David Fann, President and CEO, TorreyCove Capital Partners outlines some possible options for currency risk management within a private equity portfolio.

One of the most striking macro-trends of recent years has been the appreciation of the dollar versus currencies in both mature and emerging markets. Uncertainty in Europe—with last year's Brexit vote adding to the mix—combined with China's slowdown, has made the dollar a relative safe haven for investors, to the detriment of other currencies. But what does this mean for the US private equity investor committed to non-dollar-denominated funds? Should they be hedging their investments to stem losses?

In most cases, a well-structured, diversified private equity portfolio can mitigate currency fluctuations. As investors make both contributions and receive distributions over the 10-year lifespan of a fund, this acts as a natural, inbuilt hedge that evens out currency swings over time. Across an entire portfolio, this effect is magnified.

However, recent years have witnessed a persistent appreciation of the dollar, which poses a greater challenge for US investors exposed to non-dollar currencies.

We believe that if an investor strongly expects a local currency to which they are exposed will fall into secular decline, there may be a valid case for a hedging strategy.

By its nature, private equity is illiquid and its cash flows (drawdowns and distributions) are unpredictable, making it incredibly difficult—although not impossible—to hedge at the individual fund level. Indeed, investors should analyze to what extent the private equity managers with which they are invested already hedge at this level, as doing so themselves may be redundant. Because of this, we advise clients eager to dampen the effect of currency movements to install hedges at the portfolio level, where estimated cash flows are more stable. Even then, it is far from an exact science.

Proprietary analysis has shown us that projected compared to actual net cash flows range from anywhere between 3 percent and 95 percent, with an average of more than 35 percent. This means the portfolio would be substantially over- or under-hedged most of the time.

For those willing to embark on a program, there are a number of solutions open to investors, including forward contracts, futures, options, swaps and exchange-traded funds that focus on currency exchange rates, and each comes with its own pros and cons.

We believe that futures contracts are unsuitable for most institutions since mark-to-market adjustments require that any gains and losses are settled daily. Aside from the fact that private equity assets are valued on a monthly or quarterly basis—making fair market valuations imprecise and potentially increasing risk in the hedged portfolio—many investors lack the time and resources required to manage such daily settlements.

For this reason, a more suitable alternative may be options, which effectively act as an insurance policy against major losses. However, options are not without their drawbacks, namely the premium required to purchase them, a cost that increases as currency markets become more volatile and more investors seek insurance.

We advise investors to carefully ascertain their currency exposure, as they may already have a degree of cross-currency hedging in place. For example, a euro-denominated fund investing in a Swedish company will have kroner exposure.

Furthermore, today's globalized economy means that many businesses' cost and revenue streams are diversified by currency, helping to mute volatility. Additionally, in the case of buyouts, which represent the majority of private equity investments by value, the leverage taken out on acquisition targets may act as an inherent hedge at the company level, since a weakened local currency will be partly offset by a fall in the value of the debt denominated in that same currency.

Over the long and medium terms, the effect of currency movements in mature, diversified private equity portfolios tend to be moderate. The more diverse the portfolio, the less impact FX risk is likely to have, assuming that currency exposures are actively monitored and managed.

Arguably one of the most effective hedges is selecting a pool of talented fund managers able to identify companies with diversified costs and revenues, who can differentiate between macroeconomic challenges and company-specific currency risks, and who can support the growth of their investee companies in spite of market volatility. It is these managers who will deliver returns during uncertain times.