The following article is part of an ongoing column titled ‘Investor Insights.’
Brought to you by Ed Truant, founder and content manager of Slingshot Capital, ‘Investor Insights’ will provide thoughtful and engaging perspectives on all aspects of investing in litigation finance.
EXECUTIVE SUMARY
- There has been an unprecedented & swift fluctuation in currency markets globally
- Currency fluctuations can have a significant impact on litigation finance funds with currency exposures
- Impartial currency advisors will provide market transparency and specific solutions geared towards your specific situation
INVESTOR INSIGHTS
- Currency hedging is an important risk mitigation strategy to consider for portfolios exposed to multi-currencies without hedging
- Hedging cannot eliminate currency risk entirely but can mitigate its impact
- When assessing manager returns, ensure the effects of currency gains/losses are removed to understand the actual return profile of the portfolio
Editor’s note– the following contribution appears with illustrative graphs and charts here.
The recent unprecedented and rapid strengthening in the US dollar has created a significant 8% swing in currency rates in a matter of days.
Such abrupt swings can have significant implications for businesses or financial instruments that are exposed to currency. As an example, in 2014, the owners of the famous ‘Gherkin’ building in the city of London were forced to sell the building, which was 99% occupied and performing exceptionally well. The only problem was, the debt the owners had used to acquire the building was denominated in multiple currencies, including Swiss francs. As a consequence of the financial crisis of 2008, the Swiss Franc appreciated against the British pound by almost 60% over a few years, which increased the debt by £100 million. This was compounded by interest rate swaps that ended up £140 million out of the money. Consequently, the owners were forced to sell their investment in order to repay the higher level of debt, as expressed in British pounds.
Similarly, there are global concerns related to the domestic currency obligations of US dollar denominated debt of developing countries (US bond holders did not want to accept currency risk and insisted on US dollar denominated bonds). These developing countries have seen their dollars depreciate relative to an appreciating US Dollar, which makes their US dollar denominated debt that much more expensive in terms of their domestic currency, exacerbating their debt obligations in the middle of a global financial crisis.
All of that is to say that currency fluctuations can happen quickly, and have a material impact on the value of the underlying instrument to which they relate.
Implications for Litigation Finance Investing
In a previous article, I made reference to the fact that the commercial litigation finance marketplace has quickly become a global marketplace. Typically, we would see alternative asset managers toil away in their backyards for a number of years until they achieve sufficient scale to justify replicating infrastructure worldwide, in order to expand operations into less familiar but potentially less efficient markets – ‘pursuing greener pastures’ one might say. Commercial litigation finance, on the other hand, has been a rather global marketplace right from its origins. Some of the larger funders, including hedge funds, have been focused on major opportunities that have taken them into international markets for specific cases (international arbitration, investor-state arbitration, intellectual property or class action cases) with sufficient size to justify their due diligence efforts and costs. Other funders have specialized in particular case types (e.g. intellectual property) which have enabled them to apply their expertise and networks into vast geographic locales.
The globalization of the industry has implications for the return profile of those managers that invest globally in multiple currencies. Some fund managers, like Omni Bridgeway (formerly IMF Bentham), have raised country-specific private partnership funds which directly address the currency issue. As an example, Omni Bridgeway has a US private partnership that was denominated in US dollars and only invests in US cases, thereby negating the impact of currency fluctuations on returns. Other funders have decided that the currency fluctuations are either immaterial relative to their expected returns, or are too difficult or too expensive to effectively hedge, and hence have left investors with the exposure.
As an investor in a fund, it is easy to enter into currency hedges to deal with currency fluctuations inherent in a portfolio of homogeneous currencies relative to one’s reference currency. However, the problem becomes difficult to solve when the fund manager invests across multiple geographies (and hence multiple currencies) within a portfolio. In those instances, it is virtually impossible to perfectly hedge the underlying currency exposure unless one is privy to information regarding the date the commitment was provided, the dates of the various funding contract draws, and the amount and date of the expected outcome. Of course, if I knew the answer to these questions on a case-by-case basis, I probably wouldn’t need to hedge (although I may choose to do so to maximize my profits).
As if the quantum of case proceeds wasn’t difficult enough, litigation finance is equally uncertain as it relates to case duration, due to the high degree of variability between the date of the commitment and the date of receipt of the ultimate settlement/award, if any.
So, in order to shed some light on the issues inherent in currencies, as well as potential solutions as relates to the commercial litigation finance asset class, I have reached out to a large, publicly-listed currency management solutions expert with the following questions:
Questions and Answers:
Q1. Is currency hedging fairly common in the alternative investment asset market?
Market volatility since 2009 has heightened peoples’ awareness on hedging currency risk, with downturns in sentiment seemingly occurring on a more frequent basis. Currency hedging has certainly been more common in assets classes with lower expectations on IRR, such as the private credit market where volatility can remove the return expectations entirely, but in comparison, the unknown exit dates of Private Equity or Real Estate assets have meant hedging currency risk is far less common. However, as mentioned before, volatility from events such as Brexit, the US/China trade war, and now the COVID-19 Pandemic, has meant an increasing number of enquiries about hedging across all asset classes, including Litigation Finance.
Q2. What advice do you have for fund managers who invest their funds across multiple currencies?
I think the most important thing to consider is whether the GP is undertaking a non-biased opinion on whether to hedge or not. Using an advisor or non-bank allows a GP further insight into hedging risk, where they perhaps haven’t looked, ensuring LP’s are receiving the best possible product or strategy in the fund. Often, a banking counter-party will offer a product to solve an issue, without understanding/knowing the risks behind that problem. A non-bank counterparty has teams of analysts who work with industry-focused partners on fully exploring all risks within each investment fund, not to mention what the competition is doing. The one piece of advice I would give, is to not follow confirmation bias on hedging, and instead explore all avenues to ensure the best policy is being implemented by the GP.
Q3. Given that managers typically raise capital on a ‘blind pool’ basis and may invest across multiple-currencies, what are some of the currency management strategies that managers should be thinking about?
A3. The four key risk areas where we engage with our clients on currency management strategies are:
- Deployment and Exit Risk
- Portfolio Risk
- Share-Class Hedging – it is becoming more common for fund managers to offer currency nominated sleeves to attract a wider investor base.
- Fee Income Risk – if the base currency of the fund differs from the main operating countries of the GP, it may be prudent to look into hedging FX risk on forecastable income.
Q4. Instead of trying to eliminate all currency movements, is there a way to offset ‘black swan’ situations related to large currency fluctuations (similar to what we have seen with the GBP volatility in the context of Brexit), using perhaps a ‘collar’ type strategy?
A collar allows you to participate up to a certain level, however, if the market exceeds that level, you may not be able to participate. It is important to get the best advice on an option if you feel that is the best strategy for your requirement. Again, utilising a non-bank counter-party is key to ensuring your LPs receive the most effective strategy for the fund to which they are committing.
Q5. Can you comment on the cost of hedging and how those costs can vary based on the solutions applied (options vs. forward purchases vs. other)?
Q5. The present interest rate environment across most G10 countries allows for a significantly reduced cost in hedging risk both on the forward and options market. This means funds can now actively hedge tenures of 5yrs+ via relatively low-cost hedging solutions, where previously they could not, particularly against USD and EM currencies. The cost of hedging differs per the product used, of course. And one thing that’s important to note, is an advisor will not only ensure you receive transparent pricing, but will also allow you to explore unique solutions, which in turn could reduce cash drag to the fund.
To the extent readers of this article would like to be connected with the currency management solutions provider referenced above, please email me and I will make an introduction.
Investor Insights
For investors that are invested in the sector or considering making an investment in the litigation finance market, currency may be an important consideration in risk assessment. Litigation Finance managers may hedge at the fund level, which would be the most appropriate level at which to hedge, given their direct knowledge of the underlying cases and their cashflow requirements, duration and the expected returns. However, it is also possible to hedge at the investor level (albeit less accurately). Given the heightened level of volatility in currency markets, hedging is more appropriate now than ever before, and in certain jurisdictions where there is country specific risks (i.e. UK – Brexit), it remains important. In assessing a manager’s portfolio that invests in various currencies, you must remove the effects of currency when assessing returns, as currency-driven returns lack persistence (positive and negative) to determine the true return profile of the fund.
Edward Truant is the founder of Slingshot Capital Inc., and an investor in the consumer and commercial litigation finance industry.
