Warning! Could a Political and Economic Omnishambles be Brewing for the Private Markets?
They say that a week is a long time in politics, so when coupled with an economic storm stemming largely from political ideology, one could be forgiven for thinking we’ve all just been through a lifetime of political turmoil and skulduggery.
As public markets appear to settle, seemingly taking the recent Fiscal Statement and associated tax impacts in their stride, assessing the landscape for private markets for the rest of 2022 and into 2023 requires wading through the reems of political statements and navigating amid the clouds of uncertainty that hang over the horizon.
Uncertainty though often presents opportunity, and while the GBP/USD rate has rebounded somewhat from the recent five-year low, the relative value of British companies has been talked up in recent times as USD denominated funds potentially eye up a shopping spree. The GBP/EUR rate moves are a little less dramatic, if you ignore the fluctuation around the time of the UK “mini-budget” announcement at the end of September.
So, while relative value for EUR denominated funds may not have moved as significantly as if shopping in USD, there could be some room for value. Notoriously fickle, the FX markets have moved slightly following the somewhat unexpected U.S. mid-terms results and the far less unexpected presidential campaign announcement. As central banks continue with expected interest rate increases to counter the global inflationary pressures, differences in jurisdictional impacts may become pronounced as those specific economic and political pressures take root.
Scanning for potential regulatory environment changes, the market turmoil and political chaos that engulfed the UK has perhaps postponed some of the leadership campaign pledges regarding the UK regulatory authorities. UK Prime Minister, Rishi Sunak, endorsed the “call in” provisions and, despite not making its way into the original financial markets bill, this is expected to be added via amendments to the bill by MPs.
Despite this endorsement, the progress of the bill had taken a bit of a backseat, but amid the tax and public spending adjustments, the autumn statement did make reference to the “Big Bang” as the current administration looks to put the UK on a competitive footing despite the economic pressures.
Of course, much of the “Big Bang 2.0” was centred around making the UK competitive, rolling back European Union (EU) laws and regulations and freeing up private capital. A review of Solvency II and relaxation of some of the capital requirements for insurance firms has been estimated as potentially releasing billions of pounds for private investment and touted as a key “Brexit dividend”. Exactly how much of a dividend this might be is arguable as the EU has also begun their own review of Solvency II with the same overall aims. Given the recent financial shock and the impact we have seen on pension funds, this move may potentially prove to be more aggressive than the macro environment can stomach.
The approach to repealing European regulations may also change under the current UK Chancellor of the Exchequer, Jeremy Hunt, who has been keen to stress the need to work with the EU rather than maintain the recent somewhat fractious relationship. With international trade being seen as a key requirement to economic growth, and many institutions pointing out that the UK is lagging other members of the G7 in terms of economic impacts following the final Brexit agreement, it is perhaps no surprise that rumours of a “Swiss Style” relationship with the EU are once again doing the rounds. Although vociferously rejected by the more hardcore Eurosceptics within the conservative party, an alignment with EU financial regulations, perhaps leading to a long wished for “equivalence” recognition, may provide the wider UK financial industry at least with some longer-term stability.
Another relationship that may swiftly change is that of the government with the Bank of England and the Financial Conduct Authority (FCA). Both entities were squarely in the crosshairs of the previous occupant of 10 Downing Street with campaign promises of combining the UK regulatory bodies (the FCA, Prudential Regulation Authority (PRA), and Payments Systems Regulator) into a single mega regulator. Campaign promises however are swiftly forgotten and it is clear the FCA is continuing with its published business plan and focussing on various areas of the market such as MiFID transaction reporting (Market Watch 70) and protecting consumers through the new Consumer Duty.
Much of this UK-focused regulatory change will not directly impact general partners (GPs), though of course the economic issues in the UK will directly impact UK portfolio companies and the global inflation and interest rate raises continue to have macro-economic impacts. Potential longer term strategic impacts however may be felt sooner rather than later. The democratisation of private equity (PE) remains a key overall strategy for the sector and while efforts to create structures enabling the desired investments are far from bearing fruit, the entire premise may come under further scrutiny as the liquidity mismatch comes under the spotlight once again following redemption requests from various real estate funds by pension funds.
The potential liquidity mismatch, as demonstrated by the issues surrounding the Neil Woodford fund issues, remains a key barrier in opening private equity to the retail market. While structures such as the Long-Term Asset Fund (LTAF) seek to address some of these issues, and other market participants are working on semi-liquid options, the overall perception of private equity being a high-risk investment and something for institutional investors alone does persist.
The current cost of living crisis will inevitably foster the attitude towards the financial sector that has lingered since the global economic crisis and the lifting of banking bonus restrictions, even if largely irrelevant in the current age, will not help. So if the private markets wish to engage with a broader investor base, then allaying some of these attitudes and fears will be critical. While the image of asset stripping sadly persists, the story of millions of jobs existing through PE ownership of companies and the increasing practise of providing equity stakes to employees of those companies is far less frequently told.
As discussed at this year’s BVCA Summit, the industry remains somewhat closed off despite being very much a part of the mainstream investment strategies. Only by engaging directly, either with regulators, industry bodies like the BVCA, or possibly even with far broader mainstream media can the scrutiny that the industry certainly faces be appropriately addressed. In the case of regulatory change, this may in turn, potentially, alleviate unnecessary pressures on the sector by effectively educating and influencing decision makers.
With these different pressures, and no one single factor outweighing the others, capacity constraints across the general operations area, including compliance, can become problematic. There is no end to the regulatory reporting requirements, be they Annex IV reports for AIFs, filings with different jurisdictions when marketing, or any of the ongoing reporting now required under IFPR. This is in addition to the business-as-usual aspect of compliance such as electronic communications (e-comms) surveillance, personal account dealing sign offs, gifts and entertainment and the small matter of the overall compliance testing plan required by the FCA.
It is thus no wonder that “outsourcing” of various compliance tasks is now becoming commonplace. Replicating actions by finance departments, which have now long been outsourcing various tasks to fund administrators or independent third-parties, the move to having third-parties operate some, or all, of a testing program, conduct chaperoning of expert network calls, review electronic communications, or process personal trading requests or gifts and entertainment notices is well underway, freeing up those critical internal resources to address the more business critical needs.
Nothing is certain in life other than things will be uncertain, and at this current moment in time, trying to predict short term, or even medium term, economic trends or regulatory impacts is akin to throwing darts blindfolded. There are challenges ahead for the markets, both public and private, and the two no longer operate in isolation as perhaps they may once have. Setting a flexible and targeted plan to deal with the items that you can predict and working with the right partners to develop a robust programme can give you the time and resources to deal with whatever emerges from the political mists.
Article originally published in Investment Week and updated following U.S. mid-terms and UK Autumn Financial Statement.
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