How Private Equity Firms Incur and Manage FX Costs

Published: December 06, 2024

Many private equity firms find themselves exposed to currency movements in their day-to-day operations yet give FX risk management very little consideration, says Joe McKenna, Global Head of Institutional Solutions, MillTechFX. Here he lays out the ways in which such businesses might incur FX risk – and how they can mitigate this.

As private equity (PE) managers seek higher returns through global investments, they inevitably face increasing exposure to FX risks. Depreciation in local currencies can reduce asset values, disrupt operations, and complicate investor relations.

The FX market is the largest and most liquid in the world, seeing daily volumes of $7.5tr.. In this incredibly interconnected market, proactive FX strategies are critical for safeguarding investments and maintaining a competitive edge.

Foreign currency assets

For PE managers, a higher return is the name of the game, leading them to look further afield for investment opportunities. So, naturally, the greater number of jurisdictions a PE managers’ strategy allows for, the greater the number of investment opportunities.

However, considering annual movements in even currency pairs within the G10 can be significant, this creates an inherent mismatch between the firm’s base currency and the currencies in which the underlying assets generate value.

For example, a US-based PE firm holding European or Asian assets is exposed to fluctuations in the euro or yen against the dollar. Such currency volatility has the potential to completely erode long-term value creation efforts when converting foreign-denominated gains back to the investor’s base currency.

Additionally, depreciation in a foreign currency may reduce the perceived value of an overseas investment, even if the asset’s performance remains strong. This risk becomes particularly pronounced during exits, as exchange rate shifts can substantially impact the realised value upon liquidation.

PE managers commonly implement short-dated hedging to lock in rates during the purchase or sale of an asset, while others may even consider hedging asset value throughout the entire hold period.

Management fees

PE firms are exposed to currency risk not only through their investments but also via the management fees they charge. Typically calculated as a percentage of invested capital, the fees are often denoted in the firm’s base currency.

However, many funds operate globally, so it’s common to see PE managers raise a fund in one currency but have offices outside the jurisdiction of their fund’s base currency. If a local currency depreciates against the base currency, the value of assets under management in the firm’s base currency may decline, potentially reducing the absolute dollar value of management fees.

Additionally, operational costs related to managing foreign portfolio companies – such as travel, due diligence, and local advisory fees – may be incurred in the local currency. A mismatch between fee income and expenses in different currencies can further exacerbate financial risks.

Investor capital

As a PE manager matures, it becomes increasingly likely that they may see FX investors commit capital to their funds. Limited partners typically commit capital in their local currencies, but the PE fund itself may operate in a different base currency.

For the fund manager, currency risk arises when converting capital calls or distributions between currencies. Fluctuations in exchange rates during the lifecycle of an investment – between the initial commitment, drawdowns, and eventual distributions – can lead to unexpected gains or losses.

Some managers may take the stance of letting their investors manage their own FX risk, while others are more accommodating and implement share class hedging.

Share-class hedging takes FX risk off the table when investors are considering to which funds to commit and, in that way, can be a useful tool for managers to broaden their investor base and make their funds more marketable overseas.

Indirect, portfolio-level FX exposure

PE firms often face indirect FX exposure at the portfolio level, which can impact returns in ways that are not immediately apparent. This type of exposure arises when portfolio companies operate internationally, generating revenues or incurring costs in multiple currencies.

As a PE manager grows its portfolio, their investment team may have to overhaul how their portfolio businesses manage FX exposure.

In a recent HSBC corporate risk management survey ,57% of CFOs say they suffered lower earnings in the past two years due to significant unhedged FX risk. That figure rises to 77% in EMEA.

A PE firm, therefore, may look to align its own set-up and processes with those of its underlying portfolio, and hold them to the same high governance standards.

As PE firms mature and expand, they incur heightened FX risk simply as a cost of doing business. The volatile and opaque nature of the FX market means in order to safeguard their investments and ensure long-term value creation, PE firms must consider prioritising FX risk management.

In an increasingly complex global market, proactive FX management is crucial for maintaining a competitive edge while fulfilling fiduciary responsibilities.