Currency Risk Management Survey - EMPEA

MAY 2016

Currency Risk Management Survey


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About EMPEA

EMPEA’s Board of Directors

EMPEA is the global industry association for private capital in emerging markets. We are an independent non-profit organization. We have over 300 member firms, comprising institutional investors, fund managers and industry advisors, who together manage more than US$1 trillion of assets and have offices in more than 100 countries across the globe. Our members share EMPEA’s belief that private capital is a highly suited investment strategy in emerging markets, delivering attractive long-term investment returns and promoting the sustainable growth of companies and economies. We support our members through global authoritative intelligence, conferences and events, networking, education and advocacy.

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Project Team

Mike Casey, Senior Director, Consulting Services Nadiya Satyamurthy, Senior Director, Consulting Services Rae Winborn, Senior Research Analyst Jamie Farrell, Consulting Services Fellow

Chief Investment Officer, International Finance Corporation (IFC)

Tope Lawani

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Roger Leeds

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Executive Editor

Robert W. van Zwieten, President & Chief Executive Officer

President & Chief Executive Officer, Global Environment Fund

Piero Minardi

Guest Contributors

Managing Director, Warburg Pincus

María Ariza, CEO, and Patricio Velarde, Vice President, AMEXCAP Mounir Guen, CEO, MVision Private Equity Advisers Tom Speechley, Partner and Head of Global Markets, The Abraaj Group

Sanjay Nayar

Member & Head, KKR India Advisors Pvt. Ltd.

Ziad Oueslati

Founding Partner, AfricInvest

Production Assistance

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Chief Executive Officer & Chief Investment Officer, The Rohatyn Group

Acknowledgements

We are grateful for the generous support we received from EMPEA Members and industry participants in producing this publication. In particular, we would like to thank the numerous fund managers and institutional investors who completed our survey, or made time to share their thoughts with us on a confidential basis. Finally, we would especially like to thank the following organizations for providing key thought leadership, as well as the financial support necessary for this project: SUPPORTING UNDERWRITER

H. Jeffrey Leonard

CONTRIBUTING UNDERWRITER

Jean Eric Salata

Chief Executive & Founding Partner, Baring Private Equity Asia

Mani Saluja

Partner & Co-Head, Emerging Markets Private Equity, Quilvest Group

George W. Siguler

Managing Director & Founding Partner, Siguler Guff & Company

Tom Speechley

Partner, The Abraaj Group & Chief Executive Officer, The Abraaj Group (North America)

Yichen Zhang

Chairman & Chief Executive Officer, CITIC Capital ©2016 EMPEA All rights reserved. Neither this publication nor any part of it may be reproduced, stored in a retrieval system or transmitted in any form or by any means—electronic, mechanical, photocopying, recording or otherwise—without the prior permission of EMPEA. Please contact Holly Radel at [email protected] or call +1.202.333.8171 for more information or to obtain permissions.

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Foreword from AMEXCAP Currency volatility has become a pressing issue over the last 18 months. The impact of the decline in crude oil prices and China’s slowdown continues to be felt across the globe, hurting the currencies of nations that rely heavily on demand from the world’s second-biggest economy. Mexico has not been immune, and last year the peso fell by 17% relative to the U.S. dollar, which is notable since the economy of Mexico does not demonstrate any real signs of weakness. Indeed, Mexico grew at a rate of 2.5% last year compared with the 1% rate seen across Latin America as a whole. As private equity markets have become more integrated and limited partners invest in private equity funds across the globe, currency risk presents growing challenges for both limited and general partners. Exchange rates fluctuate, especially over the longer holding periods typical of private equity investments, and sometimes more so in emerging markets where FX markets are not as mature or as liquid. In emerging markets with flexible exchange rate regimes, movements occur continuously, and currency risk is present at various stages of the investment process. For example, a limited partner that commits to a foreign-currency denominated private equity fund will be affected between the date the commitment is made, and when the drawdowns take place, potentially creating a liquidity problem for the LP. Alternatively, if there is an appreciation of the LP’s home currency relative to the fund’s currency, it may lead to underexposure relative to an LP’s target allocation. In the case of an LP that has committed capital to a fund acquiring assets exclusively in the fund’s own currency (e.g., U.S. pension funds investing in a peso-based Mexican fund), to the extent that the MXN/USD rate moves during the lifetime of the fund, returns may be reduced or even wiped out. Alternatively, currency movements could amplify returns in the fund’s currency. Another example highlighting the complexity of currency exposure would be the case of a U.S. LP committing to a euro-denominated global buyout fund that invests part of its capital in Asia. While currency risk is typically hedged for any debt used in the acquisition, the equity part in the deal is usually not. As a result, LPs are doubly exposed to currency risk—both at the individual portfolio company level as well as at the level of the fund’s overall returns. For a general partner, the challenges are also serious. If the GP’s fund economics are denominated in the LP’s currency and the GP’s currency depreciates, this could leave the fund with a hurdle rate that is impossible to obtain, creating a misalignment of economic interests. This is the condition that some funds are experiencing nowadays, and which occurs during certain global economic cycles. Unfortunately, this form of currency risk is very difficult to hedge; as cash flows are highly unpredictable in terms of their exact timing and size, and traditional instruments are largely inappropriate. Furthermore, it is not very clear if LPs can successfully hedge currency risk in their emerging market private equity portfolios due to the nature of private equity investments and the unpredictability of cash flows. Notably, CalPERS abandoned a 22 year-old passive currency hedging program because they argued that it had practically no effect on the returns or volatility on their approximately US$280 billion pension fund.1 The Mexican Association of Private Equity and Venture Capital Funds (AMEXCAP) and its members are very interested in shining more light on this topic, and want to identify best practices among LPs committing capital to country-specific GPs whose funds and hurdle rates (as well as the underlying assets of the portfolio) are denominated in local currency. Among them: • What would need to happen in order for LPs to commit in local currency? • What is the LP perspective and rationale for agreeing (or not) to fund economics in local currency or their own currency? • How are LP-GP relationships managed when fund economics are denominated in U.S. dollars but some type of hedging strategy is being implemented? • What are the hedging strategies implemented by LPs or GPs to mitigate currency risk and who bears the burden of hedging? What has been the outcome of these strategies and what is their likelihood of continuing in the future? With this in mind, we appreciate the opportunity to partner with EMPEA on the industry’s first survey of emerging market private equity practitioners regarding the important issue of currency risk management. María Ariza CEO AMEXCAP

1

Randy Diamond, “CalPERS will abandon passive currency hedging: 22-year-old program contributed nothing to fund’s bottom line,” Pensions&Investments, 3 March 2014.


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Currency Risk Management Survey Executive Summary EMPEA’s Currency Risk Management Survey is the first pan-emerging markets exploration of the impact of currency volatility on the private equity industry. The survey features the views of 146 industry practitioners, and aims to provide the industry with a better understanding of how both GPs and LPs* report and manage exchange rate movements in their EM PE portfolios—including decisions regarding whether, when and how to hedge.

Key findings from the Currency Risk Management Survey include: Approximately 75% of respondents rank currency risk as an important or very important factor for their firm. While 72% of LPs believe that ongoing currency volatility will lead to a delay in exits, only 31% of GPs do. Nearly 60% of respondents say exchange rate movements have subtracted value from their realized EM PE investments, with several respondents estimating losses of US$500 million or more since 1 January 2014. Only one-third of respondents believe EM currency depreciations / devaluations create a worrisome misalignment of interest between GPs and LPs with respect to fund economics. There is a lack of agreement on preferred methodologies for translating local currency performance into the fund’s functional currency. While the IPEV Guidelines† advise using the spot rate as of the reporting date, only half of the respondents in the Survey indicate this as their preferred approach. When the local currency differs from the fund currency, slightly more than half of LP respondents evaluate GPs by looking at the performance of both in parallel, while 46% primarily rely upon performance in the fund’s currency. In instances where an FX move causes a U.S. dollar fund’s performance to fall below its benchmark, 75% of LPs indicate that they would consider a GP’s local currency performance when evaluating a commitment or re-up.

* †

A majority of respondents—63% of LPs and 57% of GPs—do not construct their portfolios with currency risk as an explicit objective. A majority of GPs neither hedge their investments nor exits. For those GPs that do not hedge entries, 25% say they elect not to do so, while 36% report that the price of hedging products is too expensive. Amongst the 45% of GPs that hedge exits, deal-contingent forwards are the most-preferred vehicle for doing so. Approximately 65% of LPs do not hedge FX risk with their EM PE commitments, while roughly 11% run a currency overlay, which hedges the institution’s exposures across their entire portfolio of assets and fund managers. Approximately one-third of LP respondents want their EM PE GPs to hedge FX risk. When asked which types of EM PE funds they believe should hedge FX risk, LPs most frequently selected country-dedicated funds. Amongst the 68 firms that have implemented FX hedges, less than one-third report that they have paid off, while 38% report that it is too soon to say.

The breakdown of participants is 96 GPs and 50 LPs. For more information on the International Private Equity and Venture Capital (IPEV) Valuation Guidelines, see: http://www.privateequityvaluation.com.

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© EMPEA 2016. All rights reserved.

Introduction

The Trend Is Your Friend Until the Bend at the End An inflection point in global liquidity conditions occurred in 2013, when the U.S. Federal Reserve Bank began tapering its asset purchases (known as Quantitative Easing), thus reversing a decadelong declining trend line in the value of the U.S. dollar (see Exhibit 1). At the time, market participants observed heightened volatility across emerging market asset classes, and the so-called “Taper Tantrum” led to reductions in net private capital inflows in emerging markets—particularly with respect to bank loans.2

Chief Investment Officer of Merrill Lynch Wealth Management, has determined that currency volatility is at its highest levels for non-crisis2: periods over the last 20correlations years.3 Moreover, this volatility Exhibit Cross-currency have been is occurring in an environment in which many free floating or lightly increasing over the last decade—particularly managed EM currencies have become more correlated with one since another, creating potential risks2013 for pan-EM and regional funds that previously may have benefitted from greater diversification (see Exhibit 2). Exhibit 2: Cross-currency correlations have been increasing over the last decade—particularly since 2013 1

Cross-currency Correlation

Long-term investors in emerging markets are no strangers to currency risk. Over the last 20 years, the Asian financial crisis, the Russian rouble crisis, and the Argentine and Brazilian crises— among others—have all demonstrated the inherent risks of currency depreciation and devaluation. Indeed, the severe economic and human consequences of past currency crises have prompted many governments to implement a number of structural reforms that have underpinned emerging markets’ relative growth and financial stability over the last decade. The extraordinary scope and duration of expansionary monetary policies following the global financial crisis, however, injected an enormous amount of liquidity into the global financial system; and as the onset of the U.S. Federal Reserve Bank’s tightening cycle reverses this process, currencies are absorbing a large degree of the shock, creating challenges for the emerging markets private equity community.

0.5

0 2005

2007

2009

2011

2013

2015

-0.5 BRL-INR

INR-CNY

BRL-CNY

INR-NGN

ZAR-NGN The U.S. dollar has appreciated rapidly over the last 18 months and is MXN-NGN BRL-MXN currently stronger than it has been at any time since 2002. The strong Source: IMF. Exhibit 1: The U.S. dollar has broken a decade-long weakening trend line dollar has coincided with increased FX volatility, lower oil prices and Note: Representative rates, with two-year average correlations. Data as of 15 and has hit levels 2002 Februarysince 2016. weaker EM currencies. With respect to volatility, Ashvin Chhabra,not seen BRL-ZAR

Exhibit 1: The U.S. dollar has broken a decade-long weakening trend and has hit levels not seen since 2002

Trade-Weighted U.S. Dollar Index (Broad)

140 Strongest value since 2002

130

120

Inflection point for US$ strength or relief rally?

Breaks decadelong trend

110

100

90

80 Jan-95

Jan-97

Jan-99

Jan-01

Jan-03

Jan-05

Jan-07

Jan-09

Jan-11

Jan-13

Jan-15

Source: Federal Reserve Bank of St. Louis. Note: Jan 1997=100. Data as of 13 April 2016.

2 3

For an earlier treatment of this topic, see the EMPEA Brief, “European Bank Deleveraging: Opportunities and Challenges for EM PE Investors,” October 2012. Ashvin B. Chhabra, “A Sleeping Giant Awakens,” CIO Reports: The Monthly Letter, February 2015.


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Introduction, continued

to three to five years ago; and as one survey participant notes “devaluation risk is ever-present in our investments.” For other investors, FX risk may inhibit commitments to EM PE altogether— in EMPEA’s 2016 Global Limited Partners Survey, currency risk was cited as one of the two largest deterrents to investing in the asset class in seven out of ten markets / regions.4

While U.S. dollar strength has historically been associated with low oil prices (and vice versa), the surge in U.S. shale production led to a glut in supply, and amplified the decline in the price of oil beginning in 2014. When married with the slowdown in China and the broader softening of demand for products in the commodity complex, the currencies of natural resource exporters and countries that rely on oil revenues—such as Brazil, Mexico, Nigeria and Russia—have depreciated sharply against the U.S. dollar (see Exhibit 3).

Outline of the Report This report blends quantitative findings from a survey of 146 industry professionals undertaken between 7-22 March 2016, with qualitative insights derived from in-person and telephone interviews with LPs, GPs and service providers (see Participant Demographics on page 20).

An “Ever-present” Risk In EMPEA’s 2014 Global Limited Partners Survey, currency risk ranked as the top macro-related concern amongst LPs, with 21% of respondents labeling it as the “most concerning risk” (followed by an economic slowdown in China). They may have been right to be concerned. To wit, according to EMPEA data, nearly 25% of the capital invested in EM private capital deals between 2013 and 2015 has been deployed into countries that have experienced a depreciation of 30% or more in their currencies against the U.S. dollar. The question remains whether the worst is now behind us, or if tepid global growth could lead to competitive devaluations. In the process of drafting this report, Janet Yellen, Chair of the Board of Governors of the U.S. Federal Reserve System, signaled that global economic weakness may present risks to the U.S. economic / inflationary outlook, implying a “flatter” curve for policy normalization (i.e., fewer rate hikes in 2016), thereby potentially reducing pressures on EM currencies.

Following a thought leadership contribution from Tom Speechley, Partner and Head of Global Markets at The Abraaj Group, this report opens with an assessment of how important currency risk is to industry professionals and to what extent practitioners believe FX volatility will impact investment and exit activity. It then turns to how practitioners prefer to translate local currency performance into a reporting currency, as well as how LPs evaluate the performance of GPs in light of currency volatility. This section also includes views on whether carried interest terms should be adjusted based on GPs’ local currency performance. The third section explores whether and how firms hedge their FX exposure. Finally, the report concludes with some thoughts on what all of this means for the industry writ large.

Be that as it may, 69% of respondents in our Currency Risk Exhibit 3: Low oil has prices and compared anticipation Management Survey believe FX risk increased

of Fed rate hikes weakened a number of EM currencies

Exhibit 3: Low oil prices and anticipation of Fed rate hikes weakened a number of EM currencies BRL

CNY

INR

IDR

MXN

NGN

Crude oil breaks US$50

120%

Fed hikes by 25bps

RUB

China surprise devaluation

100%

% Depreciation against US$

100%


80%

120%

80% 60%

60%

Taper Tantrum

40%

40%

20%

20%

0%

0%

-20% Jan-13

-20% Jul-13

Jan-14

Jul-14

Jan-15

Jul-15

Jan-16

Sources: IMF and Investing.com. Note: Representative rates for the period 1 January 2013 through 15 February 2016. Data as of 15 February 2016. 4

Currency risk ranked as the largest deterrent in Latin America ex-Brazil, Southeast Asia and India, and the second-largest deterrent in Russia / CIS, Turkey, Sources: Brazil and Africa. IMF Sub-Saharan and Investing.com. Note: Representative rates for the period 1 January 2013 through 15 February 2016. Data as of 15 February 2016.

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Managing Private Equity Currency Risk in Global Growth Markets Mission Impossible or Holy Grail? Tom Speechley, Partner and Head of Global Markets, The Abraaj Group Last year’s fluctuations in global currencies brought currency risk into focus for LPs and GPs, many of whom invest not only in developed markets but also in growth markets across Asia, Africa, the Middle East and Latin America. Expectations of a stronger U.S. dollar, backed by higher U.S. interest rates, depressed the values of currencies around the world. The Fed, in effect, has been setting monetary policy for many other countries since the advent of Quantitative Easing. Moreover, current monetary policies increase the chances of ongoing currency turmoil during 2016. The low frequency and uncertainty of the timing of cash flows in private equity, as well as the relatively low liquidity and market depth of financial products in many global growth markets, create challenges for investors wanting to hedge their exposure. However, where traditional hedging solutions may not offer a solution, GPs should not throw in the towel. Once one recognizes that currency depreciation does not impact all companies in the same way, much can be done in practice to manage the exposure. It should all start at the strategy development stage and, though always subject to the limits imposed by the capital available to the GP, diversification will inevitably offer benefits. When carefully diversified, the impact of currency depreciation can be minimized. For example, the weighted average depreciation of Abraaj’s portfolio currencies across more than 30 countries in 2015 was less than the depreciation of the euro over the same period. The recent depreciation cycle has not been a growth market phenomenon but an “everything but the U.S. dollar” one. For example, during 2015 the Canadian dollar depreciated 19% against the U.S. dollar, roughly two times the move in the Indonesian rupiah (though the latter generates more headlines). More fundamentally, an investment strategy can be tailored toward companies that are better able to weather currency depreciation. At one extreme, a company with a local currency cost base and dollarized revenues will benefit from depreciation against the dollar, but such scenarios are rare in practice outside of a few specialized sectors. More commonly, a company will have a mix of local currency and dollar-linked input costs with revenues denominated largely in local currency. Such a company needs a mechanism to operationally hedge the mismatch, such as alternative supply channels or pricing power to pass on the implied cost of depreciation to their consumers as inflation. The point, as with most factors impacting the risk-return realities of private equity, is that microeconomic performance is still at the heart of a private equity investment’s success. Therefore, when investing in a company, two types of currency-related risk need to be differentiated. Currency risk on fund-level transactions needs to be managed separately and independently from the currency risk on operating performance, which is specific for each partner company. The most significant fund-level transactions in private equity are the purchase, sale and periodic dividend flows, and conventional shortterm hedges can mitigate the worst impacts of volatility during these events.

Managing the currency risk on operating performance, however, requires additional systems and tools. Traditional hedging solutions are simply not practicable in most growth markets over the life of an investment. Starting from the initial proposal to the investment committee, the company’s sensitivity to currency risk depreciation needs to be analyzed and assessed. Each investment opportunity has a different revenue / cost base and balance sheet structure with exposures that can create currency mismatches. Each of these elements affects the company’s sensitivity to currency depreciation. Sensitivity analysis at an individual investment level also helps diversification at the fund level. Due consideration of currency assumptions can ensure that a buffer is embedded in ex-ante returns analysis, helping to hold the notional risk at a manageable level. In the final analysis, the growth profile of a target company is arguably the most important aspect to get right. Companies with expanding revenue bases and increasing productivity will inevitably fare better, and the best companies can outgrow whatever the financial markets throw at them over a typical investment cycle. Put another way, a private equity investor can view currency risk differently from a trader or a macroeconomist. The latter will ultimately default to observations of the nominal exchange rates impacting a country’s currency and the reasons behind any volatility—such as current account deficits, commodity revenue volatility or Fed policy—but what truly matters for a private equity investor is the inflation and price-adjusted currency change, since this will be reflected in the performance of the specific companies in which it has invested. A company’s pricing power plays a key role in creating U.S. dollar-based returns. For example, even though the Ghanaian cedi lost more than 50% of its value against the U.S. dollar over a period of 24 months, our investment in a consumer product company operating in the country was able to increase its revenues in U.S. dollar terms by 24% during the same period, following a 25% price increase carefully timed not to cannibalize sales volume growth. Other angles must also be considered, with vigorous legal and compliance analysis essential to avoid taking risks where there should be limited risk appetite. Due to the nature of certain growth markets, unsuspecting GPs can be faced with jurisdictions where there are strict controls on currency transactions either internally within the jurisdiction, or externally with other jurisdictions. Investing in global growth markets has many challenges when it comes to managing currency risk. GPs who take a holistic approach that differentiates company-specific currency risks from those that are related to macroeconomic factors, who are aware of the limitations of financial market products, who have strong systems and processes in place to understand and price the risk, and who have a flexible investment mandate are the ones who will be turning the higher risks they are taking into higher returns.


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Importance of Currency Risk

“

While volatility has increased, the underlying risk has remained the same. It’s the LPs’ perceptions of the market that have changed.

“

You either invest in emerging markets or you don’t. If you do, you live with the currency risk. – Private Pension Fund

– Global Fund Manager

“

Much of the bad news is behind us. Emerging market currencies have recently experienced a significant devaluation, which provides a good set up for the next couple of years. – Global Fund Manager

6


25bps


120%

China surprise devaluation

100%

% Depreciation against US$

100% 80%

Importance of Currency Risk


80% 60%

60%

Taper Tantrum

40%

120%

40%

For 20%

most industry practitioners, currency risk is top of mind, with 73% of all survey participants ranking it as an important 0% or very important factor for their firm. However, GPs appear to be more concerned than LPs (see Exhibit 4). To illustrate, 47% -20% Jul-13 Jan-14to be very important Jul-14 of Jan-13 GP respondents consider currency risk compared to only 23% of LPs, while only 21% of GPs consider currency risk to be not important or somewhat important compared to 40% of LPs.

Notably, despite the possibility of currency depreciation and 20% devaluation negatively affecting returns and subsequently carried 0% interest for the GP, in the case of U.S. dollar funds, 65 of the 139 respondents (47%) do not think that EM currency-20% depreciation Jul-15 Jan-16between LPs and createsJan-15 a worrisome misalignment of interest GPs with respect to fund economics (see Exhibit 5). As one India-focused GP explains, “The currency mismatch is known upfront to all parties, and portfolio management strategy is made accordingly.”

Sources: IMFisand Investing.com. Currency especially pertinent for GPs that do not raise local Note: Representative rates for the period 1 January 2013 through 15 February 2016. Data as of 15 February 2016. Nonetheless, 46 respondents do see a misalignment, and these currency funds, 52% of which report currency risk as very respondents represent a blend of LP types, as well as fund important compared to 36% of GPs that raise local currency managers active across multiple geographies and strategies. funds. As one West Africa-focused GP explains, “We raise funds Reflecting on a worst-case scenario, one South Africa-focused in U.S. dollars and invest in the local currency, so our returns fund manager offers, “GPs can do everything right and fall below are affected by changes in the local FX rate relative to the hurdles due to currency depreciation, which dilutes the incentive U.S. dollar.” to ‘rescue’ funds where carry is significantly underwater.”

Exhibit 4: How important of a factor is currency risk to your firm? Exhibit 4: How important of a factor is currency risk to your firm?

GPs

100%

23%

36%

80%

52%

47%

60%

36%

38%

40%

32%

24%

20%

Raises local currency funds

35%

20%

29% 18% Does not raise local currency funds

0% LPs

GPs

Not important

Somewhat important

Important

Very important

Exhibit 5: In the case of a U.S. dollar-donminated fund, do EM currency depreciations against the U.S. dollar create a worrisome Exhibit 5: In the case of a U.S. dollar-denominated fund, do EM We want to make sure that misalignment of interest? currency depreciations against the U.S. dollar create a worrisome

“

misalignment of interest?

GPs

33%

LPs

34% 0%

49%

41%

20%

40% Yes

25% 60%

No

18%

the fund managers we invest with have an awareness of and strategy for dealing with currency risks.

80%

100%

– Fund of Funds

I don't know


7

Exhibit 5: In the case of a U.S. dollar-donminated fund, do EM currency depreciations against the U.S. dollar create a worrisome misalignment of interest? Exhibit 6: For EM PE investors of 5+ years, what impact has exchange rate 33% 49% movement had on your EM Exhibit 5:18% In the case of a U.S. dollar-donminated fund, dorealized EM investments? currency depreciations against the U.S. dollarPE create a worrisome Historically, currency volatility has had a negative impact on the misalignment of interest? Being a dollar-denominated Importance of Currency Risk, continued

34% 41% majority of GP respondents. For firms25% that have invested in EM

0%

PE for five years or more, 58% of respondents say that exchange rate value (see100% Exhibit 6), with 20%movements 40% have subtracted 60% 80% several recording dollar value losses18% of US$500 GPs 33% estimated total 49% Yes No I don't know million or more since 1 January 2014. Furthermore, a majority of respondents (69%) report that currency risk has increased compared to three to five years 41% ago (see Exhibit 7). LPs 34% 25%

Nevertheless, respondents (68% of LPs and 78%) of GPs do not 0% 20% 40% 60% 80% 100% think that EM currency volatility will delay their commitments or I don't(see knowExhibit 8). However, investments next 12Nomonths Exhibit 6: For over EM the PEYes investors of 5+ 72% of LP respondents do expect to see a delay in exits due to years, what impact has exchange rate currency volatility compared to only 31% of GPs (see Exhibit 9).

movement had on your realized EM PE investments? U.S. dollar-donminated fund, do EM nst the U.S. dollar create a worrisome nment of interest? Exhibit 6: For EM PE investors of 5+

years, what impact has exchange rate 9% 11% movement had on your realized EM PE investments?

Exhibit 6: For EM PE investors of Added 5+ years, 23% value what impact have exchange rate movements had on your realized Subtracted value EM PE investments? Negligible impact I don’t know

9% 58%

“

private equity fund that focuses on investments in South America, 9% 11% currency risk is crucial not 23% only for the foreign Added exchange value Subtracted value Negligible impactdollar translation impact on U.S. I don’t know valuations and returns, but also 58% for its operational impact on some Exhibit 7: How does EM of therisk businesses currency compare to(e.g., 3-5 businesses years ago? that import components in U.S. dollars but sell end-products in local currency).

Exhibit 7: How does EM Exhibit currency 8: Due torisk EM compare currency volatility, to 3-5 23%– Regional Fund Manager do you expect to delay your years ago? commitments to EM PE funds/ increased Exhibit 8: Due to EM currency volatility, do you expect to delay your investments over theItIt has next 12 months? has decreased commitments to EM PE funds / investments over the next 8% 12 months?

It has stayed the same

69%

100%

7%

16% 23%

11% 80%

23%

Added value Subtracted value Negligible impact I don’t know

60%

8%

78% 69%

68% 40%

It has increased It has decreased ItIhas stayed don’t knowthe same No Yes

58%

Exhibit 8: DueExhibit to EM currency volatility, 7: How does EM do you expect to delay your to 3-5 currency risk compare commitments toyears EM PE funds/ ago? investments over nextrisk 12compare months? Exhibit 7: How does EMthe currency to 3-5 years ago? 100%

Exhibit 8: Due7%to EM currency volatility, do you expect to delay your 23% commitments to EM PE funds/ investments over the next 12 months?

20%

0%

Exhibit 9: Due to EM currency volatility, do you expect to see a delay in exits? 100%

16%

16% 80%

60%

8% 68%

40%

20%

0%

8

It has increased I don’t know It has decreased No It has stayed the same Yes

78%

100%

69%

16%

7%

15% 68%

GPs

78%

40%EMPEA 2016. All rights reserved. ©

20%

I don’t know No Yes

12%

Exhibit 9: Due to EM currency 17% volatility, do you expect to see a delay in exits?

60%

20%

16% 60% LPs

80%

40%

80%

Exhibit 9: Due to EM currency 16% 15% volatility, do you expect to see a LPs delay in exits? GPs

0%

52% 100%

72%

16%

80%

12%


17% 31%

60%

52%

LPs 40%

20%

GPs

72%


Reporting & Evaluation

“

We will rarely fault a GP for a significant unexpected move in a currency. We generally feel like we should shoulder the blame for big currencyrelated events in our portfolio. That said, currency events more often than not are tied to broader economic cycles, and if we have a GP that is plowing money into an overheated market that subsequently collapses, and one of the byproducts is currency depreciation, then we are going to be giving them grief for reasons that have less to do with the currency and more with their ability to manage vintage risk.

“

When U.S. dollar and EM currency performance are both presented, it helps us to see better the alpha versus the beta. If the manager emphasizes local currency performance and obscures U.S. dollar performance, that reduces our trust in the manager. On the flip side, should the GP be rewarded if the FX works in favor of the fund through no alpha creation by the GP? – Family Office / Private Trust

– Endowment / Foundation Currency Risk Management Survey

9

44%

LPs

Reporting and Evaluation of Fund Managers GPs

18%

52%

20%

22%

A majority of GP respondents and slightly less than half of Volatile FX movements across a number of emerging markets LP respondents indicate that this is their preferred approach have led some managers to seek guidance on the appropriate for translating local currency performance into the functional methodology for valuing and translating the fund’s investments for currency (see Exhibit 10). However, professionals employ a quarterly and annual reports. The December 2015 edition of the variety of approaches, including the use of average exchange International Private Equity and Venture Capital (IPEV) Guidelines rates for the reporting period (18% of LPs and 22% of GPs), and suggests that in instances “where the reporting currency of the Exhibit Preferred methodology for translating currency performance into the a blendlocal of average and spot rates depending upon whether the fund is different from the 10: currency in which the investment is fund's items werecurrency related to the cash flow statement or balance sheet denominated, translation in the reporting currency forfunctional reporting / reporting (20% of LPs and 19% of GPs). These differing methodologies purposes should be done using the bid spot exchange rate prevailing can have a material impact on how a company’s performance at the measurement date.” is communicated. Exhibit 10: Preferred methodology for translating local currency performance into the fund’s functional / reporting currency 44%

LPs

18%

52%

GPs

20%

22%

Exhibit 11: How do you evaluate GPs' performance when the fund is denominated Spot rates as of the reporting date 9%in 7% a different currency than the one used Average exchange rates for the reporting period Blend ofthe average and spot for the reporting period where firm is rates investing?

19%

EM currency valuations are not translated into a functional currency Effective swap rate Other

5%

Exhibit 10: Preferred methodology for translating local currency performance into the fund's functional / reporting currency

Evaluation of Fund Managers

Exhibit 11: How do you evaluate GPs’ performance when the fund is denominated in a different currency than the one used where the firm is investing? 2%

While there is generally broad agreement that FX risk is exogenous to the GP, the question remains whether it impacts how LPs evaluate the performance of the fund manager. We sought to ascertain how Spot rates as of the reporting date LPsLPsevaluate GP 44% performance, and whether 18% determine 20% 9% 7% currency Average exchange rates for the reporting period Blend of average and spot rates for the reporting period volatility impacts LPs’ decisions to commit or re-up to a fund. With EM currency valuations are not translated into a functional currency We evaluate the fund currency and local Effective swap rate respect to evaluation, a slim majority (52%) of LP respondents currency performance in parallel GPs 52% 22% 19% 5% Other We primarily rely upon the performance in examine a GP’s performance in the fund and local currencies in 46% the fund’s currency 52% parallel (see Exhibit 11). As one DFI representative confides, “We We primarily rely upon the performance in the local currency track gross and net IRRs in local currency and U.S. dollars because we have to take both of them into account. The local currency performance tells you what’s driving the return: are revenues Exhibit 12: If an FX move were to erode growing? Margins? Is it multiple expansion? But we also want the the U.S. dollar returns of a fund below 11: Howthat do they you may evaluate GPs' GPsExhibit to be cognizant need to adjust their strategies its benchmark, consider performance the isinvestors, denominated going forward when since we arefund dollar and as a DFI we are Exhibit 12: If an FX move were to erodewould the U.S.you dollar returns ofthe a fund below its benchmark, would you consider the GP’s local GP's local currency performance when in a different currency than theinto one used trying to attract more dollar investors these markets.”

where the firm is investing?

currency performance evaluating when evaluating a commitmentor or re-up? re-up? a commitment

Forty-six percent of LP respondents say that they primarily evaluate Exhibit 12: If an FX moveonwere to erode We would evaluate a case-by-case the U.S.basis. dollar returns of aare fund below Exhibit 11: How you evaluate GPs' Nevertheless, when asked if they performance indo the fund’s currency. Absolute returns most its benchmark, would consider performance when the fund is denominated important, but weyou understand the the would consider a GP’s local currency performance when evaluating GP's local currency performance when in a different currency than the one used difference between macro risk and a commitment or isre-up if FX volatility were to take a fund below evaluating a commitment or re-up? where the firm investing? a manager’s value creation. – Endowment / Foundation its benchmark, nearly 70% of LP respondents indicate that they would (see 2% Exhibit 12). These respondents represent a wide array of institutions, including funds of funds, DFIs, family offices / private trusts, insurance companies and corporate pension funds. Three of the2% four respondents who indicate that they would not commit 23% capital to a fund whose returns were below its currency benchmark We evaluate the fund and local due to currency performance in parallel an adverse FX move are representatives from public pension funds. We primarily We evaluate the fund currency and local rely upon the performance in fund’s currency currency performance inthe parallel

46% 46%

52%

52%

9%

We primarily rely upon the performance in We primarily rely upon the performance in the fund’s currency

68%

the local currency

We primarily rely upon the performance in the local currency

Yes

10


No

I don’t know

We consider both currencies, but ultimately we need to deliver U.S. dollar returns to investors and our carry is dependent on U.S. dollar returns. – Fund of Funds We are measured in U.S. dollars so it is the primary benchmark; however, when considering re-ups, local currency returns carry23% weight and are likely a better predictor of future returns. – Endowment / Foundation A re-up really depends on our outlook for that country and the manager’s investment thesis. – Family Office / Private Trust 9% Local currency performance is relevant for a 68% rearview mirror context, but the current local currency risk and devaluation expectations also affect projected U.S. dollar returns and the required projected IRR hurdle rates. – Fund of Funds

Yes

No

I don’t know

19%

Currency Risk and Carried Interest While only 33% of LP and GP respondents believe that EM currency depreciations against the U.S. dollar create a worrisome misalignment of interest with respect to fund economics (see Exhibit Exhibit 13: Would you consider agreeing to 5), there can be instances where FX volatility can take a fund below carried interest based exclusively on a GP's its water line and thus reduce or eliminate carried interest payments local currency performance? to the GP. This can have enduring consequences. As one respondent notes, “If a GP is unable to reward the performance of their team, it may impact their ability to retain talent over the long term.”

We wanted to explore whether LPs in U.S. dollar-denominated funds would be open to paying carry based on local currency performance. Roughly a quarter of LP respondents indicate a willingness to consider carried interest based on local currency performance, while slightly more than half report that they would not be willing to do so (see Exhibit 13).

Exhibit 13: Would you consider agreeing to carried interest based exclusively on a GP’s local currency performance?

Exhibit 14: Do you construct your portfolio with currency risk mitigation as an explicit objective?

We would consider it; in doing so we would look for a demonstrated ability to achieve high enough returns in local currency to offset possible devaluation expectations, and / or a demonstrated ability to select sectors and companies that mitigate FX risk (e.g., contracts in hard currencies, export revenues, etc.). – Fund of Funds

13% 20%

Yes – we have done so in the past Yes No No – though we have done so in the past I don’t know

It would depend upon the investment thesis and the quality of the GP’s team. – Public Pension Fund

We would look for significant investment from LPs in local currency, or a high enough hurdle rate in the local currency. – DFI

13%

4%

We would not agree to manage the currency risk through portfolio GPs to local currency 43%carry because the GP has 57% management—their selection of companies, whether they have natural hedges, do they Yes have pricing power, etc. If we take away the incentive to manage the currency risk of the portfolio, then they’re No not going to think about it. They would just do whatever is best for them in local currency. – Fund of Funds LPs

49%

37%

63%

We are unlikely to accept this risk. Our view is that the GP has the role and visibility on the timing of cash flows to take on managing the FX risk. – Family Office / Private Trust Our returns are calculated in U.S. dollars, so GPs should be paid in U.S. dollars to maintain an alignment of interest. – Public Pension Fund

“

It’s a constant debate whether we should consider carried interest based on local currency Exhibit 15: Do you employ dealperformance. I understand the contingent forwards, vanilla options or other instruments to hedge entrybut we disclose GP’s perspective, prices? our portfolio publicly, and it could come back and bite us if we were paying out profit 8% when we didn’t earn any ourselves. I might be open toNever it, though, if the waterfall was 31% Occasionally Frequently structured well and if there Always 60% were clawbacks in instances where the GP might be reaping profits from currency upside—we would want to share in that process, and the reverse would true ifrisk exchange Exhibit 17: Do you hedgebe currency at exit? rates moved against them.

WHAT WOULD YOU LOOK FOR IN A GP / LPA TO CONSIDER PAYING CARRIED INTEREST BASED ON LOCAL CURRENCY PERFORMANCE? “The GP has no control over FX, but the GP does have control over the portfolio companies’ FX exposure. When it comes to Exhibit 16: haven't you instruments to hedge evaluating theWhy GP, we would askused ourselves: (1) is it reasonable entries? to expect the GP to target a local IRR of, say, 5% more than a normal U.S. dollar return in order to cover the FX risk? (2) Is some of the FX loss the GP’s fault? If so, is there a way to adjust price of hedging products is – Fund of Funds the GP’sThe carry accordingly?” too expensive “We would look fornot higher 19 with We elect to hedgepreferred return hurdle rates graduated carried interest (i.e., increased carry if net returns These products are not available exceed base expectations).” – Family Office / Private17Trust in our market(s) are unfamiliar with these “Strong GPWeclawback clauses products and / or 5some form of equalization so that the LPs do not inherit the entire magnitude of currency Number of Votes risk.” – Fund of Funds

“The hurdle would have to be adjusted by inflation rates, so that the fund manager doesn’t have a free ride.” – Public Pension Fund 18: How do you prefer to hedge exits? Exhibit

26

Deal-contingent forwards

– Institutional LP

Collars

Never Occasionally

7

In-the-money / Out-of-the-money puts

36%

27

4

Currency Risk Management Survey 3 Out-of-the-money calls In-the-money calls

2

11

Hedging Currency Risk

“

Everywhere I’ve been, people have talked about hedging. It’s just not possible. At the end of the day, if you were to commit, say, US$10 million to a fund, and then hedge it for five years due to interest rate differentials, the cost ends up being US$15 million. It defeats the purpose. – Private Pension Fund

“

It may be detrimental to returns in the long run to hedge currency risk with currency derivatives. However, a balanced approach to portfolio design should be used to hedge currency risks (i.e., investing in multiple currencies and allocating some capital to investments with U.S. dollar or euro revenues). – DFI

12


carried interest based exclusively on a GP's local currency performance?

Mitigating Risk Through Portfolio Construction Exhibit 14: Do you construct your portfolio 13%

A majority of respondents—57% of GPs and 63% of LPs— 20% Yes – we have do notdone construct their portfolios with currency risk mitigation so in the past 13% the extent of as an explicit objective (see Exhibit 14). Perhaps Yes 4% No recent volatility has caught investors by surprise. As one DFI No – though we have done so in the past representative explains, “This is a very new phenomenon and it I don’tbeen know something that’s hit us in a critical way in the has really last 18 months. Before it was actually going the other direction. 49% As a dollar investor you were benefiting from the emerging market currencies against the weak dollar. This is not something that we’ve had to build into our investment strategy until very recently.” For those GPs and LPs that have explicit investment criteria around risk mitigation, a variety of strategies are used. Some focus on investing in companies with U.S. dollar or other hard currency revenues, such as export-oriented businesses, while others attempt to limit the debt exposure in their portfolio companies. Participants also15: raise by sector, region and time Exhibit Dodiversification you employ dealhorizon as alternative strategies to options mitigateor FX risk. contingent forwards, vanilla

other instruments to hedge entry prices?

“

Never Occasionally Frequently Always

mitigation as an explicit objective?

GPs

43%

57% Yes No

LPs

37%

63%

In regard to mitigating risk, it’s a factor of both broad portfolio construction as well as manager selection, but we don’t have any sort of formal framework or exposure guidelines that we could build the portfolio towards. — Endowment / Foundation For EM funds, the GP has to identify who’s responsible for FX management and report regularly. — Family Office / Private Trust

Exhibit 16: Why haven't you used instruments to hedge entries?

In general, it is just too difficult to hedge these exposures. You 8% could run an overlay for the reserve currencies, but many of Never 31% Occasionally Frequently the companies based in developed Always 60% markets tend to generate revenue globally, so they are naturally hedged. When you enter into emerging market funds seeking country exposure, it’s often Exhibit 17: Do you hedge currency risk at exit? for diversification purposes. If you hedge, you reduce your diversification. – Private Pension Fund

with currency risk mitigation as an explicit objective? Exhibit 14: Do you construct your portfolio with currency risk

36%

55%

A SAMPLE OF GP AND LP PORTFOLIO CONSTRUCTION The price ofSTRATEGIES: hedging products is “We look for companies that have natural hedges and / or a 19 We elect not to hedge proven ability to pass through the impact of foreign currency changes.” – Pan-emerging Market-focused GP These products are not available in our market(s)

17

“We do not usually invest in companies with significant We are unfamiliar with these 5 liabilities in U.S. dollars as long as their revenues are in an EM products currency.” – Latin America-focused GP Number of Votes “We utilize a local cost structure and focus on export-oriented businesses, but are careful in the case of reversals, which in the past have killed portfolio companies that relied on particular currency rates in their model. Ideally we want to have flexibility Exhibit 18: How do youGP prefer to hedge exits? and diversification.” – South Africa-focused “It’s more the diversification risk that we look for. When we’re forwards looking at theDeal-contingent regional and sub-regional funds, then we look at how these individual currencies move 7and dance together. Collars What we’re looking at is the risk management that the fund In-the-money / 4 puts manager does inOut-of-the-money constructing their own portfolio. We also look Out-of-the-money at whether or not the GP hascalls thought3 about currency risk in the construction of their own portfolio In-the-money calls 2or are they just going after every lead in front of them.” – Fund of Funds Other

6%

27

too expensive

6

Number of Votes “We conduct a thorough analysis on inflation and currency movement differentiation.” – Bank / Asset Manager

“We consider diversification across countries, types of economies (e.g., commodity vs. manufacturing) and vintages. We also encourage GPs to reduce FX imbalances in their portfolio companies.” – Fund of Funds


13

26

13%

done so in the past Yes Yes – we have No done so in the past No Yes– though we have done so in the past No I don’t know No – though we have done so in the past I don’t know

4%

20%

49% 49%

4%

13% LPs

13%

LPs

YesNo No

63% 63%

GPs

43%

57%

GPs

LPs

43% 37%

57% 63%

LPs

37%

63%

GPs: Hedging at Entry and Exit 49% 49%

37% 37%

objective?

Yes No Yes No

respondents note that certain hedging options such as dealThe majority of GPs surveyed neither hedge their investments contingent forwards, vanilla options or similar instruments are into nor their exits from their portfolio companies. With respect not available in their markets (see Exhibit 16). Notably, 19 GP to capital deployment, roughly 60% of GPs say they never Exhibit 15:entries Do you employ respondents elect not to hedge their entry prices. hedge (see Exhibitdeal15). When asked why, the prohibitive Exhibit 15: Do you employ dealcontingent forwards, vanilla options or cost of hedging instruments is most frequently cited, while 17 contingent forwards, vanilla options or other instruments to hedge entry Exhibit 16: Why haven't you used instruments to hedge other instruments to hedge entry Exhibit 16: Why haven't you used instruments to hedge prices? entries? prices? entries? Exhibit 15: Do you employ deal-contingent forwards, vanilla Exhibit 16: Why haven’t you used instruments to hedge entries? other instruments Exhibitoptions 15: Do or you employ deal- to hedge entry prices? ontingent forwards, vanilla options or Exhibit 15: Do youtoemploy The price of hedging products is other instruments hedge dealentry Exhibit 16: Why haven't you 27 8% The price of hedging products is used instruments to hedge too expensive ontingent forwards, vanilla options 27 8% or too expensive prices? entries? other instruments to hedge entry Exhibit 16: Why haven't you used instruments to hedge 19 We elect not to hedge prices? 19 We elect not to hedge entries? Never Never Occasionally Occasionally Frequently Frequently Always Always

31% 31%

8%

60% 60%

8% Never Occasionally Frequently Never Always Occasionally Frequently Always

31% 31%

60% 60%

Exhibit 17: Do you hedge currency risk at exit? Exhibit Do you hedge currency GP17: respondents are slightly more risk likelyat toexit? hedge currency risk at exit, though 55% of GPs relay that they never hedge their exits, while 36% do so occasionally (see Exhibit 17). With respect to favored instruments, deal-contingent forwards received 26

Exhibit 17: Do you hedge currency risk at exit?

17:you Do you hedge currency risk ExhibitExhibit 17: Do hedge currency riskatatexit? exit? 36% Never Never Occasionally Occasionally Frequently Frequently Always Always

Never Occasionally Frequently Never Always Occasionally Frequently Always

36%

55% 55% 36% 6% 6% 36%

These products are not available areproducts not available TheThese priceproducts of hedging is in our market(s) in our market(s) too expensive are unfamiliar with The price We of hedging products is these We are unfamiliar with products these We electtoo notexpensive to hedge products

5

5

We elect hedge These products are not not to available in our market(s)

19 Number of Votes Number of Votes 19 17

We are unfamiliar with these products Exhibit 18:

27

Number of Votes

In-the-money / In-the-money /

4

Out-of-the-money puts 4 Exhibit 18:puts How youtoprefer hedge exits? Out-of-the-money Exhibit 18: How do youdo prefer hedgeto exits? Out-of-the-money calls Out-of-the-money calls Deal-contingent forwards In-the-money calls In-the-money calls Collars Deal-contingent forwards Other In-the-money / Other Collars Out-of-the-money puts Out-of-the-money calls/ In-the-money Out-of-the-money puts In-the-money calls Out-of-the-money calls Other In-the-money calls

55%

Other

3

3

26

2

2

7 6 7

4 3

26

6 Number of Votes Number of Votes

4

23 2

6 6

Number of Votes Number of Votes

Note: Respondents were asked to select all that apply.


27

5 How do you prefer to hedge exits? Exhibit 18: How do you (seven prefer to hedge exits? GP votes, followed by collars Number ofvotes) Votes and in-the-money and out-of-the money puts (four votes each; see Exhibit 18). 26 Deal-contingent forwards Other strategies employed by GPs include the use of26forwards, Deal-contingent forwards synthetics and forward swaps. Collars 7 Exhibit 18: How do you7 prefer to hedge exits? Collars

6%

14

17

These products are not available Note: were asked to select all that apply. 17 We areRespondents unfamiliar these in ourwith market(s) 5 products

55% 6%

17

GPs: Hedging over the Holding Period 20, some GPs indicate that they make underlying hedges at the company level, hold interest payments in escrow and buy or sell volatility to create synthetic put or call options.

Unlike entries and exits, where the size and timing of cash flows can be reasonably estimated within a short window, hedging throughout the holding period of an investment can present a number of challenges. Fully 64% of GP respondents indicate that they never hedge currency risk during the holding period of investment—including for dividend payments—while 27% occasionally hedge (see Exhibit 19).

For those GPs that do not hedge, the cost of hedging is ranked as the primary inhibitor (receiving 65 votes), followed by the lack of suitable hedging products in their markets (42 votes; see Exhibit 21 for ranking). Some respondents note that their Limited Partner Agreements restrict hedging activities to short-term known cash flows, thus largely preventing them from entering derivatives contracts the holding period ofdo an you investment. Exhibit 20:throughout Which hedging instruments prefer to use?

For those GPs that do hedge, they employ a wide variety of instruments (see Exhibit 20), with collars being the preferred Exhibit Do you hedge currency during the in Exhibit hedging19: instrument. In addition to therisk options ranked

holding period of your investment? Exhibit 19: Exhibit Do you 19: hedge risk during risk the during the Exhibit 20: Which hedging instruments do you prefer to use? Do currency you hedge currency Exhibit 20: Which hedging instruments do you prefer holding period of your investment? holding period of your investment?

Exhibit 19: Do you hedge currency risk during the holding period of your investment? 8% 8%

1

27%

64% 64%

Never Occasionally Frequently Always Never Occasionally Frequently Always

64%

Collars

2

Out-of-the-money puts 1 Collars Collars 3 (tied) Rollover1 forwards on a 3- or 6-month basis 2 Out-of-the-money puts Out-of-the-money putsbasis 3 (tied) Rollover2 forwards on a 9- or 12-month 3 (tied) Rollover forwards on a 3- or 6-month basis 3 (tied) Rollover forwards on a 3- or 6-month basis 5 Out-of-the-money calls 3 (tied) Rollover forwards on a 9- or 12-month basis 3 (tied)puts Rollover forwards on a 9- or 12-month basis 6 (tied) In-the-money 5 Out-of-the-money calls 5 Out-of-the-money calls 6 (tied) In-the-money calls 6 (tied) In-the-money puts 6 (tied) In-the-money puts 6 (tied) In-the-money calls 6 (tied) In-the-money calls

8%

27% 27%

Exhibit 20: Which hedging instruments do you prefer to use?

Never Occasionally Frequently Always

Exhibit 21: Inhibitors to hedging currency risk during the holding period of an investment Exhibit 21: Inhibitors to hedging currency during the holding period of anperiod of an Exhibit 21: Inhibitors to hedging currency risk during the holding periodrisk of an investment Exhibit 21: Inhibitors to hedging currency risk during the holding investment investment 65 65

65 42 42

42 24

21 24

Cost of hedging

Lack of suitable hedging products

Existing hedging products are too short in tenure

15 10

24 21

21

Trading in local currencies remains relatively illiquid

15

Lack of knowledge / expertise about hedging

15

9 10

Hedging creates liquidity risk within the fund

10 9

Other Hedging creates Lack of knowledge / Trading in local Hedging creates of knowledge / in local Existing hedging risk within expertise about Lackliquidity currencies remains Trading liquidity risk within expertise currencies remains products are illiquid too theabout fund hedging relatively Note: Exhibit shows number of respondents selecting the answer. Respondents were asked all that apply. the fund hedging illiquid short in tenureto selectrelatively Cost of hedging

9

Other

Existing hedging Lack of suitable Cost ofproducts Lack of suitable products are too hedging hedging hedging shortproducts in tenure

Other

Exhibit 22: Do you hedge FX risk with your EM PE commitments? Exhibit 22: Do you hedge FX risk with your EM PE Exhibit 22: Do you hedge FX risk with your EM PE commitments? commitments?

No – we do not hedge the foreign exchange risk of our EM PE commitments Yes – we hedge some of our EM PE fund commitments Yes – we hedge our EM PE commitments as part of an overlay across the entire portfolio No – we do not hedge the foreign exchange risk of our EM PE commitments Other No – we do not hedge the foreign exchange risk of our EM PE commitments Yes – we hedge some of our EM PE fund commitments Yes PE – we hedge someas ofpart our of EMan PEoverlay fund commitments Yes – we hedge our EM commitments across the entire portfolio 64% 11% as part 11% 14%across the entire portfolio Yes – we hedge our EM PE commitments of an overlay Other


15

Cost of hedging

Lack of suitable hedging products

Existing hedging products are too short in tenure

Trading in local currencies remains relatively illiquid

Lack of knowledge / expertise about hedging

Hedging creates liquidity risk within the fund

Other

LPs: Perspectives on Hedging A clear majority (64%) of LP respondents do not hedge FX risk with their EM PE commitments, while roughly 11% run a currency overlay (which hedges the institution’s exposures across their entire portfolio of assets and fund managers), and a similar number hedge some of their fund commitments (see Exhibit 22). One experienced pension fund investor relays, “In general it is just too difficult to hedge these exposures. You could run an overlay for the reserve currencies, but many of the companies based in developed markets tend to generate revenue globally, so they are naturally hedged. When you enter into emerging market funds seeking country exposure, it’s often for diversification purposes. If you hedge, you reduce your diversification.” In addition, one endowment representative notes, “We have found that it’s just too expensive to hedge, particularly in some of the far-flung emerging markets. Where possible, we will try to do a dollar-cost average over a commitment period, but even when we looked at overlays they didn’t appear to be as effective as we thought they might be.”

“Invest to the Best of Your Ability and Create the Most Alpha that You Can” A Conversation with Mounir Guen, CEO of MVision Private Equity Advisers

How are LPs approaching the issue of currency risk in light of the volatility we’ve seen over the last 18 months? There are different philosophies toward the question of FX risk. In some cases, investors believe that they are in it for the long term, and that over the long term currency risk washes out. But they are actually being reviewed over the short term. So while the planning itself might have a long-term structure, the individuals who are working with the exposure are assessed on their performance on a quarterly basis, which then leads to discussions of comfort with economic dynamics and potential risks. From the GP perspective, have you seen any best practices with respect to currency risk management? It’s extremely difficult to protect yourself because you can’t really use structured instruments to manage your portfolio. If you look at general partners that are active in reserve currency markets, you will see that they have quite dynamic policies at the portfolio company level, but not at the fund level. In my experience, when I have seen GPs employ hedges at the fund level, in most cases those hedges have actually taken out a large chunk of the performance, because the instruments are extremely expensive. That’s not to say that there’s nothing to be done—you can work at the company level to mitigate the impact of FX movements, for example by matching revenues to costs and liabilities.

16


Exhibit 22: Do you hedge FX risk with your EM PE commitments?

Exhibit 22: Do you hedge FX risk with your EM PE commitments? No – we do not hedge the foreign exchange risk of our EM PE commitments Yes – we hedge some of our EM PE fund commitments Yes – we hedge our EM PE commitments as part of an overlay across the entire portfolio Other

64%

11%

11%

14%

FX risk is an explicit risk that we want to take on; it is part of our investment thesis that the underlying currency will appreciate against the U.S. dollar over the life of the investment. – Family Office / Private Trust Our experience is that over time, the currency losses are partly recouped by the higher growth of the investee companies and inflation in local FX. It is more important to focus on well-positioned companies with pricing power that can increase prices in line with inflation. – DFI

In some developed markets, such as Australia and Japan, GPs raise local currency funds and earn carry based on the local currency performance of their investments. Why don’t we see more LPs agreeing to commit to funds and pay carry in local currency in emerging markets? This is an interesting question, because a lot of emerging market and new economy funds are in U.S. dollars; and that creates a potential risk at the waterfall level for the general partners. What you will find is that most GPs are open to living with that risk. Part of the nuance with countries like Japan and Australia is that local investors can invest with local general partners that perform well without having to worry about the fluctuation of the currency. They can truly just focus on the alpha—they don’t have exogenous factors that can impact their final return profile. The reason that these funds earn carry in local currency is because almost all of their capital comes from local investors. What advice would you give to industry participants who are currently battling FX volatility in their unrealized portfolios? The best practice is to have a consistent, regular return and have repeat investors who, over the long term, can wash through this. Unfortunately, that’s not always the case. I think the only policy you can follow is: invest to the best of your ability and create the most alpha that you can. If you start becoming too financially focused, you could impact the portfolio by creating a drag during good years and maybe get the hedge wrong. Then it’s unexplainable. The investors won’t tolerate it. They won’t tolerate you making money off the hedge, and they will never tolerate you losing money on the hedge.

LP Perspectives on Hedging, continued

LP Views on GPs’ Use of Hedges

Amongst those LPs who answered in the affirmative, we asked them to select which types of funds—defined by geographic When it comes to LP views toward GPs’ use of hedges, the remit—they want to hedge currency risk. Country-dedicated findings are a bit more mixed—the yes and no votes are split funds received the most selections (11), followed by regional virtually equally, with a quarter of respondents answering “I funds (8; see Exhibit 24). This is a somewhat ironic result, given don’t know” (see Exhibit 23). Most of the respondents answering that country-dedicated funds may be the least well placed in the affirmative were representatives from select DFIs, while to hedge—they tend to run smaller funds, and thus have less the “no” respondents represent a blend of commercial and Exhibit 23: Do you want EMoperating PE GPs budget to manage FX risk. multilateral investors.

to hedge FX risk?

Exhibit 23: Do you want EM PE GPs to hedge FX risk?

25% 36%

Exhibit 23: Do you want EM PE GPs to hedge FX risk?

Yes No I don’t know

39%

25% It is usually too expensive and few GPs 36% Yes

GP hedging needs to be evaluated have the sophistication / experience on a case-by-case basis. If there is No high visibility into cash flows, then to do so effectively. The appropriate I don’t know pacing of fund disbursement hedging can be appropriate, but in our experience this is a rarity in EM PE. throughout the investment period and usage of seller financing and local – Public Pension Fund credit when opportune are good GP Exhibit 24: Which of the following types of EM I see it as a best practice to use somehedge FX risk? practices. – Fund of Funds kind of hedging instrument when it comes to exits if it is within three to six Internal hedges within companies are months. – Fund of Funds good. Hedges of a fund portfolio are both difficult and may cost more than 11 the benefits derived from such hedges. 8 – Fund of Funds 6

39%

It is too expensive. Natural hedges should be considered. – Insurance Company

Country-dedicated funds

Regional funds

PE funds do you want t

Pan-emerging market funds

6

Global funds

Exhibit 24: Which of the following types of EM PE funds do you want to hedge FX risk?

Exhibit 24: Which of the following types of EM PE funds do you want to hedge FX risk? 11 8


6 paid off, given the costs associated Exhibit 25: Have 6your EM PE hedges implementing them?

Regional funds LPs


Global funds

27%

40%

33%

Note: Exhibit shows number of respondents selecting the answer. Respondents were asked to select all that apply.

32% 9% 19% Exhibit 25: Have yourGPs EM PE hedges paid off, given the costs associated with Currency Risk Management Survey implementing them? Yes

No

I don’t know

Too soon to say

40%

17

hedge FX risk? 11 8

Have Hedges Paid Off? Country-dedicated funds

Regional funds

6

6

Pan-emerging

Global funds

market funds that they have paid off, the respondents represent a blend of country-dedicated (e.g., Brazil, India, Russia and South Africa) and regional funds. The vast majority of respondents across both firm types, however, report that they either don’t know or it is too soon to say.

Amongst the 68 respondent firms that have implemented FX hedges—15 LPs and 53 GPs—less than one-third report that they have paid off, while only 9% of GPs (and zero LPs) report that they have not (see Exhibit 25). Within the GP segment answering

Exhibit 25: Have your EM PE hedges paid off, given the costs associated with

implementing them? Exhibit 25: Have your EM PE hedges paid off, given the costs associated with implementing them?

LPs

GPs

27%

40%

32%

9%

Yes

18


33%

19%

No

I don’t know

40%

Too soon to say

Conclusions Until such time as the global economy operates under Keynes’s Bancor (his proposal of one universal currency), FX risk will remain a part of every international investment decision. Beyond the risks of depreciation and devaluation—China surprised global investors with its move last year, and a number of countries maintaining pegs are encountering stress—investors in emerging markets occasionally experience capital controls. The latter have been implemented in Egypt and Nigeria as this report goes to press, serving as an added layer of complication. Currency risk, in short, is here to stay. There are, however, some areas where agreement upon— and broader adoption of—best practices could be useful. These include: • Methodologies for translating local currency performance into the fund’s functional currency in quarterly and annual reports. This survey highlights that within LP and GP cohorts, opinions differ on the best methodology for doing so; and though IPEV suggests using the spot rate as of the reporting date, only about half of respondents prefer this method. EMPEA has endorsed the IPEV Guidelines along with a large number of private equity and venture capital industry associations. • Due consideration should be paid to reporting local currency and fund currency performance in parallel. There is a general consensus that local currency reporting provides LPs with a clearer view on the GP’s ability to create value, and a majority of LP respondents report that they would consider local currency performance when evaluating a commitment or a re-up.

down during periods of stress, precisely when hedges are needed most. Perhaps some enterprising entrepreneurs can find a solution to this problem; according to practitioners interviewed for this publication, previous efforts to offer more affordable hedges through mutualization worked until EM currencies stopped appreciating against the dollar. At the end of the day, it’s hard to avoid the conclusion that LPs should acknowledge the currency risk associated with EM PE investments, and view it as diversification within their portfolios. On the other hand, GPs should give due consideration to managing their portfolios to perform in the functional currency, sourcing deals with natural hedges or pricing power when appropriate, and selectively employing hedges (when reasonably priced) on entry and exit. In grand perspective, the gradual opening up of local capital across emerging markets is one of the most promising developments for the mitigation of currency risk within the asset class. As has been demonstrated not only in the United States, but also by select fundraises in Australia, Japan, China and South Africa, a proper match between the local currency and the fund currency creates true alignment of interest, and shared participation in a fund manager’s ability to create value. EMPEA would welcome the opportunity to engage with you on this issue. Please contact us at [email protected].

• Recognition that a majority of industry participants—as measured by this survey—do not construct their portfolios with currency risk as an explicit objective. Moreover, most LPs do not hedge the currency risk of their EM PE commitments, and most commercial LPs that responded to this Survey don’t want their GPs to hedge either. • Recognition that in most cases, fund managers should not hedge during the holding period of their investments; hedges often are simply cost prohibitive. However, fund managers should explore the feasibility of using hedging instruments when they have visibility on the relative timing and sizing of cash flows tied to an entry or exit, and when the fees don’t create an undue drag on performance. At this point in time, many FX hedges for most emerging market private equity funds appear to be impractical. The costs are prohibitive and trading in most currencies remains relatively illiquid, and synthetic hedges based off of interest rates or commodity prices offer impure protection—historical correlations can break


19

Exhibit 26: Survey respondents by firm type

institution type

Participant Demographics and Survey Definitions Exhibit 27: LP respondents by Exhibit 26:type Survey respondents by institution firm type

100%

Exhibit 26: Survey respondents by firm type Exhibit 28: Geographic remit of GP respondents' funds In March 2016, EMPEA surveyed 146 GPs and LPs headquartered across 40 countries.

80%

Int'l / Multilateral Org

Exhibit 26: Survey respondents by firm type

Exhibit 28: Geographic

SWF

34%

of GP respondents’ funds 66%

44

Bank / Asset Manager

60%

GPs LPs remit

38

Insurance Company

31

Government-owned Organization 40%

Corporate Pension GPs LPs

20%

34%

Public Pension

Regional Funds


Fund of Funds

80% Int'l / Multilateral Org

44

Bank / Asset Manager

38

Insurance Company

Survey Definitions

Government-owned Organization

40%28: Geographic Exhibit remitPension of GP respondents' funds Corporate Exhibit 29: 80%Participants by headquarters region Foundation Int'lEndowment / Multilateral/ Org SWFPublic Pension 20% 44 60%

40%

Family Office / Bank / AssetTrust Manager Private 38 Insurance Company Fund of Funds Government-owned 31 DFI Organization

0%

4%

44

Endowment / Foundation

11

North America Sub-Saharan Africa Family Office / Latin America Private Trust Western Europe Country-dedicated Pan-emerging fundsFund of Funds market Middlefunds East & North Africa DFI Emerging Asia

20%

Regional Funds

0%

12% Exhibit

Global funds

29: Participants by headquarters region Central & Eastern Europe Developed Asia

18% 12% Exhibit 29: Participants by headquarters region

4% Exhibit 29: Participants by headquarters region 10%

32% 10%

12%

4%

10% 12%

18% 32%

10%

20 12%

North America Sub-Saharan Africa Latin America Western Europe Middle East & North Africa Emerging Asia Central & Eastern Europe Developed Asia North America Sub-Saharan Africa Latin America Western Europe Middle East & North Africa Emerging Asia

© EMPEA 2016. All rightsCentral reserved. & 18%

Country-dedicated 38

Pan-emerging

Global funds

“Private equity” (abbreviated to “PE”) encompasses funds market funds buyout, 31 growth capital and venture capital investments.

32%Pension Public

10%

31

Exhibit 28: Geographic of GP respondents' “Emerging markets” (abbreviatedremit to “EM”) encompass the funds private equity markets of all countries outside of the United 11 States, Canada, Western Europe, Israel, Japan, Australia and New Zealand, collectively referred to as “developed markets.” Regional Funds

Corporate Pension

10%

Global funds

Note: Respondents were asked to select all that apply.

Exhibit 27: LP respondentsSWF by institution type 60% 100%


Exhibit 28: Geographic remit of GP respondents' funds

DFI

0%

11

66%

66%

Family Office / Private Trust

100%

34%

GPs LPs

Endowment / Foundation

Eastern Europe Developed Asia

“Emerging markets private equity” (abbreviated to “EM PE”) 11 funds encompass PE funds that principally target investments in emerging markets. “Limited partners” (abbreviated are investors in funds Regional Funds Country-dedicated to “LPs”) Pan-emerging Global funds market funds PE funds. “General partners” (abbreviated to GPs”) are PE fund managers. “Development finance institution” (abbreviated to “DFI”) is a government-backed institution that provides financing and technical assistance for projects in developing countries to catalyze economic growth and development. “Limited partnership agreement” (abbreviated to “LPA”) is a legal document that outlines the terms and conditions governing the relationship between LPs and GPs in a private equity fund. Note: In some exhibits, percentages may not sum to 100% due to rounding.

Investing in Foresight

The Abraaj Group is a leading growth markets investor with c. $9.5 billion in assets under management across targeted private equity strategies. With over 140 investments and exposure to more than 30 currencies across our markets, we take a holistic approach in managing currency risk by differentiating between the macro environment and micro factors that determine the real impact of currency movement on our investments. We couple this with a rigorous investment process, best in class underwriting standards and robust legal and compliance frameworks to generate value for our partners everyday, everywhere. abraaj.com

@abraajgroup

The Abraaj Group

EMPEA

Consulting Services CUSTOM RESEARCH WHITE PAPERS SYNDICATED REPORTS CASE STUDIES

For more information, please contact [email protected] or call +1 202 333 8171.


21

Our mission is to foster the development of the Private Equity Industry in Mexico.

US$ 37.1Billion

155

Cumulative capital commitments managed by Mexican funds

Funds (PE, VC, RE, Infrastructure & Energy)

Accumulated Capital Commitments in Mexico USD Millions (2005-2015)

Accumulated Capital Commitments in Mexico USD Millions (2005-2015)

$40,000

$30,000

$23,227 $20,000

$17,480 $14,279

$10,000

$4,550

$500

$270

$372

$7,027

$5,562 $4,801

$6,817 $5,045

$5,287

$1,608 $2,456 $125 $110

$270 $3,335 $2,993 $135 $192 $110

$155 $192 $178

$155 $192 $178

2005

2006

2007

2008

$250

$-

$7,035

$11,159 $12,759

Alternative Assets

Debt

$29,599 $1,346

$25,211 $1,008

$14,033

$10,221 $9,115

$8,250 $6,139 $1,767

$7,364

$7,973

$10,253

$8,985

$7,564

$2,573

$2,573

$5,159

$827

$827

$857

$1,006

$1,055

$37

$37

$37

2014

2015

$183

$434 $37

$434 $37

$855 $37

2009

2010

2011

2012

Infrastructure & Energy

$11,287

$10,891

$10, 774

$698

$515

$338

$192

$1,486

$740

$2,147 $390

$1,090

Fund of Funds

$20,186

$37,145

2013

Private Equity

Real Estate

$1,293 $1,446

Venture Capital

Every year, AMEXCAP organizes Mexico’s most important PE and VC conferences where national & international GPs and LPs share their industry views: MEXICO VC DAY IN SAN FRANCISCO OCTOBER 22ND, 2016

PRIVATE EQUITY SUMMIT 2016 IN MEXICO CITY MARCH 2016

MEXICO PE DAY IN NEW YORK CITY JUNE 16TH, 2016

www.mexicovcday.com 22

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Ph: +(52) 55 5083-5090

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