Short-dated foreign exchange (FX) forwards can be used to help minimize the FX rate uncertainty that arises between the time a global fund investment is contracted and the time the deal is funded.
The situation
A US-based global fund (“Fund”) has raised USD capital and submits a bid for an overseas asset priced in euros (EUR). The bid is accepted and will be funded three to four weeks later. Simultaneously with the acceptance of the bid, the Fund may look to make a capital call for the USD needed or instead opt to draw down from the capital call borrowing facility closer to the funding date. Either way, the amount of USD needed will change between the bid acceptance date and the date the transaction is funded.
If the EUR appreciates, more USD will be needed as the price is fixed in EUR. As a result, the Fund would need to call for more USD capital to close the transaction. This is an undesirable situation, as investors will have paid more for the asset than originally negotiated, eating into internal rate of return (IRR) and other investment performance metrics.
On the other hand, if the EUR depreciates and a capital was made on the bid acceptance date, capital will need to be returned, as fewer USD will be needed for the acquisition. Economics aside, giving capital back presents and administrative and operational burden which many times renders the windfall more trouble than it’s worth.
Why hedge?
The longer the time between deal signing and close, the more the USDs required to close the transaction will fluctuate due to FX volatility. Funds may call more USD capital than needed resulting in overfunding, or insufficient capital leading to the need to call additional funds. Both scenarios present operational challenges which can be easily addressed by hedging with short-term FX forwards.
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