Cash Drag: The Hidden Cost of Protecting Returns
Cash Drag: The Hidden Cost of Protecting Returns
Earlier, I explored how global investors are often not sufficiently compensated to bear FX risk, yet there is still a tendency to avoid FX hedging on the part of investment managers. My personal opinion is that this is not due to ignorance around the impact of currency movements on investment returns but instead to operational and structural barriers which sometimes make it difficult for investment managers to actively hedge FX risk.
Key amongst those barriers? Cash Drag.
What is Cash Drag?
‘Cash drag’ is the silent erosion of returns when capital sits idle instead of being deployed into investments.
For funds executing FX hedges through banks or prime brokers, cash drag arises from the collateral deposit requirement to support those hedges. Historically, initial collateral requirements for forward contracts amounted to 5% of the notional value of the contract.
You can see why this could be a problem: if a fund manager had a $200M USD FX exposure that they wanted to cover, they would need to post $10M USD to support the hedge.
Beyond that, imagine a fund targeting a 12% net return for investors. If 5% of its capital is tied up as collateral, that leaves only 95% of capital deployed to generate returns. To maintain a 12% net return, the deployed assets now need to yield over 12.6%, a materially higher hurdle.
Collateral, Margin & Credit – Uniquely Challenging for Illiquid Assets
The reality is that margin lines can be accessed from prime brokers, and depending on your counterparties, you may be earning yield on your collateral, so it’s not all bad. Yet the ability of fund managers to access collateralized hedge facilities varies widely, and often the underlying investment in the fund greatly impacts the ability to access FX hedging lines. This is especially the case with fund managers investing in illiquid asset classes like Private Debt, Private Equity, Infrastructure and Real Estate.
Why is this?
Banks and prime brokers require margin for one fundamental reason: to protect themselves against the counterparty default risk that arises when derivative contracts lose value due to market movement. In fact, in many asset classes and markets, it is a regulatory requirement that derivatives be collateralized or margined.
For public markets investors it is relatively easy to assess the value of publicly traded assets. The market prices refresh frequently; the assets themselves are liquid so it can be easier to take custody or sell them to cover margin when hedgers can’t cover margin calls.
In private credit or any illiquid non publicly traded asset, potential default risks are amplified by structural realities:
No easy mark-to-market. Unlike public equities, private credit valuations are model-based and infrequent, making these investment vehicles more difficult to underwrite for daily margining. These ‘level 3 assets’ require specialized knowledge and quite a bit of judgement to value, banks and brokers are often not up to the task.
Illiquid Assets. If a margin call is missed, seizing and liquidating underlying private loans or private equity stakes is a process that is complex, slow, and often involves very expensive legal counsel. This can make brokers and banks more reluctant to provide uncollateralized facilities in the first place.
Fund Structure. Historically, private assets were held mostly in closed ended funds, either directly or allocated to the fund via proportional interest in a Special Purpose Vehicle (SPV), with a limited time horizon of 5-7 years, after which it would be wound down. This would be relatively easy to evaluate and understand. The growth in Evergreen and open-ended fund structures holding illiquid assets has altered this landscape, making assessing fund-level liquidity more difficult to model and `underwrite.
In the end the universe of potential investments and fund structures is almost limitless. There is no one-size-fits-all: traditional banks and brokers may not have the flexibility or capacity to deliver solutions to fund managers that allow them to hedge currency risk in a way that is both efficient and minimizes the impact of cash drag on their investment performance.
This is where providers like Corpay can help fund managers address FX risk while breaking free from cash drag and onerous margin requirements.
Read the previous article in the series: Uncompensated Risks: Currency and Cross-Border Investment
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DISCLAIMER: Opinions expressed in this article are those of the author. This article is for informational purposes only and does not constitute advice. Hedging products involve trade-offs, risks, and costs, and results may vary. Before making any decisions, consult an independent advisor not affiliated with Corpay to ensure that the solutions discussed are suitable for your business needs. A comprehensive under-standing of the complexities, benefits, and drawbacks of each hedging product is essential.
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