Welcome to In Focus, foreign exchange insight from XE to support businesses with exposure to currency volatility.
Private Equity firms throughout the UK and Europe, that have dealings in currencies other than their base currency, face unpredictable foreign exchange exposure. And, as the world becomes more financially interconnected and central banks pump greater amounts of money into the system, sharp movements are becoming more common. This means that Private Equity firms are now facing more complex FX hedging decisions when looking to protect their businesses from exchange rate volatility.
What factors can affect volatility?
There are some factors that markets know in advance are likely to influence the currency markets. Known events that can create exchange rate fluctuations include central bank interest rate announcements, political announcements and elections, release of inflation figures or trade statistics and economic events around the world.
For example, the upcoming General Election in the UK next month is a known event. Furthermore, the results of last week’s local elections can provide some hints for how the Pound is likely to react to the General Election results. Following the Conservative gains at a local level, Sterling rallied from the 1.25’s to trade close to 1.30 against the US Dollar. A Conservative majority of approximately 100 is currently being predicted in the General Election, so this is likely to already be priced in. Therefore, if this turns out to be the case, there is unlikely to be much movement for Sterling following the results. However, a lower majority is likely to weaken Sterling while a higher majority could strengthen Sterling.
But some events can come as a complete surprise to markets. These can be anything from an unscheduled political announcement to a terrorist attack or a natural disaster. Sometimes, such as last October, it can be difficult to pinpoint a specific cause. Sterling fell 9% against the Dollar in a matter of minutes with no clear reasoning behind it. While it recovered most of these losses on the same day, it struggled to fully return to pre-crash levels again until late April.
Political uncertainty also has the potential to cause volatility in the currency markets. We have seen this following the result of last year’s EU Referendum. As no country has ever left the EU before and process is unclear, there has been some nervousness around Sterling. Since 23rd June, we have seen utterances by the Governor of the Bank of England, Prime Minister Theresa May and other events cause ripples in the price of Sterling against its major currencies. As the UK enters the two year negotiation period, it is likely that we will see further ups and downs as markets react to each breaking headline.
These factors can all be compounded by the fact that, although the FX markets are oceans of liquidity, there are times when the market can suddenly become illiquid. This can cause large, noisy and exaggerated movements in FX rates. This is becoming more common, as global trading increases. Additionally, the increasing use of electronic and mobile platforms and algorithmic and high frequency trading among retail FX trades around the world is likely to start pouring further speculative funds into the market.
What are the specific risks faced by Private Equity firms?
In our Guide to Foreign exchange risk for Private Equity firms] we examine the specific risks faced by firms as they manage their exposure to foreign currency volatility:
- Transactional Risk: Currency volatility can have a favourable or unfavourable effect on the purchase or sale price of assets.
- Purchase exposure and Net Asset Value (NAV): By holding foreign assets within a fund, movements in FX rates can have an impact on the NAV.
- Management fees and expenses: Receiving management fees in a different currency to the base of the fund.
In the current environment of political and economic uncertainty, it seems likely that exchange rate volatility will continue. So Private Equity firms and funds involved in cross border investment, or with investee companies that have significant foreign currency revenues or expenses, need to consider how to manage these risks.
The best way to minimise the risk of volatility is to make a plan while the market is calm and trading is orderly. This enables funds to get the best pricing in liquid markets. A proactive approach also helps to avoid the risks that can accompany making knee-jerk decisions in the heat of the moment.
And as discussed, there is always the potential for an unexpected event to disrupt the markets at any time. With this in mind, it is prudent for funds to actively hedge significant FX exposures rather than assuming business as usual.
An experienced FX partner, which understands your business and the sector, can provide the support and expertise you need in order to create a plan that suits the requirements of your fund. For example, they can suggest different hedging options such as forward contracts and FX options, where the best solution may vary depending on the level of risk associated with the deal.
XE, and our sister companies under Euronet have over ten years of experience supporting the private equity sector and our range of hedging options can help you to prepare for any scenario. If you’d like to discuss your firm’s situation in more detail, please call our Corporate Team.
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