US steps up as European LPs ‘strike’ over Brexit

UK private equity funds are under increased scrutiny from continental investors but US LPs seem to have fewer doubts.

A flurry of recent successful fundraises for UK-only vehicles suggests that Brexit has yet to have a material impact on LP appetites for Europe’s largest private equity market.

London-headquartered ECI is perhaps the most notable of these, having gathered £700 million ($927 million; €791 million) for its largest fund to date within 80 days of launch. NorthEdge Capital reached the £120 million hard-cap for its debut SME fund and lower mid-market investor Apiary Capital, set up by a former Bowmark Capital exec, held a final close on £200 million.

But it’s not been smooth sailing. Lyceum Capital was a notable victim of Brexit headwinds, citing a lack of international appetite as a factor in its decision to pull fundraising in January. The firm switched to deal-by-deal investing and completed its first transaction of the new strategy. UK heavyweight Exponent Private Equity also curtailed plans to dramatically increase its fund size, though sources say it continues to raise capital steadily.

The amount of capital raised for UK-focused funds in 2017, excluding funds that also invest elsewhere, was $4.5 billion, according to PEI data. This is above the previous five-year average of $3.2 billion, with 2018 set to be higher still.

Though most UK-only funds are still able to raise capital, there is a darker trend emerging; European LPs are becoming more hesitant to commit to these vehicles, leaving North American investors to pick up the slack. The managing partner of a UK mid-market firm that has raised a fund within the past 18 months described some European LPs as “on strike” from UK-only vehicles until further notice.

“Brexit has had an overall effect,” Adam Turtle, co-founder of European placement agent Rede Partners, tells Private Equity International. “It’s possibly had a bigger effect on Europeans than it has on the US, if I’m honest, maybe because the Europeans are closer to it, maybe because there’s some emotion tied up in that.”

One portfolio manager at a Dutch asset management firm tells Private Equity International demonstrable preparations for Brexit are now top of the agenda when it performs due diligence on a UK-only fund. This scrutiny is due to pressure from its own clients, who have quizzed the LP on exposure to Brexit and sought reassurance on how its GPs were approaching the issue.

ECI’s eleventh fund saw a rise in the proportion of North American investors at the expense of those in Europe. Around 50 percent of Apiary’s capital was also from LPs across the pond, with just one-sixth originating from continental LPs.

“European investors weren’t necessarily looking to increase their exposure to the UK given Brexit and they’re actually quite long already in the UK,” Apiary’s managing partner Mark Salter says. “Whereas the US investors were not necessarily as long in the UK as European investors, so they were reasonably sanguine about it.”

A hole in the bucket

The European Investment Fund was historically a key supporter of UK private equity funds. This has lessened since the EU referendum, with the fund having to deny reports that it had ceased commitments to UK vehicles in August last year.

While the EIF insists there is no official moratorium on UK-only funds, its appetite has certainly plummeted. The €28.6 million it provided to WestBridge II, a lower mid-market vehicle targeting UK investments, in May 2017 was its sole commitment to a UK-only fund last year, according to its annual report. This is compared with €404.9 million-worth of UK equity deals in 2016.

Sander Slootweg is managing partner of Amsterdam-based Forbion Capital Partners. The venture capital firm – which held a first close on €270 million for its fourth life sciences fund last week – is a longstanding recipient of EIF backing.

Funds that receive commitments are typically mandated to invest a portion of the vehicle into EU businesses, Slootweg says. Forbion’s requires it to invest two-thirds into Europe, with the remainder reserved for North American, UK or Swiss companies. The UK’s departure from the EU could mean British companies will have to compete against targets in those markets for a slice of that smaller bucket of capital.

“That automatically raises the bar a little bit. If you only have one-third to consider this huge geography of North America and Switzerland where there’s a lot of biotech companies, then the bar is higher.”

The special relationship

What are US LPs seeing in the UK that Europeans aren’t? The muddle around Britain’s exit and a recent string of departures in Theresa May’s government are unlikely to inspire confidence regardless of geographic location or political alignment.

The answer may lie domestically. “Trump has levelled the playing field” for US LPs, the unnamed managing partner says. Political and social turmoil at home has made Brexit a less intimidating proposition and renewed appetites for diversification through the world’s second most-developed private equity market, according to his LPs.

Trump aside, the US is arguably becoming a less appealing market for private equity as record levels of dry powder force prices through the roof. Buyout value grew 9.6 percent to $195.6 billion last year as stiff competition for high-quality assets drove valuations to a record 11.2 times average EBITDA purchase price multiple for LBO transactions, according to Bain & Company’s Global Private Equity Report 2018.

Overheated valuations could be driven even higher by increased corporate spending in the wake of the US Tax Cuts and Jobs Act, which introduced a hefty reduction in corporate tax to 21 percent from 35 percent and a 15.5 percent one-time charge on profit gathered overseas, meaning businesses will be able to repatriate cash to spend at home without paying additional taxes.

Even US GPs are beginning to look abroad. International deals accounted for 50 percent of the $5.5 billion invested by US GPs in the PitchBook database during 2017, according to The Internationalisation of Alternative Funds from Maples Fund Services. This compares with just 28 percent of the $4 billion invested in 2016.

Bounce back

LPs and GPs often espouse the need to “wait and see” over Brexit. Uncertainty surrounding the terms with which the UK will continue to trade with Europe means the economic impact of the referendum remains a mystery.

Provided the aftermath is not disastrous, the UK is unlikely to lose its standing as Europe’s largest private equity market. “It’s a large and important market from a private equity perspective,” ECI’s David Ewing says.

“For the big international investors it is wholly appropriate for them to maintain or indeed even increase exposures to UK private companies. There’s lots of entrepreneurs in the UK and if people are serious about running global private equity programmes they need to maintain exposures to the UK.”

Continental LPs are unlikely to permanently reduce their diversification by concentrating capital in smaller European markets such as Spain, Italy and Germany. The need to maintain a certain level of exposure to the UK over the long-term means we could see an up-swell of European commitments to UK funds once the conditions of Brexit are – in theory – made clear in 2019.