Tom Speechley, Partner at The Abraaj Group, examines how private equity GPs are managing the associated risks of currency volatility in emerging markets
There is no doubt that currency volatility has been one of the major challenges for international private equity investors over the last two or more years. Emerging markets, in particular, have been buffeted, as monetary policies in the US and Europe have resulted in volatile global capital flows and related nominal FX rate instability. Countries with structural current account deficits and those reliant on the export of commodities have been hardest hit. And yet private equity is uniquely well placed to navigate such difficulties. Unlike macroeconomists, finance ministers and central bankers, a private equity investor need not worry about an entire economy or monetary system. By definition, private equity is about cherry picking and, in the context of increased FX volatility, that can include selecting companies that are more resilient to nominal FX depreciation than others.
For example, a Nigerian fertilizer producer that exports the majority of its output actually benefits from depreciation of the naira to the extent that its dollarized revenues hedge out its local currency cost base. For companies that cater to a local consumer market and thus have local currency earnings, inflation may provide some relief through increased consumer prices that absorb the depreciation over time. Conversely, a market leader may be able to take additional market share by holding prices at the lower level to weed out less strong competition. On the cost side, certain companies are able to switch a supply chain element from one source and currency to another and thus hedge out some exposure. Even companies that are not operationally hedged may be growing so rapidly in local currency terms that the US dollar equivalent growth is still at a level that provides exceptional returns for the investor.
FX-specific considerations are not confined to the operational profile of the company concerned, and the private equity investor can also structure or model some resilience into an investment. For example, contractual distributions will reduce the exposure before a full exit. Similarly, deferring deployment of an entire growth equity package until utilized by the company reduces the period of exposure to FX risk. Whether such features can be negotiated into a transaction is, of course, case-specific.
On the other hand, one structuring tool that all investments can incorporate is a conservative assumption of depreciation into the investment case itself. In doing so, the investor is, in effect, screening out companies that have insufficient base- case growth potential and operational hedging capacity to withstand the assumed level of depreciation.
For all of the reasons given above and more, a private equity investor is not simply concerned with the nominal FX rate for a given day or period. Between structuring, inflation adjustments and the operational hedging capacity of the companies in which it invests, a private equity investor has much more to consider and to leverage in risk reduction.
Perhaps counterintuitively, formal hedging instruments have not been mentioned above. The reality is that traditional instruments are not well suited to hedging equity exposure in emerging market currencies over a period of several years, and aside from short-term price hedging at entry and exit, they do not figure prominently as a risk- mitigating tool.
Looking beyond the individual investments made, a private equity investor will also have the opportunity to hedge the FX risk by portfolio diversification.
Undoubtedly, many emerging market currencies are directionally correlated in terms of their relationship to the US dollar, especially when the driver of volatility is US monetary policy, rather than something germane to the country concerned. But that does not exclude diversification benefits. Indeed, several emerging market currencies have been relatively strong performers against the US dollar in the last two years, such as the Indian rupee (3.5 percent annual depreciation) or the Indonesian rupiah (3.8 percent annual depreciation), while others, such as the Saudi riyal and the United Arab Emirates dirham, remain robustly pegged to the US dollar. As a result of diversification alone, The Abraaj Group basket of more than 30 currencies outperformed the euro, Canadian dollar and Australian dollar in 2015, and comfortably outperformed sterling in 2016, reminding us that 2015 and 2016 were less about weak emerging market currencies and more about a strong US dollar. Moreover, the diversification effect described here merely reflects the nominal FX position and does not factor in any of the company-specific resilience described earlier.
When building a truly hedged portfolio, an investor should also bring together companies with high baseline growth levels that can simply outpace depreciation and those with operational hedging resilience. Portfolio construction will also incorporate vintage diversification to smooth out short-term volatility.
Capital allocators should not be too despondent when scanning the FX screen on their Bloomberg terminal; private equity offers several solutions to reduce the impact of nominal rate movement. For general partners that are new to these markets, steep currency falls over the last two years or more may suggest a buying opportunity, but history has shown that individual emerging markets are not easily timed. A long-term approach based on growth, careful portfolio construction and active currency management will more likely yield repeatable and desirable results.