Alternative Insight – December 2016

The Revolution of 2016: what have we learned?

2016 has seen a dizzying succession of electoral earthquakes which have made it the most revolutionary year since the fall of the Berlin Wall. To borrow Tony Blair’s words from October 2001: “The kaleidoscope has been shaken, the pieces are in flux.” Here are six lessons that asset managers and investors can take away from the year:

1. There are no certainties, only probabilities.

Since the end of the Second World War, Western liberalism has come to regard itself as the natural, perhaps even inevitable, end-point of political and economic progress. This consensus is now at clear risk of dissolving amid populist rage on both left and right. Voters frustrated by diminishing economic opportunities and/or unwelcome social transformation have seized their opportunity to deliver a sharp rebuke via the ballot box in Britain, Italy and America this year, and France, Germany and the Netherlands all have general elections scheduled for 2017 in which the same dynamic could play out.

Therefore, investors should no longer blithely assume that an advanced economy’s political stability or general free-market/free-trade framework are set in stone. Political risk analysis is going to have to be added to the investment evaluation toolkit.

2. Plan for contingencies.

Lack of certainty (or even of good information) is perhaps the most defining characteristic of the Brexit process so far. As at the end of the year, we have a rough idea of the timetable (with Article 50 set to be triggered in March 2017, kicking off the official two-year negotiation), but we still don’t know what the UK government’s objectives or priorities are. However, even in the ‘fog of war’, there is still value in making contingency plans and adapting them as new information emerges.

For instance, if managers rate EU passporting rights as essential, they should open a channel to financial regulators in alternative EU27 jurisdictions now, to narrow down the possibilities. It’s also worth getting in touch with local professional advisers to get a sense of the regulatory application process, the availability of premises, the logistics of relocating operational or management functions, or setting up regulated subsidiaries. It’s also worth liaising with other GPs, LPs and industry trade bodies in a joint effort to ensure that ministers and officials are apprised of their concerns and preferences.

3. There may be opportunity in turmoil.

In the run-up to and immediate aftermath of Brexit, a ‘wait and see’ attitude took hold, as PE funds pulled or postponed deals and fundraising. But the British economy remained resilient, and the steep fall in the value of sterling, although it will import inflation, has also made it cheaper for investors holding other hard currencies to invest in British companies.

Likewise, the private equity industry looks well placed to do well from some Trump policies. Although Trump famously criticised the carried interest tax rules during the campaign and played on voters’ general hostility toward the financial sector, he also promised a bonfire of financial regulation and a huge package of tax cuts. Since the election, Trump has tapped several Wall Street veterans, including Stephen Schwarzman of Blackstone and the distressed-investing titan Wilbur Ross, for senior positions in his nascent administration, strengthening the industry’s ability to defend its interests in the new order.

4. Regulatory stability is a thing of the past.

The years after the 2008 financial crisis saw a veritable mountain of new rules and regulations make their way onto the statute book. In America, at least, this process may well be about to shift into an unexpected reverse gear. Early indications are that we will see an aggressive push next year by Republicans at both ends of Pennsylvania Avenue to scythe down or chip away at much of the reform legislation, principally the Dodd-Frank Act, and including items such as the Volcker Rule, which obliges banks to divest themselves of private equity and hedge fund holdings.

The implications of extensive financial deregulation for long-term economic stability are worrying to many independent experts, given the costly catastrophe of 2008, but in the short to medium term loosening regulatory capital requirements and other controls placed on banks post-2008 will probably result in a sharp increase in the availability of credit, making it easier to finance deals. It also poses a competitive challenge for the many private debt funds that found their way into the lending business in the aftermath of the financial crisis, back when banks were having to retrench.

5. The battle for transparency still needs to be fought.

LPs on both sides of the Atlantic have long been pressuring GPs to improve disclosure and reporting practices, and subject themselves and their funds to more thoroughgoing oversight. In recent years they have been joined in this effort by regulators, especially America’s SEC, which had a strong 2016 pursuing PE firms that were found to have taken undisclosed fees, misallocated expenses or failed to disclose material conflicts to their LPs. Since the US elections, however, several key figures in the SEC enforcement effort have announced their departure. If regulators take their foot off the pedal, LPs are going to have to depend even more on coordinated trade groups like ILPA and its growing stable of best practice guidelines and reporting templates to hold GPs’ feet to prevent backsliding by GPs on the transparency front, especially in a red-hot market such as 2016’s in which managers were increasingly calling the shots on new fund terms.

6. Prioritise cybersecurity.

Finally, if you don’t already treat cybersecurity as a top priority, then you certainly should after 2016. The year’s news was repeatedly driven by extravagant hacks and tactical leaks of confidential information – from the ‘Panama Papers’, which caused a worldwide scandal and a renewed legislative push to improve corporate beneficial ownership disclosure, to the email logs of senior officials of the Democratic Party and the Clinton campaign, whose drip-feed disclosure could well have swung a tight presidential election in Trump’s favour. Nor is unauthorized disclosure the only problem – hacked information can be used to blackmail companies or gain an edge on competitors, for instance in auctions or negotiations. The fund industry hasn’t been a prominent target of hackers so far, but then nothing’s ever a problem until it suddenly is.

On which cheery note, may we take this opportunity to wish all readers a Merry Christmas and a Happy New Year!


 

Alternative Insight is produced by MJ Hudson’s private funds lawyers. We provide expert legal advice to fund managers, other financial sponsors, investors and advisers on the formation, structuring, investment into and regulation of private funds, managed accounts and similar vehicles. Our practice covers the full spectrum of alternative assets, including private equity, venture capital, hedge funds, private debt, real estate and infrastructure. Clients praise our entrepreneurial approach, commercial outlook and dedication to helping them achieve their objectives, regardless of the obstacles.