EMPEA’s Currency Risk Management Survey is the first pan-emerging markets exploration of the impact of currency volatility on the private equity industry. The survey features the views of 146 industry practitioners, and aims to provide the industry with a better understanding of how both GPs and LPs* report and manage exchange rate movements in their EM PE portfolios—including decisions regarding whether, when and how to hedge.
Long-term investors in emerging markets are no strangers to currency risk. Over the last 20 years, the Asian financial crisis, the Russian rouble crisis, and the Argentine and Brazilian crises— among others—have all demonstrated the inherent risks of currency depreciation and devaluation. Indeed, the severe economic and human consequences of past currency crises have prompted many governments to implement a number of structural reforms that have underpinned emerging markets’ relative growth and financial stability over the last decade. The extraordinary scope and duration of expansionary monetary policies following the global financial crisis, however, injected an enormous amount of liquidity into the global financial system; and as the onset of the U.S. Federal Reserve Bank’s tightening cycle reverses this process, currencies are absorbing a large degree of the shock, creating challenges for the emerging markets private equity community.
The Trend is Your Friend Until the Bend at the End
An inflection point in global liquidity conditions occurred in 2013, when the U.S. Federal Reserve Bank began tapering its asset purchases (known as Quantitative Easing), thus reversing a decadelong declining trend line in the value of the U.S. dollar (see Exhibit 1). At the time, market participants observed heightened volatility across emerging market asset classes, and the so-called “Taper Tantrum” led to reductions in net private capital inflows in emerging markets—particularly with respect to bank loans.
The U.S. dollar has appreciated rapidly over the last 18 months and is currently stronger than it has been at any time since 2002. The strong dollar has coincided with increased FX volatility, lower oil prices and weaker EM currencies. With respect to volatility, Ashvin Chhabra, Chief Investment Officer of Merrill Lynch Wealth Management, has determined that currency volatility is at its highest levels for non-crisis periods over the last 20 years.3 Moreover, this volatility is occurring in an environment in which many free floating or lightly managed EM currencies have become more correlated with one another, creating potential risks for pan-EM and regional funds that previously may have benefitted from greater diversification.
While U.S. dollar strength has historically been associated with low oil prices (and vice versa), the surge in U.S. shale production led to a glut in supply, and amplified the decline in the price of oil beginning in 2014. When married with the slowdown in China and the broader softening of demand for products in the commodity complex, the currencies of natural resource exporters and countries that rely on oil revenues—such as Brazil, Mexico, Nigeria and Russia—have depreciated sharply against the U.S. dollar.
An “Ever-Present” Risk
In EMPEA’s 2014 Global Limited Partners Survey, currency risk ranked as the top macro-related concern amongst LPs, with 21% of respondents labeling it as the “most concerning risk” (followed by an economic slowdown in China). They may have been right to be concerned. To wit, according to EMPEA data, nearly 25% of the capital invested in EM private capital deals between 2013 and 2015 has been deployed into countries that have experienced a depreciation of 30% or more in their currencies against the U.S. dollar. The question remains whether the worst is now behind us, or if tepid global growth could lead to competitive devaluations. In the process of drafting this report, Janet Yellen, Chair of the Board of Governors of the U.S. Federal Reserve System, signaled that global economic weakness may present risks to the U.S. economic / inflationary outlook, implying a “flatter” curve for policy normalization (i.e., fewer rate hikes in 2016), thereby potentially reducing pressures on EM currencies.
Be that as it may, 69% of respondents in our Currency Risk Management Survey believe FX risk has increased compared to three to five years ago; and as one survey participant notes “devaluation risk is ever-present in our investments.” For other investors, FX risk may inhibit commitments to EM PE altogether— in EMPEA’s 2016 Global Limited Partners Survey, currency risk was cited as one of the two largest deterrents to investing in the asset class in seven out of ten markets / regions.
Outline of the Report
This report blends quantitative findings from a survey of 146 industry professionals undertaken between 7-22 March 2016, with qualitative insights derived from in-person and telephone interviews with LPs, GPs and service providers (see Participant Demographics on page 20).
Following a thought leadership contribution from Tom Speechley, Partner and Head of Global Markets at The Abraaj Group, this report opens with an assessment of how important currency risk is to industry professionals and to what extent practitioners believe FX volatility will impact investment and exit activity. It then turns to how practitioners prefer to translate local currency performance into a reporting currency, as well as how LPs evaluate the performance of GPs in light of currency volatility. This section also includes views on whether carried interest terms should be adjusted based on GPs’ local currency performance. The third section explores whether and how firms hedge their FX exposure. Finally, the report concludes with some thoughts on what all of this means for the industry writ large.