How important is creating a hedge share class for emerging market GPs
Private equity general partners are constantly striving to outperform public markets and provide higher returns to their investors. GPs are increasingly looking to diversify their allocation and are focusing more on emerging markets to quench their desire for exotic returns.
And with higher returns come higher risks.
Because they are expanding into new markets such as Latin America, Africa, and parts of Asia, it is impossible to have a conversation with an LP about investing in those without bringing up the topic of currency volatility. As a result, the fund value is vulnerable to such turbulence, affecting its returns.
Research by Private Equity International says that currency risk is the number one reason why many LPs are hesitant to commit capital to emerging markets in the long term. Investors consider that it has the potential to wipe out their gains in the long term.
A recent example is a Brazilian fund manager who suffered a loss of double-digit IRR on returns due to currency exchange headwinds.
That being said, what should fund managers do to keep their streak of investing in emerging markets effective in terms of returns?
A simple and powerful solution is the “Hedge Share Class.”
The purpose of this article is to demonstrate the value that GPs can derive from hedge share classes, which includes not only protecting returns from foreign currency fluctuations but also increasing confidence in allocating to these emerging markets and raising more money from offshore investors.
1. Introduction to hedge share classes
In search of superior returns, GPs are rushing into emerging markets, which have relatively high currency volatility, thereby making their funds vulnerable to those market fluctuations.
Hedging minimizes, if not eliminates completely, the fund’s value against exchange rate fluctuations between the fund's base currency and the investor's preferred currency. Hedge share class involves hedging the fund in a way that investors’ returns are protected while paid back in their own preferred currency. This technique basically offsets the risk of currency fluctuations on returns, as shown in figure 1.
Of course, hedged share classes are not without their own limitations, and you should always talk to an expert before making any decisions.
However, if you're GP, who is investing in emerging markets like Latin America, Africa, and Asia, that can be a great way to minimize your FX exposure and thereby protect your returns in the long run.
Figure 1. Investor’s return components. Source: Deaglo
2. Why consider creating a hedge share class?
Consider a situation before a pandemic where a USD-based investor has invested in a fund denominated in BRL.
During the pandemic in 2020, as per the Refinitiv data, the Brazilian Real took a hit of almost 30%.
In that case, if gains in the BRL portfolio were 20%, the final returns to the LPs would come to -10%, owing just to currency depreciation.
This is not limited to the BRL. Other emerging market currencies, such as the ZAR, MXN, TRY, INR, and RUB, have taken a beating, as illustrated in the graph below.
Figure 2, EM Currency depreciation during the Covid pandemic. Source: Refinitiv
LPs who were subscribed to the funds with these currencies all took a hit due to the deterioration of local currencies.
One of the reasons is that the bulk of emerging markets is export-driven, and a slowdown in global growth hurts their economies and currencies. As a result, any financial or economic instability is likely to be severe in comparison to developed economies.
Not only that, but market volatility also surged by over 50% during the pandemic and previous financial crises.
Figure 3, WSJ VIX Index
So, what’s the mitigation strategy in such a financial turmoil and a highly volatile environment?
A hedge share class, based on a layered hedging strategy, would have helped minimize volatility by up to 70% for BRL exposures, thereby lowering FX risk and generating steady returns for the USD-denominated investors.
Deaglo's FX analysis platform, as shown below, demonstrates the effects of a layered hedging approach on volatility for your foreign currency exposures.
Figure 4, Source: Deaglo FX platform
That’s one of the reasons GPs should establish and consider a hedge share class while allocating in emerging markets, to offset FX exposures in adversity and deliver stable returns.
Fast forward to today, 2022 has been highly volatile and unpredictable, thanks to the Russia-Ukraine conflict, Semiconductor tussles, Britain’s fiscal stability issue, Supply chain lags due to Covid’s after-effects, and rising inflation pressures.
That being said, volatility in emerging markets has shot up again, as shown here.
Figure 5, WSJ VIX Index
Also, as per the WSJ currency markets, the Mexican Peso has lost 4% this year, the South African Rand has lost 22%, and the Japanese Yen has lost nearly 26% against the strong dollar. The Fed’s aggressive monetary tightening is expected to give a further boost to the greenback and, in turn, undermine emerging economy currencies.
Thus, LPs who are USD-denominated and have subscribed to funds in any of these emerging markets risk losing their returns if they are unhedged.
This gives one more strong reason for GPs to go with the hedge share class while allocating LPs’ commitments in emerging markets to avert such market adversity.
3. How does a hedge share class work?
An alternative manager raising capital from international investors and allocating in local currency can face FX risks during the following two phases of investments.
Deployment phase: the goal is to reduce functional currency depreciation risk.
Harvest phase: the goal is to reduce local currency depreciation risk.
A hedge share class allows the protection of both phases of the investment cycle, and the process is known as round-trip hedging, which aims to protect the fund’s entire lifecycle.
A common approach is to hedge foreign currencies using forwards (see Table 1 for Spot +/- Forward Points), but there are also other derivatives available.
In some cases, using forwards, interest rate differentials will favor the hedger, and these profits can partially offset the costs associated with the other side of the hedge.
Table 1. Forward Points. Source: Bloomberg forward points
Not only this, GPs can select from varied hedging methodologies available, that is, from layered hedging, fire and forget, and rolling hedges. For round-trip hedging, our FX platform shows that a layer hedging arrangement has been quite effective.
Finally, the deployment of hedging share classes is dependent on the risk appetite and goals of a fund manager (GP).
4. What are the benefits of creating a hedge share class?
The first and most important advantage of establishing a hedge share class for GPs in emerging markets is gaining confidence when allocating LP funds to such unpredictable market locations in search of high returns. This breaks the top barrier of LPs while investing in emerging markets, which is currency volatility.
Secondly, GPs can credibly present their FX risk management strategy, run by Deaglo's FX platform, to the LPs who are scrambling to access emerging markets but are sidelined due to the FX risk.
Thus, GPs have a greater chance of attracting more offshore investors for their funds in emerging economies because they have an effective risk management plan in place to navigate adverse market conditions.
Other benefits of hedge share class include:
Diversification at less risk: Many GPs seek exposure to emerging market assets for the diversification benefits they provide, but they do not want to pass the risk of foreign currency volatility that these assets may bring to their investors. That’s where hedged share class gets an edge.
Reduce volatility: A hedged share class for BRL fund using a layered strategy reduces the volatility up to 70% and smoothes out the fluctuations in the USD/BRL rate, as shown below.
Figure 6. Volatility reduction under a layer hedging arrangement. Source: Deaglo’s FX platform.
Consistent and stable returns: A layered hedging strategy implemented by an emerging market GP provides investors with returns that are correlated with the fund's base currency returns. Additionally, the hedged IRR (Internal Rate of Return) distribution is much narrower than the unhedged IRR distribution, which significantly minimizes the downside risk. That implies that hedged IRR is more stable over time.
Convenience: GPs with hedge share classes allow investors to buy fund shares in their preferred currency rather than dealing in the fund's base currency, thereby making it easy for investors to take part in foreign investments.
In essence, hedge fund managers have an advantage when it comes to FX risk management, giving them a better chance of acquiring more overseas investors and raising more funds.
5. What are the limitations of a Hedge Share Class?
Gains/losses: The hedged share class will bear all gains/losses and expenditures resulting from the hedging program implementation.
Losing on additional gains: Currency changes can benefit non-hedged share classes sometimes, whereas currency-hedged share classes may miss out on those additional gains in similar circumstances.
Interest rate differential - Because hedging costs are calculated using the spot rate and the difference between the interest rates on the two currencies, forward points may rise or fall, affecting the moneyness of the strategy.
Margins and collateral drag: Financial adjustments might be negative or positive depending on market movement and the fund's open positions. Margin facilities and collateral are requested often.
As GPs increasingly seek to diversify their portfolios by allocating to emerging markets, developing hedge share classes allows them to minimize foreign currency exposure risks and deliver steady returns. That practice, in turn, benefits GPs by attracting a greater pool of offshore investors who wish to protect themselves against currency volatility and reap high returns by tapping into emerging markets.
Deaglo is at the forefront of this trend, assisting GPs in the development and implementation of hedge share classes while also working to avoid some of the constraints that may arise during the process.
If you are a fund manager trying to raise capital from foreign investors you can now request early access to our FX risk management platform:
Protect your investors against currency volatility
Analyse, select and create the best FX strategy for your hedged share classes
Show your investors you have their FX exposure under control