hese currency hedged sleeves allow European investors to deploy capital in their performance currency without the need to run a FX hedging programme on their own. The recent surge in EUR/USD FX volatility has increased LPs’ focus on whether and how a currency sleeve is hedged and the impact on expected returns.

Why a hedge sleeve

Offering hedged sleeves that mitigate FX volatility can broaden the appeal of US funds to European investors. Currency hedging is particularly relevant for strategies that generate relatively predictable returns, such as private credit, real estate, and infrastructure, where FX volatility can outsize the fund investment return profile.

Key choices for a hedging strategy

Fund managers tend to use FX forwards for hedging due to the simplicity and ease of communication with LP regarding the hedging strategy. When setting up a hedging facility, two key choices emerge: how long to hedge (or tenor of FX forwards) and the hedge ratio.

For how long to hedge, managers often weigh the flexibility of rolling short-dated forwards against longer-dated hedging. When a forward contract is rolled, it is extended before it matures by entering into a new forward contract with a future maturity date. This allows the sleeve to maintain the hedged position beyond the initial contract period, extending the forward at each rollover. Rolling short-dated forwards allows for adjustments to the hedged principal as capital is drawn down or amortised and tends to be offered against better conditions.

Regarding the hedge ratio, the manager will have to decide what share of the exposure to hedge (the hedge ratio), balancing the cost of hedging with LP preferences regarding the degree of currency risk exposure.

Cost of hedging

Liquidity

Different FX hedging strategies have different cash flow impacts. Short-dated FX forwards are more likely to be offered without the need to post collateral by FX counterparties. Still, they require the fund to maintain a sufficient level of liquid assets to settle the market-to-market of the hedge at each role. Longer-dated FX forward often requires the fund to post collateral with the FX counterparty. Both the collateral the fund might be required to post and the liquidity that the fund holds to settle the forwards at point of roling them create a drag on the funds returns.

Interest rate differential

The FX forward rate is determined by the difference between the interest rates in Europe and the US. With US interest rates higher than European rates, the conversion rate in the future (the forward rate) against which USD is sold against EUR is worse than the FX spot rate. That means investors whose home currency yields lower than the foreign currency will incur a cost of hedging equal to the interest rate differential.

Conclusion

Currency sleeves can support US GPs in accessing European capital. To offer a currency hedge sleeve, GPs are required to make several design choices, the main ones being the hedge ratio and for how long to hedge. The choices made in setting up a sleeve will impact the cost of hedging through the interest rate differential and the liquidity drag.