Leveraging local currency to maximise returns
September 2015 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
Private equity, despite being global, is largely a hard currency dominated industry with the majority of funds being raised in US dollars, even those that are focused on shores far beyond those of the US. Consequently, the issue of currency risk is becoming an ever increasing concern for those private equity investors that are looking to emerging and frontier markets for their returns.
The reality for these private equity investors, seeking to benefit from the wealth being generated by the growing middle classes in developing economies, is that the majority of the growth being created is in local currency, and as such their returns are impacted by volatility in exchange rates between local currency and the dollar. Returns are further compromised by the fact that most private equity investors also choose to leverage their investments using hard currency debt rather than local currency debt, usually attracted by single digit interest rates for hard currency loans versus double digit interest rates for local currency loans. The attractiveness of local currency is further hindered by less sophisticated local debt markets, the lack of hedging products and higher transaction costs. However, for those investors who are able to take a broader view, there are also several potential benefits to considering local currency as part of their investment thesis. Advantages of using local currency manifest in almost all aspects of the lifecycle of a transaction.
A lot of attractive investment opportunities within emerging and frontier markets are privately owned. Local investors and financial institutions contain significant knowledge about these companies and the markets in which they operate. Thus, by creating opportunities for these local investors and financial institutions to co-invest with them, private equity funds stand to gain from local knowledge that may not be readily available to buy-in from the market. Consequently, utilising local currency markets presents the opportunity to both originate new investment opportunities and to obtain intelligence on their prospects.
In the financing of a transaction, the high interest rates that are a feature of a lot of emerging and frontier markets do make local currency debt unattractive at first sight. However, where a potential portfolio company’s revenues are solely or predominantly in local currency, the currency mismatch that can arise from the use of hard currency leverage creates a significant risk to the overall transaction and can destroy value very quickly. A local currency will typically depreciate in a scenario of macroeconomic stress and consequently the ability of a portfolio company to shift any increase in currency risk on to its customer base will be limited by the financial stress being experienced by the general population. Whilst hedging derivatives are available in more mature emerging markets, they tend to be either scarce or prohibitively expensive in the majority of emerging and frontier markets. However, the addition of a local currency tranche amounting to 20-50 percent of the total debt structure can provide the portfolio company with a natural hedge and room to manoeuvre in times of currency volatility, and thereby help preserve value. A blend of hard and local currency interest rates can also help the company to reduce the impact of the debt structure on its cash flows over the long-run.
In a scenario where a portfolio company has become distressed, local currency lenders will tend to better understand local issues and thus can help calm offshore investors and lenders. Furthermore, they are also more likely to want to support the company through a restructuring rather than by seeking an exit at the first opportunity. Furthermore, in situations where US dollar liquidity is scarce, as is currently being experienced in a number of emerging and frontier markets, local currency markets can help provide much needed liquidity to a portfolio company but are more likely to do so where the company has been an active participant in the local currency markets and local knowledge of the company is good.
Local institutional investors such as pension funds and insurance companies are amassing significant assets under management and are now seeking to actively invest in private equity assets and thus represent a further source of capital or an exit opportunity. These institutional investors tend to be natural shareholders for portfolio companies given their local presence and long-term outlook.
A natural pathway for a private equity investor to manage an investment in an emerging or frontier market would be to use the local banking market to help acquire a portfolio company, then once a business plan has been implemented, seek a recapitalisation via the local bond markets so as to engage local institutional investors and build local market knowledge of the portfolio company. Once an exit horizon has been reached, then the same institutional investors can be approached to anchor a trade sale or stock market flotation. While the ease with which this path can be walked will vary from market to market, for a private equity investor that wishes to establish itself in a market for the long-term, using such a pathway represents a significant but ultimately worthwhile investment in their future success. Local currency is not always the easiest option but it can certainly play a role in maximising value.
Lasitha Perera is an executive director at Frontier Markets Fund Managers. He can be contacted on +44 (0)20 3696 1864 or by email: firstname.lastname@example.org.
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Frontier Markets Fund Managers