Currency Impact in Brazilian PE/VC Deals Performance

Transcription

1 VOL. 20, NO. 3 SUMMER 2017 Currency Impact in Brazilian PE/VC Deals Performance ANDREA MARIA ACCIOLY FONSECA MINARDI, RICARDO VINICIUS KANITZ, RAFAEL HONORIO BASSANI, AND PEDRO ROBELO SCHITTKOWSKI The Voices of Influence

2 Currency Impact in Brazilian PE/VC Deals Performance ANDREA MARIA ACCIOLY FONSECA MINARDI, RICARDO VINICIUS KANITZ, RAFAEL HONORIO BASSANI, AND PEDRO ROBELO SCHITTKOWSKI ANDREA MARIA ACCIOLY FONSECA MINARDI is a professor at Insper Institute of Education and Research in Sao Paulo, Brazil. minardi@insper.edu.br RICARDO VINICIUS KANITZ is a founding partner of Spectra Investments in Sao Paulo, Brazil. rkanitz@spectrainvest.com RAFAEL HONORIO BASSANI is a partner at Spectra Investments in Sao Paulo, Brazil. rbassani@spectrainvest.com PEDRO ROBELO SCHITTKOWSKI is an undergraduate student at Insper Institute of Education and Research in Sao Paulo, Brazil. pedrors@al.insper.edu.br Many private equity/venture capital (PE/VC) firms that invest in emerging markets raise capital with international investors. Funds call capital in U.S. dollars and convert it into local currency to invest in portfolio companies. At the time of exit, they receive the proceeds in local currency and convert them back into U.S. dollars. Because performance and profits most commonly are measured in U.S. dollars while the investments are in local currency, funds and international investors run currency risk. Private equity investments are not hedged against currency fluctuation. The time horizon is too long for making effective hedge at a reasonable cost. This article analyzes how currency risk has affected the performance of Brazilian PE/VC investments in the last 20 years. Brazil was one emerging market that attracted a lot of PE investment in the last 20 years, and the currency fluctuated significantly during the period, which may be the case for other emerging markets. Our main findings are that currency risk is irrelevant for the long-term performance of limited partners (LPs) and PE/VC firms. But the impact at the deal level may be substantial, affecting performance fees. Although there is diversification across deals, depending on the vintage, some funds may not be able to diversify across cycles, and foreign exchange risk may affect funds performance. Currency appreciation/devaluation misleads assessment of general partners (GPs ) track records. SAMPLE INFORMATION We used in this analysis the Spectra- Insper database, a comprehensive set of information about private equity organizations, funds, deals, and people in Latin America. This private dataset has been built through a partnership between Spectra Investments, a Brazilian investor in PE and VC funds, and Insper Institute of Education and Research, a leading Brazilian business and economics school. In order to protect the identity of firms, funds, and deals, Spectra Investments sanitizes the data before filling in the database. Main sources of information are private placement memoranda in possession of Spectra, although some data were hand collected from CVM (Comissão de Valores Mobiliarios Brazilian Security Exchange Commission) and other sources, such as Thomson TRAA. Our sample contains PE and VC deals invested between 1994 and 2014 that are fully liquidated. We excluded 1) write-offs and other deals with missing information about divestment date and 2) deals missing information for both internal rate of return (IRR) and multiple of money (MoM that is, cash inflows divided by cash outflows). The final sample has 239 observations. Exhibit 1 contains the distribution of the deals SUMMER 2017 THE JOURNAL OF PRIVATE EQUITY

3 E XHIBIT 1 Distribution of the Deals in the Sample According to Vintage Year according to vintage year (the year the fund invests in the deal). We observe that 90% of them have vintages between 1997 and 2010, and vintage 2007 alone concentrates 13% of the investments. Because we do not have cash flow information, we considered that all cash outflows were disbursed at investment (entry) date and all cash inflows were received at liquidation (exit) date. E XHIBIT 2 Basic Statistics about BRL Appreciation per Year of Deals Invested, CURRENCY RISK For each deal, we collected the exchange rate for BRL/USD at the day the fund invests in the deal (entry) and at the day the funds exit the deal (exit). We used PTAX (official Brazilian Central Bank sell rate) as the conversion rate. We calculated the Brazilian real appreciation per year according to the following expression: BRL appreciation per year = BRL / USDentry BRL / USDexit 1/ T 1, Exhibit 2 contains basic statistics of annualized foreign exchange appreciation series for all investments in our sample. We observe that the sample mean is close to zero. This implies that the BRL appreciation per year in a portfolio containing all 239 deals invested between 1994 and 2014 is 0.4% that is, practically zero. In other words, the long-term currency impact is zero. Because long-term-oriented LP and PE/VC firms invest or manage a portfolio of many deals with vintages where T = holding period in years. CURRENCY IMPACT IN BRAZILIAN PE/VC DEALS PERFORMANCE SUMMER 2017

4 E XHIBIT 3 Histogram of BRL Appreciation per Year of Deals Invested, spread throughout time, vintage diversification mitigates currency risk. Contrary to this finding, however, the currency impact for a single deal may be substantial. Exhibit 3 contains the histogram of the BRL appreciation per year during the deals holding periods. Note that 2% in the horizontal axis represents the range of BRL appreciation per year between 4% and zero, and 23% of the deals in the sample had BRL appreciation per year in this range; 2% represents the range between 0% and 4%, and it contains 15% of the deals in the sample. Although mean and median are close to zero, the dispersion is high: 33.5% of the deals had a BRL appreciation per year over 12% or +12%; 12.1% of the deals had a BRL appreciation per year either over 16% or +16%. SENSITIVITY ANALYSIS OF BRL APPRECIATION IN THE PERFORMANCE FEE General partners may not receive the performance fee (carry) from deals that performed well in Brazilian reais because of currency devaluation. We perform a sensitivity analysis using a preferred return of 8% and estimating the probability of a GP not receiving carry given different levels of IRR in Brazilian reais. 1 For this analysis, we estimate the BRL devaluation (or negative appreciation) per year that makes the IRR in U.S. dollars equal to 8% according to the following relationship: Minimum BRL appreciation per year = [(1.08)/(1 + IRR BRL)] 1 We used the sample distribution of BRL appreciation per year to see the probability of having a currency appreciation lower than the minimum. SUMMER 2017 THE JOURNAL OF PRIVATE EQUITY

5 We report the results in Exhibit 4. Observe that the sample probability that a deal has a BRL appreciation lower than 16% (or a BRL devaluation higher than 16%) is 5%. A deal with an IRR in Brazilian reais of E XHIBIT 4 Sensitivity Analysis of Currency Impact in Deal Performance 10% will not generate a performance fee if the BRL devaluation per year in the holding period is higher than 1.8%. The probability of this scenario is 41.8%. A deal with an IRR in Brazilian reais of 20% will not generate a performance fee if BRL devaluation per year is higher than 10%. This scenario has a probability of 10.5%. Currency risk may create incentive problems. If there is significant currency devaluation and the probability of not receiving the performance fee becomes high, even if the investment performs well in Brazilian reais, general partners will find it challenging to motivate their teams to remain on board. CURRENCY IMPACT IRR USD < 8%. Exhibit 5 shows the fluctuation of the BRL/USD exchange rate at the investment date. The horizontal axis has the deal vintage year, and the vertical axis gives the exchange rate at the investment day. Each plot corresponds to a single deal. We observe that after 1998, E XHIBIT 5 BRL/USD Exchange Rate on the Day the Fund Invests in the Deal CURRENCY IMPACT IN BRAZILIAN PE/VC DEALS PERFORMANCE SUMMER 2017

6 E XHIBIT 6 BRL Appreciation per Year During Deal s Holding Period dispersion in the BRL/USD rate is high even across deals of a specific vintage year. See, for instance, 2002, when the BRL/USD rate fluctuates from 2.4 to 3.6, and 2004, from 2.8 to 3.5. We also observe cycles of BRL appreciation and cycles of BRL depreciation. Exhibit 6 shows the dispersion in annualized BRL appreciation during the deal holding period. Investing when the local currency is appreciated implies in buying expensive Brazilian reais for USD That increases the probability of having a local currency devaluation and, consequently, a negative impact in USD performance. See, for instance, the vintages 1994 until 2000 (with BRL/USD exchange rates between 0.8 and 2.0). We observe in Exhibit 6 that with few exceptions, deals from these vintages had BRL devaluation (or negative appreciation), independently of the length of the holding period, and this negatively affected IRR in U.S. dollars. The opposite is also true. Investing when the local currency is undervalued implies buying cheaper Brazilian reais for USD 1.00, increasing the probability of having a local currency appreciation that inflates IRR in U.S. dollars. See, for instance, vintages 2002 until 2006 (with BRL/USD exchange rates between 2.1 and 3.6). With few exceptions, deals from these vintages had BRL appreciation per year, inf lating their performance in U.S. dollars. Funds raised in the beginning of a BRL devaluation cycle had positive currency impact in most of their deals, and funds raised in the beginning of a BRL appreciation cycle had negative currency impact in most of their deals. Therefore, even if funds are portfolios of deals, they will not be sufficiently diversified throughout time to mitigate currency risk. Funds that invest in the beginning of a devaluation cycle are candidates for incentive problems. SUMMER 2017 THE JOURNAL OF PRIVATE EQUITY

7 E XHIBIT 7 IRR in BRL versus IRR in USD One example is the possibility of higher turnover rate in the GP team. Talented human resources may quit the firm if they do not see any prospect of receiving carry in the medium term. The currency impact in the short and medium terms for international limited partners should be irrelevant. International investors usually invest in PE/VC funds of different countries, and currency diversification mitigates currency risk in the short and medium terms. In the longterm currency, risk is irrelevant for LP and PE/VC firms, because good cycles compensate bad cycles. LOCAL CURRENCY APPRECIATION MAY MISREPRESENT USD PERFORMANCE Exhibit 7 compares IRR in Brazilian reais (horizontal axis) with IRR in U.S. dollars (vertical axis). 2 Plots correspond to deals. IRR in U.S. dollars may be misleading when judging track records of general partners. Currency devaluation may transform exceptional performance in Brazilian reais into mediocre returns in U.S. dollars. For example, see that one deal with an IRR in Brazilian reais of 37% has an IRR in U.S. dollars of 6%. The opposite is also true. Currency appreciation may also convert mediocre return into exceptional returns. See, for instance, the deal with an IRR in Brazilian reais of 8% and an IRR in U.S. dollars equal to 29%. Limited partners should require performance data in local currency in order to access the real picture about general partners track records and make good judgments about its ability to generate high-performance deals. CONCLUDING REMARKS Brazilian currency risk is irrelevant for foreign limited partners with long-term horizons and at CURRENCY IMPACT IN BRAZILIAN PE/VC DEALS PERFORMANCE SUMMER 2017

8 the firm level. If they are diversified across vintages, good cycles of currency appreciation compensate for bad cycles. But the BRL/USD currency rate fluctuates significantly in Brazil, and currency impact is substantial at the deal level. Currency risk also affects the performance of funds that invest in the beginning of a currency devaluation cycle, decreasing performance in U.S. dollars, and in the beginning of a currency appreciation cycle, increasing performance in USD. Our data do not allow us to test whether an international investor that invests in a basket of different countries and currencies diversifies currency risk in the medium term. Currency impact at the deal level and at the fund level may create incentive problems. GPs may have an incentive to make less effort in deals that face substantial currency devaluation and have a high probability of not receiving carry. Talented human resources may quit PE/VC firms if currency risk destroys the prospect of receiving carry in the medium term. LPs should require performance information in local currency to have a real picture of GPs track records and to better judge their ability to generate highperformance deals. BRL appreciation can be misleading about the track records of general partners. ENDNOTES 1 Deals with IRR in U.S. dollars lower than 8% do not generate performance fees. 2 IRR USD = (1 + IRR BRL ) (1 + BRL appreciation per year during holding period) 1. To order reprints of this article, please contact Dewey Palmieri at dpalmieri@iijournals.com or SUMMER 2017 THE JOURNAL OF PRIVATE EQUITY