Brexit – The great disorder under the Heavens?


July 7, 2016

It looks that the financial industry bet the wrong way on the biggest market event since the 2008 financial crisis. The Brexit referendum’s outcome has already been called ‘the greatest Black Swan event of the millennium’ (personally, I believe that this unexpected result rather falls into the category of what we practitioners refer to in our daily work as ‘king size …-up’), creating, in the words of Mao Zedong, ‘great disorder under the Heavens’. Private equity as a highly illiquid asset class tends to react sluggishly but in one way or the other will be affected by this market turmoil – what does this mean for existing assets and for investments going forward?



To do or not to do?



Simplistically, there are two ways of looking at this. From one perspective, clearly global markets are in chaos. The Pound fell by more than ten percent against the dollar — a bigger slump than during Black Wednesday in 1992 when speculators forced the British currency out of the European Exchange Rate Mechanism. Similarly, equity markets are down with, for instance, the mid-cap FTSE 250 index suffering the biggest fall ever. Private equity assets can only be affected by this negatively and something ‘must be done’ about this – now!


Alternatively, one could take the view that due to their structure as closed end funds with firmly committed limited partners as investors, private equity portfolios are largely insulated from such events.  Looking at the frequency of the proverbial Black Swan events – the demise of the hedge fund Long Term Capital Management in 1998, the dot-com bubble of 2001, the Lehman crisis in 2008, to name just a few – one can conclude that next to every private equity fund was exposed to one or two of such apparently near death experiences in the course of their lifetime of typically between 8 and 12 years. Nevertheless, the asset class regularly has been proven highly resilient in the face of difficult global market conditions. Therefore, investors would be well advised to stay calm.



Action for action’s sake


A few months ago I wrote a blog about mechanistic rules for maintaining pre-set investment allocation levels and as important part of an institutional investor’s prudential apparatus. To recall, guidelines set targets such as 10% allocation to private equity, 20% to hedge funds, 10% to real estate, etc. These targets are difficult to maintain when the market changes direction. Investors who enforce them and sell off private equity assets throw the principle of a structurally illiquid asset class, where they accepted upfront its illiquidity, over board. Such investors usually suffer losses by trying to sell into a secondary market where in this situation the buyer holds all power – mainly because their rules state this and everybody else is doing it.


In theory, investors with a long-term focus should have an advantage in private equity, but investment policies are still insufficiently addressing contrarian investing in order to overcome human biases like exuberance, fear and peer-pressure. There is a wide agreement among practitioners that serious investors avoid timing markets. The proven modus operandi is to consistently invest a fixed amount throughout the vintage years, despite the progressive increase in perceived risk, as it essentially gives a countercyclical exposure to the ups and downs of the private equity market. While this intellectually makes sense, there is pressure from all sides and constraints – notably current financial regulation tending to focus on short-term liquidity – that can make it difficult for owners of private assets to avoid the lure of the secondary markets.



Stay calm…



Markets tend to overreact first and think later, offering opportunities to contrarian investors who thought this through in advance. In fact, my colleague Didier Guennoc started looking at this well before the Brexit referendum in order to bring some quantitative elements and allow limited partners to stay focussed while the debate continues. Specifically, he analysed the returns and the holding periods of 1,925 UK buyout deals at the lower end of the spectrum (i.e. €10m to €300m transaction price) which were completed between 1987 and 2015 and that are now exited by their backers. These deals were sorted into four scenarios depending on the GDP annual growth rate that they experienced during their holding periods (Figure 1[1]):




  • Contraction: GDP annual growth rate negative between entry and exit (the average annual GDP growth rate for those deals was -0.8% compounded rate);


  • Slow growth: GDP growth rate between 0% and 1.5% (average 0.7%);


  • Moderate growth: GDP growth rate between 1.5% and 3.1% (average 2.6%);


  • Strong growth: GDP growth rate 3.1% or higher (average 3.4%)


The results in Table 1 help us to draw the following conclusions:


  • Exits happen even when the GDP contracts over the holding period. Note that during the period analysed the Pound was also relatively weak compared to the Euro (on average a rate of 0.8348 £ per €).


  • It is, however, true that in this sample the number of exits (131) during contractions is significantly lower than for the various growth scenarios;
  • During contractions the achieved average exit gross multiple is not much lower compared to the other scenarios: 1.4x, at par with ‘moderate growth’ and, respectively, 0.2 and 0.3 lower than the ‘slow growth’ and the ‘strong growth’ scenarios;


  • The big and surprising difference lies in the average holding period, which is much shorter for the ‘contraction’ scenario: 3.1 years, against up to 5.4 years during ‘slow growth’. One possible reason for this discrepancy is that the exited deals were exceptionally strong and managers disciplined enough not to keep their assets for too long in their portfolios when the offered price was appropriate.




According to this analysis cash events are likely to occur, even if the Brexit is followed by a recession and a weak Pound. Expect that these exits will be less numerous and performed by managers with strong skills in identifying and seizing the opportunity for disinvestments. These findings provide some pointers for owners of private assets where to look first for assessing the resilience of their portfolios to the consequences of the Brexit.



…and don’t trigger Article 50


However, this analysis would not be complete without taking one last element into account. Deals during the ‘contraction’ period were mostly invested during the period 2007-2008 and divested around the years 2009-2011. During this exit phase and until now, asset prices have highly benefited from the intervention of the central banks – actors that may not be able to play a similar positive role in the near future.


Particularly in the current environment of turmoil we must not forget the clichéd disclaimer that past performance is not indicative of future results. Macro and micro economic structures that provided for the UK’s growth for so long are not a given any longer. Moreover, and probably more than ever, the political uncertainty in London, Brussels and the European capitals is likely to be protracted. How strongly should investors with allocations to private equity be worried? When China was at the verge of collapsing, Mao Zedong dispassionately concluded that there was ‘great disorder under the Heavens and the situation is excellent.’



Is the situation excellent?


Today only few would consider the situation ‘excellent’ but secondary buyers with sufficient dry powder certainly belong to this group: despite of what was argued before, a significant number of limited partners are likely to fall victim to the herd mentality that usually plagues markets in such times and try to exit their funds prematurely. Fund managers will probably be less sanguine. The UK’s status as a hub to access clients and markets across the European Union is likely to change. It is possible that the UK asset and fund managers’ disrupted access to EU investors will for some period have a negative impact on fund raising. On the other hand, alternative investing to a large degree is even thriving on change, for instance, by targeting industries in need of restructuring – this time it will be the financial industry itself that will be experiencing a seismic shift. Indeed, from this perspective the future may be excellent for private equity.


As several wise men have observed, it is difficult to make predictions, especially about the future. Most economic models are of limited use during periods of ‘great disorder’. In such a situation, owners of private assets should analyse their specific portfolio first and avoid the temptation of following the herd. Maybe other limited partners invested in the same funds are now willing to sell at a bargain price? Indeed, it is import to consider the various options from the perspective of competitors and other major market participants faced with different constraints and pursuing own objectives.[2] Putting oneself into the others’ shoes helps in this competitive environment to identify weaknesses, challenge assumptions, and anticipate potential opportunities. Insights gained from such an exercise allow developing a strategy to survive and prosper while others are still confused.

[1] The figure shows the annual growth rate of the UK’s GDP (volume) from 1985 to 2013 (source: Eurostat).

[2] In this context I should mention the 3rd Risk Management Symposium (13-14th December 2016) we are currently organizing with the Private Equity Institute at Saïd Business School, University of Oxford. At this occasion Professor Philip Sabin of the King’s College will discuss and explain how to use strategic simulations and role playing, also known as ‘war gaming’ as tool to prepare for the unexpected in an uncertain environment. The Symposium’s program is close to final and you can already register here:

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