Strong sterling: a cause for concern for portfolio companies?

UK PLCs have notably suffered over the past month because of the sterling's strength; indeed, 19 blue-chip companies publishing annual reports have lost an estimated total of £1.5bn in year-to-date profits. This includes a £460m profit loss for Barclays, £350m for Diageo and £400m for British American Tobacco. According to EY, a fifth of the 63 UK PLCs that issued profit warnings this year did so due to currency fluctuations.

For private equity firms pushing portfolio companies further abroad in search of growth beyond Europe's flat economy, the continued strength of sterling is becoming a worry. Furthermore, according to James Stretton of JC Rathbone Associates, the current implied low-volatility outlook for foreign exchange is not only counter-intuitive, but worryingly reminiscent of 2007.

"Considering upcoming, planned events, including the referendum for Scottish independence, the general election in the UK in 2015, the end of quantitative easing in the US and an expected interest rate rise in the UK, it is odd that implied levels of volatility are very close to all-time lows," says Stretton.

A deflated Europe
Indeed, the next 12 months will witness several key events likely to have a major impact on markets, which appear to be remarkably calm despite this. "It is the same with the euro," says Stretton. "There seems to be a general consensus that the euro's problems are over." However, Stretton points to a potential deflation crisis across Europe, with Italy, in particular, experiencing very low levels of inflation at the moment against a background of alarmingly high levels of debt. Furthermore, Sweden has cut its interest rates to an extremely low 0.25% because its CPI has not been positive this year. Says Stretton: "Widespread deflation across Europe is not a definite, but the probability of it happening is not yet negligible."

Stretton believes if the markets are wrong about low levels of volatility for foreign exchange over the next three months, this could cause serious damage for portfolio companies with sales generated in foreign currencies.

Travellers' checks
One firm extremely well-versed in dealing with currency headwinds is Baird Capital, due to its investment strategy of international expansion, typically developing European companies into Asia. Managing director Chris Harper, explains the GP's approach: "We always try to naturally hedge against foreign exchange by seeking as far as possible to match income and cost in the same currency. We match the currency of sales to the cost of the business."

If this is not achievable, Baird smartly matches income and cost through the portfolio business's funding structure: "If the majority of the company's income is in US dollars and the costs are in sterling, Baird will look to finance the company in the most relevant currency, so in this example taking debt in US dollars, creating a natural hedge."

Harper points out that using forward currency contracts is understandably more difficult for smaller businesses, with smaller, less-predictable cash-flows. An alternative that is sometimes possible for smaller suppliers is to negotiate with a global customer to be paid in a currency of choice to avoid the currency risk.

It would appear that private equity firms have been better at protecting themselves against currency headwinds than their PLC counterparts. In its 2013 annual review, Terra Firma reported a €15m loss due to currency fluctuations across all of its funds, which in aggregate total more than €10bn. This is down to denominating portfolio companies in their relevant countries – akin to Baird's strategy.

While the continued strength of sterling makes exports a tougher growth strategy, thankfully currency fluctuations move quickly, meaning portfolio companies with long-term ambitions to expand overseas are undoubtedly moving in the right direction.

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