Hedging against big currency swings to gain an advantage

Amid growing competition, the ability of debt funds to manage foreign exchange risks has assumed greater importance, writes Afex's Ashley Hall.

The popularity of private debt investments among institutional investors has continued to grow unabated in recent years. The last 12 months has seen $133 billion raised by funds holding a final close, according to PDI data. That’s an increase of 8 percent from a year earlier.

A total of $58 billion has been raised by funds holding interim closes – accounting for 140 separate offerings that are currently raising capital. There are 326 funds currently in market, aiming to raise $160 billion. With industry growth, however, comes increasing competition.

This competition is putting the squeeze on debt funds as borrowers find themselves able to negotiate more favourable rates – driving down returns for investors. At the same time, investors are presented with a growing number of options and are able to shop around for the best home for their capital. Funds, therefore, need to find ways to maximise returns for investors while minimising risks.

Against this backdrop, debt fund managers’ ability to manage foreign exchange (FX) risks effectively and efficiently has assumed greater importance. It can even lead to a competitive advantage.

Given that returns on private debt investments are often in the high single or low double digits, currency swings can have a considerable impact on the performance of a fund. FX risk mitigation has always had a major role to play in fixing IRR on a debt fund.

This is particularly the case in Europe where debt funds are typically raised, reported on and paid out in US dollars, while the loans themselves are predominantly made in euros. As such, most European funds have currency hedging strategies in place. Increasingly, these are essential to attracting cornerstone investors.

A recent wave of volatility in FX markets, driven by political sentiment rather than economic fundamentals, has fueled some of the demand for currency strategies. This was seen, for example, following last year’s EU referendum in the UK, when sterling fell by 20 percent and 15 percent against the dollar and euro respectively.

At Afex we’ve seen a huge increase in funds looking to fully hedge their portfolios in an effort to eliminate currency risks entirely and protect investor returns following the referendum.

The strategies, facilities, terms and products available to private debt fund managers for managing their currency risks, as well as the associated costs, can vary dramatically.

While it may not necessarily be a core competency for a debt fund manager, in the face of intense competitive pressure managing FX can be used to gain a competitive edge. Finding an FX partner which understands the demands of fund managers can add tremendous value throughout the investment lifecycle, helping to maximise cashflow, returns and profitability.

Anyone who has looked into FX products will know spreads and hedging costs can vary wildly. With firms increasingly looking to hedge currency exposure on entire portfolios, these can quickly mount up and really eat into profitability. This is particularly true for fund managers with less than $500 million in AUM which potentially lack the bargaining power of larger funds. With greater pressure to deliver competitive returns, debt funds cannot afford to ignore price.

Additionally, funds are also often required to post collateral and maintain allowances for margin calls to secure FX hedging facilities, which can eat into the working capital available to invest. Terms vary dramatically from one FX provider to the next and fund managers should shop around to ensure they’re working with one offering flexible terms and adopting a commercially minded attitude towards hedging facilities.

In volatile markets understanding the costs and exposures involved in FX facilities is essential to avoid nasty surprises. These liabilities, however, aren’t always made immediately obvious. When opening a new line, fund managers should find out whether their provider offers fixed spread agreements – helping to factor in those costs.

There is also a human capital dimension to managing currency risks. Debt fund managers have specific and varying needs at different points in the investment cycle.

Finding a counterparty which understands those needs and offers tailored solutions can free up time spent managing FX to allow more time to be spent managing investments.

Managing FX risk is a necessary part of private debt fund management for many in the market, but with mounting pressure on IRRs it’s also an area that can increasingly be used to achieve a competitive edge.

Ashley Hall is a sales director, fund and institutional EMEA, at Afex, a London-based global payment and risk management solutions specialist.