KPMG on the Brexit effect

Brexit spells uncertainty for portfolio companies, but private equity firms that manage this well will gain the upper hand. Mark Essex, director of public policy, and Mike Mills, global target value leader, at KPMG discuss what Lewis Hamilton can teach them about how to respond.

What assumptions should private equity houses have about Brexit?

We do not yet know what will happen. The UK may have to fall back to World Trade Organisation rules, which would mean substantial tariffs for exports to the EU. This is more likely if Britain insists on reducing immigration from Europe. But it may agree a deal to retain access to the single market on a transitional basis. This would probably ensure full access to EU workers during transition.

The EU Commission and the UK government are likely to negotiate until the cliff edge looms. It is likely to take about six months to get any deal ratified by the EU member states, so the effective deadline is not in March 2019 when Brexit is due to take place but autumn 2018.

How does the outcome of the negotiations impact portfolio companies?

Mark Essex
Mark Essex

Brexit’s shape is important for any portfolio business with UK interests – not just domestic businesses, but also exporters to the UK and suppliers to British companies.

It is wrong to consider the different effects only in terms of conventional industrial sectors. Take the motor industry. A retailer importing cars from outside the EU might benefit from tariff restrictions imposed on cars made in the EU that are sold by a rival retailer, because this will push up the price of the rival cars. But neither retailer would be immune from a reduced flow of mechanics from the EU. A carmaker with a UK factory would be hit by the tariffs imposed on its exports to the EU, but a post-Brexit immigration policy would probably not restrict its ability to hire highly skilled engineers from across the Channel.

If there is no deal, will this make any portfolio companies better off?

Sticking to the motor sector, it is sometimes said that Lewis Hamilton has an edge over Formula One rivals when it rains. Like everyone else, he is slower than when it is sunny. But he beats other drivers in the rain because he slows down less than they do. In other words, few will gain from Brexit, but the relative competitive advantages will change.

How will the advantages shift?

Mike Mills

Imagine you are a fast fashion retailer sourcing from Turkey – a member of the customs union even though it is not in the EU. Imagine also that a competitor sources from Morocco at the same price. Neither has an advantage over the other. But that will change if the UK has to rely on WTO rules, because imports from Turkey will be subject to a tariff. The retailer that has planned ahead by talking to potential suppliers in Morocco will win out.

Is it not better for companies to wait to see the shape of Brexit before reacting?

No. By the time they can see the future clearly – about six months ahead – it will be too late. In many cases it will take more than these six months for them to re-engineer complex supply chains. Moreover, competitors will have stolen a march by good contingency planning. They will have already built relationships with potential suppliers outside the EU, so that they are ready to buy up capacity before it is all filled.

So is pre-Brexit preparation all about contingency planning?

Not necessarily. There is some spending that must be done eventually, such as IT improvements. Which is better to do sooner rather than later. Consider a UK manufacturer that currently exports mainly to the EU. At the moment this takes broadly the same paperwork as selling in the UK. But if the UK leaves the customs union, the company’s IT system will have to provide a lot more information on issues such as what is in its trucks. If it does not have fields in its system for these new data points, an IT upgrade is essential before Brexit. It is best to book this now rather than doing it later when IT service providers won’t have the capacity – except at a high price – because every other exporter is demanding the same thing.

Portfolio companies’ boards must also remodel their management structures to allow the next layer down to make a greater number of conditional decisions: not “Please do x”, but “Please do x in six months’ time, unless the UK seems poised to leave the customs union. If that happens, please do y”.

How should portfolio companies respond to possible immigration changes?

The UK’s labour market will probably tighten as Brexit approaches. Granted, we do not yet know if there will be any restrictions on EU workers coming to the country. But regardless of this, some workers will not want to relocate to the UK if they think they will have to leave again; others will feel less motivated to work in Britain because the fall in sterling reduces their UK earnings back home. Because of this, some businesses are locking in their labour forces by taking on more permanent staff and fewer agency workers.

In a tighter labour market, companies will also have to work to make their culture more attractive by, for example, offering interest-free loans to help employees onto the housing ladder. Other companies will emulate the highly unregimented culture of innovative tech firms, which offer employees a day off a week to work on their own idea if they think it has potential.

You say that private equity firms must be agile in considering Brexit. You also say they need to work at improving portfolio company cultures. Can they cope?

General partners’ structures for portfolio companies are often already well-designed for agility: many ask boards to report to them every month. They can use this existing setup for regular monitoring of Brexit readiness.

Historically, private equity houses have not always been good at making portfolio companies better places to work. However, many have embraced the idea of improving corporate culture.

Any last thoughts on how to prepare for Brexit?

Brexit means tough times ahead so portfolio companies need to find every angle that will increase profitability. One is working capital, which needs to be kept to the bare minimum. The case for doing this is all the more important because Brexit could make working capital a more expensive line item: for example, a pan-European retailer may need one depot in the UK and another in the EU, to deal with tariffs and customs delays. In short, private equity houses need to squeeze every last penny of possible profit out of operations.

This article is sponsored by KPMG