Geopolitical uncertainty is at an unprecedented high. How should private equity firms be mitigating macro risk? A group of senior dealmakers and advisers meet to discuss how buyout firms are navigating unpredictable times
At the table:
James Scotcher, Pollen Street Capital
Louis Elson, Palamon Capital Partners
James Yates, IK Investment Partners
David Porter, Apposite Capital
Ophir Shmuel, MVision
Michael Slane, Investec Fund Solutions
Ryan Djajasaputra, Investec Economics
Moderator: Amy Carroll, Real Deals
Managing risk is a perennial issue. But Brexit, trade wars and the looming threat of an economic downturn have thrown risk management into the spotlight. What do you consider to be the biggest external threats facing your business right now and what is your approach to mitigating them?
We have been running Brexit scenarios for some time. We have both private equity and credit funds. Obviously, there will be exposure in the private equity portfolio, albeit over an extended period of time. On the credit side, our approach has been to have someone else put the first loss piece in. That offers us some protection. If there is a shock we haven’t foreseen then at least we have that additional buffer. We can run models all day long, but our job is to deliver consistent returns and so volatility is undesirable. The smart thing to do is have someone else who is willing to take a bit more risk.
As an equity investor, what we have done is limit leverage levels. In the current environment you want to be able to give your portfolio companies breathing room. If there are any nasty surprises around the corner, you want to give them the opportunity to work those through. There is a huge amount of liquidity around at the moment and banks are keen to put as much into structures as they can. But that doesn’t mean it is the right thing to do.
Firms like ours are not as macro-sensitive as the mega funds. The way we view it, there are three key things we need to worry about. Number one is regulatory change. We focus a lot on political dynamics to make sure there are no regulatory shocks that could disadvantage our small businesses. Second is credit. Like James, I don’t see any contraction in availability. In fact, there is money sloshing around all over the place. Yes, global growth is slowing and yes, that could result is some form of retrenchment. But the reality is we now know what Central Banks are prepared to do. We are seeing unbelievable terms from banks, and funds, with very few covenant restrictions and a lot of cushion which I think eliminates that risk for us.
The biggest risk, we believe, lies with demographics and behavioural changes. We are seeing a lot more disruption in specific business models because of the rapid evolution of technology. Businesses and consumers are able to change the nature of what they are doing within a one-year cycle. We have spent a lot of time trying to think through whether a particular business model will survive a change in the way its customers are behaving. Those things can have a massive impact in a short period of time.
We tend to live in our own little bubble as a dedicated healthcare fund. We have infinite demand driven by demographic and lifestyle factors, with things like type 2 diabetes and dementia coming to the fore. But, of course, the ability for payors to finance those demands is not infinite. Those are the factors that affect our businesses.
Our biggest challenge at the moment is that everyone knows about the protective qualities of healthcare in a recession and we need to be clever to avoid the wall of money swirling around the sector. Because, if you normalise some of the prices being paid for larger deals, it can be difficult to see how they will work from a returns point of view. Not that I complain when it comes to exiting our investments, of course!
What about interest rates? With low unemployment and strong consumer spending, how long can inflation stay low and how long can central banks ignore the need to get rates back to normalised levels?
The Bank of England doesn’t want to do anything until we have certainty over Brexit. That’s the bottom line. Once we have clarity there, I think we will see a gradual rate rise in the UK.
Globally, you have to consider the vast amount of liquidity in the system from QE. The Fed has been shrinking its balance sheet, but that is probably going to end this year. The ECB is nowhere near contemplating reducing the size of its balance sheet, and it is the same with the Bank of England. And then there are concerns around economic growth as well. All that, means that interest rates are likely to remain low. The Fed may even ease rates in 2021 and there are question marks over whether or not the ECB will raise rates again this cycle.
I think it is incredible that we haven’t seen inflation. Unemployment is at record lows and we definitely see pressure coming from that. We own a dental services business where we are finding it tough to recruit. And we have a beauty retailer that is struggling with deliveries because the Yodels of this world can’t find drivers. That should all be leading to inflation.
Where does managing FX volatility sit in terms of your priorities? Even without today’s heightened risks, the Euro/Dollar has experienced swings of between 20 and 30 per cent for each of the past 18 years. Is this something you focus on?
We hedge transactionally. We hedge on the way in and we hedge on the way out. But we don’t hedge the hold period. That is mainly driven by the fact that there are no over-the-counter solutions. You can’t just walk into a bank and say ‘I would like this for five years please’. You have to build something which tends to be more expensive and complex.
The other challenge we have is in understanding what you are hedging in terms of quantum and duration, because, at the end of the day, you don’t really know how long you are going to hold an asset and you don’t really know what the proceeds are going to be. We are also lucky in that we don’t invest in very volatile currencies. We are a euro fund and invest mainly in euro areas. We have a little bit of exposure to Scandi currencies but they tend to be less volatile than say, the Polish zloty or even the US dollar – or sterling, as we have seen over recent months.
We are highly transparent with our investors, however. We tell them exactly what value we are holding in what currency and then if they want to hedge that they can. It is an interesting topic. We have been looking at the issue of how best to hedge for 20 years. I still don’t know what the right answer is.
We have tried all sorts of different approaches and found that we can’t really control it in the way that we would like.
What I would say though is that portfolio companies do need hedging today because their ability to reach outside of their current boundaries is now infinite and we are encouraging them to do that. We do a lot of spot hedging within businesses we own.
At the same time, there are some interesting dynamics going on. Currency volatility from top to bottom is increasing, but the time curves are shortening. For us, with average hold periods of just under five years, that means we can almost call the market. We have found ourselves less exposed to currency fluctuations because we have more timing control.
That’s a really good point. We don’t have to sell at any one point in time, so if we hold for an extra three to six months, we know the
FX will probably move back to a more favourable position.
What we see with our clients reflects just what you are saying. We see a lot hedging between signing and completion but not much in between.
Larger funds will often have multiple currency sleeves, but beyond that it becomes more difficult.
What about emerging markets? Managing currency risk there can be very challenging.
We do a lot of work in emerging markets and those funds really do see large currency fluctuations. We have worked with LatAm managers that have had most of their returns wiped out once they have switched back to US dollars. And, again, it’s very expensive for them to be able to hedge it.
What we see is that they take a very careful approach to vintage year diversification, really spreading out deployment to make sure if they are hit in a down cycle, then at least they are averaging out over the investment period. It is a smart approach and as close as it gets without having to spend heavily on hedging.
We were talking to our emerging markets team yesterday. They work with 90 per cent of the Africa-focused funds. They were saying that these funds are having a really tough time fundraising. We thought it was just the Abraaj hangover but they believe there is more to it.
It seems that emerging markets funds have consistently failed to justify the associated risk. They just haven’t quite delivered on
I think that is right. When we speak to our US investors, if they are in a non-US fund, they expect a premium on return because they see the FX risk.
If you are an African GP and you are returning the same as a European mid-market manager and you have got FX and political risk to contend with on top of that then that makes it a difficult proposition.
A lot of the large LPs are doing currency overlay programmes where they are hedging at the top of their structures. It’s a good product but it’s expensive if you don’t really know the end points and you don’t really know what you are hedging. It’s almost an exponential cost. You need to be able to be specific about the result you want to lock in.
Given these obstacles that private equity faces in hedging currency risk, what are the options available?
We are not oblivious to the challenges that private equity faces. Funds, by definition, have uncertainty around exit and hold periods can often be longer than anticipated. Any hedging solution has to be efficient and flexible. What we have done is combine our credit business – our fund finance business – with hedging products and that means we don’t have to ask for cash collateral, which is the biggest cost in fund hedging.
We can also allow managers to move delivery date without having to meet variation margin.
As long as the fund is looking sensible – if NAV hasn’t dropped to below 30 per cent of the original fund size, for example – you can keep moving that date and we will never call you for cash. That flexibility point is crucial. Fund managers cannot have cash tied up in hedges. That is a killer for private equity.
We have worked with clients through Brexit where their mark-to-market on, say a £100m hedge, was 15 per cent. With traditional hedging products you would have to settle that £15m, which is a major cash drag.
But as long as the fund is living within the fairly loose covenants that we set, we can allow that fund to continue to roll without settling.
We have looked hard at fund hedging and concluded that given we are primarily a sterling fund and primarily a sterling investor, it probably doesn’t make sense.
But like Louis, we are really concentrating on our portfolio companies. We have international healthcare businesses that are importing supplies from one part of the world and selling into another.
You have to stay on top of currency. That is where we are concentrating all our effort.
Michael, what changes have you seen in terms of the asset class’s approach to hedging in general? Is it becoming more widespread?
Real assets and debt funds have always hedged, while private equity has done so less.
We recently surveyed almost 300 managers as part of our latest GP Trends survey. That showed that 40 per cent of firms are now hedging and that percentage is increasing year-on-year. It starts with the big funds but moves down through the market for a number of reasons.
Banks develop products in response to what the big funds want, that makes hedging easier and more flexible. LPs see that their big funds are hedging efficiently and start to talk to their other GPs about it too. Then there are factors such as Brexit. Product development, changing LP sentiment, and macro events are all having an effect. We see it in our trading figures too. Our primary fund trading volumes are up 67 per cent year on year.
Are GPs hedging management fees?
We do hedge our management fees on a 12-month cycle because we have sterling costs but euro cash in. We use rolling three-month hedges for that which works quite well. It just smooths the curve and gives you relative certainty.
We looked at that but decided it really wasn’t worth it because we were picking up on one side but losing on the other.
That’s exactly what we found. It eases that volatility from quarter-to-quarter, so you end up with almost the same result but on a smoother path. It makes you feel like you are swimming with trunks on.
Does pressure on returns make hedging currency more important?
Depending on the amount of exposure of a particular fund outside of the core currency, and depending on what is happening in the markets at that time, my analysis shows that the cost of a mismatched currency book on fund performance can be up to around 300bps. 300bps when funds were doing 30 per cent IRR is no big deal. But with returns sinking into the teens and low 20s, that is a significant hit.
How concerned are LPs about a manager’s approach to FX risk?
We primarily operate in the mid-market where concerns may be a little different. LPs all want to make sure that GPs have the right policies in place in terms of risk management and that leverage is moderate. What has changed is a far more stringent approach to due diligence on these factors. Many LPs have separate operational due diligence teams that go on site, talk to the CFO and try and understand the processes and make sure the governance is all in place.
Some will even have full risk management committees that sit separately from any investment committee and try and identify the risks from a top level point of view. What does this group look like from a vintage year diversification perspective? How consistent is its deployment? What is its loss ratio? They will evaluate those risks and then feed them into the investment decision, but at arm’s length. FX gets rolled into that as well. Where is this GP investing? How are they managing those currency risks? LPs want to know whether the GP has got a handle on them.
Take Italy. That is a challenging market right now. But there are a lot of active Italian GPs being backed by investors and, actually, we are seeing German managers coming down into the country. People aren’t shying away from these risks. It is just about how you manage them. And, in a lot of cases, LPs will trust their GPs to do that.
Real Deals would like to thank Investec for making this roundtable possible.