THE IMPACT OF FOREIGN EXCHANGE ON PRIVATE EQUITY PERFORMANCE

Investing in private companies is essentially a local activity. Most fund managers invest in locations close to their headquarters. Funds invest the capital collected from local and international investors in local currency. In developed markets, the local currency is also the currency of reference of the fund. Fund managers do not have to deal with foreign exchange issues. This can be different in emerging markets, as fund managers often label their funds in one of the international currencies. As a result, the performance of these funds can be rather volatile depending on the evolution of the local currency against the currency of reference of the fund. However, fund managers do not hedge this risk. Moreover, they tend to communicate their performance in local currency on their track record. Therefore, fund investors ultimately have to handle the delicate task of managing their foreign exchange exposure.

This is challenging as the duration of investments is largely unknown and usually rather lengthy as it spans multiple years. Not only would hedging the currency exposure associated with a private equity fund be difficult, it would also be rather expensive. However, if this exposure cannot be neutralized, investors often still want to manage it. A traditional approach would be to aggregate assets in their currencies of reference, determine the net exposure and hedge it. Although this technique is attractive, it can be difficult to implement with investments of very different durations. Private equity investments appear in many respects as a foreign exchange “anchor” that the rest of the portfolio will add on or subtract to. However, balancing this exposure is risky as this anchor can partially be released without much notice (usually a few weeks) in case of an asset sale. Moreover, it may ultimately be neutral in terms of currency exposure over time, while the cost of regularly rebalancing it can be significant. Balancing it on a weekly, monthly, quarterly or even annual basis can also increase the volatility of a portfolio instead of stabilizing it.

Another solution would be to establish a portfolio of private market assets that is neutral in terms of foreign exchange. Assuming a diversified private equity program, maturities should balance each other and currency exposures could also compensate each other. This reasoning, however, assumes that this is possible. This is not necessarily the case, as the US represents roughly 65% of the investment universe in private equity. It also assumes that fund investors want the same foreign exchange exposure in private markets as in their overall portfolio (there is no net balance to handle). Institutional investors might want to adjust their currency exposure over time.

Therefore, managing currency exposures is challenging for private equity investors. Before engaging in complex strategies, it might be useful for investors to assess the share of their net performance at stake due to foreign exchange matters. eFront Pevara supports this assessment thanks to its high-quality data, and its capacity to compute cash flows with foreign exchange spot prices. The recent data update as of Q3 2017 provides an even better perspective for this purpose.