Private Equity Investing: The fallacy of mean reversion in FX markets
A common misconception is that currencies are mean-reverting and, therefore, hedging is a poorly-allocated cost.
The problem is: most of the time, we either don’t have time to wait for the mean-reversion or it happens way too quickly and goes away; in many other cases, it may never happen anyway (as the concept of mean-reversion in this case is much more complex than a simple return to a pre-existing level). This is especially true for illiquid investments, such as the ones made by Private Equity firms – where we’ll focus on today.
To exemplify this issue and put some numbers around it, we will look at real-life FX data and understand how fictitious PE investments would have performed from a currency perspective over the last 10 years.
As we all know, the past will not show us what the future will hold, but it helps us make an educated estimation of the possibilities.
We’ll start with a simple cash flow profile:
Day 1: -10,000,000 investment in local currency
Day 1 + 5 yrs: +20,000,000 exit value in local currency
IRR (Internal Rate of Return): 14.85% / Multiple at exit: 2x
Now let’s look at the last 10 years and assume any given day is an opportunity to invest. We start with an investment made on 01/Jan/2010 and exited on 01/Jan/2015, then move on to 02/Jan/2010 exiting on 02/Jan/2015 and so on. Fast forward all the way to investments exited in July 2020 and we have over 1400 potential investment days in our sample.
We now compare three different scenarios:
a) No FX hedging during the whole period
b) FX hedging from the outset, using a 1Y rolling forward strategy (ie, reset every year)*
c) FX hedging from the outset, using a 5Y forward strategy
*For the purpose of this analysis, we assume no margin/ mark-to-market exchange during the whole period. For the 1Y forward strategy, this would be equivalent to rolling trades forward using HRR (historical rate rollover)
Why is it relevant to compare 1Y and 5Y strategies? Because the carry will vary and potentially affect your final result. On the next article, we’ll investigate this dynamic in more detail.
Let’s start with an investment fund based in USD, investing in a EUR asset.
On Day 1, the fund will convert US dollars called from investors into EUR. Five years later, the EUR value of the asset will be converted back to US dollars for distribution to investors. Nice and easy.
Let’s take a look at what would have happened to the final investments’ IRR under the three scenarios discussed above:
As we can see, the unhedged IRR varied from 8.6 to 16.3%, staying below the base case during the vast majority of the days. In fact, during the 10 years analysed, in 95% of the cases FX had a negative impact on IRR. The hedged IRR, on the other hand, ranged roughly between 15 and 18%.
The volatility on the hedged outcomes (1Y and 5Y) is largely explained by the variability of carry, or the cost of hedging (more on this in the next article of this series).
Now, I can guess what you’re going to say:
- This is a massively skewed sample because the USD had a remarkable bull run during this period, which will probably not repeat for a while.
Yes, I agree.
- This is again skewed because the EURUSD carry massively benefited USD investors during this period, which may also not repeat.
Yes, I also agree.
This is not the point (and don’t worry, we have many other examples below).
The point is: in most cases, the timing of investments and divestitures will not be driven by FX conditions, but by the entry and exit opportunities of the assets itself (unless you are actively investing in FX markets, which is a whole other story). Because of that, if not hedged, FX will add a significant amount of volatility to the investment profile – in the example just shown, unhedged EUR investments varied within a 770 bps IRR range, while hedged investments varied within a 250 bps IRR range over the last ten years, everything else constant.
This could well work in favour of the assets (as we will see in other examples below), but it could also work against it.
Let’s now turn to other currency pairs and combinations of base currency/investment currency. We have combined all the data into box plots, to be interpreted as follows:
- The colored boxes show the 2nd and 3rd quartile of observations, ie. the range where 50% of the observations are placed
- The top and bottom lines show the maximum and minimum observed IRRs; the space between the end of the colored boxes and the top lines contain 25% of the observations, with the space between the colored boxes and bottom lines containing the final 25% of observations
To exemplify the interpretation of the graph above, let’s focus to GBP investments. We can conclude that, over the last 10 years, isolating the FX effect:
50% of the observations ranged between 9.7 and 12.3% IRR
25% of the observations ranged between 12.3 and 16.1% IRR (the maximum)
25% of the observations ranged between 9.4 and 7.4% IRR (the minimum)
Hedged – 1 Y rolling:
50% of the observations ranged between 14.7 and 15.6% IRR
25% of the observations ranged between 15.6 and 16% (the maximum)
25% of the observations ranged between 14.7 and 14.7% (the minimum)
Hedged – 5Y:
50% of the observations ranged between 15.2 and 16.1% IRR
25% of the observations ranged between 16.1 and 16.6% (the maximum)
25% of the observations ranged between 15.2 and 14.9% (the minimum)
Conclusion: simple hedging strategies reduced the earnings volatility in GBP from a 870 bps to a c. 160 bps range, all other factors constant.
We now show the results for EUR- and GBP-based investors:
If we define risk as the volatility of outcomes (the textbook definition), simple FX hedging strategies have reduced the risk by 6x or more over the last 10 years on the observed currency pairs. This is not a prediction for the future, nor is it a full picture of the past (as we’re ‘only’ talking about 10 years) but it certainly helps us to understand the possibilities.
To highlight the importance of this discussion, I quote Howard Marks (co-founder of Oaktree Capital) in The Most Important Thing: “Dealing with risk is essential – I think the essential – element in investing. It’s not hard to find investments that might go up. If you can find enough of these, you’ll have moved in the right direction. But you’re unlikely to succeed for long if you haven’t dealt explicitly with risk.”
So, should everyone be hedging? No. But, like everything else, hedging or not hedging should be an active decision and investors should always be asking the questions:
- Do I understand the amount of FX volatility this asset could be facing?
- Is this extra layer of volatility part of my investment case?
- Do I understand the pros and cons of different hedging strategies when compared to the unhedged position?
- Have I made a truly informed decision to hedge/not hedge?
If you would like to take a deep-dive into these questions and understand the financial risks your investments are facing and how to manage them, please get in touch with our expert team:
Phone: +44 208 057 9180
For this initial analysis, we took a simplistic approach and considered every observation as equal. There are other factors (mainly carry and valuation), however, that may impact the likelihood of achieving a positive or negative final result – we’ll explore these on our next article.
Summary tables of all results: