3 Consequences of “Brexit” for Private Equity

Even the bookies were shocked by this one.

Hours before the landmark June 23 referendum in the United Kingdom, European betting agencies were 90 percent confident that British voters would decide to stay members of the European Union. Traders in financial and currency markets took the same bet; the British pound sterling (GBP) and FTSE 100 surged when polls showed a lead for the “Remain” camp earlier in the week.

The experts got it all wrong. The UK voted 51.9 to 48.1 percent to leave the EU. British Prime Minister David Cameron announced his resignation. The GBP hit its lowest level against the U.S. dollar since 1985. Investors unwound their long positions in Japan, Europe, and the United States, wiping out most of the year’s gains.

How will this affect private equity? We won’t know the final answer for a while — under EU rules, the process for leaving the union is two years long. Here are some important potential consequences, short-run and long-run, for the PE crowd to consider:

1.   PE Might Lose British Passport to Continent

Earlier in June, we spoke with Headwaters MB Managing Director Steven Lewis about Brexit (among other cross-border PE topics). Lewis previously served as executive director of cross border solutions at GE Corporate Financial Services, Europe.

“As a member of the EU, British-domiciled businesses, banks, and individuals have a so-called ‘passport’ into Europe,” says Lewis. This passport has been very important because it:

1. Abolished tariffs through a master trade agreement;
2. Simplified travel for businessmen and workers between EU member nations;
3. Avoided “a whole lot of regulatory red tape that non-EU members have to go through;” and
4. Gave U.S. M&A actors a “path to trading on the continent.”

Lewis predicted that “if Britain withdraws, the passport goes away and impacts not only M&A activity but jobs in the financial sector and access to capital” (see page 4 of this New Financial survey to see the importance of the UK to EU capital markets).

British PE professionals shared Lewis’ sentiments and few supported Brexit over fears it would ice dealmaking. According to a Private Equity International newsletter, “75 percent of individuals in private equity were in favour of a vote for Remain” and “more than two-thirds of UK-based GPs felt their businesses would be worse off if Britain voted to leave.”

There are other domiciles with friendly legal and business environs to consider. Lewis identifies Ireland, Luxembourg, and the Netherlands as possible landing spots where PE can “avail themselves of the passport.”

2.  Stronger Dollar Might Present Opportunities

The GBP/USD and EUR/USD both fell sharply during morning trading after Brexit. American exporters might lament an even stronger dollar, but PE firms could take advantage to realize opportunities. When the dollar goes up, foreign assets become cheaper.

“Companies are looking very carefully at arbitraging the dollar’s strength by purchasing assets and businesses abroad,” notes Lewis. “But they are taking their time doing so because they have seen their friends get burned by moving too rapidly without sufficient diligence.”

Even if capital deployment and fundraising suffer inside the UK, investors and fund managers should scrutinize other foreign markets for bargains. This might encourage some LPs or GPs to diversify in terms of geography; multi-jurisdictional portfolios may be less susceptible to single-country political risks.

3.  Uncertainty Might Limit UK Deals in Short Term

Year-on-year PE deals for UK-based companies was already much smaller in 2016 than 2015, which saw record levels of fund activity and M&A transaction value. Most professionals expect a pause in dealmaking and fundraising as the UK renegotiates trade deals and considers its investment policies. This process won’t end quickly; a minimum 18 to 24-month period of policy uncertainty is expected.

Trade deals are not the only hurdle. The government in Westminster needs to formulate a friendly tax and fiscal policy to prevent huge capital flight. The Bank of England stands ready to inject liquidity into British markets, but inflation might be on the horizon. And then there is the potential for an entirely new regulatory regime in the UK, but those changes may take years to implement. For the time being, businesses in the UK still have to play by the EU’s rules.

Great Britain has a long and proud history of supporting international trade and low tariffs. One prominent British economist backing Brexit, Patrick Minford, argued the “best option would be for the UK to abolish all the EU trade barriers and trade freely with the world.” Unilateral free trade might make the UK a very attractive long-term destination for PE.

However, a vocal segment of the Leave movement remains skeptical of globalism generally and the European single market specifically. Parties to international contracts need to keep an eye to possible adverse changes to trade laws and dispute resolution in the UK, and decide if they should introduce clauses to improve flexibility for EU single market access.

There are hopes for UK deregulation from some Brexit cheerleaders, but that seems unlikely in the short term. Populists make up the bulk of the Leave coalition, and surveys suggest they remain skeptical of unfettered capitalism. UKIP leader and Leave evangelist Nigel Farage has previously talked up deregulation, however.

PE Should Remain Resilient

Gerry Murphy, chairman of Blackstone Europe and newly installed chair of industry body Invest Europe, told Private Equity International that “one of the great advantages of private equity is through a crisis or a challenge it can hunker down and play a long game.”

His point is well taken. PE performed admirably (compared to other segments) during the Great Recession, and few anticipate a return to those conditions. “I don’t expect — at least I hope,” said Murphy, “that any post-Brexit period of uncertainty will be nothing like what we went through in 2008, and our industry came through that crisis in quite good shape.”