Currency complexities ahead for PE

The director of private equity at JCRA, an international financial risk consultancy, analyses the foreign exchange market’s take on Brexit, other European issues to watch out for and how to mitigate them.

Currency risks loom for private equity firms as the Brexit process gets underway. To understand the factors compounding currency risks and how to mitigate them, sister publication pfm spoke to Benoit Duhil de Benaze, the director of private equity at JCRA.

What Brexit-related risks should private equity firms be wary of?

The sterling has been the worst performing G10 currency so far this year and as Theresa May triggers Article 50, two views dominate the market.

The first is that Brexit is already priced into the current foreign exchange rate and the pound is cheap, with the UK economy forecast to grow 2 percent this year. The second sees further pain and depreciation (£1.10 against the dollar, and parity between the pound and the euro). A lower pound would create opportunities for foreign private equity funds to buy sterling assets at a lower price, but it would also hit the IRR of those investors currently holding sterling assets. Valuation of operating assets with sterling FX risk could also be impacted even further.

The two-year countdown to Britain’s exit from the EU will be a lengthy process and full of uncertainties. Regardless of the prevailing views on the pound, private equity funds should be vigilant and follow negotiations closely, being aware of their impact on foreign exchange rates and financial markets. The expected additional volatility will have to be factored carefully in any FX risk management decision. Outside of Brexit, sterling’s direction will also be driven by US rates, Trump policy and political developments in Europe.

What other risks from the eurozone should private equity firms prepare for?

The main risks faced by European businesses aside from Brexit is the uncertainty linked to US policies and the risks in Italy, France and Germany. Because of these risks, one could expect the euro to depreciate against the so-called safe heaven currencies, namely Swiss francs, yen and the US dollar, should they materialise.
A victory in May for Marine Le Pen would put strong pressure on the euro and while it may be unlikely for Le Pen to win the second round of the election, as Brexit and the US election have shown, it pays to be cautious.
The euro is likely to become more sensitive as high-risk events approach, as [the] pound [did around] the UK referendum. In the case of a European financial sponsor planning to buy a US asset using a euro source of funding, if the euro depreciates from signing to closing, the asset will become more expensive in euro terms. This risk is significantly higher when the period to complete the transaction is also full of political risk events. Political risk in Europe has also pushed some central banks (the Swiss, Danish and Czech) who are averse to large currency swings, to intervene in the FX market.
Private equity investors should keep a close eye on:

• a stronger Swiss franc, which is an issue for the Swiss economy
• the euro to koruna and euro to Danish krone, which are both pegged against the euro.
Two years ago, when the Swiss National Bank abandoned its cap at SFr1.20 francs per euro, the Swiss franc soared by almost 30 percent against the euro and triggered hundreds of millions in losses.

How can firms mitigate such risks?

With regards to cross-border M&A, the volatile FX environment will add significant risk. Finding an efficient way to hedge the FX risk from signing until closing is generally seen as a difficult puzzle for financial sponsors or a CFO to solve.

However, deal-contingent hedging is a cost-efficient strategy that allows mitigation of those risks and has become increasingly popular in the past few years among private equity funds, and increasingly with corporates as well.

In 2016, Air Liquide entered into a series of deal-contingent FX forwards for a total amount of €6.3 billion for the acquisition of the US company Airgas. This solution helped Air Liquide to fix the euro component of its US dollar purchase on a forward basis over a very risky period (UK referendum, US election).

The beauty about deal-contingent hedges is the flexibility to walk away from them without incurring a cost if the M&A falls through. In return for this flexibility, a small spread is embedded in the product, [but this] is payable only if the M&A is successful. With multiple, potentially turbulent events happening in 2017, deal contingents will remain the preferred solution in cross-border M&A situations.

Outside M&A, at the operating asset level, hedging programs to address recurrent day-to-day FX exposures have remained largely unchanged over the years and have often failed to mitigate risks in the recent volatile conditions. This is a reminder that FX policy needs continuous attention and refinements to protect the business. Both private equity funds and corporates should be consistently revisiting their policy to ensure better hedging solutions for G10 and emerging currencies.

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