On June 23, 2016, British voters surprised much of the world by voting in favor of “Brexit” in a 52% to 48% vote. By now, most people that watch or read the news are familiar with the term Brexit, but for any uninitiated readers, Brexit is the withdrawal of the United Kingdom (“UK”) from the European Union (“EU”). The Brexit vote on June 23 began a period of uncertainty that has shaken, to some extent, nearly every business sector in the world. The Brexit vote did not actually cause the UK’s withdrawal from the EU, rather, the UK is required to give formal notice of its withdrawal under Article 50 of the Treaty on European Union. Under Article 50, the UK must give two years notice of its intent to withdraw, but this notice has not been given and the UK government has not yet set a definitive timeline in which it will give such notice. A major source of consternation is the fact that Article 50 has never been tested before and no one has any visibility as to how smoothly this process will go (or not go).
But how does this affect the average US-based middle market private equity fund? Many articles have been written about the Brexit impact on UK-based business and multi-national businesses with significant presence in the UK and EU in general, but Brexit has the potential to be felt by many of our own middle market private equity firms in the coming years. Brexit has the potential to directly affect two areas that are of vital importance to most private equity funds – interest rates and trade in the EU.
In the leveraged private equity world, any threat to interest rate levels is a concern. Many had deep concerns about the impact of a negative Brexit vote on global interest rates. Pre-Brexit vote reports warned of significant potential harm to the UK economy, and the world economy, if Brexit became a reality. A number of institutions, including, for example, the International Monetary Fund, cited the potential for a decline in the UK economy as a result of delayed investment, a lack of hiring, and a litany of other reasons. This instability raised fears that we would see a drastic increase in global interest rates.
Take for example the London InterBank Offered Rate to Fed Funds (“LIBOR-FF”) spread, a key measure of credit risk within the banking sector that tracks the movement of LIBOR against the US federal funds rate. During times of economic peace, the LIBOR-FF spread typical stays within a narrow range close to zero basis points. The spread will rise as banking institutions perceive more risk with other financial institutions and charge more for interbank borrowings. The LIBOR-FF spread is a direct measure of interest rate risks for many private equity groups. In a post-financial crisis world, the commonly available choice in floating rates between a US prime-based rate and a LIBOR-based rate has, in many cases, been replaced by the LIBOR-only based rate. Thus, many private equity portfolio companies no longer have the prime-based option to fall back on.
During the financial crisis of 2007, the spread reached levels north of 350 basis points. In contrast, despite turmoil in worldwide stock markets in the days that followed the Brexit vote, the LIBOR-FF held fairly stable around a range of 25 to 35 basis points. Unlike in 2007, the world’s banks had plenty of time to prepare for the Brexit vote, and several central banks pledged to maintain liquidity in the markets to quell Brexit fears in the days leading up to the vote. The immediate risk of large movements in the interest rate market appears to be low, but the longer-term risk is still open. With the requirement of a two-year notice for the UK to leave the EU, coupled with the fact that no such notice has been given or has a definitive timeline to be given, the full impact of Brexit will not be known for some time. During that time the interest rate market will likely depend on the willingness of the world’s major central banks to remain committed to stepping in to provide stability. So far, the indications are that central banks will stay ready to provide support when and if needed.
Trade and the EU “Passport”
A potentially greater impact of Brexit on US-based middle market private equity groups is the access their portfolio companies will have, or not have, to EU countries. As a member of the EU, the UK has the equivalent of a “passport” to trade with other EU member countries in a streamlined fashion. This “passport” is a combination of harmonized trade policies that streamline the ability to transport goods and people throughout the EU without the imposition of tariffs and many other restrictions. Due to the benefit of this “passport,” an overseas business that establishes itself in one of the EU member nations essentially establishes itself in the entire EU.
The UK, and London in particular, is one of the primary springboards into the EU utilized by US middle-market companies due to the lack of a language barrier, a huge talent pool, and easy access to the rest of Europe. Establishing a presence in the UK is an obvious choice for any middle-market US company looking to expand into Europe. Without this “passport,” US-based companies looking to expand into Europe may have to establish themselves in other EU member nations, and, unless these companies desire to abandon doing business in the UK, they may also need a separate establishment in the UK, increasing the cost of an expansion into European markets.
During the two-year notice window required of the UK to leave the EU, it is expected that the UK will negotiate specific agreements with the EU to govern how an orderly exit will take place. It is possible that agreements will be reached that seek to replicate the current “passport” the UK currently has. In fact, certain non-EU countries, such as those in the European Economic Area (Iceland, Liechtenstein and Norway), enjoy a similar “passport” into the EU without being member nations. Certainly many hope that, should the UK formally separate from the EU, the UK will reach an agreement similar to the one with the European Economic Area (or that the UK will even join the European Economic Area), but the procedures under Article 50 of the Treaty on European Union are untested and there is no guaranty such an agreement will be reached. Further, with the UK government’s plan to not even begin discussing a Brexit plan until next year at the earliest, it could be years before any such agreement is reached. This creates a dilemma to those US companies that are looking into establishing a presence in the EU now, as they could be forced in the future to repeat the process in the future by establishing in another current EU member nation.
For the time being, it appears that Brexit will not alone increase the cost of debt to private equity firms and their portfolio companies, but private equity firms looking to acquire domestic companies with an eye on international expansion had better take a second look at the forecast for European growth, or more specifically the cost of European growth. The next few years will likely be a period of uncertainty where such expansion may not be as efficient, or cheap, as it has been while the UK enjoyed its “passport” into the EU.
 LIBOR: Origins, Economics, Crisis, Scandal, and Reform, Federal Reserve Bank of New York Staff No. 667, March 2014