Debt funds — what is the impact of currency movements on fund performance?

Example: a EUR €2 billion fund plans to provide GBP £510 million of loans to borrowers in the United Kingdom across various corporate sectors, which is about 30% of capital commitments. The manager has a minimum target of 6% IRR from EUR-denominated loans and expects the GBP-denominated loans to return 8% IRR on average — higher yield on one hand, currency risk on the other. While the loans differ in contractual maturity based on the needs of the borrowers, the manager projects the effective tenors to be four years on average.

Chatham builds custom models for fund managers to quantify the currency risk to their fund performance. The currency risk can be positive (i.e., the foreign currency strengthens against the reporting currency) or negative (i.e., the foreign currency weakens against the reporting currency), and fund managers want to see the range of potential IRR. Table 1 reports the simulated IRR in different paths of future EUR-GBP spot rate (a sample output of our models). For debt funds with lower target returns than other private equity strategies, the extent of potential erosion may be unacceptable.

Many fund managers facing such currency risks will formulate and implement a currency risk management programme. Our models incorporate two–three common risk management strategies, along with realistic hedging costs, so that the managers can see their impact and compare the relative pros and cons. Table 2 reports the simulated IRR in the same scenarios assuming that the GBP loan principals are being hedged with four-year Sell GBP Buy EUR forward contracts. If the future EUR-GBP spot is the same as the current level — i.e., no currency risk transpires — then the hedged IRR of GBP loans is 1.1% point lower than the un-hedged IRR. That is the cost of hedging. The benefit is that the hedged IRR is much healthier in GBP weakness. Currency risk management offers investors less variance in potential IRR, notwithstanding the wide range of currency scenarios.

Constructing a currency risk management programme is seldom viewed by debt fund managers as one of their core competencies, but the task unavoidably becomes their responsibility as they and their investors seek to preserve the investment performance. The process can be complex: a manager must consider several clusters of factors that in turn may interact with one another. For example, a manager may find a cross-currency swap to be ideal on paper. It mirrors the GBP loan principal and interest and synthetically converts the loan into EUR. However, since the fund is domiciled in the EU and is classified as a Small Financial Counterparty under the European Market Infrastructure Regulation (“EMIR”), a cross-currency swap falls under variation margin — whereas a forward contract does not. While EMIR may not apply in full when an EU-domiciled Non-Financial Counterparty trades with non-EU financial institutions, regulations in other jurisdictions may come into play. Table 3 lists the key considerations in constructing a currency risk management programme.

Diversifying geographically and earning higher yield may be financially and strategically important to debt fund managers. In so doing, currency risk becomes inherent to their investment thesis. As demonstrated above, the risk can be substantial. Quantifying the risk and evaluating mitigation approaches is fundamental to an informed dialogue with investors and internally within the risk committee. Constructing a risk management programme is not simple as there are several clusters of factors to consider, including how they interact with one another. We at Chatham are uniquely positioned to partner with debt fund managers in crafting a risk management programme, communication with investors, and sustaining the programme.