Why mastering FX risks is vital for VCs in emerging markets.
Venture capitalists are increasingly flocking to emerging markets in search of high-growth opportunities with higher returns than in developed markets. However, they are unaware of one huge risk that might wipe out all their profits.
Currency risk, or the risk of fluctuating currency prices, is a critical challenge that all VCs in the emerging market face and should strive to overcome. According to studies, if it gets materialized, this risk can damage the fund's underlying strategy. This article will discuss why currency risk is important to overcome and the advantages of managing those risks.
Emerging Markets studied: Africa, Southeast Asia, Latin America, and India.
Note: VC or Venture capitalists, EM or emerging markets, and currency risks or FX risks are used interchangeably.
Venture Capitalists' success wasn't limited to developed markets like the United States and Europe throughout the pandemic. Despite the risk, emerging markets around the world were able to make their imprint. Lately, the Magnit market report says that the amount of investment surged to 3.5x in 2021 compared to the previous years; that shows dramatic growth of 228% YoY in EM VC funding.
Also, according to a report by Crunchbase, the number of venture capital deals signed and the sheer channel of funding flows into businesses in emerging regions such as Latin America, Africa, and Southeast Asia has surged in the last few years.
Pic source: Crunchbase database
The reason VC funds find the region attractive is because of the fast growth of startups and favourable demographics. Encouraging trends include a rapidly rising middle class, a youthful population, and growing digital adoption. Some of these trends have been accelerated following Covid.
Additionally, Rebecca Hwang, co-founder and CEO of YouNoodle, a startup that assists corporations and governments in identifying high-performing entrepreneurs and talent, states that.
“One reason these emerging markets appeal to investors is that they are ideal testing grounds for new products, with a young population that is connected to social media ”.
Along with the potential for rapid growth, investing in emerging markets also has one major drawback, which is the challenge of currency risks. That is due to the highly volatile nature of these emerging markets as well as the less stable economic and political conditions of these countries.
For Investors, currency risk or FX means the fear that an investment return in EM companies will be washed away when converted back to U.S. dollars or Euros because the local currency loses its relative value over time. That fear keeps billions of dollars off the table, according to an EMPEA report.
So far, we have discovered that with the rapid rise of VCs in emerging markets, they are also confronted with the threat of currency risk. The following section attempts to quantify how challenging this risk can be for VC funds and their portfolio companies.
A. Risks for the VC funds investing in emerging markets
The volatility in emerging markets is higher than in developed economies. A statistical term known as value at risk is used to explain how volatility would affect your currency exposures. Assume a USD-denominated fund is investing in Brazil, where BRL has annual volatility of 16%. That being said, there is a risk of loss of 26% or $263,000 for every million dollars invested or spent, as per Deaglo’s FX platform.
Source: Deaglo FX platform
Moreover, if we look at the performance of emerging market currencies over the last year, we can see that a majority have depreciated against the dollar. This means that if a fund manager invests in local currencies in any of these economies, there is a guaranteed chance that the fund's return gets washed out when converted to the original currency.
Source: Deaglo FX platform
B. Risks for portfolio companies
When VCs are investing in portfolio companies in emerging markets, they face currency risks of two types. First is when these portfolio companies raise funds and begin deploying the funds internationally in local currencies. The longer the deployment period, the greater the risk. Second, as these companies grow, they may have overseas revenues and cost structures that expose them to multi-currency risks. A pictorial representation of these risks is shown below.
Source: Shahid Bharucha, Deaglo
To summarise, losing 26% of capital while investing overseas is a substantial loss; similarly, risk when transacting in portfolio firms or companies with foreign currency exposures is a clear warning that the downside of currency risks is significant and must be managed appropriately.
That being said, venture capitalists funds that are active in investing in emerging market companies should employ an effective currency hedging strategy at the fund level as well as at the portfolio company levels to avoid such losses. In this regard, companies like Deaglo offer FX risk management solutions for VC fund managers to understand their FX exposures and develop strategies to mitigate those risks and ensure maximum returns.
To deal with foreign currency exposures, the company employs a straightforward four-step method. Quantify the risks, design different strategies to compare and contrast, execute an effective strategy on the best credit terms, and lastly, report the results.
Deaglo’s step-by-step process to deal with currency exposures.
Given the huge downside of FX risks and the necessity to reduce them, let us look at the advantages of hedging FX risks.
3. Benefits of hedging currency risks
For VC fund managers operating in unstable emerging economies, currency hedging results in lower volatility and more stable profits. As a result, they provide consistent returns to investors, in turn, which boosts their capital-raising potential.
At the same time, for a company having overseas operations or looking to expand globally, it is critical that the local operating entity considers an effective FX risk management framework through which it can maximize value for its investors by improving its own key profitability metrics.
The following are the advantages of an FX hedging program for portfolio companies, primarily potential startups.
Hedging enables a startup to lock in a foreign exchange rate that stabilizes its overseas operating costs or sales revenue while protecting its budget rate.
Allows a company more time to respond to rate changes.
Profit from perceived low market rates.
Hedging provides predictability in the face of uncertainty in future cash flow projections. As a result, effective business planning is now possible.
Setting and protecting a budget rate can help a company enter new markets with confidence, expand its global operations, and scale more comfortably and clearly.
Moreover, a Silicon Valley Bank study backs up the benefits of the aforementioned hedging program. According to the study, which focused on post-IPO companies, small-cap public technology firms that hedged currency risk with derivatives demonstrated better valuation and profitability metrics than ones that did not opt for hedging.
Lastly, currency hedging is increasingly important as the current market conditions of global monetary tightening have sent a wave of volatility across all asset classes.
Hence, currency hedging in volatile markets gives greater predictability over uncertainty for portfolio firms, resulting in steady and consistent returns for investor funds.
In summary, although venture capitalists rush to developing countries in search of new development prospects, they face enormous currency risks that, if realized, may wipe out their profits. Such downside serves as a reminder that FX risks must be hedged, which, when executed right, results in benefits such as more steady and consistent profits.
About the Author
Shahid Bharucha is a market analyst for Deaglo, where he contributes to the company by presenting daily, weekly, and monthly currency reports for major and developing economies.
You can contact Shahid at email@example.com.
Deaglo is a cross-border technology firm specializing in the execution and risk management of global transactions with Investment Managers, Investors, and startup companies.
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*Note: This article first appeared on OpenVC' S blog at https://openvc.app//blog/fx-risks-vc-emerging-markets#