It is no secret that pension funds are allocating more capital to private investments, such as private equity, private credit and other illiquid assets, either directly or more commonly via dedicated fund managers.
According to some estimates, these asset classes now make up almost a quarter of all pension fund investments globally.
The market for private assets is indeed global. With almost half of all private capital assets under management being managed by funds outside of the US, the increased allocation to private investments has also increased pension funds’ currency risk.
And this risk is not immaterial — many investors have seen significant depreciation of investment performance due to currency volatility. More importantly, this risk is normally an uncompensated byproduct of the investment strategy, not a core part of it.
Most investors are acutely aware of the ‘hidden’ risks but are dissuaded from actively managing them
Currency risk is nothing new for pension funds. Most will hedge some or all of the foreign exchange risk associated with fixed income investments. Many will also hedge at least some portion of their international equity portfolio.
However, when it comes to private capital portfolios, it may seem like currency risk is a subject that is avoided altogether.
Conventional tools difficult to apply to private assets
We reviewed hedging policies of 23 local UK government pension funds and found that while about half (48 per cent) hedge at least some of the currency risk within their public equity portfolio, not a single one hedged the same risks associated with their private capital holdings.
This might seem to be a counterintuitive finding. Why would pension funds feel it appropriate to hedge currency risk associated with public market investments, but not when it comes to their private capital portfolio?
We believe that there are two main reasons why this might be the case. First, private investments have historically represented a relatively small proportion of the typical pension fund portfolio.
As such, the associated currency risk may have been considered immaterial. Clearly, this position is less compelling now, with private market allocations exceeding 20 per cent on average.
Second, the operational complexity of hedging the forex risk associated with private investments is considered more onerous, when compared with hedging public equities or bonds.
Most private investments are done through a limited partner/general partner structure where capital is committed up front and drawn over a period of time, and there are typically long lock-up periods.
There may also be a lack of visibility of underlying assets since information about new investments, exits and valuations is typically only provided to investors periodically — for example, quarterly.
As such, the conventional tools and methodologies used to manage forex risk can be difficult to apply to private assets. Perhaps more than anything, the struggle to identify and quantify currency risk in private capital portfolios could be the biggest hurdle. As author and management theorist Peter Drucker famously said: “You can’t manage what you can’t measure.”
We do not believe the lack of forex risk management in private capital investments is down to ignorance.
Schemes aware of ‘hidden’ risks
Most investors are acutely aware of the ‘hidden’ risks but are dissuaded from actively managing them due to the issues described above.
However, there are some exceptions: for example, the Danish €21bn (£18.2bn) pension fund PenSam, which recently changed its strategy for forex hedging to account for its growing allocation to alternative investments.
Other pension funds have opted to push the responsibility of forex risk management to the private capital fund managers (general partners) they invest in.
Many general partners are consequently implementing fund-level hedging programmes to deal with mismatches between asset currencies and fund currencies, and expanding their fund structures to offer investors hedged feeder funds or share classes.
While these approaches certainly have merit, given the fact that general partners often are closer to the risks and therefore have access to more information, they are not always available.
As a result, pension funds should seek to delegate the management of forex risk to general partners where it makes sense and is possible, but should also be equipped to manage these risks themselves where required — or seek assistance from independent expert advisers who can enable such sophistication through market-tested turnkey solutions.
As private capital allocations continue to increase and become more globally diversified, the impact of forex risk will have an even bigger impact on investment performance for pension funds worldwide.
Kevin Lester and Haakon Blakstad are chief executive and chief commercial officer of Validus Risk Management
