Autocratic for the people

The long-term nature of private equity investing leaves it particularly sensitive to political risk. Once a firm acquires an asset it’s not easy to exit in the event of a crisis or a shock election result, and many GPs don’t appreciate how exposed they are.

“Our clients often look at their investment in a bubble, without understanding the role political stability plays,” says Michael Baker of Diligence, a cross-border investigative company serving several private equity firms. “They might even ask us about competitors, but we have to stress the need to look at upcoming elections or how certain regimes create uneven playing fields.”

Brexit, the election of Donald Trump and the expanding influence of Putin’s Russia may make GPs sensitive, but those aren’t the only political events in play. The rise of populist parties in Europe creates a new kind of uncertainty, since they’re tied more to a dynamic leader than any traditional ideology.

What they share is grievances about EU membership and an anti-foreigner strain of nationalism. This means reforms likely to make investing in the region a riskier affair. The outlier may be Germany, with an upcoming election that will likely solidify the country’s stabilizing force on the continent. However, doubts remain about how much a single country can do.

“There’s a new level of uncertainty, the likes of which we haven’t seen in five, even 10 years,” says Baker. And most observers expect that uncertainty to continue, with radical groups winning support with vows to overturn longstanding political norms.

Off the political spectrum

The popularity of such groups can be traced to two key factors: the rising inequality of wealth and unease with immigration trends. “Economic inequality destabilizes the middle class and reduces its moderating influence,” says Jeff Berman of the law firm Clifford Chance. “Which makes countries more susceptible to the appeal of more extreme parties and candidates.”

What makes some populists so harmful to private equity activity is how they can undermine the rule of law. “To fundraise, to make and guide investments, GPs need to know they can rely on the basic protections against arbitrary government conduct,” says Berman.

“Traditional parties sit more reliably on the political spectrum, and their policies generally can be predicted. For example, a left-wing party will be more interventionist with higher taxes and more regulation, but they’ll have a consistent program. But these new, populist parties are linked to a charismatic leader, more than any governing philosophy, so the laws they support, and which ones they choose to enforce, may change on the whims of that leader.”

And those leaders can be fickle, contributing to an overall uncertainty about regulatory attitudes. One diligence expert suggested an autocrat would make it easier to restructure operations at a local enterprise, only to prohibit outsourcing labor of that same business to a low-cost country.

A US lawyer stressed this isn’t new, explaining a lot of current regulations are rooted in protecting a country’s “crown jewel” businesses from foreign GPs, out of an attempt to “safeguard national identity” rather than because of any unsavory private equity practices.

Even so, an autocrat might identify one business in an industry as a “national champion” over a competitor that’s partially owned by a foreign entity, undermining the latter with selective enforcement of tax and regulations.

Because these movements are driven by a leader, rather than an ideology, it can be hard to predict what “protects” a country’s national identity at any given moment. However, these movements can agree on one threat: the EU.

The future of the EU, and autocratic populists, will be at stake during upcoming elections in France, Germany and the Netherlands. As this magazine goes to print, Italian elections are likely in the wake of Prime Minister Matteo Renzi’s resignation. It’s important to note that populists don’t need to win to have a lasting influence.
“Even if the establishment parties manage to win the elections, or form a broad coalition that keeps a victorious euroskeptic party out of power, a strong showing by the likes of the Party for Freedom in the Netherlands, or say, the National Front in France would create pressure on the respective governments to push the EU to voluntarily carry out internal reforms,” says Christopher McKee, chief executive of The PRS Group, a political and country risk rating and forecasting firm.

Experts argue that even limited reforms of current rules, to the extent that they diminish the authority of EU institutions and shared mechanisms, would undermine the favorable business climate it’s fostered.

However, not all populists are cut from the same cloth, and it’s best to note the trend, while examining them on a country-by-country basis. Some might bring stability and more favorable conditions for investors in the near term; others might only serve to cast doubt for years to come.

France

Country comes first – with or without Le Pen

Few believe Marine Le Pen and her National Front will win the presidential elections in April, barring another major terrorist attack or a sharp rise in unemployment. Experts expect the center-right François Fillon to prevail over both her and independent center-leftist Emmanuel Marcon.

Fillon has close ties with Russian President Vladimir Putin and would foster a cozier alliance with him, even if that runs counter to the wishes of the US. Fillon supports remaining in the EU, but has shifted right on immigration.
“If the National Front doesn’t win but fares well, it may argue for reforms that further distance France from the EU,” says McKee.

Italy

Comedian candidate promises more than laughs

In December, Italians overwhelmingly voted against reforms put forward by Prime Minister Matteo Renzi, who promptly resigned. Paolo Gentiloni took the top job and looks set to continue Renzi’s program to address a banking crisis, political gridlock and corruption.
Most expect the country’s technocrats will stay in power, but after the Brexit and Trump shocks there’s concern over the opposition led by stand-up comic Beppe Grillo. He is leader of the country’s high-profile populist Five Star Movement, which has backed staging a referendum on whether the country should still use the euro and is faring well in the polls.

The Netherlands

Popularity is not power

Euroskeptic Geert Wilders may have been convicted of inciting discrimination, but his anti-Islam Freedom Party leads in the polls ahead of elections in March. Slow growth and budget cuts have harmed the prospects of Prime Minister Mark Rutte’s conservative VVD party. Yet Wilders might not have free rein even if his party claims victory. The Freedom Party has routinely polled well, only to find tepid support when voters cast their ballots. “Even if the Freedom Party maintains its strong lead, they will fall short of a majority, and will face governing within some kind of a coalition,” says Hans Witteveen of Benelux law firm Stibbe.

Even if there is a landslide and the Freedom Party launches a referendum on the EU, the same polls showing support for Wilders show little desire to leave the bloc. There remains skepticism towards the nature of that membership, with the Dutch striking down an EU trade and diplomacy agreement with Ukraine last April.

Hungary

The pioneer

While most leaders here are relatively new to the big stage, Hungary’s Viktor Orban has been prime minister since 2010. Orban’s rhetoric grabbed headlines in 2016, but it’s his tenure that may serve as a model for what to expect with measures that seem to target international investors, such as hefty taxes on banking and retail.
But long-time investors in Hungary are well aware of such policies and haven’t steered clear. “There have been, and will continue to be, private equity successes in Hungary, particularly for those who are investing in export-oriented businesses, where downside risk is mitigated, while taking advantage of a highly skilled and relatively low-cost workforce,” says Anthony O’Connor from the Budapest office of law firm Kinstellar.
But how will Orban govern if he’s joined by other like-minded leaders? And more to the point, how will the EU operate when he’s no longer the outlier?

Poland

The bellwether

The Law & Justice Party in Poland may be the best measure of how autocratic populists may lead. Winning the presidency and a parliamentary majority in 2015, they capitalized with an agenda that defies easy categorization.
It launched a generous social welfare program with requisite taxes to fund it, nationalization of some industries and a program to promote Polish enterprises abroad. It’s right-wing on social issues, openly striving to become a white Catholic majority nation.
However, even with a sluggish stock market and a stand-off with Brussels over democratic norms, Poland remains the most popular destination for private equity in Central or Eastern Europe, and investment has only grown since the election. A KPMG survey from August 2016 found that 65 percent of private equity practitioners believe they’ll find more attractive investment opportunities in the country in the next two years.

Germany

The holdout

The good news is that most onlookers expect Germany to continue its place as champion for the EU and democratic values. There is a euroskeptic party, Alternative for Germany, but few see it as a big player in the fall 2017 elections. Most experts expect Angela Merkel will win and form a coalition between her Christian Democrats and the Social Democrats or with some combination of the Green or the Liberal Party. “All these likely scenarios are expected to have, at least in the short- and medium-term, only limited impact on the country’s stable business environment,” says Ulrich Blech, a partner in the Berlin office of Hengeler Mueller.

But Merkel won’t be able to stifle the anti-EU sentiment that seems be spreading among member countries. How that attitude will be reflected in the actual governance of those members, and who might still be eager to woo private equity into their economies, is open to question.

Brazil’s tough medicine

In August 2016, the president of Brazil, Dilma Rousseff, was impeached for manipulating the budget. Her replacement, interim President Michel Temer, faces his own scandal-ridden administration, made even more unpopular due to recession and a harsh austerity program.

Maurizio Levi-Minzi of the law firm Debevoise & Plimpton recently co-chaired a private equity conference in the country and found that despite concerns for the short and middle-term, overall attitudes were bullish. “The most experienced firms are making good deals while the currency is weak,” says Levi-Minzi. “There are motivated sellers facing real challenges from high interest rates, inflation and low consumer demand.”

Matthew Posthuma, a partner at law firm Ropes & Gray, adds: “What makes the investments worth the risk is faith in long-term macro trends, such as a young population, vast natural resources and western culture as key advantages over other emerging markets. Most of all, these investors see the wave of scandals as a commitment to transparency.”

Mixed motivations for China’s ‘anti-corruption’ agenda

Recent reforms by President Xi Jinping have not solely been concerned at preventing corruption. “Many people believe it’s a matter of exerting greater control,” says Baker, of the investigative firm Diligence, which advises clients active in China.

Experts cite the tendency to enforce laws on convenient targets, such as Xia Lin, a lawyer who often represented clients against the state, including dissident artist Ai Weiwei, found himself sentenced to 12 years for defrauding clients to pay gambling debts. One diligence expert views the reforms as evidence that the authoritarian wing of the ruling party is on the rise, bolstered by public unrest and an economy losing steam.

Not everyone is so pessimistic, but few expect a massive leap forward in transparency or regulatory oversight. Baker explains that even with recent judicial reforms, the country doesn’t have a consistent rule of law just yet. “In the event of a conflict, foreign investors will have to find some way to move forward without running afoul of their domestic bribery and corruption laws, which isn’t always easy.”