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BVCA Research Note Number 07 How do exchange rates affect PE returns? Private equity (PE) funds are denominated in a variety of currencies. Investors in PE funds (known as the limited partners or LPs) often have to convert the cash flows and the unrealised values of the underlying funds from different currencies into a single base currency, in order to gauge and report the performance of their portfolio. The fluctuation of the relevant exchange rates therefore has an impact on the value of the underlying cash flows and unrealised assets in an LP’s base currency, and ultimately the return of the overall portfolio. This research note aims to examine the extent to which PE returns are affected by exchange rate movements, using the BVCA’s database of fund performance. The impact of currencies on long-term returns The BVCA database covers 470 PE funds invested by UK managers in the past 30 years. These funds are all denominated in one of three currencies: sterling, euros or US dollars. While over 70% of BVCA funds are denominated in sterling, euro-denominated funds carry significantly more weight in terms of fund size, cash flows and the unrealised asset values. For instance, the amount committed to the euro funds accounts for approximately 70% of the total commitment to all BVCA funds as at the end of 2009. In order to measure overall industry performance, the BVCA converts all euro and dollar-denominated cash flows and valuations into sterling. The returns reported in the BVCA’s Performance Measurement Survey are therefore closest to what a UK-based investor would have achieved by committing to UK funds over time. Chart 1: Market exchange rates 2.6 Table A: Since-inception IRRs Base currency Foreign currency units per £ 2.4 IRRs (to Dec 2009) IRRs (to Dec 2007) Euros 12.0% 16.3% US Dollars 14.0% 18.5% Sterling (a) 14.1% 17.0% Constant exchange rates 12.7% 16.8% Sterling PPP 14.7% 19.8% Euros (a) 2.2 US dollars 2.0 1.8 1.6 1.4 1.2 1.0 0.8 1980 1984 1988 1992 1996 2000 2004 2008 (a) The SI IRRs reported in the table above differ from previous research notes due to the inclusion of pre-1986 vintage funds. Sample: 1980-2009. Source: BVCA. (a) Synthetic euro series prior to 1999. Source: Bloomberg and BVCA. However, instead of converting cash flows and valuations into sterling, we could convert them all into euros or US dollars, using the daily market exchange rates in Chart 1. By doing so, we would get a sense of how currency fluctuations affect PE returns. Using the exchange rates shown in Chart 1, we obtain the pooled since-inception 1 internal rates of return (IRRs) reported in Table A. These suggest that movements in exchange rates do not appear to have a major impact on returns over the long term. The difference between the sterling-denominated return and the dollar-denominated return is negligible. But the return when using the euro as the base currency is a little lower than both sterling and dollar-based returns, which reflects the gradual appreciation of the euro against sterling since 2000, and the surge in the euro-denominated funds over the same period. Overall, though, US or European investors have experienced similar returns to their UK counterparts over the long term. Using alternative currency adjustments Converting fund data into different currencies offers one gauge of the impact of exchange rates on returns. But there are also alternative ways we could measure differently-denominated returns. One simple metric would be to use the average observed exchange rate over the life of the funds – essentially, to convert currencies at fixed exchange rates. When we do this, the differences between differently denominated funds obviously disappear, and the overall return is between the range of our single-currency measures of return (Table A). In addition, we could measure returns using some alternative economically-derived measure of currency valuations, rather than a market-based measure. Exchange rates, like other global financial prices, can often decouple from the values that are implied by underlying economic conditions or policies. In order to abstract from these market dynamics, economists sometime focus on so-called ‘fundamental’ measures of exchange rates, which are often theoretically driven. One of these measures is the notion of Purchasing Power Parity, or PPP. This essentially states that identical products should cost the same amount in different countries – and hence the fundamental or PPPbased exchange rate is the one that normalises prices across countries. The IMF calculates PPP-based measures of exchange rates on an annual basis, which we then interpolated to get a daily sterling series. When we convert cash flows and valuations into a PPP-based measure of sterling, the IRR is broadly similar to the ones we found using market exchange rates. This again suggests that, over the longer term, movements in exchange rates do not have a major impact on returns. Impact on short to medium term returns Exchange rates could have a more significant impact on short Table B: Five- and three- year IRRs or medium-term measures of returns. For instance, sterling Base currency Five-year IRRs Three-year IRRs declined significantly against both the US dollar and the euro (2005-2009) (2007-2009) during 2008, which would tend to boost sterling-based Euros 12.4% -4.7% returns but lower other measures. Table B presents five and US Dollars 13.0% -2.6% three-year backward looking returns, using the three currencies in the BVCA database. The differences between Sterling 17.0% 4.1% these measures of returns are commensurately larger than Constant 13.0% -3.2% for since-inception measures of returns, particularly on the exchange rates three-year measure, reflecting the sharp moves in exchange Sample: 1980-2009. Source: BVCA. rates seen over this period. This demonstrates that, even though long-term investors in private equity probably do not need to be too concerned about hedging against currency risk, shorter-term measures of returns can be distorted by large but infrequent movements in exchange rates. This is another reason why investors should focus on since-inception measures of PE returns, and place less weight on short-term measures that can been unduly affected by factors that are beyond the control of PE houses. If you have any questions or comments, please contact Mei Niu or Devash Tailor: [email protected], [email protected] 2