Caught in the currency crossfire?

But take a moment also to ponder what this shows about the region’s private equity market as it is now.

For one thing, this points up the single-country risk that has been building in the region. An upset in China, as explained last issue, has the potential to at least slow down, if not derail, the Asian PE gravy train, because so many LPs have now taken direct or indirect bets on that market. Perhaps this is an unavoidable corollary of the overall macroeconomic importance of China’s growth: but if so, many LPs have done relatively little to mitigate or hedge against the risk.  Now, any potential upset could be sooner and stronger than anticipated.

Hedging: hold that word for a moment. For the current spat revolves around currency levels, and currency movements are a legitimate risk that PE firms hedge against when investing internationally. They are usually prohibited, though, from hedging on the currency markets for speculative purposes. But many GPs and LPs who are investing into China have effectively taken a bet on long-term appreciation of the RMB, and more distantly, on eventual full convertibility.

Expectations of medium-term RMB appreciation are broadly-based, and strong, in some cases as high as a rise of 70% against the USD over the next ten years. For GPs and LPs looking to invest into China over at least five years in the typical course of a USD PE fund vehicle, this is quite a gain to put alongside the underlying growth already there in the market. And for a fund that has concentrated on domestic businesses rather than the export sector, as many GPs have recently, trade tensions are less likely to derail the growth of their investments, at least in the short term.

Furthermore, RMB appreciation is more than just a question of outside pressure. Unlike Japan in the 1980s, China does not have political and defense obligations to the US to magnify the impact of American displeasure, and there has been less than uniform global support for the US position. Rather, China is likely to appreciate its currency for its own reasons, and when no loss of face is involved. The global rebalancing of wealth suggests that the RMB should appreciate over time, and expectations are of a series of gentler increments, rather than a single big move to appease the US. Appreciation will happen in a way and on a timescale that China feels is safe.

Currency movements are absolutely not part of a PE firm’s core investment thesis, and no good GP would put them before the primary objectives of finding good assets at a fair price that can be made better. However, the overall optimistic expectation of steady RMB gains is a bonus. But it is one that has to be offset against other important considerations. First is the question of whether those RMB gains, and indeed, the gains from overall market growth, are lost in the asset price inflation that follows the growth and the capital inflow seeking to tap the opportunities. The capital overhang looking for deals in China has been estimated at up to $50 billion – quite enough to bid away many currency gains, in a market already known for high entry valuations. Second is the question of whether international GP gainers on RMB appreciation, once in the investment, are pre-investment losers, as the value of their fund currency declines. And finally, LPs’ fears of growing protectionism and political risk that might upset the relatively rosy story of post-GFC Asia Pacific recovery could be all too justified.

Further reading

Speed bumps ahead for Asian private equity returns

• Performance
• 05 Oct 2010

What drives your private equity returns?

• Performance
• 05 Oct 2010

Caution: Lower returns ahead?

• Performance
• 09 Jun 2010

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• Topics
• Greater China
• Regulation
• Performance