As a new financing landscape emerges, European direct lending is growing and with it, more sophisticated solutions to investment challenges.
Investors are struggling to achieve strong returns amid low interest rates, continued depressed yields in conventional fixed income and increased volatility in equity markets, all helping the growth of the sector.
As the direct lending sector matures, fund managers are increasingly looking to use foreign exchange (FX) hedging to manage asset and investor cross-currency risk, their own income streams and lock in returns.
Direct lending funds can be impacted by FX risk at two levels; investor funding and at asset level. Currency volatility can have a significant impact, both positive and negative, on both.
As well as fund-level FX risk, many managers are considering the impact of currency exposure on returns at the general partner level, in terms of their management fee currency denomination versus that of their cost base.
To date fund managers have typically employed an ‘all or nothing’ approach to FX hedging, however, they are increasingly looking at more sophisticated ways to manage FX risk to optimise fund performance, using this as a tool to attract increased investment.
The most common approach by direct lenders is a rolling FX forward programme between asset acquisition and disposal.
This removes all spot FX risk, as currency gains or losses will be almost entirely offset by profit or loss on the corresponding hedge.
This strategy is especially popular among direct lenders as the exposure is fixed and the hedge exactly matches the fund’s exposure – unlike in the private equity sector where realisation amounts and timings are more variable.
However, it’s worth noting the fund is still exposed to a movement in the FX forward point adjustment caused by a widening in the interest rate differential between the two hedged currencies. Funds will typically roll these positions to the financial period ends in line with net asset value / fund performance reporting to investors.
Until recently, direct lending fund managers would choose to denominate a fund in either the same currency as investor commitments or the target market for assets. This simplifies the structure and reduces the FX risk at investor or asset level.
However, as funds look to grow and attract a range of global investors, fund managers are looking at alternative structures.
RBS has seen a growth of multi-currency funds offering several currency share classes, whereby the fund will mirror returns in the same currency as the limited partner’s investment, broadening the FX hedging requirement further.
A fund may nonetheless make a conscious decision not to hedge FX risk. This decision may be driven by the potential liquidity requirements of a hedging programme. Alternatively, the decision may be made with investors based on their risk appetite. For example, investors may be prepared to accept currency risk as an inevitable by-product of a fund’s multinational exposure or carry the FX risk themselves as part of an investment portfolio approach.
The key considerations when developing an FX hedging strategy are:
Fund liquidity: managers must ensure the fund has sufficient liquidity to meet potential FX hedge losses. This may be in the form of uncalled investor capital, cash reserves or bank facilities. Fund-level finance can be used to collateralise or settle FX trades, potentially removing the need to draw investor capital or provide additional liquidity. Whilst there is a cost associated with having fund-level finance, this is offset by the reduced cash drag on the fund, as well as the opportunity cost of partial fund deployment.
Investor appetite: potential investors must be aware of any planned hedging strategy and dialogue regarding fund FX exposure could help fundraising.
Treasury resource: the fund must have sufficient resource to set up and actively manage the FX hedging as well as ongoing portfolio analysis, cash management, FX execution and legal document negotiation.
Netting ability: Direct lenders may be exposed to FX risk at both the level of the fund and the lending vehicle. Netting these exposures could reduce the size of the hedging programme and reduce costs. Treasury teams should consider where each FX hedge is booked and consider hedging on a consolidated basis.
“Beechbrook manages euro-based private debt funds and a sterling-denominated UK SME credit fund. Our investors come from both the UK and eurozone countries, which creates a currency mis-match with our underlying investments. We also have a mis-match between our GP income in the euro funds and our UK-centred cost base. To manage our funds and business, we have worked closely with RBS to structure multiple FX solutions and have benefited from their expertise in providing a choice of solutions, trade execution and support for ongoing management. This gives us confidence to plan ahead and reduce uncertainty to our investors.”
Paul Shea, co-founder and senior partner, Beechbrook Capital