Latin American currencies have had a challenging time over the past six months, with the coronavirus pandemic and political risk leading currencies to slump to record lows against the US dollar.
The BRL has been one of the worst-hit as it closed out this week down 33.0% since the beginning of the year, while the Argentine Peso was down 34.2%, the Colombian Peso fell 11.0% and the Chilean Peso 1.4% lower.
Source: Bloomberg
As typical with emerging countries, their economies are severely affected by the weak global trade, alongside the reciprocal collapses of commodity prices.
This context is important, since foreign exchange volatility can have a large impact on private equity (PE) returns. Therefore, hedging FX exposure within private equity might be more important in the current environment, than ever before.
There are many international PE firms, with a considerable degree of foreign currency exposure, and many are adopting inadequate hedging solutions or, even worse, giving little attention to FX policy. Managers may be reluctant to venture into the perceived abyss of FX hedging, because there is an idea that hedging costs are too expensive from a collateral perspective.
This is not utterly false! A major deterrent in past years has been hedging costs (especially in LATAM and specifically over longer tenors).
Meanwhile, hedging costs have fallen as a result of a global synchronized slowdown in interest rates in an attempt's central banks to boost economic activity. The figure below shows that the annualized cost of hedging the US dollar against the Brazilian real (BRL) is currently around 1.3%/year. Therefore, now is the time to reconsider hedging strategies.
There has been a shift to PE firms seeking out natural hedges - e.g. Investing in companies whose revenues and liabilities do not present a currency mismatch, or selecting businesses that generate U.S. dollar revenues and local currency costs - This strategy is a new source of risk in their operations and it may become bigger if there are persistent exposures that go unaddressed.
So, first things first, the PE firm must identify the risk and recognize the current strategies may not be the best fit.
From the PE's perspective, the FX exposure is different from usual corporate FX exposure. That is, the PE fund could be exposed in several ways depending on the structure and the investment lifecycle. For instance:
Portfolio company level, there is FX exposure within of each company;
PE fund level, all FX exposures of each portfolio company are present;
General Partner (GP) level, receiving management fees in a non-base currency;
In an investors level, capital from foreign investors is locked in not less than 5 years, hence they focus their attention on mitigating near/medium-term FX risk.
To conclude, it allows General Partners and Investors either reduce or neutralize returns volatility, in other words, it helps them to reduce considerable uncertainty in regard to the performance of a fund, even in emerging markets such as Brazil and Mexico, where currency fluctuations are a natural outcome of a fragile economic environment.