Institutional investors are increasingly embracing global strategies in their private market investments, to achieve desired return and diversify portfolios. How they choose to manage the resulting foreign exchange risk can be a key driver of performance. Institutional Connect had a conversation with Haakon Blakstad, Chief Commercial Officer at Validus Risk Management, about the “hidden” risk of FX exposure in private capital portfolios.
Institutional Connect (IC): I read the article you wrote for the Financial Times specialist publication Pensions Expert and was intrigued by some of the observations and comments there, including the difficulty of managing FX risk in private capital portfolios. Can you tell me a bit about the pretext of this article?
Haakon: Our mission for the past 11 years has been to help people in various sectors manage their market risks better, more effectively, or perhaps in a more efficient way – depending on the situation. The article was a specific address to pension funds regarding FX risk, but the message is more or less the same as in other sectors: identify and measure your risks, and look for ways to mitigate those that you are not expecting compensation for. Pension funds / Limited Partners and private capital managers across the globe are increasingly investing in diverse geographic regions, through asset classes such as private equity, private credit, infrastructure and real estate. How they manage FX risk has become a critical element of achieving desired returns and lowering volatility in their portfolios.
IC: You make the point in the article that pension funds are actually well versed in managing FX risk in what has been, traditionally, the main parts of their portfolio: public equities and fixed income. But for various reasons, many of which you expand on in the article, they are not doing the same for their commitments and assets in the private capital or alternative investment bucket. Would you say this is a proactive and decisive choice or something else?
Haakon: The most common observation is that pension fund managers are acutely aware of these risks, but many have concluded that it would either be too difficult or too expensive to do anything about it. So when people are actively choosing not to manage FX risk it is rarely because they actually want the exposure. As we mentioned in the article, a popular trend has been to push the responsibility down to the fund managers/GPs, which actually works really well and has been keeping us very busy since we are retained by a large proportion of GPs to help them do exactly that. But not every GP is able to offer such services, and none of them are really able to offer customized hedging programmes for each LP – unless they create SMAs, which is really only available to the largest LPs.
IC: So delegating responsibility is not a bad thing then?
Haakon: If by responsibility you mean accountability then I think it is impossible to delegate this. Pension fund managers are ultimately accountable for the performance of their investment decisions and the associate risk taking, whether they allocate capital to managers or invest directly. But responsibility can also mean duty, and delegating the duty to perform certain services is not a bad thing at all, in fact we would have very little to do if that were the case! We definitely think it’s good practice for pension funds and other LPs to make use of fund manager’s offerings to provide hedged returns where possible, because these GPs have more visibility of the source of the risk (typically nature of underlying assets combined with distribution profiles) and so are often better placed to manage it. But pension funds still need to be able to measure the risk, evaluate it, and apply mitigation techniques where there may be gaps.
IC: So how do they do that? It’s clearly not easy, otherwise surely everyone would be doing it?
Haakon: It comes down to two things: Understanding private assets really well and understanding FX really well. And not just the theoretical parts, but the practical ones too. And you need the tools, or at least you need to know where to find them. This includes everything from effective risk models to negotiating bespoke terms with banking counterparties to having the right technology systems to monitor and report on the FX risk arising from investments and underlying assets as well as any associated hedges. Seeking out best practices is obviously key too, but this is difficult in such an opaque market.
IC: It all makes sense. Then what are the options for pension funds to manage FX risk in their private portfolios?
Haakon: We have seen some pension funds invest heavily in in-house capabilities in this space, and been very successful at implementing robust risk management policies and techniques for exposures stemming from private capital investments – including FX. But it has taken them time, and it hasn’t always been straightforward. The alternative approach, for pension funds that either have less internal resources or want to leverage insights and established best practices, is to work with an external expert firm. As independent advisors we can offer advisory mandates and delegated services, but can also act as a sounding board and trusted partner where people want to build out capabilities themselves.
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