The UK chancellor George Osborne warned of a DIY recession and threatened a Brexit budget; IMF president Christine Lagarde feared the rise of “economic nationalism”; and US president Barack Obama chipped in with his opposition, violating the usual protocol of foreign leaders not intervening in another nation’s domestic affairs. Their words, and those of a conveyer belt of experts, however, were not enough to convince British voters on 23 June.
The interventions showed Britain’s decision to leave the European Union was not a domestic affair. The long-running Brexit drama attracted a worldwide audience. Many depicted the battle as heart versus head, as the passion for full sovereignty was pitted against economic reality. “Leave” triumphed unexpectedly in what analysts have reasoned was down to a mixture of complacency from the establishment and a nationalist insurgency.
It’s fair to say the private debt market did not want this. Although opinion was not unanimous, there was an overwhelming sense across the industry that a “remain” vote would benefit all activities from fundraising to deploying capital. After all, it is rudimentary economics that investors do not like uncertainty.
This is a year conceived in turbulence: a slowdown in China coupled with a plunge in oil prices contributed to a slow fundraising environment and caution on investing capital. On 24 June, the fundamentals of the economy had not radically changed from the day before. The UK is still the largest non-bank lending space in Europe and it is still governed by a political elite that looks on favourably to the continued development of the asset class.
Opportunities in distressed
Nevertheless, it is possible that a recession is on the horizon – a situation some had anticipated regardless of which way the Brexit vote went, but are now more confident will occur. PDI’s Germany forum was held on the day of the vote. James Newsome, managing partner at advisory firm Arbour Partners, told attendees to prepare for a “distressed surge” in a presentation where he argued that private equity firms are paying high multiples and leverage had returned to 2007 levels.
Reports of a steady increase in defaults across Europe have pushed some firms to find these opportunities. Shortly after the referendum vote, CVC Credit Partners held a final close on its special situations fund, raising €650 million. Despite the vehicle’s global mandate, the firm will predominantly target opportunities in the European market. On the fund closing, CVC partner and global head of special situations, Mark DeNatale, said: “We believe the structural changes across the European banking landscape, potentially impacted by the recent UK referendum result, have created attractive investment opportunities.”
Additionally, Bain Capital closed its distressed fund (the first since it was rebranded from Sankaty) after raising a sizeable $3.1 billion. And a letter from Angelo, Gordon managing director Dan Pound said to investors that “while unsettling for markets, it is possible [Brexit] creates an opportunity for EU investing and we are focused on both immediate investment opportunities and medium-term distressed prospects from any significant economic traction”.
The immediate impact has not necessarily borne out these predictions. Oaktree Capital Group co-chairman Bruce Karsh noted on the firm’s recent second-quarter earnings call that there was not the uptick in opportunities that some in the industry had expected.
As a result of Brexit, the IMF downgraded its forecast for UK economic growth due to the increased political and economic uncertainty. “Brexit has a thrown a spanner in the works,” IMF chief economist Maurice Obstfeld said. But there have been attempts by the Bank of England to ensure the short-term shock to the UK economy is cushioned.
One of the most eye-catching announcements was reducing interest rates to 0.25 percent, a historic low for the 322-year-old institution. Part of the same announcement was a package outlining the bank’s purchasing of £60 billion ($78 billion; €69 billion) of government bonds and £10 billion of corporate bonds. The key to this injection of capital is to help stimulate the economy amid uncertain circumstances.
It is clear that there is a real fear of banks’ further retrenching. A month before the August cut in interest rates, Mark Carney, the BoE’s governor, announced the easing of a number of restrictions on bank lending. The BoE reduced regulatory capital buffers by £5.7 billion in an attempt to unlock, what he estimated, would be a £150 billion credit supply to UK households and businesses. The greater flexibility, Carney reasoned, would result in more companies accessing credit, which may not be otherwise available following Brexit.
But does this mean the banks are back in the market? The often-repeated narrative is that their retreat from lending following restrictions on the amount of capital held in the wake of the global financial crisis is the reason a space opened up for private debt to develop as a fully-fledged asset class.
However, speaking to some in the industry, it is clear there are no fears that the nascent asset class will be knocked out of its stride. Cheap debt, one fund manager tells PDI, may encourage the type of behaviour that caused the financial crisis. There is decent liquidity in the system, he adds, before concluding that the measure is not likely to not have too much impact in the long term.
The regulatory effect
One area of uncertainty that threatens to derail UK funds’ activity is the possibility of the country no longer qualifying for an Alternative Investment Fund Managers Directive passport. Introduced in 2011 following its adoption, the passport enables funds based in EU member states to market products to investors across the region.
Without membership of the EU, funds based in the UK do not automatically qualify for the right. The largest funds in Europe are based in the UK. Moreover, US funds favour a London location to begin marketing their funds, bypassing the onerous burden of applying to each individual member state to market their products.
Until now, no country outside the EU has been granted the right. Last year, the European Securities and Markets Authority recommended Guernsey, Jersey and Switzerland be allowed the passport. Other countries including Australia and South Korea have prepared applications.
However, barring a political issue over the right being extended to the UK, there is no reason to believe the UK could not qualify, having already established the legal framework that is compliant with the AIFMD. A failure in the Brexit negotiations to secure the passport right may result in a number of funds, especially ones based outside Europe, relocating to a new jurisdiction. There have been no reports of this being on the agenda yet, which suggests many funds are applying a ‘wait and see’ approach or are quietly confident it can be won in the upcoming negotiations of the UK’s departure.
According to some, Europe may suffer from more restrictive regulations in the future as a result of Brexit. The European Commission is considering adopting an EU-wide framework for alternative investment funds to originate loans as a way of better harmonising laws. Greater convergence, the EC argues, will mean companies operating in the lower and mid-market will have greater access to funding as cross-border activities increase.
The patchwork of laws across the region currently undermines this, where loan origination is restriction or prohibited in certain member states.
The UK’s representative on the EC, Jonathan Hill, had been tasked with overseeing the Capital Markets Union plan. But shortly after the referendum he announced his resignation from the position and will be replaced by former Latvian Prime Minister Valdis Dombrovskis.
Hill was praised for his more liberal approach to regulation and steering the EC’s support for a larger direct lending market. It contrasted with the more conservative approaches to the asset class, which some in the industry have suggested may lead to stricter regulations. Patricia Volhard, a partner at Germany-based law firm P+P Pöllath, says that “because the UK input may be missing [on the CMU], it may be shaped by other member states that have a stricter view on regulations”.
A comedy of errors
Only hours after the vote, panic had set in. The rate of sterling fell like the rapid downward trajectory on a rollercoaster and the FTSE 250 also plunged. Promises made by the ‘Leave’ camp have already been reversed and ‘Bregrexit’ – the term for someone who regretted voting to leave – had entered the social lexicon. Weeks afterwards, retail investors spooked by the result started pulling out money of open-ended funds targeting real estate investments managed by established players such as M&G and Aviva, which subsequently closed redemptions to prevent a further run on their funds.
But fast forward two months and JP Morgan, a firm ‘Remain’ supporter, has retained its “overweight” recommendation on UK equities, citing high yields and the possibility of a further cut from the BoE. Siemens, which warned prior to vote it may reconsider future operations in the UK, confirmed it will continue to invest in the country. GlaxoSmithKline, another ‘remainer’, has moved forward on a £275 million investment, citing the UK’s skilled workforce and tax system as the main factors.
For LPs and GPs, it’s important not to be persuaded by either an apocalyptic narrative or an optimistic one at this stage. The declaration by Theresa May, the UK prime minister, that “Brexit means Brexit” offers little sign of what the negotiating strategy will be and rumours continue to fly that Article 50 may not be triggered until late next year.
At this point, Brexit has the feeling of a performance – a cast of characters controlled by events that are a mixture of both the tragic and the farcical.
Mark Hedges, chief investment officer at Nationwide Pension Fund
“The environment was one of low rates and low growth for longer, even without Brexit. Brexit will most likely extend the time period of this experience as the uncertainty around the UK’s position will persist for several years as exit and trade deals are negotiated. Whether it leads to a recessionary environment remains to be seen but the overall economic impact is likely to be detrimental. This doesn’t mean economic activity ceases; many businesses will still have a need for credit.
“I suspect that Brexit will not have a significant impact on the growth of private debt funds and pension fund investment in them. Pension funds invest globally and private debt can be utilised globally. Banks, particularly across Europe, still need to reduce their balance sheets and risk exposure to SMEs and CRE. Both of these sectors will still require funding and this opportunity is likely to persist for some time yet as Europe and the UK are still a long way from the more balanced funding supply seen in the US, which has a much more established private debt market.
“I suspect that pension funds’ demand for income will mean more of them will have an allocation to private debt within their portfolio as it can provide a steady stream of income once they can come to terms with the risk/reward and illiquidity of the assets.”
THE LP’S VIEW
Jim Strang, managing director investment committee, Hamilton Lane
“The thing you have watch to out for is: the UK is passported into the AIFM regulations. It may be the case that if the treatment of UK-based managers is not effectively dealt with in the exit negotiations that this passporting ceases to take effect. That would make it very difficult for London-based credit managers to raise money from European institutions. It's unlikely that such a thing would come to pass, but it’s certainly a possibility.”
THE LP’S VIEW
Trevor Castledine, chief investment officer, LPFA
“Our approach has always been to build a conservative portfolio that is carefully underwritten and avoids situations with particularly high leverage. We seek to avoid refinancing risk through the use of mainly amortising loans and cash sweeps.
“There will be some positions in private debt portfolios that will default and recovery expectations in a depressed market might be reduced; so having a conservative portfolio, rather than one that has highly leveraged, sponsor-driven syndicated loans should see us holding a relative advantage.”
THE GP’S VIEW
Christophe Evain, chief executive of ICG
“The Brexit vote is very disappointing; the impact on the City and the UK cannot be positive. Short-term we are already seeing other European cities competing to attract parts of the UK’s financial services sector. For ICG’s business the continuing low interest rate environment and withdrawal of banks from the investment market creates favourable market conditions. It is too early to say what impact the UK’s referendum will have on the performance of underlying portfolio companies, but we expect it to be limited.”
THE GP’S VIEW
Paul Shea, managing director at Beechbrook
“While the medium- and long-term implications of Brexit remain unclear, we expect a slowdown in growth in the short-term and, possibly, less appetite for risk from the banks. This could mean more opportunities for private debt managers, and at lower leverage levels. Beechbrook focuses on the lower mid-market, where the main influences are micro rather than macro. Our policy is to maintain our strict credit disciplines and select only high-quality investments so we are cautiously optimistic.”
THE ADVISOR’S VIEW
Peter Hobbs, head of private European markets, bFinance
“Infrastructure debt is likely to remain an increasingly attractive asset class given the prospect of interest rates remaining ‘lower for longer’. The UK will be most significantly affected in terms of the economic impact. For the UK and Europe, one of the major concerns relates to the political and regulatory impact of potential moves towards more protectionist economic policies.”