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White & Case Private Equity Viewpoint - Issue #1

Private equity firms find opportunities as volatility continues to dominate the financial markets

Stepping into uncertain times

The White & Case Private Equity group discusses how well equipped the private equity industry is for the uncertain conditions investors face today

There has been much political upheaval in the last 12 months, from the change in the US administration to questions over the future unity of Europe. Anecdotally, there's a sense of uncertainty about future policymaking, how this will impact the economy and what it will mean for investors, including private equity funds.

Recent research confirms this sense of unpredictability. The Economic Policy Uncertainty Index, devised by economists from Stanford, the University of Chicago, and Northwestern, measures the occurrence of words in newspaper articles that relate to economic uncertainty and politics, as well as the number of expiring tax laws and the spread among economic forecasts. The change in presidency is the third-biggest source of uncertainty since the Index was introduced more than 30 years ago, ahead of both the 2008 financial crisis and the 1987 stock market crash.

Investors like certainty. It helps them to deploy capital with confidence. Private equity funds are no different in this respect, however they are also some of the most tenacious investors in the world and possess a knack for turning uncertainty, and even market disruptions, to their advantage.

In recent years, funds have not only become more operationally minded, creating lasting value in investments by genuinely transforming companies, there has been a growing tendency to think longer term. Funds with extended life cycles are beginning to be raised, and we would expect this to smooth out the effect of uncertainties or market swings as divestment schedules become more flexible.

While the details of much of the new administration's policies remain to be seen, many sectors stand to benefit from new tax and regulatory rules, and investment programs. For instance, America's infrastructure is likely to receive substantial investment, and this will benefit funds that are targeting these assets as well as the construction businesses required for them to be built and renovated.

More generally, any reduction in regulation and a lowering of corporation tax would be a boost for business. Of course, there is concern that protectionist measures designed to make America more competitive relative to other countries may have unforeseen, undesirable consequences such as raising import costs. Such knock-on effects have the potential for investors to lose confidence, which could depress what have become frothy stock markets and filter into private market valuations. This would certainly give cause for caution. However, stock market turbulence can play to private equity's advantage, as IPOs become more challenging and such sales divert to buyout funds.

Furthermore, so-called PIPEs (private investment into public equities) and take-privates become more attractive to the buy-side, and an easing of private valuations would be welcome after a period of persistently high purchase multiples.

Not only that, we have seen a healthy pipeline of corporate divestments to private equity in recent years as businesses continue to home in on their core products and services. If uncertainty continues, so will the pressure on corporates to sharpen their focus through such disposals. 

Clearly private equity, like every other investor type, would like to see a clear, predictable path ahead. But the tools and know-how at its disposal mean that, even in the period of uncertainty that we find ourselves today, the industry will remain very much open for business. 

Preparing the ground

Josh Lerner of Harvard Business School

Josh Lerner of Harvard Business School on private equity's knack for navigating uncertainty

Brooklyn Bridge, New York

Currency risk: Here to stay

Tom Speechley, Partner at The Abraaj Group

Tom Speechley, Partner at The Abraaj Group, examines how private equity GPS are managing the associated risks of currency volatility in emerging markets

Hong Kong

To hedge, or not to hedge?

David Fann, President and CEO of TorreyCove Capital Partners

David Fann, President and CEO, TorreyCover Capital Partners outlines some possible options for currency risk management within a private equity portfolio

digital financial stock display

To hedge, or not to hedge?

4 min read

David Fann, President and CEO, TorreyCove Capital Partners outlines some possible options for currency risk management within a private equity portfolio

In most cases, a well-structured, diversified private equity portfolio can mitigate currency fluctuations.

One of the most striking macro-trends of recent years has been the appreciation of the dollar versus currencies in both mature and emerging markets. Uncertainty in Europe—with last year's Brexit vote adding to the mix—combined with China's slowdown, has made the dollar a relative safe haven for investors, to the detriment of other currencies. But what does this mean for the US private equity investor committed to non-dollar-denominated funds? Should they be hedging their investments to stem losses?

In most cases, a well-structured, diversified private equity portfolio can mitigate currency fluctuations.

As investors make both contributions and receive distributions over the 10-year lifespan of a fund, this acts as a natural, inbuilt hedge that evens out currency swings over time. Across an entire portfolio, this effect is magnified.

However, recent years have witnessed a persistent appreciation of the dollar, which poses a greater challenge for US investors exposed to non-dollar currencies.

We believe that if an investor strongly expects a local currency to which they are exposed will fall into secular decline, there may be a valid case for a hedging strategy.

By its nature, private equity is illiquid and its cash flows (drawdowns and distributions) are unpredictable, making it incredibly difficult—although not impossible—to hedge at the individual fund level. Indeed, investors should analyze to what extent the private equity managers with which they are invested already hedge at this level, as doing so themselves may be redundant. Because of this, we advise clients eager to dampen the effect of currency movements to install hedges at the portfolio level, where estimated cash flows are more stable. Even then, it is far from an exact science.

Proprietary analysis has shown us that projected compared to actual net cash flows range from anywhere between 3 percent and 95 percent, with an average of more than 35 percent. This means the portfolio would be substantially over- or under-hedged most of the time.

For those willing to embark on a program, there are a number of solutions open to investors, including forward contracts, futures, options, swaps and exchange-traded funds that focus on currency exchange rates, and each comes with its own pros and cons.

We advise investors to carefully ascertain their currency exposure, as they may already have a degree of cross currency hedging in place.

We believe that futures contracts are unsuitable for most institutions since mark-to-market adjustments require that any gains and losses are settled daily. Aside from the fact that private equity assets are valued on a monthly or quarterly basis—making fair market valuations imprecise and potentially increasing risk in the hedged portfolio—many investors lack the time and resources required to manage such daily settlements.

For this reason, a more suitable alternative may be options, which effectively act as an insurance policy against major losses. However, options are not without their drawbacks, namely the premium required to purchase them, a cost that increases as currency markets become more volatile and more investors seek insurance.

We advise investors to carefully ascertain their currency exposure, as they may already have a degree of cross-currency hedging in place. For example, a euro-denominated fund investing in a Swedish company will have kroner exposure.

Furthermore, today's globalized economy means that many businesses' cost and revenue streams are diversified by currency, helping to mute volatility. Additionally, in the case of buyouts, which represent the majority of private equity investments by value, the leverage taken out on acquisition targets may act as an inherent hedge at the company level, since a weakened local currency will be partly offset by a fall in the value of the debt denominated in that same currency.

Over the long and medium terms, the effect of currency movements in mature, diversified private equity portfolios tend to be moderate. The more diverse the portfolio, the less impact FX risk is likely to have, assuming that currency exposures are actively monitored and managed.

Arguably one of the most effective hedges is selecting a pool of talented fund managers able to identify companies with diversified costs and revenues, who can differentiate between macroeconomic challenges and company-specific currency risks, and who can support the growth of their investee companies in spite of market volatility. It is these managers who will deliver returns during uncertain times.


David Fann
President and CEO, TorreyCove Capital Partners

TorreyCove is a non-discretionary specialist advisor focusing exclusively on private equity and real assets.



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