Direct Lending Funds and Brexit

What will Brexit mean for UK-focused direct lending funds?

Originally published in the July | August 2016 issue

Following last month’s vote by the United Kingdom to leave the European Union, many investors will be wondering what sort of impact they can expect on their UK investments, and in particular they will be evaluating whether they should even continue to hold sterling-denominated assets. The outcome of the vote has been a shock to many, but this article will outline the fundamentals that continue to underpin the UK’s economic story post-Brexit (should it even occur) and in addition, the likely impact on UK-focused hedge fund strategies. As a specialist loan-based fund manager with almost 100% UK exposure, we feel we are well-placed to comment on the prospects for the UK in the coming years.

Why did the UK vote to leave?
Many investors and fund managers were shocked when they woke up to find the UK had voted to leave. Key among those reasons cited were a lack of control of the UK’s political processes, sovereignty, immigration (causing wage suppression), which has seen uncontrolled migration into the UK from elsewhere in the EU.

There is also an awareness of the increasing volume of legislation being imposed on the UK via Brussels, and a perceived lack of transparency, governance and accountability within the various EU institutions. Small businesses in the UK – a sector in which we specialise – are facing a burdensome level of bureaucracy, whether or not they actually export to the EU. Indeed, just approximately 6% of UK companies export beyond the UK.

What happens next?
Clearly little will change for up to two years, while the UK government negotiates its new relationship and level of exit. The rights and obligations of EU laws within the UK will remain until negotiations and agreements are finalised.

The UK would like the ability to trade with Europe without the excessive political interference from the EU on day-to-day issues. Much of the Brexit debate revolved around the degree of political control and external influence, rules and laws that now exist, rather than just trade.

The British Isles were able to operate successfully prior to joining the Common Market in 1973, and the UK has the capacity to operate and to survive outside the EU, just as Norway and Switzerland have done for many years. The UK has never adopted the Euro nor has it joined the Schengen Zone. It remains the largest trading partner for India in Europe, while at the same time the EU has yet to achieve a free trade agreement with either the USA or China. Germany continues to have a large trade surplus with the UK:  it is by far Germany’s most profitable export market, with a $56 billion trade surplus for Germany in 2015, 42% higher than Germany’s trade surplus with France. Indeed, Germany’s exports to the UK last year were 20% higher than its exports to China. The EU represents just 44% of UK exports and that number has been falling for many years.

Many commentators believe that some level of trade agreement will be thrashed out, perhaps based on the European Economic Area (EEA) rules, either through the European Union or the European Free Trade Association (EFTA). EFTA membership, or an association agreement directly with the EEA, has been discussed already with regard to Andorra, San Marino, Israel, Morocco, Turkey, the Faroe Islands and the Isle of Man. Both Norway and Switzerland have traded with the EU for many decades on a similar basis.

Having said all this, the process of leaving the EU may take many years, or indeed, the UK may not leave at all. It is also possible that it can negotiate some form of hybrid status, given its overall importance to the EU. We must not ignore the importance of the UK to the EU, including as a source of trade and tourism, and also its active role in the EU’s security (the UK is the second largest NATO contributor) and military objectives (e.g. playing an important role in underwriting the security of EU members in Eastern Europe and the Baltic states).

Financial markets, following some short term volatility, seem to be taking a more sanguine view of Brexit. The Pound (GBP) has fallen significantly and many world markets have tried to price in a level of uncertainty. As in 1992, when the GBP was forced out of the Exchange Rate Mechanism (ERM), it is likely that over time the pound will recover some of its losses, while in the meantime making it more attractive for British goods and services to be exported. It should be noted that the UK already has a significant trade surplus with the US.

Clearly, a falling pound will increase inflation for imported goods and services, which in turn could lead to wage rises, higher consumption and higher interest rates. A weaker pound may also make some UK-based agricultural exports more attractive for the first time in a generation. Foreign investors now view the GBP as better value – and an attractive place for yield – given that approximately a third of the global economy remains in negative interest rates.

A weaker currency also has the potential to re-ignite M&A activity in the UK and to encourage more inward foreign investment. Some large deals already concluded post-vote include the £921 million paid by US-based AMC Theatres for the UK’s Odeon and UCI cinema chain and South Africa’s Steinhoff bought Poundland for £450 million. At the time of writing, Japan’s Softbank had just announced its intention to purchase the UK’s ARM Holdings for approximately £24 billion, in what would be the largest acquisition of a European technology business. ARM is a good example of a UK company with a global leadership role and primary earnings in US dollars.

From a purely practical perspective, funds focused on UK assets should have hedged their currency share classes, thereby mitigating any short term impact of the pound as a base currency.

How will this affect direct lending funds?
Direct Lending Funds have been playing an increasingly important role within the hedge funds universe in recent years, particularly as they have taken up much of the slack from commercial banks in the wake of the financial crisis of 2008. This has led to a situation where many small enterprises in key areas like agriculture and energy in the UK are having difficulties in obtaining finance.

The Brexit vote may cause the flow of capital around the EU – and the UK – to slow, and this may mean that access to credit for small businesses in the UK (and elsewhere) may be even further constrained. Lending volumes to small businesses in the UK has never recovered from 2008. For direct lending funds, the Brexit vote holds out the prospect of greater opportunities, commanding higher rates of interest and with the commensurate demand for greater levels of security and pledges.

Prestige manages several loan strategies that provide credit to small businesses, particularly those involved in the farming, food and agricultural related industries or those that support farmers. Most of those firms which borrow from us have little to no exposure outside the UK. This sector has already proved how robust it is following the 2008 financial crisis: farmers and food businesses that are associated in some way with the creation and supply of food-related output will continue to service their loans and will continue to buy and sell their products.

In our view, farming and food production across Europe remains a deeply inefficient, largely unmodernised, unproductive, wasteful set of industries. Approximately a third to half of the EU budget goes to farmers, with the UK being the third largest contributor (and was expected to soon be the second). The EU’s focus remains firmly on ‘food security’ rather than efficiency and productivity. Hence, up to one third of all food produced daily is wasted.

Brexit has the potential to provide additional impetus to the activities of direct lending funds in the UK, which continue to replace banks as a source of financing in non-traditional areas for smaller firms, not only in farming but across numerous critical sectors (e.g. alternative energy). Banks continue to close down branches and restrict their commercial lending operations, leaving asset managers to play the important role of providing credit for business growth and modernisation in the UK.

The UK government, for example, will still have to seek to replace the UK’s ageing power generating capacity, regardless of the outcome of Brexit talks. It has committed to producing 15% of its energy from renewable sources by 2020. While this was part of an EU agreement, we don’t expect the UK to deviate from this, particularly due to domestic political pressure. Problems with flagship energy deals like the Hinkley Point nuclear plant also mean that more emphasis will be placed on small to mid-sized green energy projects. Like the modernisation required in the UK’s farming sector, such projects will have to draw on a shrinking pool of available credit to succeed, but on the upside have the support of the government – e.g. in terms of assistance in the form of tax breaks, subsidies and guaranteed prices for larger projects feeding into the national grid.

We anticipate that Brexit will lead to even less lending by the traditional banking sector, as well as higher rates for businesses. It could create a more competitive environment for credit, which in turn translates into more security and transparency for the lenders themselves. It will also allow lending strategies to exercise more control or influence over debentures and/or bank accounts, thereby reducing credit risks in already diversified portfolios of loans.

At the same time, with a European and British banking sector already on the ropes (the share price of Royal Bank of Scotland has declined from £360 to £148 in the space of just a year), the deal flow for direct lending funds is only likely to increase, allowing for both more capacity for investors, and a higher level of overall loan quality for fund portfolios.

The fear factor
Commentators in the UK fear that Brexit will discourage investors from overseas allocating to the UK, yet many of the aspects of the UK that encouraged foreign investors in the first place remain in situ. Many of the loans in our portfolios are secured against British farmland, which has seen steady annualised growth of 14% since 2002, according to Savills.

The recent 2% downturn in UK farmland prices looks muted, and if the GBP continues to trade at current levels into the end of the year, there will be a significant increase in UK farm subsidies in 2017. The weaker pound is also likely to stimulate overseas interest in UK real estate and increase consumption of locally produced goods and services.

While the terms of any eventual UK exit from the EU have yet to be negotiated, our analysis suggests the UK is in a stronger position than many media pundits have grasped. Prestige and it’s Direct Lending businesses have conducted over 15,000 loans to 7,000 small businesses since 2001 and therefore we believe it has a strong sense of what’s actually happening on the ground.

We must also not underestimate the amount of time leaving theEU will take. During this period, investors will still be seeking uncorrelated investments, possibly investments that are more insulated from the economic risks of the Eurozone, and which will be available at cheaper levels than they have been for decades.