The outcome of the UK referendum in June in favor of leaving the European Union shocked the City of London and contradicted widespread support within the private equity industry for the UK to remain a member of the EU.
Over the coming years, while Britain negotiates the terms of its exit, UK-based funds will continue to battle political and economic uncertainty. There are short-term steps they can take to mitigate the risks of Brexit, industry experts say.
1- The plummeting pound: Don’t over-hedge your bets
While the future remains unclear – not least as to the date the UK government will formally request to leave the EU, how long those negotiations will take, and what kind of relationship the UK will maintain with the rest of Europe afterward – one immediate impact of the vote has been a steep devaluation in sterling.
In August the pound was still trading at historic lows at around $1.30, curtailing sterling-denominated funds’ ability to buy international assets, shrinking the book value of UK-based portfolios and threatening performance.
One way to address the currency risk to track record is to report both hedged and unhedged performance to investors to demonstrate the impact, says Hermes GPE head of strategy and environmental investing Elias Korosis.
Any hedging against volatility in the pound needs to be managed carefully, Korosis cautions. GPs, LPs and portfolio companies have responsibility for managing their own level of currency risk. “There is a risk that people will over-react in the short-term. You don’t want to go into panic mode.”
2- Batten down the hatches: The recession risk is real
“Uncertainty is the key risk. The base case is, we are looking at a recession, how deep or shallow we just don’t know,” says one London-based GP, adding that contagion across Europe is a possibility. One result is likely to be a slowdown in exits.
Ideally, funds should have developed a contingency plan prior to the vote, the GP says.
“Funds needed to have a check-list like they had for the GFC [global financial crisis].”
Keeping an eye on costs at both fund and portfolio company level is a significant element of any plan to weather an economic downturn. “You have to look at costs you can cut and assume the economy will get worse,” the GP says.
UK-based firms will also have to model for future additional expenses incurred operating outside of the EU. These range from acquiring British passports for EU national staff based in London, to setting up an additional office in the EU, or relocating entirely.
3- Living outside AIFMD: Don’t rush
No one knows yet what shape a deal with Europe will take, and what it means for the UK’s status within the Alternative Investment Fund Managers Directive (AIFMD). UK managers do need to prepare for the future loss of their EU marketing passport, but in the immediate term, they should not be hasty.
“For those UK funds that have taken the time to get AIFMD authorization, it is too early for them take a decision on restructuring themselves,” says Debevoise & Plimpton partner Sally Gibson. “For fund managers that have real substance in the UK, it is not a five-minute exercise to open up in another European jurisdiction. They need to be watching and waiting to see what is going on.”
Beyond assessing the tax implications, staffing considerations, and the logistical expense of setting up in Europe, managers might consider converting UK-based funds into a European vehicle, domiciled in Luxembourg for instance. This would require investor consent, Gibson notes.
4- Fundraising worries: Timing is everything
A decision on how and when UK fund managers address their AIFMD status is likely to be dictated by their fundraising timetables, and these will need to be reviewed.
Some managers may lean toward conservatism and delay plans while they gauge the ramifications of the Brexit vote, says Travers Smith partner Sam Kay. “Funds need to work through the implications and think about when the new rules come in and how that impacts the fund marketing process,” he says.
Others may bring their fundraisings forward to take advantage of their current AIFMD accreditation that will remain while the UK negotiates its exit from the EU (expected to take two-years once the UK makes its formal request by triggering Article 50 of the Lisbon Treaty). This would allow them to tap European investors, a number of which, such as insurance companies, can only invest in AIFMD-authorized funds, notes Gibson.
“The real concern is the intervening period and using the passport. If you are a UK manager and want to go to market at the time [when the passporting rights are rescinded] that is when the problem will arise,” she says.
5- Political distraction: Regroup and lobby
While the new government led by Prime Minister Theresa May grapples with the process of uncoupling the UK from the EU, planned domestic reforms intended to make the UK a more competitive fund jurisdiction are in danger of being pushed onto the back burner. Key among them is proposed changes to legislation governing limited partnerships.
However, while GPs and their advisors are now concerned that outside Europe the UK is a much less competitive fund domicile, the negotiations do provide an opportunity to communicate their view on the specifics of any deal with Brussels. A central consideration for the UK-based alternative funds industry is that the UK obtain AIFMD third-country status and retain passporting rights.
Withdrawal from Europe is also an opportunity to push a domestic reform agenda. “The industry should be as active as possible to improve regulations and the attractiveness of the UK fund market,” Kay says.
These could include introducing the concept of legal personality for funds in English limited partnership law; simplifying value added tax for fund structures, which is currently an EU tax; introducing a “corporate vehicle” as a new fund structure;
and streamlining the authorization of foreign fund managers that are already accredited elsewhere, Kay says.
This article is sponsored by Deloitte. It was published in the September supplement with pfm magazine.