The carry cost of rolling forwards, the cash a dollar rally demands while the NAV gain stays illiquid, how little volatility the hedge removes, and the NAV-lag trap.
Usually only partly, and never without a liquidity budget. For a euro-based LP with $1,000m of US private equity, a 50 per cent hedge with rolling three-month forwards costs about 99 basis points of NAV a year at an illustrative 2-point rate gap, cuts the volatility of the euro return only from 21.54 to 20.40 per cent, and in a quarter when the dollar rises 10 per cent demands €47.7m of cash while the offsetting gain sits in illiquid NAV.
Worked in full in The Private Markets Limited Partner by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
An LP can hedge a listed portfolio precisely: the value is known daily and can be sold to settle a hedge. Private equity NAV is reported a quarter late, cannot be sold quickly, and moves far more than the currency does. The hedge, meanwhile, is a forward contract that settles in cash every time it rolls. Each of those facts changes the arithmetic. How currency moves pass into the reported return itself is covered in how exchange rates change a private equity IRR; this is about whether to hedge them.
| Input | Value |
|---|---|
| US private equity NAV | $1,000m (€909.1m at 1.10) |
| Hedge ratio | 50%, $500m sold forward |
| Instrument | 3-month forwards, rolled quarterly |
| Dollar and euro short rates | 4.0% and 2.0% |
| Volatility of private equity in dollars, unsmoothed | 20% |
| Volatility of EURUSD | 8% |
| Correlation, base case | 0.0 |
Forward rate = spot × (1 + rUSD × T) / (1 + rEUR × T) = 1.10 × 1.01 / 1.005 = 1.1055
Euros received for $500m: 452.30 at the forward against 454.55 at spot: 2.25m a quarter
Annual cost = 9.0m, 1.98% of the hedged amount, 0.99% of the whole NAV
When dollar rates are above euro rates, a euro investor selling dollars forward gives up the rate differential. The cost is not a fee and appears in no expense ratio, but at 99 basis points of NAV it is in the same range as a management fee.
Dollar up 10 per cent in a quarter (EURUSD to 1.00): settlement = 500 / 1.1055 − 500 / 1.00 = −€47.7m, paid in cash at the roll
Offsetting gain on the full NAV: 1,000 / 1.00 − 1,000 / 1.10 = +€90.9m, unrealised
Dollar up 15 per cent (EURUSD to 0.9565): settlement −€70.4m against a NAV gain of €136.4m
The LP is better off on paper, but the €47.7m loss is cash, due now, and equal to 5.3 years of carry cost. It arrives when the dollar is strong, which is often when risk assets are weak, the denominator is moving and capital calls are still coming. If the dollar instead falls 9.09 per cent, taking EURUSD to 1.21, the hedge pays €39.1m in cash while the NAV loses value on paper. The hedge belongs in the same stressed liquidity forecast as unfunded commitments, as in what overcommitment ratio a programme can afford.
Volatility of the euro return ≈ √(σPE2 + (1 − h)2σFX2 + 2(1 − h)ρσPEσFX)
Unhedged, ρ = 0: √(0.202 + 0.082) = 21.54%; 50% hedged: 20.40%; fully hedged: 20.00%
| Correlation of PE with the dollar | Unhedged | 50% hedged | 100% hedged | Lowest-volatility hedge |
|---|---|---|---|---|
| −0.2 | 20.00% | 19.60% | 20.00% | 50% |
| 0.0 | 21.54% | 20.40% | 20.00% | 100% |
| 0.2 | 22.98% | 21.17% | 20.00% | above 100% |
Because private equity volatility is two and a half times currency volatility, the currency adds little to total risk. A 50 per cent hedge removes 1.14 points of volatility for 99 basis points a year, about 87 basis points of carry per point of volatility. If the dollar tends to rise when private equity falls, a negative correlation, the unhedged position already diversifies and a full hedge removes nothing at all.
The hedge is sized on the last reported NAV, which is a quarter old. If true NAV has already fallen 20 per cent, to $800m, the $500m hedge is 62.5 per cent of the real exposure, and a full hedge on the lagged figure would be 125 per cent: a speculative short dollar position. LPs that hedge usually stay well below 100 per cent for this reason.
The stressed liquidity forecast, with its indicators and breach protocol, is among the working documents in the free companion files for this book.
With forwards, roughly the interest rate differential on the hedged amount. For a euro investor hedging dollars with an illustrative 4.0 per cent dollar rate and 2.0 per cent euro rate, selling $500m three months forward costs 2.25m euros a quarter, 9.0m a year, or 1.98 per cent of the hedged amount and 99 basis points of a $1,000m NAV.
Because the forwards settle in cash while the gain on the private equity is unrealised. If the dollar rises 10 per cent in a quarter, a $500m hedge loses 47.7m euros at the roll, while the $1,000m NAV gains 90.9m euros on paper. The cash must come from the LP's liquid assets, often in a quarter when capital calls are also due.
Usually well below 100 per cent. NAV is reported with a lag, so a hedge sized on a stale $1,000m NAV becomes 62.5 per cent of a true $800m at a 50 per cent ratio, and 125 per cent at a full hedge. And with private equity volatility of 20 per cent against 8 for the currency, a 50 per cent hedge cuts total volatility only from 21.54 to 20.40 per cent.
Chapter 7 of The Private Markets Limited Partner sizes the liquidity buffer for a stressed year; the companion files price it as insurance. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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