Currency Hedging for Illiquid Asset Classes and Strategies

By Hamlin Lovell, NordicInvestor

It is natural for asset managers remunerated on internal rate of return (IRR) to be averse to any cash outflows that might be entailed by some currency hedging approaches. Historically, many asset managers of illiquid strategies did not carry out currency hedging and many still do not, leaving investors to do their own hedging. “Increasingly, investor demand for a choice of currency share classes or feeders is one factor requiring asset managers to take responsibility for hedging”, says Carl Beckley, Director at Record Currency Management.

Currency share classes or feeders are only one level at which currency hedging may take place. At the master fund level, underlying assets could be denominated in different currencies from the fund’s base currency. Controlling the cost of cross border acquisitions could also provide a more opportunistic reason for occasional hedging.

Even after managers have decided which assets or investment vehicles to hedge, there are many further choices to be made about the quantum and nature of hedging.

Modelling could be based on historical analysis and it could stress test or simulate other scenarios”, says Torrie Callander, Director at Record Currency Management.

The spectrum of illiquid strategies

“In broad terms, less volatile illiquid strategies such as private debt, private credit, and possibly private equity management buyout (MBO) funds, are more likely to want a higher proportion of hedging, sometimes up to 100%. For more volatile private equity growth, real estate and venture capital strategies, there is more uncertainty over the timing and amounts that may need hedging, but nonetheless managers may still be keen to hedge the risk of extreme outcomes, possibly using option strategies”, says Callander.

Similar logic applies to other illiquid strategies such as infrastructure, which can span a wide spectrum of volatility, ranging from infrastructure debt with low single digit returns to core, plus infrastructure private equity targeting mid-teens or more. Strategies such as forestry can also have somewhat unpredictable cash flows as there is some optionality over whether and when to harvest lumber from the trees.

Once the size of the actual or potential hedge is agreed, there are further choices over fine tuning strategies, instruments, counterparties, and which legal entity is party to the hedges.

Managing cash outflows

“One generalization about all of these strategies is that their underlying assets are unlikely to be acceptable collateral for currency hedges, which generally creates a risk of cash outflows to roll some types of hedges or meet margin calls in between roll periods”, says Callander.

“This risk can be managed through smoothing strategies such as dividing a hedge into smaller parts and staggering rolls over a number of overlapping dates, reducing the chances of a large outflow occurring on a single date. Flexible settlement dates are another way to manage cash outflow risk”, says Beckley.

“Or a proactive hedging programme of rolling shorter term hedges can use less margin, and utilize less of a fund’s credit limit, than simply using a multi-year forward matching the expected maturity of an asset”, says Callander.

Lines of credit

The cashflows needed to maintain currency hedges can also be managed through lines of credit from certain banks, which might delay the cash outflows until forwards mature.  “Here it is worth distinguishing between collateral and security….

They may look closely at the profile of LP investors”, says Callander. “Revolving credit facilities (RCFs) can also be used to raise cash swiftly to meet margin calls on negative mark to market movements”, he adds. Typical spreads for such facilities could be comparable to a AAA CLO spread.

Structuring choices

“The pure costs of these strategies, in terms of margin, lending spreads, and other fees can vary not only between banks but also between desks within the same bank, and according to which asset manager investment vehicle or other entity is used for the currency hedges”, says Callander. “Entities could include the fund, a special purpose vehicle owning certain assets, or another vehicle created expressly for currency hedging. Legal and structuring teams will help to determine which entity is used”, he adds.

Currency hedging or associated credit facilities could well be part of an existing relationship with a bank, but asset managers should not let the “inertia factor” lead them to presume that their current bank will necessarily offer the most competitive terms for any or all aspects of their currency hedging strategies. “FX sales desks at banks generally cannot give advice or offer a discretionary management service”, says Callander, who previously worked for one of the larger banks in the space;

This is one of the main reasons why hedging can often seem unappealing to funds, where specific FX knowledge is not always readily available.” Specialist currency managers can offer advice and discretionary solutions.

Active management of swaps and options

“The old adage “don’t set it and forget it” applies to currency hedging strategies in the private funds space, especially where there is less certainty around divestment date”, says Callander. “Whatever hedging instruments you choose to utilize, remaining nimble and opportunistic is essential.”

Currency hedges can benefit from some active management since the most obvious maturity or roll dates may not offer the best pricing. “The cross currency swap price can diverge from interest rate differentials between the two currencies, due to market dislocations or imbalances creating a basis. This is especially prevalent on particular dates.” By choosing particular value dates managers can reduce costs, says Callander.

A more active approach can also be helpful for option based strategies: “if standalone options are expensively priced, collar or spread strategies, and more exotic strategies, can be used to reduce premium outlays”, says Beckley.

Operational overheads and expertise

The total cost of a currency hedging strategy also needs to consider asset managers’ internal overheads – and if they do not have the appropriate internal operational expertise and counterparty relationships it may be prohibitively expensive to develop them. “Negotiating paperwork such as ISDAs, trading lines and credit support annexes, and the ongoing management of currency hedging strategies, could be time consuming”, says Beckley.

Regulatory reporting

There are also likely to be regulatory reporting obligations in terms of EMIR and MiFID II best execution, which can be handled by banks, asset managers, or third-party service providers. “Even when a manager or relevant entity is not themselves subject to EMIR, they need to do EMIR reporting if another counterparty to the deal is in scope of EMIR”, says Callander. “For example, many funds are domiciled outside of the EU but are still caught by EMIR because their FX counterparty is in London.”

“We are doing EMIR reporting for nearly all clients”, says Beckley. Record also complies with the FX Global Code of Conduct.

All in all, it could be worthwhile for managers of illiquid strategies to explore the diverse, and sometimes complex, range of currency hedging approaches.