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I cannot conclude this thesis without tackling the issue of international exposure within PE funds. Nowadays, for a PE firm to succeed, or even to get a chance to succeed amid a fierce competition of deal hunters and makers, a PE management firm must have a broader exposure than its domestic market. Beyond the competition, another factor plays an important role here: the already international exposure of the companies where PE funds are investing.
Like all the previous parts and chapters, this issue could be a big endeavor to undertake in regard to a thorough analysis, and as said previously, it is not the purpose of this thesis to dig in the details of the issue. The goal here is just to bring to light a subject that became paramount to focus on for PE firms. Hence, I will just explain how important some international finance concepts are for international PE firms and try to do my best to answer a common question for all the topics here exposed: are PE firms already tackling the issue?
The frame of this chapter is derived from the book of Eun & Resnick, «International Financial Management» (Mc Graw Hill, 2006). I will obviously not touch on all the topics reported by the book but rather select two important concepts that are the most relevant to this chapter as a personal assessment. These concepts are:
- Foreign Exchange Exposure and Management
- International Portfolio Investment
Foreign exchange exposure and management:
We all know that as the nature of business becomes international, and this is the case for more and more companies even small ones because of a more globalized world economy, many firms are exposed to the risk of fluctuating interest rates. In fact, changes in exchange rates may affect the settlement of contracts, cash flows, and the firm valuation as a whole. It is thus important for the firm executives to know the firm's foreign currency exposure and properly manage this exposure.
Actually, we already touched on this subject in chapter 6 when we discussed how PE funds deal with the «financial risk management» of their portfolio firms. So by discussing this international finance part, we have the chance to dig more in its dynamics. In fact, when investing in firms with international exposures, PE funds are immediately faced with a dilemma that is paramount to them: how this international exposure will affect the cash flows and the value of the fund portfolio firms?
Since PE funds are professional investors in non public companies, their number one concern is the value of their investments. Yet, this value is affected by the international activities of their portfolio companies. So what do they do to manage this risk and should they act differently?
In chapter 6, we already exposed the notion of «direct level» and «indirect level» and we've also given some advices to how this risk should be monitored. We're not therefore going to repeat this discussion. We will rather explain in more details the nature of this risk. In fact, it is conventional to classify foreign currency exposures into three types:
- Transaction exposure
- Economic exposure
- Translation exposure
Translation exposure can be defined as the sensitivity of «realized» domestic currency values of the firm's contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Since settlements of these contractual cash flows affect the firm's domestic currency cash flows, transaction exposure is sometimes regarded as a short-term economic exposure.
Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in exchange rates would have been already discounted and reflected in the firm's value. Changes in the exchange rates can have a profound effect on the firm's competitive position in the world market and thus on its cash flows, capital structure and cost of capital.
Translation exposure refers to the potential that the firm's consolidated financial statements can be affected by changes in the exchange rates. Consolidation involves translation of subsidiaries' financial statements from local currencies to the home currency. Translation involves many controversial issues, because resultant gains or losses represent the accounting system's attempt to measure economic exposure ex post; and does not provide a good measure of ex ante economic exposure.
For PE funds, my view amid this trilogy is to let the company manage «transaction» and «translation» exposures as we slightly discussed the matter in chapter 6, although the PE fund should quarterly monitor those exposures in the board meetings; yet the PE fund should manage by itself the «economic exposure» since the fund is the party that has the more to lose if the portfolio firms lose value.
There are two ways to do that for a PE fund:
1- Directly manage this risk by geographically diversifying its investments in different regions that tend to behave not exactly in the same economic trend (For example: invest in developed countries and in emerging markets) so that the currencies moves tend to offset one another hence decreasing the PE fund portfolio overall risk. Said differently, PE funds should «negative economic correlation» between the different regions or countries where they invest.
2- Directly manage this risk on a stand alone basis, meaning that the PE fund should manage each portfolio company economic risk by exiting the one that has lost a certain level of value already defined by a threshold.
In any case, parallel to the management of this risk, the PE fund should also monitor the economic exposure of the fund by looking quarterly to the transaction and translation exposures of the entire portfolio.
International Portfolio Investment:
We will try in this paragraph to see how we could translate the theory of international portfolio investment from a security and financial markets perspective to a PE funds holding non public companies.
From a financial market perspective, it is clear that security prices in different countries don't move together very much. This suggests that investors may be able to achieve a given return on their investments at a reduced risk when they diversify their portfolio holdings internationally rather than domestically. In fact, investors can reduce portfolio risk by holding securities that are less than perfectly correlated; we already know from the financial management principles that the less correlated the securities in the portfolio, the lower the portfolio risk.
In fact, international diversification has a special dimension regarding portfolio risk diversification: security returns are much less correlated across countries than within a single country. This is so because economic, political, institutional and even psychological factors affecting security returns tend to vary a great deal across countries, resulting in relatively low correlations among international securities. In addition, business cycles are often asynchronous among countries, further contributing to low international correlations.
Yet, relatively low correlations imply that investors should be able to reduce portfolio risk more if they diversify internationally rather than domestically. And the magnitude of gains from international diversification in terms of risk reduction depends on the «international correlation structure» which from an empirical base strongly suggests that international diversification can sharply reduce risk. In fact, the empirical studies (Solnik, 1974) show that as the portfolio olds more and more stocks, the risk of the portfolio steadily declines, and eventually converges to the «systematic» and non-diversifiable risk. Systematic risk refers to the risk that remains even after investors fully diversified their portfolio holdings.
Now to push the discussion further, let's move from the «international diversification» to the «optimal international portfolio» selection by considering not only the risk factor but the returns associated as well. We know that investors are willing to assume additional risk if they are sufficiently compensated by a higher expected return. We are here again in the «portfolio theory» analysis we touched on in chapter 7, at a difference that introduces internationalization as a factor of diversification to reduce risk and push toward an optimal risk-return frontier.
Here, the gains from holding international portfolios could be measured in two different ways:
1- The increase in the Sharpe performance measure, which is given by difference in the Sharpe ratio between the optimal international portfolio (OIP) and domestic portfolio (DP): ÄSHP = SHP (OIP) - SHP (DP), with ÄSHP representing the extra return per standard deviation risk accruing from international investment.
2- The increase in the portfolio return at the domestic-equivalent risk level, which is measured by the difference in return between the domestic portfolio DP and the international portfolio IP that has the same risk as the DP. This extra return ÄR accruing from international investment at the domestic equivalent risk level, can be computed by multiplying SHP by the standard deviation of the DP that is: ÄR = (ÄSHP)(ó DP)
Now if we try to translate all the above discussion to a non market point of view, does this analysis apply to PE funds investing in non public and closely held companies? Does international diversification reduce the risk of their portfolios? And are PE funds looking for an optimal portfolio when they are selecting international prospects?
My answer is for sure yes. Yet, when thinking and trying to stick to all these concepts, PE funds are not applying the mathematics of «international portfolio theory» compared to other international equity markets investors like international mutual funds because PE funds do not have the market historic data available for them to construct an optimal portfolio. Their process is more driven by experience and hunch to make an international deal decrease risk or increase excess return to their portfolio. Even sometimes, the target is both decreasing risk and increasing excess return by investing for example in mature industries by in a developing or emerging country; which is in opposition to other market investors for which the outcome from such diversification sticks to the rule of thumb «the less risk, the less return» (see chapter 7 for this discussion).
