A structure's currency of account is chosen once, and the Gulf pegs make the choice look easier than it is.

A fund has a currency of account: the currency in which commitments are stated, drawdowns called, the net asset value struck, the hurdle measured, the charge computed and distributions made. The choice is made in the constitution at the first close and it is rarely revisited, because the pegs make it look settled. Most Gulf currencies are pegged to the dollar at fixed rates maintained by their central banks, and a fund in dollars investing in pegged currencies appears to carry no currency risk. It carries three. The peg is a policy, and a policy is maintained until it is not. Kuwait's currency is managed against a basket rather than pegged to the dollar alone, and India's floats. And the holders are not all dollar investors: a holder whose own currency is not the dollar bears the difference between the dollar and its own, and a fund that does not hedge for it has allocated that risk to the holder without saying so. The currency of account decides which holders bear which risk, what the hurdle is measured in, and what a lender lends, and it is chosen with those three in view or it is chosen by default.

This note sets out what the currency of account governs, the pegs and their nature, the currencies that are not pegged, the holders' currencies and the allocation of risk, the hurdle in the wrong currency, the onshore vehicles' currencies and the translation, the lender's currency and the security, the hedging question and who bears its cost, the classes by currency, the Indian position, the distribution's currency and the repatriation, a comparison, a worked choice as a type, cases, what each party holds, the sequence, questions, terms and what to read.

What the currency of account governs

Commitments are stated in it, so a holder commits a dollar amount and funds it in dollars or in its own currency converted at the drawdown date's rate. The net asset value is struck in it, so every position's value is translated into it at each valuation date. The hurdle runs in it, so the preferred return is a dollar return, whatever the positions earned in their own currencies. The charge is computed on it. The waterfall runs in it. The accounts are prepared in it, or in a presentation currency the accounting standard allows alongside. The lender lends in it, or in a currency the facility converts. And the distributions are made in it, so a holder receives dollars and converts at the distribution date's rate. The currency of account is the fund's measuring stick, and everything the fund measures is measured in it.

The pegs

Several Gulf states peg their currencies to the dollar at a fixed rate the central bank maintains by buying and selling its currency against its reserves. The pegs have held for decades and the central banks' reserves are large, and a fund investing from dollars into a pegged currency treats the two as one for most purposes. But a peg is a policy decision, maintained by reserves and by the state's view of its interests, and a change in either changes the peg. The risk is small in probability and large in size, and it is borne by whoever holds positions in the pegged currency against obligations in dollars. A fund in dollars with pegged-currency positions bears it in its net asset value; a fund in the pegged currency with dollar holders bears it in its distributions; and the constitution says which.

The currencies that are not pegged

Kuwait manages its currency against a basket of currencies in which the dollar is the largest weight, so the rate against the dollar moves within a range. India's currency floats, with the central bank intervening to manage volatility, and its movement against the dollar over a fund's life is large. A fund in dollars with Kuwaiti positions has a small currency exposure; one with Indian positions has a large one, and the Indian position's dollar return is the position's rupee return less the rupee's movement, which over a decade has been a material fraction of the return. The choice of dollars for a fund with Indian positions is a choice to measure Indian returns in a currency the returns are not earned in.

Why the pegs mislead

A peg removes the daily movement and leaves the event. A manager that has watched a pegged currency for a decade has watched a flat line, and a flat line is read as the absence of risk rather than the presence of a policy. The pegs are also different from each other: some are to the dollar alone at a fixed rate, one is to a basket, and the states' reserves and their interests differ. A fund that treats the region's currencies as dollars treats a set of policies as a fact, and the constitution that says nothing about peg risk has allocated it by silence, to the net asset value if the fund is in dollars and to the holders' distributions if it is not. The pegs make the choice look easy because they make the question look absent, and the question is where the event lands.

The drawdown in another currency

A holder committing in the fund's currency and funding from another converts at each drawdown, and the administrator's notice states the fund's currency amount with the holder converting at its own bank's rate. A holder that wants the fund to accept its own currency, at a rate the administrator fixes, has asked the fund to take the conversion risk between the notice and the receipt, and the constitution says whether the fund does, usually not. A holder that funds late under a drawdown notice bears the rate's movement as well as the default interest, and the notice says so.

The net asset value between valuation dates

A fund with positions in a floating currency has a net asset value that moves with the rate between valuation dates, and the movement is a valuation event for any use the net asset value feeds: a transfer price, an equalisation, an interim carry test. The administrator translates at the rate of the valuation date, and a transfer priced on a net asset value three months old in a currency that moved is a transfer priced on a stale translation. The constitution ties each use to a translation at the use's date or to the nearest valuation with a rate adjustment, and the administrator's computation shows both.

The holders' currencies

Holders commit in the fund's currency and think in their own. A Gulf holder whose own currency is pegged thinks in dollars, in effect; a European holder thinks in euros, an Indian holder in rupees, a holder from a floating Asian currency in that. A dollar fund gives the dollar-thinking holders their own currency and gives the others a currency exposure the fund does not manage. The constitution may say that holders bear their own currency risk, which is the usual term, and the holders' counsel read it; or the fund may offer classes in other currencies, hedged at the class's cost; or the fund may be in a currency other than the dollar because its holders are. The allocation is a term, and it is made in the constitution and the memorandum.

The hurdle in the wrong currency

The preferred return is a rate on contributed capital in the currency of account, and a position that earns its return in another currency earns a hurdle-clearing return or not depending on the translation. An Indian position that earned its rupee hurdle and lost the rupee's depreciation against the dollar has not cleared the dollar hurdle, and the manager earns no carry on a position that performed in its own terms. The reverse, a pegged-currency position after a revaluation upward, clears the hurdle on the translation alone. The hurdle's currency is the manager's incentive as well as the holders' protection, and a manager with Indian positions in a dollar fund has an incentive the rupee sets.

The onshore vehicles and the translation

Each onshore vehicle keeps its accounts in its own state's currency, as the state's law requires, holds its cash in it, borrows in it or in dollars as the onshore lender offers, and distributes in it. The fund translates at each valuation date and at each distribution, and the translation is a gain or loss in the fund's accounts that the waterfall treats as the constitution says: as part of the position's return, which is the usual term, or separately. An onshore vehicle in a pegged currency translates at the peg until the peg moves; one in India translates at the rate of the day, and the fund's net asset value moves with the rupee between valuation dates whether or not the positions did.

The lender's currency

A capital-call lender lends in the fund's currency against commitments in it. A lender to an onshore vehicle lends in the state's currency or in dollars, and the mismatch between the vehicle's income in the state's currency and its debt service in dollars is a risk the lender prices and the vehicle bears, usually with a covenant that the vehicle hedges or holds reserves. A lender with security over an onshore asset valued in the state's currency and a loan in dollars has a loan-to-value that moves with the rate, and the covenant tests it at each date. The facility's currency is chosen with the vehicle's income currency in view, and a facility in the wrong currency is a covenant breach waiting for a rate.

The hedging question

A fund may hedge its currency exposures: the holders' currencies against the fund's, the positions' currencies against the fund's, the onshore debt's currency against the vehicle's income. Each hedge costs, in the forward points between the two currencies' interest rates and in the counterparty's margin, and for a floating currency with higher interest rates than the dollar the cost of hedging it to dollars is large and continuous. The constitution says whether the fund hedges, what it hedges, who bears the cost, and whether the hedge's gains and losses are part of the return. A fund that hedges Indian positions to dollars pays the rupee's forward points for a decade; one that does not bears the rupee's movement. Both are choices and the memorandum discloses the one made.

Classes by currency

A fund may issue classes in different currencies: a dollar class and a euro class, each with commitments in its currency, each hedged to the fund's currency of account at the class's cost, each with its own net asset value. The class's hedge is a forward contract rolled at intervals, with collateral the fund posts and cash flows the administrator allocates to the class. Classes by currency are an administrative burden and a cost the class bears, and they are offered when the holders in the other currency are large enough to justify it. A class unhedged is a class in name only, because its holders bear the same risk as if they held the fund's currency.

The Indian position

A fund with Indian positions has the largest currency question in the region. The rupee's movement is material, hedging it is expensive, and the Indian regulatory regime adds its own rules on the currency of inward investment, the pricing of shares in foreign currency terms, and the repatriation of proceeds in foreign currency through authorised banks. The fund's choice is to hold Indian positions unhedged and disclose the rupee exposure, to hedge at the cost, or to raise a rupee-denominated vehicle for Indian holders and a dollar vehicle for the rest with a co-ordination agreement. Each is a structure, and the currency of account is its first term.

The distribution's currency and the repatriation

Distributions are made in the currency of account from cash the fund holds in it, and the cash arrives from the onshore vehicles in their currencies after repatriation. The repatriation converts at the rate of the day through the state's authorised channels, and a distribution notice issued on the onshore sale's completion is a notice for an amount that depends on a conversion not yet made. The administrator computes the distribution after the conversion, and the notice follows the cash.

By choice · by effect	Dollar fund, pegged positions	Dollar fund, Indian positions	Pegged-currency fund, dollar holders	Fund in the holders' currency
Peg risk	In the net asset value, small probability	Not applicable	In the distributions	Depends
Floating risk	None	In the net asset value, material	None	Depends
Holders' currency risk	Borne by non-dollar holders	Borne by non-dollar holders	Borne by dollar holders	Borne by non-holders'-currency positions
Hurdle	Dollar hurdle on pegged returns, close	Dollar hurdle on rupee returns, far	Pegged hurdle on pegged returns, close	The holders' hurdle
Lender	Dollars against dollar commitments	Dollars, with the Indian vehicle's rupee income mismatched	Pegged currency	The holders' currency
Hedging	Rarely	Expensive	Rarely	Against positions

A choice, as a type

A fund for Gulf institutional holders and a European pension institution, investing in two pegged states, Kuwait and India, chooses dollars as its currency of account. The constitution says holders bear their own currency risk; offers a euro class to the pension institution, hedged monthly at the class's cost; treats translation gains and losses as part of each position's return; and permits hedging of the Indian positions at the manager's discretion within a cost cap, disclosed. The onshore vehicles keep their accounts in their states' currencies. The onshore facilities are in the states' currencies against the vehicles' income. The capital-call facility is in dollars. The memorandum discloses the peg risk, the Kuwaiti basket, the rupee exposure and the hedging policy. The administrator translates at each valuation date and computes distributions after repatriation and conversion. In year six the rupee has depreciated, the Indian positions have earned their rupee hurdle and missed the dollar one, and the manager's carry reflects it as the constitution said it would.

The structure paper's page

The structure paper carries a page on currency: the holders by currency, the positions by currency, the lenders by currency, the currency of account and the reasons, the allocation of each risk, the translation's treatment, the hurdle's currency and its incentive effect, the hedging policy and its cap and bearer, the classes, the onshore facilities' matching, the Indian regime's rules, and the distribution's sequence after repatriation. The page is written before the term sheet so that the currency is a choice in it, and it is the page the European holder's counsel and the onshore lender each read.

The parallel vehicle by currency

Where the holders in another currency are large enough, a parallel vehicle in that currency, investing alongside the main fund pro rata under a co-ordination agreement, replaces the hedged class: the parallel has its own currency of account, its own hurdle and its own net asset value, and it bears the translation of its share of the positions itself. The parallel is more than a class and less than a fund, and the co-ordination agreement fixes the allocation, the exit and the economics between the two. An Indian rupee parallel for Indian holders is the usual form where the Indian regime's rules on domestic investors' vehicles make it efficient, and it holds the Indian positions without the dollar fund's translation.

The second fund's reading

A manager's second fund is read against the first fund's currency record: the hedging policy's use and cost, the translation's effect on the hurdle, the euro class's performance against the dollar class's, the rupee's effect on the Indian positions' dollar return. A first fund whose holders understood where each risk landed, because the memorandum said, is a fund whose second raise the same holders join on the same terms; one whose holders learned the allocation from the distributions is a fund whose second raise is asked to hedge. The currency choice is the one term of the first fund that every holder felt in its own currency, and the second fund's terms are written by holders who remember.

The accounts' presentation currency

The fund's accounts are prepared in its functional currency under the accounting standard, which is usually the currency of account, and may present in another alongside. A fund whose functional currency the auditor determines to be other than the currency of account, because the positions and the cash flows are in another currency, has accounts whose translation differs from the administrator's net asset value, and the two are reconciled in the notes. The functional currency question is asked at the first audit and answered by the standard's tests, and the manager asks it at design so that the answer is the currency of account.

Four cases, as types

A dollar fund with Indian positions is silent on hedging and on translation. The rupee depreciates, the Indian positions' dollar return is a fraction of their rupee return, and the holders ask why the memorandum described the Indian strategy in rupee terms and the fund measured it in dollars.

A pegged-currency fund is raised from dollar holders on the strength of the peg. The peg is adjusted in the fund's seventh year, the holders' distributions fall in dollars, and the holders read the constitution for the term that allocated the peg risk to them.

An onshore vehicle in a pegged state borrows in dollars against income in the pegged currency with no covenant on the mismatch, and the lender's loan-to-value covenant is tested in dollars. The peg holds and nothing happens, and the lender's counsel at the next facility writes the covenant.

A fund chooses its currency with its holders, its positions and its lenders in view, allocates each risk in the constitution, offers a hedged class where the holders justify it, and discloses the rest. Each holder bears the risk it was told it bore.

What each party holds

The manager holds the choice, the hedging policy and the disclosure.

The holders hold the allocation of their own currency risk, and the class if offered.

Counsel holds the constitution's terms on currency, translation, hedging and classes.

The administrator holds the translation at each date, the class hedges and the distribution after conversion.

The onshore vehicles hold their accounts in their currencies and their facilities' mismatches.

The lender holds its currency, its covenants and its reading of the mismatch.

Where it surfaces

It surfaces at the term sheet, where the currency is stated as though it were obvious. It surfaces at the European holder's diligence, when its counsel asks who bears the euro risk. It surfaces at the Indian position's first valuation, when the rupee's movement is a line in the net asset value. It surfaces at the onshore facility, when the lender asks about the mismatch. It surfaces at the hurdle, when the Indian position performed and the dollar return did not. It surfaces at the repatriation, when the distribution notice was issued before the conversion. And it surfaces at the peg's adjustment, if it comes, when the constitution is read for where the event landed.

The cost of getting it wrong

A currency chosen by default costs the holders a risk they did not know they bore, the manager a hurdle the rate sets, the lender a covenant the rate tests, and the memorandum a description the measurement contradicted. The cost of the choice is a list of currencies, a term per risk, a hedging policy and its disclosure, which is the work of a week at design and nothing afterwards, because the pegs are flat lines until they are not and the choice is what holds when they are not.

The committee's reading

The committee reads the currency exposures annually: the positions by currency, the holders by currency, the facilities by currency, the hedges in place and their cost, the translation's effect on the year's net asset value, and the manager's use of the hedging discretion within its cap. It reads the rupee exposure in particular, because it is the one that moves, and it reads the hedging cost against the movement to ask whether the policy is serving the holders. A change in a peg's terms, or a state's announcement about its currency regime, is a matter the committee asks about at its next meeting.

A timeline, as a type

At design the currencies are listed and the choice is made: dollars, holders bear their own risk, a euro class hedged at its cost, translation in the return, Indian hedging at discretion within a cap. At the first close the memorandum discloses the pegs, the basket, the float and the policy. In year one the onshore facilities are placed in the vehicles' income currencies. In year two the Indian position is acquired and the manager hedges half within the cap, disclosed. In year four the rupee depreciates; the hedged half holds and the unhedged half falls in dollars; the committee reads the cost against the movement. In year six the Indian position is sold; the proceeds are repatriated through the authorised bank after clearance; the administrator computes the distribution after conversion; the dollar hurdle is missed on that position and the manager's carry reflects it. In year eight a pegged state adjusts its rate; the net asset value moves; the constitution's allocation of the event holds and the holders read where it landed.

The sequence

1. The holders' currencies, the positions' currencies and the lenders' currencies are listed.
2. The currency of account is chosen with the three lists in view, and the allocation of each risk is drafted.
3. The translation's treatment in the waterfall and the hurdle's currency are fixed.
4. The hedging policy, its cost cap and its bearer are fixed, and classes by currency are offered where justified.
5. The onshore facilities are matched to the vehicles' income currencies, with covenants on any mismatch.
6. The memorandum discloses the pegs, the basket, the float and the policy, and the administrator's computations follow the cash.

Questions a manager asks

Is a dollar fund the default. For Gulf holders and pegged positions, yes; for Indian positions or non-dollar holders, it is a choice with a cost somebody bears.

Should the fund hedge the pegs. The cost is low while the pegs hold and the protection is against an event the market prices as remote; most funds disclose and do not hedge.

Who bears the euro class's hedging cost. The class, through its own net asset value; the other classes are unaffected.

What if a holder wants to commit in its own currency without a class. It converts at each drawdown and bears the risk; the constitution's term says so.

Does translation count toward the hurdle. As the constitution says; the usual term treats it as part of the position's return, so that the hurdle is on the dollar outcome.

How are rupee proceeds repatriated. Through an authorised bank under the Indian regime's rules on repatriation by foreign investors, at the rate of the day, with the tax clearance first; the distribution follows.

Terms used

Currency of account: the currency in which the fund's commitments, net asset value, hurdle, charge and distributions are measured.

Peg: a fixed rate to the dollar maintained by a central bank.

Basket: a managed rate against a weighted set of currencies.

Translation: the conversion of positions' values and cash flows into the currency of account at a date.

Hedged class: a class of units in another currency with forward contracts to the currency of account at the class's cost.

Mismatch: debt service in one currency against income in another.

What to read

The constitution's currency, translation, hedging and class provisions; the memorandum's currency disclosures; the onshore facilities' currencies and covenants; the Indian regime's rules on currency of investment and repatriation; the administrator's translation and class computations. On this site, the economics room under Structures, the Gulf development room and the development structures room.