As co-CEO of private equity firm The Carlyle Group, Bill Conway regularly travels to London to assess the company’s investments in the region. Following the United Kingdom’s historic vote to negotiate its withdrawal from the European Union, his recent trip was anything but routine. The somewhat unexpected success of the “Leave” campaign in the June 23rd referendum has sent markets into a tailspin, with the British Pound plunging to multi-decade lows, and a shadow of uncertainty cast over Europe. However, likely the most pressing concern for The Carlyle Group, and other asset managers with a presence in the UK and EU, was what would become of business operations in a world where unimpeded trade between the two regions is no longer guaranteed. The question is particularly relevant to private equity firms, as Britain generally accounts for between a third and a half of private equity’s European deal making.
Needless to say, asset managers and their investors have approached the increased uncertainty and volatility following the Brexit vote with caution. Wary of having their money locked up during private equity’s long investment horizons, many investors are seeking to reduce their allocations to funds with exposure to the UK. Consequently, asset managers have been compelled to be increasingly transparent with their investors regarding their total UK exposure, and in some cases are even considering adjusting their investment criteria to mollify their investors’ concerns.
In turn, existing private equity funds have been more cautious when scouting deals and deploying capital in the UK. Even before the Brexit vote, the prospect of the UK leaving the EU led to a dearth of private equity investment in the UK, with Thomson Reuters data suggesting an approximately 83% decline from the comparable period last year. With the vote now in, the latter half of 2016 is unlikely to be any more promising, as asset managers continue to be skittish about UK deals. Consider the example of private equity’s interest in British telecommunications company O2, which had previously attracted interest from Apollo Global Management, Apax Partners and CVC Capital Partners. Interest has waned as the potential bidders have chosen to step onto the sidelines. O2’s parent company, Spain’s Telefonica, has been shopping around the unit in order to pay down its debt load, and has been courting private equity firms since an earlier proposed sale to a rival was blocked by EU regulators. Telefonica has reportedly scrapped the sale, citing post-Brexit market conditions. As such, it is predicted that there will be fewer transactions in the UK until private equity fund managers can get a better grasp of the post-Brexit landscape.
Also not helping matters is the volatility of the British Pound, which has plummet since the Brexit vote, and will likely remain unstable as the Bank of England has cut interest rates amid concerns of an economic contraction. The instability of the British currency not only limits private equity firms’ availability to use the issuance of British Pound-denominated debt as a financing option, but also limits their ability to properly price British assets in other currencies. For example, Anheuser-Busch InBev recently had to revalue its offer to purchase British brewer SABMiller, as the precipitous decline of the British Pound created a material discrepancy between the value of its all-cash and cash-and-stock offers. Such currency risks are particularly relevant to private equity firms investing in the UK, as such funds are often denominated in Euros or U.S. Dollars, and/or cater to non-British investors, meaning that their investors’ ultimate investment returns will be deflated by a sinking British Pound.
Location, Location, Location
On an operational level, asset managers are also being forced to evaluate how to reorganize their own operations, as well as those of their portfolio companies, for the post-Brexit business environment. While what such a world will look like remains opaque, the general consensus seems to be that operations will need to be moved from the UK to other EU countries, if Britain loses access to the European Union’s single market. Accordingly, research conducted by Preqin suggests that about one quarter of private equity fund managers in London are reevaluating the appropriateness of their current location. Their concerns are twofold: firstly, will private equity fund managers continue to be able to conduct European-wide operations from London, and secondly, can London maintain its status as Europe’s leading financial center? While the answer to the former question is almost certainly yes, even if it becomes considerably less seamless to do so, the latter question is considerably more concerning. At the very least, securities traders will need to be relocated to continental Europe, as British clearinghouses will almost certainly lose the rights to settle EU-regulated securities. Consequently, virtually every major financial institution operating in London, both foreign and domestic, has disclosed that they may be forced to move thousands of employees from London. For example, J.P. Morgan and HSBC have indicated they may be required to relocate a combined five thousand traders to Paris, with other banks considering Dublin, Frankfurt and Amsterdam as alternative locations for their trading operations. Should Paris or another continental European city emerge as a rival financial center as a result of this exodus, London may become considerably less attractive as a hub for private equity.
Trying to Find Stability Amid the Uncertainty
One welcome sign of relief amid the Brexit hysteria has been that, unlike the European Union’s other crises, this one appears to have little risk of contagion. In fact, the business environment in mainland Europe has remained relatively stable, which has helped geographically-diversified British and European companies mitigate some of their Brexit risk. Likewise, the performance of Europe-focused private equity funds with UK exposure are likely to vary based on similar factors, with larger and less concentrated funds seeming to have the advantage. As Sunaina Sinha, a managing partner of Cebile Capital who was quoted by The Financial Times, explained: “Large-cap buyout firms will have a very different experience to mid-cap ones.” In particular, noting that mid-cap UK firms “will not have the advantage of diversification of geographies like in the larger fund.” Hence, at least for private equity funds with the capacity to invest within multiple geographies and in companies with pan-European or global operations, there may be a less risky path towards making UK investments.
Also adding stability to the markets is the emerging consensus that a move towards Brexit would be a gradual and orderly process. The fact that the government of newly-appointed British Prime Minister Theresa May will not begin the legal process for withdrawal from the European Union until at least 2017 has alleviated initial concerns that either Britain’s Conservative government or hardline EU leaders would push for an earlier exit. Furthermore, the two year negotiating timetable for withdrawal established by EU law should give asset managers enough time to adjust to the changing landscape and position their investment portfolios accordingly.
It is often said that a good crisis should never go to waste. It is in that spirit that many asset managers are surveying the UK for investment opportunities. Particularly well positioned to take advantage of such opportunities are British asset managers catering to British investors, who are not exposed to the same currency risks as foreign firms. One such example is the Business Growth Fund, which is wholly owned by a consortium of British banks and invests exclusively in British companies. Given its ideal position, the Business Growth Fund has been able to take advantage of the anxiety in the markets, with CEO Stephen Welton telling The Telegraph that “the eleven days after the vote were the busiest eleven days in [their] history,” referencing the volume of attractive deals. Likewise, record redemption requests received by UK open-ended property funds are likely to produce bargains in real estate, as those funds are forced to sell buildings, potentially at fire-sale prices, in order to meet redemptions. This has caught the attention of Madison International Realty, which having just closed its most recent fund, has already indicated to the Financial Times that it would allocate “a disproportionate amount of this fund into London,” with its total exposure to the UK potentially reaching £1 billion.
Wait and See
The current unease over Brexit is unlikely to dissipate, as the future of the United Kingdom’s relationship with the European Union (and vice versa) still very much remains an open question. British Prime Minister Theresa May has called for a post-Brexit world where the UK can remain a part of the EU’s single market, while regaining sovereignty over its own immigration policy. However, a number of prominent European officials, including German Chancellor Angela Merkel and European Council President Donald Tusk, have asserted that the European Union would never agree to such terms. If the UK stands firm on its position regarding immigration at the expense of not being a participant in the European single market, it would be the only major Western European economy outside of the single market, as non-EU European countries such as Norway, Switzerland, Iceland and Liechtenstein all participate in the European single market through their membership in either the European Free Trade Association or the European Economic Area, which require open borders with the European Union as a condition of membership. Of note, however, is that Switzerland has decided to withdraw from the European Free Trade Association as the result of a 2014 referendum seeking to implement immigration controls with the EU. If anything can be learned from Switzerland’s experience, given the close parallels to Brexit, it is that more than two years since the Swiss referendum, negotiations are still ongoing with few signs of progress towards a mutually beneficial resolution. Hence, private equity funds and other asset managers will need to learn how to successfully operate amid the post-Brexit uncertainty, as it may be around for a while.