Beating local currency blues

With hedging often too expensive an option, what are LPs at allocation level doing to mitigate this risk?

LPs often cite currency risk as a major barrier to investing in emerging markets’ private capital – and there’s no doubt this has the potential to wipe out returns. With hedging often too expensive an option, what are LPs at allocation level doing to mitigate this risk? And what strategies should they look for at GP level?

LP strategies

1. Diversifying exposure.

“We seek balanced exposure across all emerging markets,” says Julien Kinic, Managing Partner at idi EM Partners. “That provides a natural hedge. We also choose investments that are not exposed to international capital flows or commodities.” Added to this, idi EM Partners has developed models to manage the risk. “We run simulations to track any correlations between currencies,” explains Abderahmane Fodil, also Managing Partner at the firm. “We then make sure that every portfolio investment we make does not add to that risk.”

2. Investing in countries pegged to mainstream currencies.

This is easier in some regions than others, as Alexander Bebov, Managing Partner at BAC Securities, explains. “If you target a region such as Central and Eastern Europe, you have some countries that are euro members and some are in the exchange rate mechanism,” he says. “Even those with their own currencies, such as Poland and Romania, have weathered the Ukraine shock pretty well – their currencies have come back to similar levels pre-crisis and that gives extra comfort to investors.”

3. Considering fund extensions.

Even with the best mitigation strategies, some fund managers may still be caught out at the last minute. And while far from ideal, LPs can still potentially generate the returns they were expecting by waiting out any currency storm. “If a devaluation occurs towards the end of a fund’s life, it can pay to look at extending the fund and giving managers time to exit in better circumstances,” says Cem Baytok, Managing Partner, idacapital.

4. Having at least some secondaries exposure.

Knowing what you are buying, rather than investing in a blind pool vehicle, can help. “Secondaries can help you manage FX exposure because you have more visibility on it,” says Kinic.

GP strategies

1. Creating pan-regional or global companies to diversify currencies.

This helps diversify the risk away from a single country and currency. “The elections in Brazil may impact currency in the short-term, although we see a trend of appreciation over the long term,” says Noberto Jannuzzi, Partner at Patria Investimentos. “But one of the ways we manage currency risk is by diversifying into other Latin American markets, such as Colombia and Chile. We also seek to create pan-regional leaders in the sectors we invest in. That takes time and there are different dynamics in different countries, but it also creates a more appealing asset for strategic acquirers.”

2. Seeking out companies that already trade in stable and/or multiple currencies, such as those focused on exports.

This is essential in markets such as Turkey, where the lira’s annual depreciation versus the US dollar has been around 30% to 40% for the past few years. “Our portfolio generates US$600m in annual revenues,” says Enis Hulli, General Partner at 500 Istanbul. “Only 3% is denominated in lira; meanwhile our cost base is in lira.”

3. Targeting accelerated growth.

While not a panacea, many emerging markets GPs look for this in companies trading primarily in local currency. “If we invest in a lira-denominated company, it has to be ultra-high growth,” says Neil Harper, Chairman of Turkven Private Equity. “You can then overcome the reasonable risk that the currency will depreciate over the medium term.”

4. Capitalising on currency risk.

In some cases, GPs can take advantage of valuations discounted on account of currency risk. “This can give you bargaining power when you enter a business,” says Baytok. “You can then set about expanding the business into new markets – and this works especially well for asset-light digital companies because markets are global and you can generate revenues in multiple currencies. This can even be an advantage if the local currency depreciates because your overhead costs can fall.”

5. Staging investments.

Deploying steadily over time can average out any swings in foreign exchange, as Luis Fernando Lopes, Partner and Chief Economist and Strategist at Patria Investimentos, explains. “If you deploy, say 20% of the capital you plan to invest in stage one, then a further 20% subject milestones being met, you can mitigate some currency risk,” he says.