How can private equity firms improve their FX risk management?

FX has become a key consideration for many private equity firms. The combination of exposure to foreign currency assets, management fees and investor capital amongst other factors means that many private equity firms may run a high risk of being negatively impacted by currency movements. As a result, we believe private equity firms should prioritise FX risk management to protect their returns.

Here are four of our top tips to help private equity firms strengthen their FX risk management strategy:

1. Transaction Cost Analysis (TCA)

Despite being one of the largest markets in the world, FX is also notoriously one of the most opaque. Transaction costs are hidden in the FX spread, typically calculated as the difference between the traded rate at the point of execution and the mid-market rate at that time. TCA was specifically created to highlight hidden costs and enables firms to understand how much they are being charged for the execution of their FX transactions. It can calculate:

• The cost on a trade-by-trade basis or the total portfolio cost of a dataset
• Cost inconsistencies across product, currency pair, tenor and counterparty
• Evidence of best execution.

Ongoing, quarterly TCA analysis can also be embedded to ensure consistent FX execution performance.

2. Efficient use of capital

Having the ability to put trades up for competition is typically central to best execution, but FX pricing shouldn’t be the only thing a private equity firm considers.

Private equity firms that hedge using forward contracts, for example, must also consider that placing a hedge typically requires margin to be posted against that position as collateral. Any capital posted as collateral, sitting dormant in a margin account and not invested, potentially earning higher returns, can cause a drag on fund performance. The FX risk, being mitigated with forward contracts, has been replaced with a potential liquidity risk.

One way around this issue is to trade via an uncollateralised FX facility so that a private equity firm can hedge (using forwards) and not worry about posting margin. If the facility is uncollateralised up to a pre-determined figure, there is a cap on how far in the red your mark-to-market can go before your counterparty has no further appetite to trade with you and starts calling for variation margin. This can result in private equity firms spreading trades between different counterparties, with FX rates being a secondary consideration, to keep sufficient headroom on trading facilities and eliminate the need to post margin altogether.

To get set up with an uncollateralised hedging facility, private equity firms can expect to share similar background information to that required for a subscription line. After all, the bank involved will have to cover any negative mark-to-market themselves.

3. Operational Efficiency

For private equity firms, we know that best execution requires multiple counterparties, but before price discovery comes the search for eligible FX counterparties. Incumbent banking relationships are the logical place to start, and custodians, prime brokers or lenders may be able to offer FX trading services too. Where it could get challenging is establishing new relationships for FX only, as there is no guarantee a counterparty will want to onboard a client that only requires one of their services.

And then there’s the setup phase. After negotiating the finer points of a non-disclosure agreement, a private equity firm must fill out paperwork, locate and share ‘know-your-customer’ documents and then go through a credit approval process. Respective legal teams will need to work through ISDAs, CSAs and any other trading agreements before setup can even begin.

Once setup is complete, the process of price discovery can happen in several different ways – telephone dealing, onscreen quotes, chat messages and e-mails. With multiple counterparties at a private equity firm’s disposal, it can soon turn into a time-consuming team operation to get the best available price.

For these reasons, the private capital market is moving towards solutions that assist in the onboarding of multiple banking counterparties. Private equity firms might also consider more centralised, digitised solutions that consolidate price discovery in one place at one time.

4. Outsourcing

Research published by the investment consultant Russell Investments “Still Overpaying for FX” analysed 173,000 FX trades conducted on assets totalling approximately $76 billion.

It concluded that for an average $1 billion fund, savings of $330,000 per annum would have been achievable from the adoption of an agency approach where FX trading is outsourced to a third-party specialist. In some cases, funds could have saved much more.

The Russell study explicitly suggested the consideration of a model whereby a third-party specialist agent is appointed to manage FX trades and pursue competition among a panel of counterparties to achieve the best possible price.

Outsourcing can free up resources for more effective use elsewhere, enabling private equity firms to dedicate more time to core business matters. Turning to a specialist often means that the end product is also more likely to be of higher quality, leading to improved execution, saving money in the long run.

How MillTechFX can help

MillTechFX by Millennium Global is the FinTech affiliate of Millennium Global Investments, one of the largest specialist currency managers globally. Our FX-as-a-Service model helps private equity firms significantly reduce both FX costs and operational burden associated with FX execution and rolling hedging requirements.

We provide an end-to-end solution, from onboarding with up to 15 counterparty banks to execution, settlement and reporting of FX transactions, including TCA, across multiple funds.

Get in touch today to find out more.