FX hedging: Know your risk

South Korea, India and Indonesia share the dubious honor of possessing Asia's most volatile currency. For Korea, a big driver of short-term movement in the won is the geopolitical situation with the north; remittances in and out of the country by non-resident Indians play a role in how the rupee behaves; and the large number of foreign holders of Indonesia government bonds has left the rupiah in a constant state of flux.

Each Asia Pacific currency clearly carries a certain amount of foreign exchange risk, and GPs in the region - who for the most part operate US-dollar denominated funds - have started to display more concern of late about the impact these idiosyncrasies could have on the life cycle of their investments. "Prior to the global financial crisis, the awareness of counterparty risk was low and the need to hedge against this wasn't as much of a priority as it is today," says K.C. Lam, director and head of foreign exchange in Asia for CME Group, which allows clients to trade FX futures and options via its online exchange.

It's not just a case of increased volatility either. More subdued returns projections mean that every dollar counts and firms can no longer afford to let currency movements erode the value they get out of their investments. "If you're making very high returns and the FX market affects you 15-20%, it's not so much of a big deal," points out Lim Wee Kian, managing director at DBS in Singapore. "But the returns are now going to be a lot lower than in the past, around 20-25%, so fluctuations in the exchange rate will affect them dramatically because it can take away the majority of their performance."

The best laid plans

Making use of a seemingly limitless selection of products available in the market, the vast majority of PE firms now start hedging their FX risk the moment they invest in an Asian company. Managing the risk on the way in is not the easiest thing to do, however. It's rare for a GP to be the sole contender for the asset it's seeking to acquire, and in the typical 3-6 month period between targeting a company and closing the deal, there could a material amount of volatility in the FX markets. At the same time, paying for or locking into a hedge can be risky business: If a GP is outbid and a deal falls through, that hedge will no longer be required and hence will need to be unwound. Depending on prevailing market levels, this could end up costing money that most PE firms only have in the form of dry powder.

"Even if I am the only investor in that particular transaction, it's still not a slam-dunk," warns Rahul Badhwar, head of corporate sales, Asia-Pacific ex-greater China at HSBC global markets in Hong Kong. Regulatory approvals might not be forthcoming, or existing shareholders might raise objections about selling their stakes. Once a deal is 100% signed and sealed, it could be barely a week before the capital needs to change hands, by which time the investor will have already been hit by currency movements over the six months past. The best way to limit exposure to volatility during this waiting period is to try and hedge the risk as far in advance of the financial close as possible. Nevertheless, Badhwar believes that it would be rare for a PE firm to hedge themselves from the moment they start bidding for an asset; most instead tend to wait until they are, at the very least, the preferred bidder and can start conducting due diligence.

One measure that allows firms flexibility is buying currency options. These products offer a known level of protection, involve a known amount of money, and if the deal falls over, the PE firm has only paid for the premium. However, as GPs often don't have excess cash flow to support hedging, many favor the deal contingent suite of products. These involve paying slightly more than for generic options and forwards, but allow the firm to walk away from the hedge if the deal does not complete - unlike vanilla options and forwards, which a PE firm has to honor whether or not its deal goes ahead. "This means that they do not have to explain to their LPs that they spent money on an FX hedge for a transaction that did not close," explains Nick Angove, head of GFFX structuring for North Asia at Deutsche Bank, which provides deal-contingent options and forwards to private equity firms.

The convenience of the deal-contingent route doesn't mean it's a clear-cut decision for a GP, though: if there's a 99% chance that a deal will go through, one PE firm might be willing to do a non-deal contingent hedge because it's less costly, whereas another might decide to pay the extra money for hedge because it doesn't want to risk being out of pocket if the deal fails to complete.

Down the line

Hedging FX risk isn't just an issue when a PE firm first acquires an asset either. If the currency moves 20% against an investor during the period of ownership, the underlying price of the asset could change drastically, even wiping out returns. Since 2011, a greater number of firms have begun to look at hedging the translation risk or the FX risk on the exit of their portfolio companies, although still only an estimated 10% are focused on hedging at this point in the investment cycle.

The main challenge when hedging post-investment is knowing when to begin, as hedging for a period of 2-3 years can seem like an unnecessary cost, especially when the best laid exit plans come with no guarantee of execution on time - or at the expected value. Although it seems doubtful that PE firms will want to hedge for the entirety of their holding, Badhwar argues that this strategy makes sense if extended periods of volatility and heightened tail risks continue to be as frequent as they have been in the last five years. "Because you're removing FX risk totally from the equation, all your return is dependent upon is the underlying equity performance of the business," he says. This could be a consideration for Bain Capital, for example, which bought MYOB from HarbourVest Partners and Archer Capital for A$1.2 billion ($1.3 billion) last August. The Australian dollar was trading at a record high of A$0.98 to the US dollar when Bain won the auction for the Victoria-based business software maker. It was trading at A$1.46 when HarbourVest and Archer acquired the company for a mere A$450 million in October 2008.

In the past, post-investment risk might not have been such an issue because most Asian currencies were on a one-way appreciation trend against the US dollar and for most PE firms the currency risk in Asia was in sync with the underlying asset risk they were taking. However, a lot has changed since 2007, and two-way volatility with large swings is the name of the game. As an example, an almost 15-17% move in the rupee, such as that which occurred over the last seven months, could wipe out any equity returns in a market in which returns have so far been lower than those of its Asian counterparts. Extending the same thought process, Badhwar believes that hedging translation risk is not only useful to protect the downside risk but also an important tool to capture and monetize large currency swings in favor of the investor. A classic example of this is the US dollar-Japanese yen move in the last five years, which has seen some PE firms interested in locking in gains of more than 25%.

One problem which can present itself, however, is that there is insufficient liquidity in the underlying market to manage risk of that size. HSBC experienced this recently, when working with a PE client looking to sell a business in an Asian country. The firm was going to receive $1.5-2 billion from selling the local currency against the US dollar, but this wasn't something that could be executed in the country itself due to the lack of liquidity in the local market. The central bank was also concerned that the sale of such a large amount of currency would cause its value to crash. The answer was to hedge the currency risk offshore in order to reduce exposure to the local market.

DBS' Wee Kian often advises clients to hedge offshore for deals in Hong Kong, Singapore or India: "When the country has capital control, the tendency to hedge is always offshore."

Interest rate awareness

Interest rates are another area of importance to Asia-focused private equity firms. Unlike equity, the interest rate risk on a loan doesn't take off until the deal actually goes through and there tends to be less volatility than for FX. But some GPs - majority stakeholders that have used leverage in the initial acquisition - feel that it makes sense from a balance sheet perspective for a portfolio company either to fix the interest rate of its debt or use swaps to hedge the risk associated with it. While this only occurs in a minority of cases, it is most likely to happen with companies that have large amounts of leverage on their books, as their potential interest payments could eat up a lot of the cash flows in the first few years of the investment.

Indeed, given that firms are currently operating in a very low interest rate environment, now appears to be an excellent time for companies to fix rates and benefit from the low cost of funding. "When there are signs that this is going to change, and it can do so very rapidly, people will be caught in a very bad position if they haven't hedged their interest rate exposure," agrees CME Group's Lam. "No one is immune from risk."

In Asian private equity, which is still relatively young, this lesson hasn't necessarily been learned. Global firms either rely on internal teams to deal with hedging strategies or outsource the job to independent financial advisers who engage with banks. Smaller players - typically indigenous Asian firms - aren't as well resourced and are known to cut corners. Once they have been through more fund cycles and seen exits go awry, it will sink in that losing 5% off one's IRR because of a risk that could have been negated is far from best practice. Some are already taking steps in the right direction, but it remains a work in progress.

"All the PE firms are definitely going through an education process. Over the last 5-6 years they have become a lot more sensitive to the impact of FX and interest rate risks, instead of brushing it away as part and parcel of the business risk they undertake. In today's uncertain markets, linear interpolations of market and return expectations just do not exist and risk needs to be assessed and dealt with at multiple levels," says HSBC's Badhwar. "The second and third-tier firms are coming up through the education process to get to where the top tier firms are."

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• Topics
• North Asia
• Southeast Asia
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