Download BVCA Research Note

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