Fund managers managing a fund denominated in a foreign currency, such as a UK-based private equity fund managing a EUR-denominated fund, can be significantly impacted by fluctuations in exchange rates through impact on the value of their management fees in their base currency. 

Managing this foreign exchange (FX) risk requires fund managers to carefully consider their hedging strategies. This is particularly true for managers of illiquid assets like private equity, real estate, or infrastructure, where cash flow timing and collateral liquidity present unique challenges.

Below are key considerations for fund managers looking to hedge the FX risk of their management fees.

Understanding FX exposure

The first step in managing currency risk is to understand the FX exposure. Fund managers must assess:

• Currencies in which management fees are received versus base currencies in which the fund manager operates. The historic volatility of the relevant currency pair is often used as a proxy for the future exchange rate volatility a manager might be exposed to. 
• Timing and size of management fee payments over time, including the expected total duration of the management fees (typically to the expected end of life of the fund). 
• Variability of management fees generated and degree of certainty of the management fees generated over time.

Hedging costs

Cost is always a consideration in hedging. A typical management fee hedging strategy is in place for several years, so the cumulative cost of hedging strategies needs to be carefully evaluated. There are several potential costs of hedging. 

The costs of executing the hedge, typically the FX spread a hedging counterparty requires to hedge FX risk, is larger than the spread required to perform a spot FX conversion due to costs of counterparty risk and liquidity costs being factored in. 

There might be a cost of ensuring sufficient liquidity is available to set up or maintain the hedge through required collateral. Finally there might be a lost opportunity of benefitting from advantages foreign exchange rate movements if the management fee revenues are hedged.

Accounting and tax

The accounting and tax treatment of FX hedging instruments differs per jurisdiction. For instance, gains or losses on currency hedges may be taxed differently than services and investment returns, so managers need to consult tax and accounting advisors to understand the treatment of their hedging strategies.

Willingness to run FX risk

Depending on the degree of commitments in base currency the fund manager might have, the amount and currency denomination of funds that are managed, any potential natural hedges in place (e.g. operational costs in fund denomination currency), the depth of fund managers balance sheet, and potential views on exchange rate developments will inform the willingness a manager might have in running FX risk. 

Choosing the hedging strategy and instrument

Both FX forwards and FX options can be used to minimise the impact of FX volatility on fund managers’ income. Forward contracts are often used because of their simplicity, and currency options are often used to allow fund managers to benefit from favourable currency movement. 

The hedging strategy is a key consideration next to the hedging instrument. The degree of hedging (e.g., is 100% of the expected fees hedged or a smaller share) is established. The maximum tenor and collateral requirements inform whether each individual fee payment can be hedged or whether a rolling strategy is deployed where the cumulative exposure is hedged (rolling hedging). 

The hedging strategy and instrument chosen result in an expected cost of hedging of setting up the management fee hedge.

Trade off hedging costs versus risk

The manager trades off its willingness to take on FX risk against the costs of hedging it expects to take on to fund the right hedging strategy and instrument. This can be an iterative process as the hedging costs and outcomes differ depending on the hedging instrument and strategy chosen.

How Ebury Institutional Solutions can help

1. We support setting up a FX policy and choosing the suitable FX instruments and strategy. 
2. Limited collateral impact by requiring no or low collateral to set up and maintain FX hedges.
3. Long tenor forwards enabling hedging up to maturity of the fund
4. Cash management and transactional accounts to support the GP in its daily transactional needs.
5. Emerging market currency capabilities enable fund managers with exposure to Asia, Africa and LATAM with reliable payments and hedging. 
6. Ebury Online platform allows to transact online and provide direct access to over 50 currencies.

Let’s start a conversation

Ebury provides transactional accounts, cash management, and FX risk management to funds.

Get in touch with our experts to discuss the needs of your fund and how Ebury can help you. You can also visit our page to learn more about our solution.