Data & Intelligence
Expanding Institutional Investment into Emerging Markets via Currency Risk Mitigation
Posted On: 22 Jun 2017
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A Roadblock to Institutional Investment in Emerging Markets
Currency risk is one of the top concerns of investors in emerging markets private equity (“EM PE”) funds. Recent surveys of industry participants, notably EMPEA’s 2016 Currency Risk Management Survey, reveal that nearly 75% of practitioners rank currency risk as an important or very important factor for their firm, while approximately 60% report that exchange rate movements have subtracted value from their realized EM PE investments (with several respondents estimating losses of US$500 million or more since January 2014). In addition, according to data from EMPEA’s annual Global Limited Partners Surveys, currency risk is the top macro-related concern amongst institutional investors in EM PE funds.
More to the point, currency risk is inhibiting institutional investment into emerging markets broadly, and into frontier markets in particular. This is a key source of capital sorely needed in these markets to foster sustainable growth and development. Beyond mere capital, however, private sector investment helps mobilize much-needed know-how, networks and other resources for local enterprises.
As part of our research for this study, we surveyed commercial institutional investors (such as endowments, family offices, foundations, funds of funds, insurance companies and pension funds) to ascertain whether a cost-effective hedging solution would increase their appetite for investing in new markets where they have not yet invested. A clear majority—70% of surveyed commercial limited partners (“LPs”)—note that a hedging solution would increase their likelihood of investing in new markets.
A Persistent Challenge
Given the series of financial crises that beset emerging economies over the last two decades, as well as the sizable currency depreciations and devaluations witnessed in recent years (such as the Mexican peso, Nigerian naira and Russian ruble), it is little surprise that currency risk plays a decisive role in commercial investors’ decisionmaking processes. After all, roughly 75% of EM PE funds are denominated in U.S. dollars.3 Moreover, nearly 25% of the capital invested in EM deals between 2013 and 2015 was deployed into countries that experienced a depreciation of 30% or more against the U.S. dollar during the same period.4 Anecdotal reports from private equity fund managers (also referred to as general partners, or “GPs”) suggest that some have fallen beneath their “waterline” (the hurdle rate at which the fund manager receives carried interest from its investments), raising fears that some fund managers may lose the incentive to harvest investments, and LPs’ capital could be locked up in assets for an extended period.
The U.S. dollar has strengthened against a broad basket of currencies, and is reaching its highest level in two decades, marking a clear reversal from the weakening trend witnessed from 2002-2012 (see Exhibit 2). As the U.S. Federal Reserve Bank pursues a policy of incremental interest rate increases, a strong U.S. dollar could become a mainstay of the emerging markets investing landscape, with all of the challenges this portends.
Outline of this Report
This report opens with findings from EMPEA’s second currency risk survey, which was conducted in January 2017 and drew responses from 119 industry professionals (see Appendix I for further details on survey participant demographics). This section begins with an exploration of whether private equity fund managers and institutional investors employ firm-wide policies for managing emerging market currency risk. It then turns to participants’ current use of hedging products—with a focus on use during the holding period of an investment—and the limitations of existing solutions. Then, it explores respondents’ demands from an ideal hedging product.
In the subsequent sections, the report shares the contours of potential hedging solutions that have been identified as part of the research efforts undertaken for this initiative, as well as the next steps the project team is conducting. Finally, the report concludes with an overview of why currency risk’s impact on private equity funds is salient to the donor / development community, and lays out a non-exhaustive list of roles that the development community could explore to ameliorate currency risk, thereby helping to mobilize further private capital flows to developing economies.
For newcomers to the topic of currency risk management, a primer on currency hedging derivatives is provided in Appendix II. The primer supplies practitioners and industry stakeholders with an overview of exchange traded and “over-the-counter” hedging instruments, as well as the size of the markets for these products. Key takeaways for the private equity industry are provided.
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Rashad Kaldany | Executive Vice-President and Growth Markets, CDPQ
David Rubenstein | Co-Founder and Managing Director, The Carlyle Group