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For a few dollars less

09 April, 2013

Had it been a spaghetti western flick by Sergio Leone, the protagonists would have merely shrugged their shoulders and went about shooting from the hip a few more vagabonds. It would have compensated them for the notional loss of seeing the value of the bounty shrink. But the cowboys did not have to bother about the value of the Greenback as they used it to buy goods (although Hollywood would have us believe they spent equally on carnal services) within the country.

Majority of the private equity and the venture capital fund managers in India, unfortunately, do not enjoy the comfort of delinking the returns they generate from their investments to the movement of currency. We say majority, as there is a fair bit of domestic fundraising happening in the country where the returns that GPs churn out for their LPs are more or less agnostic to forex swings.

Much of the debate on poor returns generated by Indian GPs and how that has affected the flow of fresh capital from international LPs to India surrounds either the high entry valuations at the peak of the bull market or poor exit valuations post the markets tanked in FY08-FY09. Indeed, that is true. But what gets underplayed is the role of currency in the matrix.

If we look at the 2007-09 vintage of PE/VC deals (many of which hang heavy like the legendary albatross around the necks of the GPs), the bulk of them happened during FY08 or the 12 months ended March 2008. And this was even as the markets tanked in January 2008. Interestingly, there were many brave souls who went about inking deals which were in a term-sheet stage, even as valuations were tumbling left, right and centre.

Some managed to squeeze their way out of the collateral damage either by renegotiating what were done deals or by delaying the closure (in a few cases, helped by the stretched approval process at the FIPB, the nodal government body monitoring foreign investment approvals in India). But that’s beside the point.

What’s interesting is that this was exactly the period (April 2007-March 2008) when the huge inflow of money hoisted the Indian currency against the US dollar to a decade high (highest since 1998). One cannot be sure, but a good chunk of the deals would have been signed when the Indian Rupee was trading at Rs 39-40 to a US dollar. But the slide of Rupee since then means the foreign investors get lower decibel bang for the buck, ceteris paribus.

Back-of-the-envelope calculation shows depreciation of the Indian currency (Rupee trades around 54.3 to a US dollar, now) has shaved off a good 700-800 basis points or a third of the total from the internal rate of return (IRR) of around 25 per cent that the fund managers chase, when viewed from the international currency perspective.

In effect, this means an Indian GP, who invested at the peak of the market (as many did), would require to churn out at least 4x returns on the principal in local currency to generate around 25 per cent IRR in US dollar, as against 3x returns in constant currency for the standard IRR.

Moreover, an Indian GP would need to churn out at least 6.3 per cent IRR in local currency (on investments in the FY2008 vintage) just to stay above water in US dollar terms after currency conversion at exit.

Factor in the fund management fee and carry, howsoever small these are, and we are looking at a much diminished value of returns for the international LPs, even for those investments which actually managed to hit the target IRR in local currency. It may well be that these returns, which may seem pretty decent, were actually a shade below the 5-year annualised return of around 15 per cent from an index fund tracking Dow Jones.

The pain is only relatively less for European LPs as the euro has also moved sharply against the Indian currency. Moreover, with most PE firms managing US dollar-denominated funds, it is more likely to swing with Rupee-USD movements.

If that was not bad enough, the Indian currency movement also compares poorly to other emerging markets such as Brazil or Indonesia, the new darling for Asian PE investments. These two markets also saw currency volatility immediately after the market meltdown but stabilised soon after, unlike the Indian currency. The obverse argument is that – Indian currency itself was outside its normal trend line when it appreciated sharply.

Either way, the actual return that international LPs generate across markets will weigh against each other. And this definitely matters. At the end of the day, this is the money which is pulled out and returned to the LPs overseas.

After sifting through the annual reports of some PE firms and speaking to a few Indian fund managers, it seems that at least in some quarters, currency hedging is either absent or negligible to provide a significant cushion to the investors.

This implies that the due diligence is, by far, superlatively dominated by business risk assessment rather than factoring in tertiary but critical, real-world risk factors such as currency. Of course, spending a lot of money for paying premium for currency-hedging instruments can be tough in a market where even the 2:20 fee-carry mix in terms of its fixed costs is being questioned.

Fund managers would have realised their mistake as their FY2008 vintage investments ripen for harvest. But the question is – how much would they be willing to add to the cost of operations by playing in the currency derivatives market and would that help at all for a relatively longer-term investor?

(Vivek Sinha is Executive Editor of VCCircle)

To become a guest contributor with VCCircle, write to shrija@vccircle.com.

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gautam gupta . 4 years ago

A question: If a vintage 2008 investment took an IRR hit of 6.3% on account of currency, this is fairly close to the actual hedging cost of INR/USD during the period. Therefore, for two PE funds having identical rupee-IRRs, if one had hedged fully and the other had not, both should still end-up with very similar dollar IRRs. i.e. it would seem that hedging or a lack of it, did not substantially affect either absolute or relative PE returns (at least for a vintage 2008 investment).

This is not to say that hedging is not worthwhile – after all, in a different time period, rupee might depreciate at a rate higher than the hedging cost.

But as long as the currency penalty was close to the actual hedging costs, it does not seem “fair” to argue that PE returns were depressed due to currency. After all hedging cost is a factor of interest rate differentials – if Indian risk free rates are themselves 6% higher than US risk-free rates, the currency penalty should be offset by the base-return premium that is available to an investor in India.

Nirmal Shah . 4 years ago

Gautam, Your point is valid that till hedge cost similar to penalty one should not make such argument… but I think fund managers business is to take local markets exposure via deals and keep currency fully hedge.. if investors want currency exposure they can do it via Currency derivatives and FOREX experts. I don’t think PE managers should allow to take indirect currency exposure when that is not their expert area… It’s like IT company should have done only IT business, if someone want real estate exposure they will take it on their own, why allow to take it through IT company (Satyam pre fiasco!!!)

vivek.sinha . 4 years ago

Nice point Gautam, but you got mixed up in the numbers. The IRR hit is 700-800 basis points so 7-8%.

For a few dollars less

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