• The notable slide of the US dollar in the last six-to-nine months has refocused the spotlight on how currency movements can impact investments, including private equity.
• Risks stemming from large currency swings can occur on several plateaus, including the portfolio level, deal level and operational level.
• Investors can help mitigate these risks through PE by constructing a diversified portfolio of assets, as well as taking advantage of the asset class’ long-term nature

Has the buck stopped here?

If 2023 is anything to go by, it certainly looks like the US dollar has come back down to earth with a bang.

According to the US Dollar Index — a measure of the value of the currency against a basket of the greenback against a basket of other developed market currencies — the dollar has fallen some 10 basis points over the past nine months, as investors looked to move exposure away from the currency against a backdrop of weaker than expected economic data and the Federal Reserve’s (Fed’s) slowing rate-hike cycle, relative to other central banks.

Recent data showing slower consumer spending has further reinforced the view that the Fed could loosen the reins and add further downward pressure on the dollar.

This is illustrated more starkly when looking at individual currency pairs. The euro, for example, hit a two-decade low against the dollar last year, falling to parity and eventually becoming worth less than one dollar for the first time since 2022. Since then, the dollar has faded to around 90 cents.

Currency fluctuations are a key factor in the modern economy, with the profits and losses of many large businesses sometimes at the mercy of these movements. Sportswear company Nike, for example, warned last year that it expected heavy dollar strengthening to knock about $4 billion off of its annual revenue.

Naturally, such a potential impact on companies will have a knock-on effect on their investors, both in the public and private spaces. And while private equity’s decade-long appreciation appears at odds with the daily ups and downs of foreign exchange, understanding how currency changes can impact your investment performance is still part of the puzzle to learn.

How currency moves affect private equity funds

At a high level, we can sort the different ways that currency changes can have an impact on a fund’s performance broadly into three categories: portfolio risk, transactional risk, and operational risk.

Portfolio risk relates to how investments made beyond the fund’s home currency can potentially hinder or boost performance. This is due to the fact that these usually non-domestic investments made in a foreign currency need to be converted back into the fund’s home currency before distribution.

Situations like this can occur among larger investors with a global presence. EQT’s ninth flagship fund, for example, includes investments across the US, UK and European Union, conducting deals across several different currencies. The effect can be significant. According to Hamilton Lane research, using the example of a Europe-based investor with money in US private equity over the past 10 years, nearly 28% of their volatility came from currency fluctuation.

Elsewhere, transactional risk can cover two elements. On a macro level, it is the fund’s overall currency exposure as it buys, sells and finances new investments, while on a deal-by-deal basis, it can refer to how an exchange rate could alter between the agreement and closing of a transaction. Operational risk, meanwhile, covers the effects of currency movements on normal fund or business operations, as outlined by the Nike example above.

Historically private equity funds have tended to accept these risks, banking instead on being able to overcome them through active management and the asset class’ general history of outperformance. However, the wild foreign exchange swings of the last year have, anecdotally at least, seen more investment managers consider currency hedging when going into deals.