Annual review 2016: Ballot box shocks

When all is said and done, 2016 will be remembered as much for the events at the ballot box as for the twists and turns of the financial markets.

At the start of the year, the idea that Britain would vote to leave the European Union was regarded by many in the financial and political establishment as an outcome so unlikely that it did not bear serious consideration. As for Donald Trump’s election as US president, that surely couldn’t happen, could it?

As the dust settles on these unlikely victories, much uncertainty remains. Just what does Brexit mean for the financial services industry? Will President Trump push through with a radical political agenda that could dismantle key parts of the post-crisis regulatory framework?

It is still too early to say, but one thing is certain: the people have spoken in 2016 and the private equity industry must now navigate a new set of risks and opportunities in a changing political landscape.

The implications of Donald Trump’s surprise victory are still sinking in, but one thing is clear: the Dodd-Frank Act seems set for a major overhaul.

A month into his presidency, and it’s fair to say that the implications of Donald Trump’s election as US president are still sinking in. Attention in the private equity world is beginning to turn to what his election means for financial regulation.

In early February, President Trump signed an executive order to review parts of the Dodd-Frank Act. Trump, who labelled the law a “disaster”, had earlier pledged to do “a big number on Dodd-Frank”. 

While the granular implication of Trump’s move is yet to be clarified – it simply directs the Treasury Secretary to submit a report on recommended changes to bank regulations within 120 days – officials say a review of the Volcker rule, which restricts banks’ trading positions, was among the seven principles the president has highlighted for change.

The rule, which caused a mass sell-off of private equity holdings by large banks, has long been criticised for its failure to define the difference between proprietary trading and market making, where trading firms hold out bids and offers across financial markets and hold short-term inventories of assets to accommodate transactions. 

While the executive order signals intention to dismantle US financial regulation, sector sources say there is little support for scrapping the whole Dodd-Frank Act from an industry perspective. This would be too onerous considering it has already implemented many of the measures.

“A new rule that amends or deletes the act would require a significant amount of time. Many broker-dealers have already spent a lot of money implementing the act. It is not likely that they will undo these efforts, choosing to move forward with the current rule as a business decision,” Todd Cipperman of Cipperman Compliance Services told PEI’s sister publication pfm.

It would also be politically difficult to eliminate many of the regulations created by Dodd-Frank. Much of the act is legislative, so would require Congressional action, new laws and Democratic consent in the Senate, which is a slow and often cumbersome process.

“I do not think [Trump is] going to get 60 senators to vote to get rid of all this. I believe he’s going to appoint people who won’t enforce the law,” said Barney Frank, the ex-Massachusetts congressman who co-authored the Dodd-Frank Act, during a radio interview. 

This was a view shared by analysts at investment bank FBR. They said they expected regulators would be able to make a number of changes, especially on the enforcement of these rules, which could have a significant impact on the business models of banks and other financial services firms. 

Peripheral changes, such as cutting compliance costs, freeing community and regional banks from the same rules as their larger peers and helping investment advisors are more widely anticipated.

But the financial deregulation is unlikely to stop with a review of Dodd-Frank. In a second executive order signed in early February, Donald Trump requested the Labor Department to review the Fiduciary Rule, which was designed to prevent investment advisers from giving conflicted advice relating to retirement plans such as 401(k), including advising on high-cost investment products like private equity funds. 

Firms have been keen to tap into the lucrative 401(k) market, which traditionally shuns the asset class because of its illiquidity and the large minimum investment. Partners Group and Pantheon have launched 401(k)-specific products, while Carlyle, Blackstone and KKR have unveiled products targeting individual investors. 

Scrapping the Fiduciary Rule would boost these firms’ access to the market, and others that follow suit, and could unlock a significant proportion of the estimated $6.8 trillion currently held in individual retirement plans. This means if advisors allocate the same proportion of capital to the asset class as other US retirement schemes, an average 7 percent, around $476 billion, could be ploughed into private equity funds. 

And while the private equity industry may not have initially welcomed the new man in the White House, fearful of his pre-election comments about the need to bring in carried interest tax changes, many have taken heart from his willingness to offer jobs in his administration to prominent private equity figures.

The private equity world is proving fertile ground for Trump administration hires, with heavyweights such as turnaround specialist Wilbur Ross and real estate investor Thomas Barrack tapped for key jobs.

Blackstone’s head of private equity Joe Baratta, excited about the infrastructure opportunities that a Donald Trump presidency could potentially unleash, in February 2017 discussed re-entering the infrastructure asset class in a big way.

Asset class: private equity

Trump’s pick for Secretary of Commerce was one of the few industry professionals to openly support the Republican candidate during his campaign. Ross founded WL Ross in 2000 to focus on distressed debt investing. The firm was bought by Invesco in 2006, but he remains chief executive and chairman of WL Ross and Invesco Private Capital. He was previously executive managing director of Rothschild Inc.

Asset class: private equity

The Blackstone co-founder will serve as head of the new presidential strategic and policy forum, which also has Jamie Dimon of JPMorgan and BlackRock’s Larry Fink on its 16-strong panel. The forum will meet with Trump frequently to discuss how government policy affects economic growth, job creation and productivity.

Asset class: real estate

The fellow real estate investor and executive chairman of Colony Capital endorsed Trump and supported him financially early in the campaign. The president chose his close friend, and frequent business associate, to chair his Inaugural Committee.

Asset class: venture capital

A contrarian in liberal Silicon Valley, the famously libertarian venture capitalist and PayPal co-founder supported Trump during the campaign. The president picked him as a member of his transition team with a remit to create a group of tech advisors.

Having rebounded from the immediate shock of the UK’s decision to leave the European Union, funds and their advisors are learning to live with uncertainty.

Few saw it coming. Certainly the result contradicted the wish of a large segment of the private equity industry. The outcome of the UK referendum on 23 June, a vote in favour of quitting the European Union, convulsed global financial markets, sent sterling plummeting to lows from where it has yet to recover and undercut UK growth forecasts. 

In the immediate turmoil that ensued – including the resignation of Prime Minister David Cameron and the political infighting that led to the appointment of his replacement, Theresa May – an astonished industry’s response was to press pause. 

“The initial reaction was one of shock and a suspension in activity,” says Travers Smith partner Sam Kay. “There was a dramatic and immediate impact on deals. The Brexit vote was regarded as having a ‘material effect’, and some deals that were signed were pulled. Deals are the lifeblood of a new fund and there was definitely a pause on fundraising. LPs went dark. They had to absorb the information and analyse the consequences. Investors had to reassess.” 

The immediate industry outlook was gloomy. According to a post-Brexit poll conducted by Private Equity International in early July, 47 percent of EU fund managers (excluding the UK) believed the result would have a negative impact on their business, while 43 percent of UK GPs thought the same, and only 5 percent of UK GPs said it would be positive. 

A September poll by the British Private Equity and Venture Capital Association (BVCA) indicated UK portfolio company leaders were equally glum with 75 percent believing a vote to remain would have been better for business. 

However, unlike the financial crisis of 2009 when the market ground to a halt, the drop in activity was not prolonged. “It took a couple of months and then it felt like people were reassured that things haven’t fallen off a cliff,” says one UK-based fund manager.

“The [UK economic] data hasn’t been too bad, and I think we are an industry that looks sunny-side up. Most of us are in the growth business and people have funds to deploy. What else would you do – sit on your hands for a year or two?”

Two years is the timeframe prescribed for negotiations over the terms of the UK’s exit following formal notification of its departure. The prime minister has indicated this would be in March 2017. That still seems likely despite the Supreme Court ruling in January requiring a parliamentary vote to trigger Article 50 of the Lisbon Treaty and the government’s subsequent promise to outline its Brexit plan in a white paper. 

Disentangling the UK from a huge and complex body of treaties and agreements will be an arduous task, raising the prospect of no deal within two years.

“The unknowns abound,” says Simon Witney, consultant at Debevoise & Plimpton. “And not just the timing. The negotiating process could take us in different directions.” Concluding a trade deal between the UK and the EU “might take many years and fund managers should not assume it will happen in two,” he says.

So early in the process, Witney warns against drawing definitive conclusions from political rhetoric. “So many things could happen in the next two years. Public statements now are not necessarily reflective of where we’ll end up.”

After months of uncertainty, in mid-January in a much-anticipated speech, the prime minister went some way to clarify the UK’s negotiating position, confirming a preference for a so-called “hard Brexit” that prioritises immigration controls over access to the EU single market. “Not partial membership of the European Union, associate membership of the European Union, or anything that leaves us half-in, half-out,” May said. 

The UK would not seek to remain within the European single market and instead the government would pursue “the greatest possible access to it” by negotiating a free trade agreement with the EU. This agreement “may take in elements of current single market arrangements in certain areas – on the export of cars and lorries for example, or the freedom to provide financial services across national borders – as it makes no sense to start again from scratch when Britain and the remaining member states have adhered to the same rules for so many years,” May said.

On Britain’s relationship with the custom’s union she was less definite, holding “no preconceived position” on how the UK reaches a customs agreement. She stressed instead the need for the UK to be able to negotiate its own trade agreements with states outside Europe. 

Whatever the shape of the final deal the UK government reaches with the EU, the government’s guarantee that there will be a parliamentary vote before it comes into force raises the prospect of further uncertainty.

“There is more clarity in the sense that we had virtually no information before,” says Debevoise & Plimpton partner Sally Gibson. “May’s statement that the UK is coming out of the single market means that UK fund managers should be working on the assumption that they will not have access to the AIFMD [Alternative Investment Fund Managers Directive] marketing passport. But I’m not sure we’ve progressed much further than where we were last year. It is still wait and see. I suspect fund managers will start to crystalise their plans once we have a better sense of what approach parliament is going to take [regarding Article 50] and what the timing is likely to be.”

Given May has indicated that post-Brexit the legal framework will incorporate all existing EU law in the UK – “the same rules and laws will apply on the day after Brexit as they did before” – in the short term fund managers in the UK will still be regulated under an AIFMD-type regime, says Gibson. However, for new fund managers without a significant UK connection and some international ones mulling a European presence, the UK has fallen down the list of attractive domiciles. “Luxembourg has always been a very popular jurisdiction and I wouldn’t be surprised if its popularity increased,” she says. 

In addition to impacting the ability of UK domiciled funds to tap European sources of capital, exiting the single market touches on a second headline concern of the industry: portfolio company access to European goods, services and talent.

“The industry would like [to remain] as close as possible to the status quo,” says the UK fund manager. In terms of access to the single market, fund mangers are “pretty sanguine”, he says, noting new deals in sectors most exposed to European regulations, supply chains and customers, such as financial services and aerospace, would be most affected. 

“For new deals, our fund looks at the specific risks around linkages to continental Europe, exposure to trade deals, risks around recruitment. We have made use of access to a large [European] market of skilled people,” he says.
“The regulatory issues will be sorted once the politics is decided,” he adds.

This already seems to be unfolding. “The implementation of the extension of the marketing passport to third countries isn’t expected in the short term,” says Gibson, despite long-awaited advice issued in July by the European regulator on the eligibility of 12 non-EU countries. “I wouldn’t be surprised if part of that delay is related to Brexit considerations that need to be taken into account now.”

Proof of the industry’s ability to adapt in the face of uncertainty was seen in its recent adjustment to the demands of AIFMD, Gibson says. “People are still establishing new funds and raising capital. The industry will do what it has always done and adapt.”

For some funds, the impact has been immediately positive. Paris-based manager Ardian closed its latest mid-market buyout fund in September on its €4.5 billion hard-cap in a record four months. “Some investors even decided to increase their allocation to continental funds versus UK-centric funds,” Philippe Poletti, head of Ardian’s mid-cap buyout team told PEI. “In some cases, the result was positive, for example the effect of currency movements on net asset values helped our cause.”

The UK fund manager also points to benefits from the drop in sterling. “It enables us to export more, increases competitiveness, our internationalisation will continue and our current portfolio profitability has actually gone up.”

The consequences of Brexit are wide-ranging and complex. One thing funds can predict is that the landscape will remain uncertain for the foreseeable future.


To be able to decipher political rhetoric, fund managers need to be informed. “Fund managers can’t put their head in the sand,” says Debevoise & Plimpton partner Sally Gibson. “They can make sure they monitor the situation and to the extent information does become available, they need to be in a position to react.”

Brexit is a Europe-wide issue with international ramifications. The shape of any future agreement will impact not only UK funds, but also pan-European GPs and any international managers with European businesses in its portfolio exposed to the UK.

Nothing is clear, yet fund managers still need to plan. Consider all scenarios, including the possibility of no deal in two years. “GPs and investors would be well-advised to plan for at least temporary trade barriers,” says Simon Witney of Debevoise & Plimpton.

While the terms of the UK’s exit remain unclear, the private funds industry has an important opportunity to contribute to the discussion. “It’s increasingly important industry bodies and their members spend time thinking about likely consequences,” says Gibson. Firms must engage with the BVCA and Invest Europe to collectively push their interests.

“You have to be an optimist to run a private equity fund,” says the UK fund manager. “We’re a robust industry of motivated people that believe they can create value out of a number of scenarios. Uncertainty will become the norm.”