Annual review 2016: Brexit on everyone's minds

There is one issue that eclipsed all others in the European private equity market last year: Brexit.

The timing of the UK’s referendum on EU membership – slap-bang in the middle of the year – meant the whole year was adversely affected, with dealmakers sitting on their hands in anticipation of the vote and then taking time to digest the unexpected outcome.

Brexit seems to have taken a particular toll on the large-cap end of the market, with just 10 deals worth more than €1 billion closing across the continent, down from 20 in 2015, according to data from the Centre for Management Buyout Research sponsored by Equistone Partners Europe and Investec Specialist Bank.

“The referendum outcome has clearly had a material impact on the buyout market, the UK in particular, with the numbers reflecting a significant decline in mega-deals in the wake of the Brexit vote,” said Christiian Marriott, partner at Equistone.

Studies have shown that UK dealflow in the lower mid-market has remained robust. Several UK-focused funds have closed above target, including Livingbridge’s eighth fund, which closed on £660 million ($820 million; €784 million), almost twice the size of its 2012 predecessor, Mayfair Equity Partners’ debut fund, which gathered £400 million, and CBPE’s ninth fund, which closed on its £459 million hard-cap.

However, despite this apparent support from investors, the LP community is cautious. We conducted a poll in the days following the referendum, which revealed more than 55 percent of LPs thought Brexit would have a negative impact on their business. More than 40 percent said they would decrease their commitments to UK-focused funds, and almost one in 10 was considering selling stakes in UK-focused funds.

Similarly, almost three quarters of LP respondents to Coller Capital’s Global Private Equity Barometer Winter 2016-17 said a “hard” Brexit – a decisive separation of the UK from the EU involving significant restrictions on the UK’s access to the EU single market and strong immigration curbs – would have a negative impact on the UK, and 64 percent believed it would negatively impact the EU.

And it looks like a “hard” Brexit is on the cards; in a speech in mid-January UK Prime Minister Theresa May said the country will not seek membership of the single market or the customs union. She also said any EU deal should give British companies the maximum freedom to trade with the bloc, without being a member.

Despite concerns it is becoming harder and harder to generate robust returns, private equity has proved as popular as ever across Europe, delivering another strong fundraising year; more than $425 billion was raised globally, of which $76 billion was for 118 Europe-focused funds, according to PEI data, on a par with the $76 billion raised for 106 Europe-focused funds in 2015.

Many European heavy-hitters returned to market in 2016, including Cinven, Permira, Apax Partners and BC Partners, and the 10 largest funds raised for Europe in 2016 accounted for more than half the year’s fundraising total.

In fact, throughout 2016 some members of the European investor community have lamented that the balance of power in fundraising negotiations has remained firmly tipped in favour of GPs, sharing tales of sky-high carried interest, eradicated hurdle rates and trebling fund sizes betraying a lack of discipline in the face of cash-rich LPs.

Smart managers, though, are demonstrating restraint, according to investor sources: in today’s environment the most in-demand GPs may well be able to demand extortionate terms, but, should the tables turn in years to come, those investors are unlikely to remain loyal.

While fund managers defended a firm stance on management fees and carried interest, some of the industry’s most prominent players across the globe admitted that maintaining such a stance depended on solid returns.

Speaking on a panel at the BVCA Summit 2016 in London in October, Marc St John, investor relations partner at European-headquartered global private equity house CVC Capital Partners, predicted that the cost of private equity would have to come down as it is “a very expensive asset class”.

He said fund managers must justify that cost “every time we raise a fund with the returns”, adding that if firms are unable to do so then smart investors will take their capital elsewhere.

“If we can’t do that – and as I just said, a lot of the GPs had difficulty with that in the global financial crisis – you’re going to have to lower your prices,” he said. ?

1. Uncertainty will drive dealflow

The market dislocation resulting from major elections across the EU and ongoing Brexit negotiations is expected to produce some interesting opportunities for buyers. Philip Sanderson, a private equity partner at Ropes & Gray, said transaction volumes were likely to be augmented in 2017 by processes which were delayed in 2016 as a result of the EU referendum. “On top of this, many sellers which have plans to make sales in 2018 are talking about bringing the processes forward to next year,” he said.

2. Multiples will contract
In some ways, private equity is becoming a victim of its own success: significant outperformance versus other asset classes has attracted more and more investors which, while causing a fundraising boom, has driven up asset prices. At a media briefing in London in December, The Riverside Company co-founder Stewart Kohl said the firm is building an assumption of multiple contraction of one to two turns between entry and exit into some of its portfolio company modelling. This makes a focus on operational improvements more important than ever.

3. Focus on co-investments will continue to rise
LPs looking to minimise the cost of private equity by focusing on co-investments and direct investments will continue to gain steam in 2017. Almost half the Western European respondents to the PEI Perspectives 2017 survey are intending to increase their co-investment activity in 2017. What’s more, Coller Capital’s latest barometer found more than 90 percent of LPs are asking their new hires to focus on direct investments and co-investments.