Monday, February 2, 2015

The Swiss Franc (SwF) Surprise and Private Equity Risk

The Swiss National Bank unexpectedly removed its cap/peg limiting the value of SwF on January 15, 2015. The SwF soared and traders who had relied on the peg since its 2011 creation to bet against the rise suffered huge losses. For example, Citi Bank, Deutsche Bank and Barclays lost a combined $300mln. Smaller trading houses like FMCX had to be rescued or failed. The losing parties claimed the situation was an unforeseen BLACK SWAN or 20 standard deviation event (AKA not their fault).

What happened is a classic example of Peso Risk. It reflects exposure-not experience-to a risk event not reflected in the sample period used to gauge risk. The termed was coined by Milton Friedman in the 1970s to describe what happened to traders engaging in a carry trade between the Mexican Peso and USD. The official Peso exchange rate to the USD had been fixed by the Mexican government since the early 1950s. Mexico had higher inflation and interest rates than the United States. Traders were borrowing USD at relatively low rates to spot into Pesos which were then invested in higher yielding  Mexican bonds and pocketing the difference. It looked like a free lunch except for one thing; namely devaluation risk. Sure enough in the early 70s, the Mexican government could no longer the support the Peso, which was promptly devalued. The losses wiped out years of “profits” – the profits were of course illusory. Traders, just as in the SwF case, blamed it on unforeseen events.

Private Equity is sometimes based on the carried trade model involving Peso Risk, and it too suffers from periodic blowups like the one experienced during the recent Financial Crisis. As debt markets overheat PE firms borrow heavily (FD/EBITDA > 6X), cheaply (low debt spreads and at relatively low absolute rates) and with favorable terms (Cov-Lite, back ended amortization and PIK) to acquire firms and achieve a positive carry (i.e. with positive debt service coverage of EBITDA/I >1). Eventually an event occurs and the carry turns negative leading to losses.

Bottom line, make your risk assessments based on exposures and fundamental analysis and not just on recent experience. Past performance is not indicative of future results because the past sample period may be biased by not including a major bad event. Assume a worst case and ask if you are prepared to accept the consequences - if not then walk. Be skeptical of claims that a worst case will never happen -they do.


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