Private equity investing in EU just got a lot harder

The impact of the referendum approving a U.K. exit from the European Union and the economic uncertainty that came with it is expected to make it even harder for private equity managers to invest the more than $186 billion in dry powder in their coffers.

nLending hasn't stopped, but financing private equity transactions even outside the U.K. has gotten more expensive due to the uncertainty the vote caused.

nTransaction volume in the U.K and Europe is expected to slow as private equity managers wait for more clarity.

nExisting EU-exposed funds might have to change their investment criteria should the U.K. end up leaving the EU.

nSome private equity firms are reconsidering possible expansions into Europe, while others are deciding whether to move their London offices to Ireland or Belgium.

One immediate impact of Brexit will be the hesitancy of U.S. investors to invest in funds with an EU focus, said Eric Zoller, co-founder and partner at Sixpoint Partners LLC, a New York investment bank working with middle-market private equity firms.

So far, this year 19 funds have raised a total of $13.1 billion for private equity strategies with U.K. exposure, compared to a combined $13.5 billion raised by 30 funds in all of 2015, according to London-based alternative investment research firm Preqin. By comparison, 89 Europe-focused funds raised a total of $64 billion so far this year as of July 5, compared to $71.7 billion raised by 172 Europe-focused funds in all of 2015.

Investors will want to know what percentage exposure private equity funds will have to U.K. companies vs. continental Europe, Mr. Zoller said.

Institutional investors are still assessing the situation.

“The New York State Common Retirement Fund is a long-term investor and is in the midst of evaluating Brexit's impact,” said Matthew Sweeney, assistant communications director for office of New York state Comptroller Thomas P. DiNapoli. “It would be premature to comment.”

The $178.1 billion New York fund has a 7.8% private equity allocation. The fund did not have data immediately available on its European exposure in the asset class, but in June officials committed $256.5 million to Cinven VI, a European buyout fund. London-basedCinven closed its sixth fund at its hard cap of e7 billion ($7.7 billion) on June 29, six days after the Brexit vote. Cinven officials declined to comment, said Julie Oakes, spokeswoman.

For their part, general partners are endeavoring to spend capital commitments in a region rife with uncertainty. And there's a lot of it. The three European buyout firms with the most dry powder have a total of $31.4 billion to spend. Cinven, with $8.7 billion in unspent capital commitments, is ranked third by Preqin on a list of European private equity firms with the most dry powder. Luxembourg-based CVC Capital Partners is in the top spot with $13.3 billion and Swedish private equity firm EQT Partnersis second with $9.4 billion.

Private equity funds with investment criteria that includes making commitments in the European Union will have to change that to include the separate U.K regime or remove the U.K. from the fund's investment focus, said Teri McMahon, partner and head of the private equity team at law firm Alston & Bird LLP. What's more, if a portfolio company is directly affected by Brexit — such as a company based in London that had regulatory authority to do business throughout the EU — the private equity firm most likely would wait to sell, she said.

“Unless there is a compelling reason to sell, perhaps due to the underlying fund nearing the point where it must liquidate its investments and close, most funds will likely wait before putting the portfolio company up for sale until the implications of Brexit are clearer,” Ms. McMahon said.

Mr. Zoller said private equity firms might slow investment throughout Europe as they try to determine which countries will be hit most by Brexit.

Companies across the EU currently face no tariffs nor duties for goods shipped from the U.K to the rest of the EU. Should the U.K. end up leaving the EU, businesses could thrive or fail depending on the new trade agreements between the U.K. and the reconfigured EU. For example, the U.K. is currently the biggest importer of cars from Germany, bringing in 809,853 passenger cars out of the total 2.8 billion cars exported to Europe, according to the Berlin-based automobile association VDA.

Any slower pace will have an impact on investors' portfolios. If the pace of private equity investment slows, then distribution of profits back to investors will be sluggish, which, in turn, could cut down on the capital investors have to commit to new funds, Mr. Zoller said.

Already, debt for private equity deals has become more expensive, even for deals in the U.S. and elsewhere outside the European Union, said Richard Grice, Atlanta-based partner in Alston & Bird's finance practice. While lending for private equity transactions has not disappeared, spreads are widening, he said.

Debt investors are “a tad nervous about the impact of Brexit on macroeconomic conditions,” he said. “Brexit is a common driver of market turbulence.”

Even so, in a late June report on global macro trends, Henry H. McVey, KKR & Co.'s head of global macro and asset allocation, saw investment opportunity in Europe as a result of the Brexit vote even while indicating economic growth in all of Europe is likely to slow this year, in part due to the Brexit referendum.

“We see the U.K.'s recent decision to exit the European Union as a significant and durable challenge to democracies around the world, but not something that will ultimately prevent investors from deploying capital in the region over time,” Mr. McVey wrote. “In fact, we are likely to see some interesting opportunities amidst the dislocation and reorganizations that are bound to occur as many corporations, multinationals in particular, adapt to the new environment.”

KKR already has forged ahead. On July 6, KKR invested $65 million as the lead investor taking a minority stake in cybersecurity company Darktrace. The firm has joint headquarters in Cambridge, England, and San Francisco and in a news release, KKR noted the company's global customer base. The investment was KKR's first U.K. investment since the Brexit vote. Other investors in the consortium included growth equity firm Summit Partners and venture capital firm TenEleven Ventures.

The firm closed its latest European private equity fund, the $3.5 billion KKR European Fund IV, in December 2014, according to a recent SEC filing. The fund has about $3 billion in uncalled commitments and its investment period extends until December 2020.

There are a few different scenarios regarding Brexit that could affect private equity, Sixpoints' Mr. Zoller said. If the U.K. takes steps to leave the EU immediately, that move could freeze the markets further, he said. However, if after the upcoming October election, the U.K.'s new prime minister does not file to leave the EU right away, there most likely will be a period in which nothing gets worse, but nothing gets better either, he said.

That uncertainty might make it difficult for private equity managers that want to attract European investors into their funds for the first time, Mr. Zoller said.

Managers without existing European limited partners could run into trouble under the EU's the Alternative Investment Fund Managers Directive, which requires non-European alternative investment managers to comply with certain rules before they can market to Europe-based investors. The U.K. had been a popular place to file under the AIFMD in order to get access to asset owners throughout the EU, he said. n