Soft landing after a hard Brexit?

A Brexit deal acceptable to all parties may appear a dim prospect, but analysts continue to hold out hope that some form of agreement will be reached – however rudimentary the shape of it may be.

Yet with talk of a hard Brexit mounting as the seemingly intractable issue of the Northern Ireland border holds up a backstop agreement, risks are mounting. Economically, these are significant: leaked UK government forecasts recently suggested that without a deal, the economy could be 8 percent smaller over a 15-year horizon relative to current projections.

The sudden elevation in uncertainty caused by a “no deal” or hard Brexit is likely to spark a severe period of risk-off, with the ensuing flight to safety seeing credit spreads widen and volatility spike, say industry observers. Even before March 2019, if the perceived risk of “no deal” continues to rise, financial conditions could start to tighten. Meanwhile, major questions over what would happen to financial passporting remain unanswered.

As European Commission and British negotiators thrash their way through the latest thicket of unexpected Article 50 consequences, the six-month headline date at which the UK crashes out without an agreement looms ever closer. So, what are fund managers and others in the private debt market doing to prepare for any unexpected outcomes? Fear doesn’t appear to be in the air. Risk is largely priced in and many are looking for a potential lining.

“Accommodating any specific post-Brexit arrangements themselves – whatever the deal or lack thereof – is not top of investors’ worry list”
James Newsome

“Accommodating any specific post-Brexit arrangements themselves – whatever the deal or lack thereof – is not top of investors’ worry list,” says James Newsome, founder of London-based placement agent Arbour Partners.

“Most market players lived in some form through 2008-09 and then the euro crisis and have since grappled with Alternative Investment Fund Managers Directive and Markets in Financial Instruments Directive II. They will cross the Brexit bridges when they come to them – and the UK posted OK numbers in the latest quarterly releases.”

That doesn’t mean serious moves aren’t being made to prepare.

“We’re seeing managers do various things: if they have a Financial Conduct Authority AIFM, they are using that as their portfolio manager and using a US entity to be the main manager delegating responsibility to their FCA AIFM,” says Diala Minott, a specialist in structured finance and partner at law firm Paul Hastings.

“They’re rushing to make their delegations pre-2019 as some regulators such as the French and English have given oral comfort that they would not re-examine any delegation arrangements; they’re using their US entities where they can and they’re starting to move their AUM slowly into their chosen EU jurisdiction with a bit of secrecy internally, so as not to worry star players.”

She adds that some firms are moving a small number of staff to continental Europe “as a taster for what is to come – so set up a [Luxembourg] RAIF (reserved alternative investment fund) with one compartment for one strategy and then use other compartments for the rest. We see some managers offering services to other managers that will need a host arrangement as soon as possible though. We’re still hopeful of a transitional period like with what we had for MIFID”.

Silver linings playbook?

Given the amount of dry powder available and a weak pound making some assets highly attractive to non-sterling funds, there is little sign of fraying nerves, more a hunt for the kind of silver linings that will result from the economic recalibration.

“We’ve naturally tightened the due diligence we do across our portfolio – we want to know that our fund managers have a sensible strategy when it comes to considering the risk of a hard Brexit,” says one continental Europe-based asset manager. “Typically, this means exactly what you’d expect: lending to defensive businesses; assessing the risk to their portfolio across FX, labour, ability to respond to any potential supply-chain disruption and, of course, resilience to the overall economic impact.

“We’re seeing managers do various things: if they have a financial conduct authority AIFM, they are using that as their portfolio manager and using a US entity to be the main manager delegating responsibility to their FCA AIFM”
Diala Minott

“But we’re hardly shying away from UK-only managers: Brexit or no Brexit, Britain is still a dynamic, viable economy and although everyone will be impacted, there will also be opportunities. A market shake-up typically results in banks retrenching and private debt is often less dogmatic about who it lends to.”

The manager also notes the UK has traditionally been one of the biggest sources of opportunity for distressed debt investment. “While it is likely the UK private debt market will feel the impact of a hard Brexit, with some smaller funds possibly disappearing, the biggest unknown is the risk of a bad UK recession causing European recession.”

To those with a global view of markets, worries of froth a decade on from the collapse of Lehman Brothers are increasing. As Oaktree Capital’s Howard Markets put it in a recent note, Moody’s Investors Service data show $104.6 billion of new leveraged loans were made in May, topping a previous record of $91.4 billion set in January 2017, and the pre-crisis high of $81.8 billion in November 2007.

He added: “The main building blocks for the crisis of 2007-08 were sub-prime mortgage backed securities, other structured and levered investment products fashioned from debt, and derivatives, all examples of financial engineering. In other words, not securities and debt instruments themselves, but the uses to which they were put.

“This time around, it’s mainly public and private debt that’s the subject of highly increased popularity, the hunt by investors for return without commensurate risk… it appears to be debt instruments that will be found at ground zero when things next go wrong”.

A hard Brexit won’t be the key risk in the private debt ecosystem, just one adjustment of many that need to be made amid a global climate of macro and regulatory changes.