Scott Price, Head of Private Equity and Hedge Fund Services – North America, and Neil Rothman, UDIS Capital Partners, advise those interested in growing with overseas investment not to let currency fluctuations stand in their way.
For several decades since the introduction of securities into the typical investor’s portfolio, both retail and institutional, asset allocation was comprised of some ratio of stocks, bonds and cash. Then the category of “alternatives” emerged onto the allocation scene around 20 years back as a way of collectively expressing the group of strategies outside of and ideally non-correlated to the big three historic components of one’s allocation.
The first group emerging of this “newcomer” of an asset class was comprised of real estate, private equity, hedge funds, commodities and currencies. Nowadays, it is widely accepted that there are many different strategies existing within each of these – whether hedge fund flavors spanning long-short equity to global macro or private equity from leveraged buy-outs to mezzanine finance, and the like.
From Evolution to Revolution
Today the growing list of strategies that fall into this alternative class continues to race on. Peer-to-peer lending funds emerged some eight years ago and now cryptocurrency seems to be the newest burgeoning trend.
While alternatives have been around some time and have undergone much change recently, they remain an area of investment that is taken advantage of by only a small percentage of the investing population. But even this is shifting as globalization has become more prominent in scale and pace over the last decade – spurred in large part by technology – allowing more investment opportunities to be globally accessible. The most prominent group of investors taking advantage are the largest institutional investors, led by some forward-thinking university endowments and foundations, looking to take advantage of real substantial allocations in alternative investments. According to Willis Towers Watson in their Global Alternatives Survey 2017, 33% of the top alternative managers’ assets are from pension fund assets reaching up to US$1.6 trillion in 2016.
While large pension funds have quickly taken advantage, there now seems to be strong penetration from the world of family offices and ultra high net worth individuals as well. As noted in the Global Family Office Report (2017), private equity (including venture capital / private equity, co-investing and private equity funds) continues to maintain a strong position in the family office portfolio, accounting for a 20.3% share with the outlook that an upward trend will mostly likely continue.
While institutional investors and wealthy families or individuals may be increasing their allocations to alternatives, there are nonetheless very few places around the world where this is happening. The United States, the United Kingdom and Singapore respectively seem to be the global leaders in the prevalence of alternative strategies and thus managers. Elsewhere around the globe, investors of all shapes and sizes from everyday households to multi-billion-dollar (or the equivalent value) pension funds are either drastically underweight or have no allocation to alternatives at all.
This is an enormous opportunity for managers primarily located in these geographies to attract and garner the next rolling generation of inflows into alternative strategies – but the environment can be challenging for overseas investors to seek opportunities in alternative investment classes that are predominantly domiciled in precious few favorable locations around the world. Along with the difficulty in properly allocating to these strategies cross-border, there is an additional concern when deploying money overseas that an allocator must consider when evaluating an investment’s prospects – for example, what will be the consequences of currency fluctuations on the investment and how can these be mitigated or accounted for?
More investors are demanding that this foreign exchange (FX) burden be placed on the investment managers by offering multi-currency share class options, domiciled in favorable tax locations to invest directly into the master fund which holds all the funds’ assets. This foreign share class is certainly worth a consideration if the investor is offering a sizeable contribution or the manager feels there are more investors likely to follow.
Fortunately, structuring and implementing a foreign share class, either hedged or unhedged, is becoming far easier and better understood than it was just half a decade back.
A Marriage of FX convenience
When Maitland was approached by an existing client with this very conundrum of managing the risks associated with offering a share class that was not the same as the home currency of the master fund, Maitland saw a partnership opportunity with UDIS Capital Partners – a leader and specialist in cross border transactions, and foreign currency solutions. And thanks to operational collaboration, Maitland and UDIS Capital were able to neatly wrap and develop a scalable solution as the following case study illustrates:
A Japanese asset management firm with existing funds was looking to set up a new parallel strategy to its local domestic fund, now marketing to the US investor community. The client mostly trades in equity and the total return swaps on the equity are generally global – with investors from various countries that result in Japanese, Korean and other currencies.
The request was three-fold:
- Help analyze opportunities to launch the fund using the US Dollar based share market – converting from USD to Japanese Yen and then back to USD
- Create a solution to hedge on unintended gain and loss in the currency of the fund
- Implement new solutions to be fully administered through Maitland.
While the challenge was in three-fold, the solution itself was executed in two parts:
Part 1: FX hedging solution
UDIS’s suite of hedging solutions is primarily used as an added measure to absorb the impact against negative FX movements for the company or investor. With vast experience in identifying common issues and isolating specific solutions across client types (investors), investment vehicles (private equity to hedge), and companies (multinationals), for this specific client, UDIS was able to create a strategy that entailed:
- An in-depth analysis including the financial costs of setting up the structure as well as the viable solutions for the client.
- Guidance on setting up both the onshore and offshore bank accounts to handle the subscriptions
- Implementing a separate credit facility that allows the fund to book forward contracts without tying up precious investor funds.
- Designing a hedging program recognizing the client’s trading strategy and proposing tools that would help in managing volatility risks to help stabilize the returns
- Acting as a de facto escrow account while the due diligence on the investors is being completed
- Converting the USD subscriptions into JPY and sending the funds over to the master account
- Locking in the base currency of the investment manager, making reporting far easier for the manager while still giving the investor a fixed USD return.
The first part of the solution – the in-depth analysis – was the most rigorous as it required a thorough understanding of the client’s goals, existing fund structure and other relevant background. Below is a snapshot of the key discussions:
The client had been considering whether it made sense commercially to take the USD conversion to JPY and then from JPY back to the USD. When UDIS consulted with the client, an intense due diligence process took place – examining the parameters and weighing the options for a foreign share class fund.
The first stage of this hedging solution included walking through various analyses, one of which was a view into the 52-week currency fluctuations as per the “Currency Conversion” chart below.
A key focus was on the change in price as a percentage against the discount / premium for booking a forward contract out for a year. Due to the interest differential, it was deemed beneficial to hedge the CHF/JPY/CAD/AUD back into USD.
Date of sample analysis: Sept. 7, 2018
To show the other perspective, if the client chose not to hedge, UDIS was able to depict the hypothetical effect on a portfolio’s return. The “Currency Movement vs Cost of Hedging” graph below is just one way of showcasing such a scenario:
Date of sample analysis: Sept. 7, 2018
Part 2: Connecting the FX and cash management with the fund administration control environment.
Once the client decided to go ahead with the new fund structure, Maitland collaborated with the client to set up the fund with its legal team as a master-feeder structure (a Cayman Master, Cayman Feeder and a Delaware Feeder).
The client’s fund was set up with investor subscriptions in US Dollars, but the master fund’s home currency and trading strategy is in Japanese Yen.
Partnering closely with UDIS, Maitland was able to seamlessly manage the full range of administration services needed for this customized solution, including:
- Notification of new investor / investment: receiving the subscription documents and completing due diligence
- Subscriptions and trades: notifying UDIS of the incoming subscriptions and ensuring the client approves the rates to lock the transactions
- Trade confirmations: Maitland providing confirmation receipts in both the spot rates of USD($) sold, and JPY(¥) bought and a second showing forward hedge rate on sold (¥) and USD($) bought.
At the outset, this multi-step and multi-party management of the fund may seem complicated, but in actuality, the solution is straightforward. The challenge that most funds have is finding the right team that:
- Can provide the level of transaction analysis needed and spend time to customize the cash management and fund administration solutions for the client’s specific needs versus an off-the-shelf approach
- Can work with other contracted specialists in a seamless fashion.
The above illustrates some of the challenges and how to overcome them when considering and launching a foreign share class to attract and ultimately garner inflows from overseas investors into a foreign share class. The UDIS / Maitland solution was not just about a FX hedging solutions provider working with a fund administrator, but rather, the ability to deliver an often-overlooked solution. Key to the solution was taking a holistic approach through forming a team of specialists and leveraging each team’s operational platform for the most efficient output in order to deliver a cohesive onboarding experience.
As the trends of the investment world have shown us over the past couple of decades, there is no stopping the rise of the alternatives, especially when the appetite of a growing global investor base continues to demand new solutions.
If you are a fund manager looking to raise capital outside of your local market and your investors are concerned about the effects of foreign currency please reach out to us:
UDIS Capital Partners is a leading alternative provider of foreign exchange solutions.
Maitland is an institutional fund administrator specializing in alternative funds.
The fund administration services discussed in this article is contracted through Maitland Administration Ltd which is registered with and licensed by the Cayman Islands Monetary Authority.