Brexit uncertainty hampers UK private equity activity
- Mutual recognition risk in the balance
The persistent uncertainty surrounding Brexit is negatively affecting the appetite for private equity activity and foreign investment in the UK, warned panellists at Debtwire’s European Distressed Debt Outlook Breakfast, hosted on 14 February.
With UK economic growth starting to fall behind its European peers for the first time in years, and inflation surging due to a weakening sterling, private equity firms are opting for a more cautious approach, while distressed debt funds are more optimistic given the potential rise in distressed opportunities, the panellists noted.
Panellists warned that the lack of visibility with regards to the government’s objectives adds to the uncertainty surrounding the Brexit process, imposing a significant toll on UK’s economy.
Markus Hunold, director at private equity firm KKR, seconded that assessment, adding that new foreign direct investment (FDI) has declined as a result of the referendum, while companies have had to increase prices to offset the negative effect of the FX-driven cost inflation.
The UK is set to leave the European Union in March 2019, but there are still significant differences on major topics, including the country’s access to the European single market, its membership in the customs union, and the future relationship of the British financial sector with the rest of the Union, the panellists said.
Ralf Ackermann, partner at Searchlight Capital Partners, warned it might be “almost too late” to “rectify” the damage caused to the UK economy by the uncertainty resulting from the Brexit negotiations and that FDI in the car industry has suffered as a result.
Ackermann also cautioned that the political risk arising from the government’s shaky majority in parliament and the prospect of a hard-left UK government was potentially even a bigger concern for financial investors, with government contracts losing their appeal an example. “A few years ago, there was nothing more attractive than a UK government contract for investors. Now it seems that there’s nothing worse,” he said.
Rates to the rescue
Towards the end of last year, central banks slowly started to raise interest rates after several years of historically low levels, and more upward adjustments are expected later in the year as a result of improving economic growth in most major economies as well as increasing inflation in some, such as the UK.
“We believe that the big four central banks, i.e. Bank of Japan, Bank of England, the US Federal Reserve, and the European Central Bank, are moving in a direction that would push the yield on the US treasury notes up to around 3% from the current level of 2.5%-2.6%,” Hunold said. “The US has had 105 months of continuous expansion; the second longest run in their history.”
But rate hikes will not necessarily lead to immediate difficulties for issuers, panellists said. The abundance of liquidity in the markets means that many issuers may still be able to refinance their debts.
“The difference with 2007 is that back then there were plenty of aggressive structures, but at the moment we are only starting to see more second lien debt and PIK instruments,” said Carlo Bosco, Head of Financing Advisory and Restructuring for Europe at Greenhill, adding that issuers were able to receive senior secured financing at high turns of leverage. “The main reason is that you actually don’t need such subordinated instruments now. You can borrow even at senior secured level very cheaply. So, who needs a PIK?”
Ackermann warned against over-optimism about potential opportunities in 2018, noting that the combination of available financing and the relatively stable macro environment means that an immediate uptick in restructuring activity may not be at hand.
“It is almost impossible for 2018 to be a peak of restructuring activity like some survey respondents suggested, but we could well be at the beginning of a credit deterioration cycle,” he said, adding that elevated volatility can lead to an increase in default rates in 2019.
In terms of distressed opportunities, the panellists expect the retail sector to remain active, pointing to Toys 'R' Us and Maplin, both of which have entered into administration in recent weeks, as examples of the difficulties of adapting to the ever-changing and challenging retail environment.
They also questioned the wisdom of funding previously distressed retailers who seemed to have turned the corner.
Meanwhile, the difficulties of the automotive sector are not limited to the other side of the pond, said Sandro Patti, director at Bain Capital Credit. But in some European jurisdictions, lenders keep allowing companies to avoid workouts.
“Every time you speak to restructuring advisors in Germany, they’re worried about the automotive sector, but at the moment there is just too much liquidity for the problems to be seen,” he said. “Also, German banks tend to help companies refinance their debt. When the cost of capital is negative, you can refinance just about anything!”
Periphery of oil
The oil & gas sector has been a fertile ground for restructuring practitioners since the freefall of oil prices in June 2014 from highs of USD 115 a barrel to lows in the USD 30s. However, after a full round of workouts, operational restructuring and oil prices to well above USD 60 per barrel of crude, many European players are still overleveraged.
“There is still more work that needs to be done in the North Sea through a mix of restructuring and consolidation,” said Bosco.
The panellists debated whether the oil price can hold up. Hunold pointed to various factors affecting the price, including the trend of electrification of cars. He added that the USD 40 to USD 50 per barrel marginal-production costs for the US shale oil provided “a rough idea about where the floor should be”.
Patti said that the flattening and widening of the price curve in the last four years is not just due to shale oil supply, but also cost cutting and streamlining in the offshore space.
“In the medium term, the floor for crude is around USD 50 [per barrel], but it’s difficult to guess the cap,” he said. “There are many drivers for the price; for instance real demand versus financial demand. The uncertainty makes it difficult for companies that need stability in oil prices to embark on a new project.”
The fluctuations in the price of crude impacted a number of industries, often catching markets by surprise, he noted.
“What many – including myself – underestimated in 2014, was the positive impact of oil prices on demand levels and movements of crude tankers,” Patti said, adding that tankers were also used as floating storage vessels.
As a result, when looking at the impact of oil prices on restructuring activity, one should look beyond the core energy sector, and consider the effect of fluctuations on companies indirectly exposed to oil prices, such as portable storage and accommodation provider Algeco Scotsman, which generated around a quarter of its sales in the energy sector at the time, he noted.
“One needs to watch out for things that are not necessarily called ‘oil’, but are significantly affected by it,” Patti added.
Italian NPL iceberg
The panellists then turned to the subject of European non-performing loans (NPLs), especially in Southern Europe. Stephen Phillips, partner and co-head of European restructuring team at Orrick, was upbeat about the continued abundance of opportunities in Italy.
“Italy was very hot last year; incredibly busy. Everybody is talking about Greece as the next one, but I think there’s still a lot to happen in Italy before it’s over,” he said.
Several Italian banks, including Banco Monte dei Paschi Siena, Banco BPM, Intesa Sanpaolo, and Carige have been undergoing painful deleveraging exercises to varying degrees by disposing of their non-performing liabilities. Patti warned that what has been seen and done so far might only be a small part of what is still to come. He noted that the new rules which could be introduced by the European Banking Authority and become mandatory as early as 2020, could require banks to have an NPE (non-performing exposure) ratio of loan book as low as 5%, while the average level of such exposures for Italian banks was still much higher as of today.
“If more draconian rules were to be ratified, the banks will need to raise even more capital, and many won’t be able to be compliant in the timeframe,” he said. “If the EBA and the ECB are strict enough on deleveraging and cleaning up balance sheets, the banks will need to place more loans under the UTP [Unlikely to Pay] category, and those that don’t have the capacity in-house to deal with them will have to sell, so you might see more action. What you see now is just the tip of the iceberg.”
Insolvency regimes competition
A discussion about distressed debt and restructuring is never complete without a mention of the main two court-supervised implementation routes, i.e. the US Chapter 11 and the UK scheme of arrangement, and their relative advantages.
Bosco called the American proceeding “a fantastic tool” which “ticks all the boxes”, and despite the improvements in the insolvency regimes of many European countries, it is still ahead of its competitors, but noted that its main disadvantage was its high cost, adding that there are cheaper and effective options around Europe, depending on the capital structure.
Phillips added that by choosing Chapter 11, a company is being run via litigation, a far from ideal and costly way of running a business, but noted the process has a good track record in terms of effectiveness, and is very useful for businesses with assets all over the world as international executives will be anxious to avoid the prospect of being in contempt of the US bankruptcy court.
He added that the US proceeding was a sort of default option. “If all else fails, you go for Chapter 11.”
But the equally popular UK scheme faces a more uncertain future in terms of its suitability for European restructuring. So far it benefitted from almost-guaranteed recognition by other members of the European Union, but there may be a cloud over the process post-Brexit, Phillips warned.
In this context, the draft agreement for the UK’s withdrawal from the European Union (Withdrawal Agreement), which was published earlier this month, is likely to be welcomed as a relief, at least in the short term.
When ratified, the Withdrawal Agreement will govern the relationship between the EU and the UK during the transition period between March 2019 and 31 December 2020. The draft refers to the ongoing application of the Brussels Recast Regulation (concerning the recognition of court judgements) and the Recast European Insolvency Regulation (dealing with mutual recognition of insolvency proceedings).
Phillips noted that the mutual recognition between EU member states has not only been beneficial in improving creditor recoveries, but has also allowed companies to implement “smart COMI shifts” to benefit from more favourable regimes, while encouraging countries to improve their competitiveness through legislative reforms.
Once out of the European system, the UK will recognise foreign insolvencies via the UNCITRAL Model Law, to which it is a signatory. However, the majority of the EU member states are not a party to that treaty. Therefore, mutual recognition cannot be automatically assumed.
“If we don’t get some sort of mutual recognition regime within the Brexit deal, we still have the Model Law, to which the UK is a signatory,” Phillips said. “The slight danger, however, is that we might end up recognising EU insolvencies, but without reciprocity.”
He said that recognition does not necessarily have to be based on multilateral treaties, adding that in the recent Ocean Rig debt restructuring, Dutch law expert evidence was obtained according to which courts of the Netherlands would recognise a Cayman Islands scheme of arrangement under international private law.
“In a couple of years absent any specific UK/EU agreement we will be in a situation comparable to the Cayman Islands vis-à-vis the EU,” he commented, concluding that it would be strange for European courts to grant recognition to decisions coming from the courts of Cayman Islands, but not to those of the UK. It remains to be seen whether the EU and the UK agree mutual recognition of insolvency filings and judgements in any future withdrawal treaty.
Phillips also noted that after Brexit, the UK may end up in a situation in which it copies much of the EU’s rules and follows them, but doesn’t have a say in shaping those rules.
“There is a great deal of regulation in place. There may be alignment on the first day post-Brexit, and they may even be total alignment on goods and services,” he pointed out. “So, effectively, the UK may find itself in a position of following European rules, while losing its veto rights and its ability to sway the Union’s decisions.”
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