In order to attract investors globally, managers of private funds, including private equity, private debt, infrastructure, and real estate may offer different currency share classes. A currency share class can broaden investor access to a fund, but also exposes them to foreign exchange (FX) risk.
This blog outlines key considerations in deciding how to set up a currency share class and implementing a share class FX hedging strategy.
Limited Partners (LP) may want the currency exposure associated with an asset and invest directly in the master fund. Others may want the convenience of a currency share class denominated in their base currency so that they can deploy capital and receive distributions without converting currencies.
For investors, the lock-in for close-ended funds diminishes their ability to liquidate an investment when a currency moves against them, making currency share classes particularly relevant for close-ended funds. General Partners (GP) might be better placed than LPs to manage the FX risk as they hold more information about the fund strategy, currency impact, and cash flow implications.
In deciding whether to set up a currency share class, the GP has to balance the increased attractiveness to global LPs with the cost and complexity of setting up and managing a currency share class. GPs typically follow 3 steps in designing the FX hedging approach of a currency share class before weighing it against the potential benefit of attracting global sponsors.
1. Assess the costs of managing a currency share class
FX Forward Contracts are the most commonly used instrument to hedge the FX risk of a currency share class. Typically, a rolling strategy is deployed, where FX forward contracts are rolled at a set frequency. This manages the currency risk while maintaining flexibility for capital movements.
The main direct costs of maintaining an FX hedging a currency share class are the interest rate differential (roll costs), transaction costs, and collateral drag.
Interest rate differential
It arises from the difference between the interest rates of the two currencies in a currency pair. Suppose the base interest rate of the currency of the share class is lower than the base rates of the operating currency of the fund. In that case, the interest rate differential leads to an interest rate differential cost each time an FX Forward Contact is rolled. The interest rate differential costs can be significant for Emerging Market funds with USD or EUR share classes. Managers might reduce the cost of the interest rate differential by partially hedging the FX risk instead of fully hedging it.
Transaction costs
They are the spread charged by financial institutions when executing FX trades. Frequent rolling over of FX contracts can be costly. A fund manager can impact the transaction costs by changing the hedge ratio, adjusting the tenor of the FX forwards, and ensuring the financial institution offers the best FX rates.
Collateral drag
When entering into FX hedging agreements, GPs might be required to post cash margins to cover potential margin call events in their positions. Collateral Drag refers to the negative performance impact resulting from holding cash in non-yielding assets.
Managers can impact the required collateral by opting for:
- shorter tenor FX forward contracts
- partial hedging
- trading with a financial institution that requires less cash collateral to place FX forwards
2. Calibrate the hedge ratio of a currency share
Some investors may seek complete protection against currency movements (favouring a high hedge ratio), while others may tolerate currency fluctuations for a potential upside (lower hedge ratio). Three main dimensions typically impact investor preference for a higher or lower hedge ratio:
Investment Holding Period
Longer investment horizons may justify a lower hedge ratio, as short-term currency fluctuations tend to smooth out over time.
Underlying Asset Exposure
If the fund’s assets are denominated in multiple currencies, the asset’s cash flows might perform as a natural currency hedge. A fully domestic asset base with foreign currency share classes typically requires a high hedge ratio.
Market Volatility
High volatility in currency markets may justify a higher hedge ratio to reduce potential losses.
3. Set the FX forward tenor (or roll frequency)
Private capital funds have lumpy cash flows impacted by capital calls, distributions, and exits. Deploying a hedging strategy where FX forward contracts are rolled either monthly, quarterly, semi-annually, or linked to major portfolio events allows rebalancing of the hedge at the moments the forward contracts are rolled. Typically, at each roll of an FX Forward Contract, a cash settlement is performed to reflect the contract’s fair value at the rollover date. The ability to manage the liquidity impact of the cash settlement is a consideration when deciding on the tenor FX forwards used (and thus roll frequency).
| Shorter tenor FX forward | Longer tenor FX forwards | |
| Flexibility | Higher | Lower |
| Cash requirements | Frequent at moments of FX rolls | Lower |
| Rebalancing/frequency of rolls | Higher frequency rolls | Lower frequency of rolls |
| Implications | Shorter tenors mean more frequent rollovers, leading to potentially higher transaction costs and the operational burden for financial institutions. | Financial institutions might require cash collateral in order to trade longer tenor FX forwards. |
Building a strong partnership
Setting up a currency share class requires balancing the increased investor appeal with the costs and complexity of setting up and implementing a share class FX hedging strategy. Key cost considerations include interest rate differentials (roll costs), transaction expenses, and collateral drag.Several calibrations and counter party selection choices can be made to set up a share class FX hedging strategy to optimise the outcomes. The primary calibrations are the hedge ratio and the FX forward tenor. Selecting a financial institution that offers competitive pricing and favourable cash collateral requirements is crucial for effective counter party management.
Working with Administrators and Corporate trustees
Ebury has a track record of working with management companies, investment managers, fund administrators and corporate trustees to provide transactional services when hedging at share class level. By working with the service providers, once the NAV calculation has been confirmed, Ebury as a preferred counterparty will process the relevant hedge transactions at share class level. Systems are in place to enable a review of the hedge to be undertaken in the light of ongoing flows into and out of the share class.Working with GPs to provide this solution in collaboration with the administrators and corporate trustees is a great way to utilise the service offering Ebury has developed specific to funds that have multiple share classes.
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