Embracing Local Capital Markets: An Alternative Approach to Hedging Currency Risk in Africa

LAGOS, Nigeria, Capital Markets in Africa: With the appearance of stalwarts of the global private equity industry in Africa such as Carlyle, the Abraaj Group and Temasek, the outlook for private equity flows into the continent should be promising. The reality for these fund managers, is that the majority of growth being created is in local currency and as such their returns are impacted by volatility in exchange rates between local currency and the US Dollar, which dominates the global private equity industry.

In the absence of hedging markets for a lot of the local currencies in Africa, fund managers need to find alternative means of managing the currency risks that their investments are exposed to. Local capital markets have the potential to provide these solutions if fund managers embrace them and engage with participants to develop capacity and create risk mitigation solutions.

Currency Risk in Nigeria
Nigeria presents a timely case study of the challenges that currency risk poses the private equity industry. Following a reduction in oil revenues and lower US Dollar receipts, the Federal Government of Nigeria decided to defend the Naira by pegging it to the US Dollar and reducing the availability of US Dollars via the Central Bank of Nigeria. This has resulted in a parallel market developing with an exchange rate that has oscillated between 50% to over 100% depreciation of the pegged rate. The Central Bank of Nigeria has recently allowed the Naira to float freely and currency traders expect significant depreciation in future exchange rates.

For a fund manager who has invested US Dollars in a Nigerian portfolio company that is earning its revenues in Naira the prospect of hyperinflation does not bode well. In a scenario of macroeconomic stress, the ability of a portfolio company to shift any increase in currency risk on to its customer base will be limited by the financial stress being experienced by the general population. Consequently, a fund manager may find themselves having to push back exit horizons to allow the value of their investment to recover over a longer period of time Which, depending on the objectives of the fund, may or may not be feasible.

Fund managers may have also compounded the problem by using hard currency debt rather than Naira debt to leverage their investment, usually attracted by single digit interest rates for hard currency loans versus double digit interest rates for Naira loans. Again, where a potential portfolio company’s revenues are solely or predominantly in Naira, the currency mismatch that can arise from the use of hard currency leverage will actually result in increased debt servicing costs, in a depreciating Naira scenario, which can become unsustainable and ultimately destroy value.

Managing Currency Risk
So where does the solution lie for the fund manager faced with currency risk? The answer can perhaps be borrowed from the central tenet of project finance which states that the success of a project is dependent on the risks associated with a project being allocated to the party that is best equipped to deal with that risk. This principle holds true in the private equity world as well and a fund manager may be best served by turning to local capital markets for the solution when considering how to manage currency risk.

While most local capital markets in Africa will lack sophisticated risk management products there are simple strategies that can be employed by a fund manager to maximise the value of what is available. The most obvious and straight-forward strategy is to blend hard and local currency leverage so as to create a currency hedge. For example, if the leverage used in a portfolio company also includes a local currency tranche amounting to between 20% to 50% of the total debt structure, then this has been found to provide the portfolio company with a significant natural hedge and room to manoeuvre in times of currency volatility thereby helping preserve value. In

simple terms, the key benefit of the approach is that it reduces the amount of US Dollars that the portfolio company needs to find to service its debt obligations. During a time when US Dollar liquidity is scarce, as is presently the case in Nigeria, this flexibility can be the difference between the portfolio company surviving or being taken over by its creditors.

In frontier markets, where the availability of currency hedging derivatives of any meaningful tenor are either scarce or prohibitively expensive, blending hard and local currency debt offers similar benefits and for tenors of 3 years or more, and at a cost, which being a blend of hard and local currency interest rates, makes commercial sense.

The challenge for the fund manager, who is typically making an investment during a period of economic stability, is to overcome the myopia which arises from the allure of nominally cheaper hard currency debt. Many will argue that in the context of a short-term investment horizon the protection offered by local currency does not justify the high cost associated with it. In other words,

“The Do Nothing” strategy. Many fund managers have made a general assumption that African currencies depreciate at an average of 5% per year. Unfortunately, the problem with African currencies is that they rarely depreciate uniformly, and most tend to punctuate a period of stability with a sudden plunge into the abyss. If a fund manager chooses to fund an investment strategy entirely in US Dollars and is able to time their entry and exit from an investment perfectly, then they may avoid currency risk. However, in the context of highly volatile African markets this approach could also be viewed as just another form of currency speculation. If there is anything predictable about African markets, it is their unpredictability.

Embracing Local Capital Markets
A better pathway for a fund manager to manage the currency risk associated with a portfolio company in an African market would be to include the local capital markets as part of the investment strategy. This could mean involving the local banking market in the acquisition of a portfolio company and the provision of local currency leverage. Then, once a business plan has been implemented, seek a recapitalisation via the local bond markets so as to engage local institutional investors and build local market knowledge of the portfolio company.

Once an exit horizon has been reached then the same investors can be approached to anchor a trade sale or stock market flotation. Local institutional investors are amassing significant assets under management and are now seeking to actively invest in private equity assets and thus represent a further source of capital or an exit opportunity. Some forward-thinking fund managers are already embracing this approach and for example, Actis, an emerging markets private equity firm, gradually exited its portfolio company, Umeme, the Ugandan electricity distributor, by floating it on the Ugandan and Nairobi Stock Exchanges.

The emergence and rise of specialist local currency development finance institutions such as GuarantCo, TCX and FrontClear highlights the growing view that developing local capital markets is key to the future stability, growth and prosperity of developing countries. Private equity fund managers interested in Africa share the responsibility of engaging with local capital markets and helping them develop the products to mitigate currency risk and attract investment.

Contributor’s Profile
Lasitha Perera is Chief Investment Officer at GuarantCo, a development finance institution that encourages the development of critical infrastructure in low income countries through the provision of credit guarantees that enable projects to raise debt finance.

This article was featured in the INTO AFRICA July edition, with focuses on Private Equity in Africa and is titled Private Equity: Africa’s Trump Card.