Currency swings grab attention of limited partners

Currency volatility is no longer the best friend of alternative investors, with recent swings biting into investors' international investments.

Although most limited partnership agreements give managers the right to hedge currency risk, few general partners do. The reasons are that the long-term nature of investors' commitments is expected to mitigate the highs and lows of currency swings and currency hedging is expensive. But for many investors and managers it is not working out that way.

New Mexico State Investment Council's most recent real asset report by consultant Townsend Group revealed that the endowment's $532.9 million real assets portfolio had a -7.9% net return for the year ended Sept. 30. Since the portfolio's 2011 inception, NMSIC has committed approximately $1.6 billion to real assets across 21 funds with 14 managers. The pension fund's internal rate of return to Sept. 30 from inception was 3.4%, down from the IRR of 8.5% as of Dec. 31 from inception, the report noted. Townsend attributed the short-term return to currency swings.

Alternative investments firm Ares Management LLC reported a $2.7 million loss in the first quarter due to currency translation.

And the Blackstone Group attributed a portion of its 38% drop in total revenue to $4.6 billion for the year ended Dec. 31 to currency translation. The New York-based alternatives investment firm suffered a $49.2 million currency translation loss in 2015. However, the situation improved in the first quarter with a $17.6 million currency translation gain.

Volatility “will come up more and more because of the dramatic movement in currency,” said Christopher J. Ailman, chief investment officer of the $186.8 billion California State Teachers' Retirement System, West Sacramento. “People are going to need to deal with it.”

CalSTRS is dealing with currency risk through a portfoliowide strategy it has had in place since 1995. But, Mr. Ailman added, CalSTRS is one of the few public pension plans that has such a strategy.

“Currency risk is an important risk factor and its relevance has increased over the past couple of years,” said Thierry Adant, investment consultant, credit research in the New York office of consulting firm Willis Towers Watson PLC.

The various monetary policies and regulations of countries around the world have increased currency swings that have cut into investors' returns, Mr. Adant said.

“New regulation and diverging monetary policies have increased currency hedging costs and volatility from low levels,” he said.

“Three years ago nobody did currency hedging,” said Elissa Kluever, managing director of credit and lending funds with London-based hedge fund manager Omni Partners LLP.

“Only a minority (of alternative investment managers) adopted currency hedging,” Ms. Kluever said. Part of the reason is because investors demanded it. “There were sizable currency moves in stable, developed markets such as the yen and the euro,” she added.

The Orange County Employees Retirement System, Santa Ana, Calif., hedges the euro and yen at 50% of portfoliowide public equity market exposure. However, its private equity managers do not hedge the currency risk in their portfolios, said Girard Miller, chief investment officer of the $12.5 billion pension fund.

"'We do not consider our current overseas private equity material at this time,” Mr. Miller said.

However, OCERS officials expect that, over time, its three-year contract to make annual commitments of between $50 million and $100 million to a custom private equity fund-of-funds portfolio managed by Pantheon Ventures will increase the pension fund's non-U.S. private equity commitments “at the margin,” he said.

By contrast, OCERS' non-U.S. private debt managers are all U.S. dollar-denominated or fully hedged for currency internally, “in order to compare their risk-return profiles with domestic direct lenders,” Mr. Miller said.

Currency's ups and downs have cut into investors' alternative investment returns, consultants said. “Depending on time frame, the strong dollar has hurt those that invested in opportunities outside of the United States,” said David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners LLC.

“If you invested in the BRICs (Brazil, Russia, India and China), not only have geopolitical and local economic issues been problematic, but adverse foreign exchange has further compounded a bad situation,” Mr. Fann said.

For example, a $50 billion U.S. pension plan might have a total exposure (predominantly to the euro) of up to $20 billion in non-U.S.-dollar investments, mostly emanating from its public equity holdings, although exposure from private equity might be more than $1 billion. Assuming the entire euro exposure was unhedged over a one-year period, a relatively conservative estimate of 10% volatility to the dollar-euro exchange, and a 10% return to the portfolio, the potential currency impact on performance could about $200 million over a one-year period, he explained.

Many investors have tried to avoid the problem by investing in dollar-denominated private equity international funds, he said. But dollar-denominated funds are not always available. “We've seen many emerging market funds do well on a local currency basis, but on a dollar basis, do poorly because the local currency exchange rate with the dollar moved the wrong way,” he said. “Significant currency devaluations can destroy investment returns.”

The alternative investment managers of the $11.1 billion New Mexico Educational Retirement Board, Santa Fe, generally do not hedge currency, said Bob Jacksha, chief investment officer in an e-mail.

“We accept the currency volatility as a component of the return of investing in foreign markets,” Mr. Jacksha said.

Investors need to think about currency hedging these days whether they do it in-house or through the manager, as alternative asset classes are increasingly global, said Julio Garcia, head of infrastructure, North America, in the New York office of infrastructure manager IFM Investors Pty. Ltd. “It's a pretty big world out there where investors can go,” he said.

How alternative invest managers handle currency risk varies widely, said Lori D. Campana, partner in the Boston office of alternative investment placement agent Monument Group Inc. Some non-U.S. managers will have a U.S. dollar-denominated fund or a U.S. dollar-denominated sleeve within a fund. Some managers will execute certain hedging strategies for investments in certain countries, however, most often they leave the hedging responsibility with investors, Ms. Campana said. “There is no blanket strategy, one size fits all policy for currency risk for a fund or specific investments.”

A number of hedge funds are now offering investors options for hedging currency risk.

Omni Partners offers a choice of an asset hedge or share class hedge, said Graham Rodford, Omni's chief operating officer. Most investors choose the share class hedge, which is a currency overlay to hedge the net asset value of the share class.

Traditional private equity funds hold illiquid positions for a number of years, Mr. Rodford said. “What they tend to do is take the money in and ignore the currency risk, he said.

Some European private equity fund executives might hedge the underlying investments. The theory is that over the long run, currency fluctuations might not mean much to investors because of the length of the funds' lives, Mr. Rodford said. By comparison, Omni's funds are two- or three-year vehicles.

Mr. Rodford added that some currency hedging strategies could “introduce opportunity risk and cost.”

Indeed, currency hedges generally work better in funds with shorter time frames, said TorreyCove's Mr. Fann.

“Currency hedges work best when there is great confidence in projected cash flow events,” Mr. Fann said. “Usually this is the case in timeframes less than one year. For instance, investors know that a stock distribution might happen or an earn-out payment will occur.”

Willis Towers Watson's Mr. Adant said it might be better for investors to hedge currencies at the portfolio level.

“For liability-driven investors, macroeconomic links between currency, interest rates and inflation suggest that considering them all at the same time will lead to a superior outcome than considering them individually,” Mr Adant said.

A falling currency could lead to rising inflation and rising rates could cause a currency to rise, for example, he said.

“In addition to thinking holistically, centralizing the hedging arrangements via a single hedging manager might be more efficient than outsourcing it to each investment manager,” Mr. Adant said. n