EMPEA Releases the First Survey Exploring Currency Risk Management in Emerging Markets Private Equity: 75% of LPs Would Consider a GP’s Local Currency Performance in Decision to Re-Up 

Washington, D.C., 11 May 2016 — EMPEA, in partnership with AMEXCAP, today announces the release of its Currency Risk Management Survey, the first examination of the impact of currency volatility on the emerging markets private equity (EM PE) industry. The survey analyzes the views of 146 practitioners, representing both fund managers/general partners (GPs) and limited partners (LPs). The report aims to provide the industry with a better understanding of how GPs and LPs report and manage exchange rate movements in their EM PE portfolios—including decisions regarding whether, when and how to hedge.

Long-term investors in emerging markets are no strangers to currency risk. Over the last 20 years, the Asian financial crisis, the Russian ruble crisis, and the Argentine and Brazilian crises—among others— have all demonstrated the inherent risks of currency depreciation and devaluation. Indeed, the severe economic and human consequences of past currency crises have prompted many governments to implement a number of structural reforms that have underpinned emerging markets’ relative growth and financial stability over the last decade.

However, the U.S. dollar appreciated rapidly in the past two years until January 2016, reaching its strongest levels since 2002, before giving up some of its gains in the past few months. Prior to reversing its trend, the strong dollar coincided with increased FX volatility, lower oil prices and weaker EM currencies. When married with the slowdown in China and the broader softening of demand for products in the commodity complex, the currencies of natural resource exporters and countries that rely on oil revenues—such as Brazil, Mexico, Nigeria, Russia and South Africa—have depreciated sharply against the U.S. dollar.

While almost 75% of global investors surveyed for this study agree that currency risk is an important or very important factor for their firm, there is a lack of agreement on how to measure and mitigate this risk. According to EMPEA data, nearly 25% of the capital invested in EM PE deals between 2013 and 2015 has been deployed into countries that have experienced a depreciation of 30% or more in their currencies against the U.S. dollar. Persistent global imbalances will very likely make some degree of currency volatility a permanent fixture in the world of EM investing. Moreover, FX risk may inhibit commitments to EM PE altogether—in EMPEA’s 2016 Global Limited Partners Survey, released last month, currency risk was cited as one of the two largest deterrents to investing in the asset class in seven out of 10 markets.

Key findings of this special report include: 

• A majority of respondents—63% of LPs and 57% of GPs—do not construct their portfolios Page 2 of 4 with currency risk as an explicit objective.
• Nearly 60% of respondents say exchange rate movements have subtracted value from their realized EM PE investments, with several respondents estimating losses of US$500 million or more since 1 January 2014.
• When the local currency differs from the fund currency, approximately 50% of LP respondents evaluate GPs by looking at the performance of both in parallel, while 46% primarily rely upon performance in the fund’s currency. In instances where an FX move causes a fund’s performance to fall below its benchmark, 75% of LPs indicate that they would consider a GP’s local currency performance when evaluating a commitment or re-up.
• Amongst the 68 respondent firms that have implemented FX hedges, less than one-third report that they have paid off, while 38% report that it is too soon to say.

​In addition to a thought leadership contribution from Tom Speechley, Partner and Head of Global Markets at The Abraaj Group, a growth markets investor, the report includes perspectives from experienced emerging market practitioners regarding how FX volatility will impact investment and exit activity, and what steps they are taking to manage any downside risks. Some of their statements include:

• “Investing in global growth markets has many challenges when it comes to managing currency risk. GPs who take a holistic approach that differentiates company-specific currency risks from those that are related to macroeconomic factors, who are aware of the limitations of financial market products, who have strong systems and processes in place to understand and price the risk, and who have a flexible investment mandate are the ones who will be turning the higher risks they are taking into higher returns.” – Tom Speechley, Partner and Head of Global Markets at The Abraaj Group 
• “Currency volatility has become a pressing issue over the last 18 months. The impact of the decline in crude oil prices and China’s slowdown continues to be felt across the globe. Mexico has not been immune, and last year, the peso fell by 17% relative to the U.S. dollar despite experiencing GDP growth of 2.5%. AMEXCAP and its members are very interested in shining more light on this topic, and want to identify best practices among LPs committing capital to country-specific GPs whose funds and hurdle rates (as well as the underlying assets of the portfolio) are denominated in local currency.” – María Ariza, CEO of AMEXCAP
• “We will rarely fault a GP for a significant unexpected move in a currency. We generally feel like we should shoulder the blame for big currency related events in our portfolio. That said, currency events more often than not are tied to broader economic cycles, and if we have a GP that is plowing money into an overheated market that subsequently collapses, and one of the byproducts is currency depreciation, then we are going to be giving them grief for reasons that have less to do with the currency and more with their ability to manage vintage risk.” – Endowment / Foundation Representative 
• “It’s a constant debate whether we should consider carried interest based on local currency performance. I understand the GP’s perspective, but we disclose our portfolio publicly, and it Page 3 of 4 could come back and bite us if we were paying out profit when we didn’t earn any ourselves. I might be open to it, though, if the waterfall was structured well and if there were clawbacks in instances where the GP might be reaping profits from currency upside—we would want to share in that process, and the reverse would be true if exchange rates moved against them.” – Institutional LP Representative 

​If the diversity of opinions and strategies that this inaugural survey revealed on managing currency risk could be summarized into one conclusion, it may be that while LPs must acknowledge the currency risk associated with EM PE investments and view it as diversification within their portfolios, GPs should give due consideration to managing their portfolios to perform in the functional currency, sourcing deals with natural hedges or pricing power when appropriate, and consider selectively employing hedges (when reasonably priced) on entry and exit.

Michael Casey, Senior Director, Consulting Services at EMPEA and lead researcher on the report, also adds, “Over the long term, the gradual opening up of local institutional capital across the emerging markets is one of the most promising developments for the mitigation of currency risk and the growth of EM PE as an asset class. Matching a fund’s functional currency with its investment destination can enhance alignment of GP and LP interests, allowing GPs to concentrate on generating alpha, and enabling LPs to harvest the outsized returns that PE can bring when done well.”

About the Survey

Between 7-22 March 2016, EMPEA surveyed 146 GPs and LPs headquartered across 40 countries. This report includes both quantitative findings from the survey and qualitative insights derived from inperson and telephone interviews with LPs, GPs and service providers. EMPEA’s Currency Risk Management Survey provides the industry a resource and starting point for discussions on how practitioners prefer to translate local currency performance into a reporting currency, whether and how firms hedge their FX exposure and how LPs evaluate the performance of GPs in light of currency volatility. This report has been released and distributed at the IFC’s Global Private Equity Conference in association with EMPEA, convening over 800 investors, practitioners and industry stakeholders, where the survey provided data and examples to serve as the foundation for discussions on this topic.

About EMPEA Consulting Services

EMPEA Consulting Services provides high-quality, bespoke research on private capital in emerging markets. Through custom research, white papers, syndicated reports and case studies, EMPEA Page 4 of 4 Consulting Services helps firms acquire actionable insights, communicate their stories and share their successes to grow their businesses. EMPEA Members receive priority service and discounted pricing.