyclical. Funds raised in the beginning of a BRL devaluation cycle will have a positive currency impact on most of their deals, and funds raised in the beginning of a BRL appreciation cycle will have a negative currency impact on most of their deals. Therefore, even if funds are portfolios of deals, they will not be sufficiently diversified throughout time to mitigate currency risk.

Funds that invest in the beginning of a devaluation cycle are candidates for incentive problems. One example is the possibility of higher turnover rate in the GP’s team. Talented human resources may quit the firm if they do not see the possibility of receiving carry in the medium term. In the long term, currency risk can be irrelevant for LPs and PE/VC firms because good cycles can compensate bad cycles.

 

PE/VC Brazilian deals realized and liquidated between 1994-2014 outperformed Brazilian public market alternatives: the Ibovespa (Sao Paulo Stock Exchange Index) and CDI (certificate of interbank deposit rate of return, a proxy for Brazilian risk free rate)

On average, PE/VC investments in our sample outperformed the Ibovespa and the CDI, corresponding to an average net PME of 1.3 for the Ibovespa and 1.2 for the CDI.

 

PE/VC Brazilian deals realized and liquidated between 1994-2014 outperformed U.S. public market alternatives: S&P 500, NASDAQ Stock Market and 10-year T-bonds

PE/VC investments in our sample also outperformed, on average, the S&P 500, NASDAQ Stock Market and 10-year T-bonds. Net PMEs were substantially above 1.0: 2.2 for the S&P 500, 2.1 for NASDAQ and 1.9 for T-bonds. It is important to highlight that the performance of Brazilian deals in USD with vintages between 1994 until 1999 was negatively impacted by currency devaluation, and that deals with vintages between 2002 and 2006 were positively impacted by currency appreciation.