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Brexit: What We Know, Don’t Know, and What PE Firms Should Expect


6/27/16

Prior to last Thursday, people around the world were largely unfamiliar with the term “Brexit.” For those who did know its meaning - the historic referendum that was taking place in the U.K. on the future of Britain’s membership in the European Union (EU) -many felt comfortable that U.K voters would  ultimately choose to remain in the EU.
 
This was not the case. By a margin of 51.9% to 48.1%, the U.K. has chosen to leave the EU, setting off a firestorm of uncertainty. World financial markets dropped precipitously the next day while Prime Minister David Cameron announced his resignation.
 
With Britain’s exit, the EU loses one of its largest economies. The U.K., in turn, separates itself from one of the strongest and wealthiest economic blocs in the world. As pieces of this new world economy begin to fall into place, here is what we currently know, don’t know, and what we see as the potential ramifications of Brexit for the global economy, for PE firms, and for their portfolio companies.
 
What We Know

  • Britain’s decision to leave the EU will not be legally binding until Article 50 of the EU Treaty is invoked. This will happen after a three month handover period to a new conservative government. Article 50 provides for the leaving member state to give notice to leave with negotiations on exit to take place within a two year period from notice. The UK government has estimated it will take more than a decade to sort out the EU legacy of shared rules.  So, for the near-term, we can expect a long, drawn-out process. As of yesterday, nearly 3 million Britons have signed a petition to “redo” the Brexit vote so, as Yogi Berra said, “It ain’t over ‘til it’s over.”
  • The UK represents a small percentage of global GDP (less than 3%). Therefore, while the global economic impact of Brexit is expected to be relatively benign, the impact will likely be substantial for UK domiciled businesses with global operations and customer bases. Multi-national corporations with substantial UK operations will also be impacted.
  • Many U.K.-based financial services providers, which utilize EU “passporting” (the right to establish a business or provide services in the EU from a “home base” in an EU Member State, will  likely move that home base into the remaining EU. They may retain a secondary base in the UK to service U.K. clients.
  • Additional legal and regulatory compliance requirements will be introduced for companies that have operations in both the UK and the EU.
  • Ordinary cross-border business activities such electricity supply, transportation, and production may be subjected to substantially higher costs unless the two year negotiation period results in cross border trade and duty agreements.
     

What We Don’t Know

  • With so much to sort out, what will be the ultimate timing for the U.K.’s departure from the EU?  EU leaders have stated that they will push for a quick resolution to the timing of the UK’s departure. However, the ultimate timing is in the hands of the UK.
  • Will the nationalistic contagion of exiting the EU spread to other EU member nations such as France, Spain, and the Netherlands? Each of these countries is holding elections over the next 24 months.
  • How difficult will the EU be in negotiating the terms of a UK exit? Will they attempt to set a tone to dissuade other member nations from following the path of the UK?
  • How will existing laws and regulations be impacted and which new laws will be enacted? Will companies with operations in both the UK and other EU countries be subjected to both EU existing regulations as well as separate, U.K. - enacted regulations surrounding business law, cybersecurity, transaction-related regulations, etc.?
  • What will be the impact of Brexit on European free trade agreements? The potential does exist for a substantial increase in tariffs and duties on both exports and imports to and from the UK.
     

Global Economic Impact
 
According to Patrick J. O’Keefe, CohnReznick’s Director of Economic Research, the consensus among international economists – including those who specialize in financial markets – is that the next several months will be chaotic as the divorcees negotiate the terms of their separation.  This implies a period of tighter credit, on dearer terms, and at higher rates.
 
Near term, intermediaries (including private equity managers) face unlimited uncertainty that is likely to persist until the terms of the divorce are defined. And divorces are seldom affable. Although opinions are all over the map as to London’s future status as a money center, its role will shrink inevitably as its global engagement contracts and money centers within the EU expand.
 
Anticipated Impact on PE Firms

  • Financial sponsors pursuing transactions in the UK and EU can expect a tightening of the credit markets with less leverage readily available and at a higher cost of capital.
  • The pending period of uncertainty in Western Europe’s regulatory and general business environment is likely to stall many of the transactions that are currently underway.
  • The U.K.’s heightened currency risk will likely lead to higher import costs within the country. This could, in turn, increase manufacturing and production costs and materially squeeze margins.
  • Given currency rate fluctuations, portfolio companies in the UK with U.S. dollar denominated debt may see the cost of debt service increase substantially (dependent upon debt service requirements) in the near term.
     

Contact
 
CohnReznick will continue to monitor the consequences of the Brexit referendum and provide updates as warranted.

For more information, contact Jeremy Swan, Principal, National Director – Private Equity and Venture Capital Industry Practice at 646-625-5716 or jeremy.swan@cohnreznick.com.

This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

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