Few saw it coming. Certainly the result contradicted the wish of a large segment of the private equity industry. The outcome of the UK referendum on June 23, a vote in favor of quitting the European Union, convulsed global financial markets, sent sterling plummeting to lows from where it has yet to recover and undercut UK growth forecasts.
In the immediate turmoil that ensued – including the resignation of Prime Minister David Cameron and the political infighting that led to the appointment of his replacement Theresa May – an astonished industry’s response was to press pause.
“The initial reaction was one of shock and a suspension in activity,” says Travers Smith partner Sam Kay. “There was a dramatic and immediate impact on deals. The Brexit vote was regarded as having a ‘material effect’, and some deals that were signed were pulled. Deals are the lifeblood of a new fund and there was definitely a pause on fundraising. LPs went dark. They had to absorb the information and analyse the consequences. Investors had to reassess.”
The immediate industry outlook was gloomy. According to a post-Brexit poll conducted by pfm sister title Private Equity International in early July, 47 percent of EU fund managers (excluding the UK) believed the result would have a negative impact on their business, while 43 percent of UK GPs thought the same, and only 5 percent of UK GPs said it would be positive.
A September poll by the British Private Equity and Venture Capital Association (BVCA) indicated UK portfolio company leaders were equally glum with 75 percent believing a vote to remain would have been better for business.
However, unlike the financial crisis of 2009 when the market ground to a halt, the drop in activity was not prolonged. “It took a couple of months and then it felt like people were reassured that things haven’t fallen off a cliff,” says one UK-based fund manager. “The [UK economic] data hasn’t been too bad, and I think we are an industry that looks sunny-side up. Most of us are in the growth business and people have funds to deploy. What else would you do – sit on your hands for a year or two?”
Two years is the timeframe prescribed for negotiations over the terms of the UK’s exit following formal notification of its departure. The prime minister has indicated this will be in March 2017. Disentangling the UK from a huge and complex body of treaties and agreements will be an arduous task, raising the prospect of no deal by 2019.
“The unknowns abound,” says Simon Witney, consultant at King & Wood Mallesons. “And not just the timing. The negotiating process could take us in different directions.” Concluding a trade deal between the UK and the EU “might take many years and fund managers should not assume it will happen in two,” he says.
So early in the process, Witney warns against drawing definitive conclusions from political rhetoric. “So many things could happen in the next two years. Public statements now are not necessarily reflective of where we’ll end up.”
Beyond the skeleton timetable, the government has yet to reveal its negotiating priorities. “There’s imperfect information or no information,” says Debevoise & Plimpton partner Sally Gibson, noting this curtails fund managers’ ability to plan. “I suspect fund managers are focusing on what’s happening right now; the impact of uncertainty on the next deal or the impact on sterling, with potential fund restructuring and changes in jurisdiction being something people recognize they will have to deal with at some point, but now is probably not the right time.”
The prime minister indicated in early October a preference for “hard Brexit” that appears to prioritize immigration controls over access to the EU single market, touching on two headline concerns of the industry: portfolio company access to European goods, services and talent; and the ability of UK domiciled funds to tap European sources of capital.
“The industry would like [to remain] as close as possible to the status quo,” says the UK fund manager. In terms of access to the single market, fund mangers are “pretty sanguine,” he says, noting new deals in sectors most exposed to European regulations, supply chains and customers, such as financial services and aerospace, would be most affected.
“For new deals, our fund looks at the specific risks around linkages to continental Europe, exposure to trade deals, risks around recruitment. We have made use of access to a large [European] market of skilled people,” he says.
In the immediate term, fund managers are less focused on a future need for a third country passport extended under the Alternative Investment Fund Managers Directive, the UK fund manager says. “The regulatory issues will be sorted once the politics is decided.”
This already seems to be unfolding. “The implementation of the extension of the marketing passport to third countries isn’t expected in the short term,” says Gibson, despite long-awaited advice issued in July by the European regulator on the eligibility of 12 non-EU countries. “I wouldn’t be surprised if part of that delay is related to Brexit considerations that need to be taken into account now.”
For the meantime, existing UK funds with AIFMD authorization are staying put, says Gibson. But for new fund managers without a significant UK connection and some international ones mulling a European presence, the UK has fallen down the list of attractive domiciles. “Luxembourg has always been a very popular jurisdiction and I wouldn’t be surprised if its popularity increased,” she says.
Proof of the industry’s ability to adapt in the face of uncertainty was seen in its recent adjustment to the demands of AIFMD, Gibson says. “People are still establishing new funds and raising capital. The industry will do what it has always done and adapt.”
For some funds, the impact has been immediately positive. Paris-based manager Ardian closed its latest mid-market buyout fund in September on its €4.5 billion hard-cap in a record four months. “Some investors even decided to increase their allocation to continental funds versus UK-centric funds,” Philippe Poletti, head of Ardian’s mid-cap buyout team told PEI. “In some cases, the result was positive, for example the effect of currency movements on net asset values helped our cause”.
The UK fund manager also points to benefits from the drop in sterling. “It enables us to export more, increases competitiveness, our internationalisation will continue and our current portfolio profitability has actually gone up.”
The consequences of Brexit are wide-ranging and complex. One thing funds can predict is that the landscape will remain uncertain for the foreseeable future.
Brexit offers a chance to reinforce the jurisdiction as the private fund domicile of choice, says Travers Smith partner Sam Kay. Changes could include:
1 Establishing a dual regime that offers one set of rules suitable for EU-focused funds and another for those marketing outside of the EU that do not have to comply with AIFMD
2 Revising the UK’s partnership legislation to allow funds to have legal personality, ie, to have their own rights and obligations and implementing a ‘White List’ of permissible LP activities that clarifies those that do not jeopardize an investor’s limited liability.
3 Introducing a new tax exempt corporate vehicle as an alternative to a partnership structure to compete with structures in other EU domiciles like Ireland and Luxembourg
4 Streamlining marketing rules and introducing a sophisticated investor category
5 Exempt management services from value added tax.
CHARTING THE COURSE
To be able to decipher political rhetoric, fund managers need to be informed. “Fund managers can’t put their head in the sand,” says Debevoise & Plimpton partner Sally Gibson. “They can make sure they monitor the situation and to the extent information does become available, they need to be in a position to react.”
Don’t think you’re not involved
Brexit is a Europe-wide issue with international ramifications. The shape of any future agreement will impact not only UK funds, but also pan-European GPs and any international managers with European businesses in its portfolio exposed to the UK.
Plan for all scenarios
Nothing is clear, yet fund managers still need to plan. Consider all scenarios, including the possibility of no deal in two years. “GPs and investors would be well-advised to plan for at least temporary trade barriers,” says Witney.
Participate in the debate
While the terms of the UK’s exit remain unclear, the private funds industry has an important opportunity to contribute to the discussion. “It’s increasingly important industry bodies and their members spend time thinking about likely consequences,” says Gibson. Firms must engage with the BVCA and Invest Europe to collectively push their interests.
Keep calm and carry on
“You have to be an optimist to run a private equity fund,” says the UK fund manager. “We’re a robust industry of motivated people that believe they can create value out of a number of scenarios. Uncertainty will become the norm.”