Private equity’s role in Europe’s brightening economic outlook
September 2014 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
The collapse of Lehman Brothers in 2008 and the ensuing chaos in capital markets shook the world of financial services to its very core. Needless to say, picking up the pieces after the event was never going to be an easy process, and so it has proved. For the UK the toll has been severe. According to the National Institute of Economic and Social Research it has taken until spring this year for our domestic economy to finally claw back all the output lost following the onset of the crisis.
Nevertheless, six years on and the macroeconomic outlook looks reasonably bright. The independent Office for Budget Responsibility believes that growth in 2014 will hit 2.7 percent, before slowing slightly to 2.4 percent next year. Public Sector Net Borrowing is also set to be £3.4bn lower this year than forecast back in December 2013, and £7bn lower than in 201213. Undoubtedly these numbers are encouraging but we must remain vigilant of structural economic trends in Europe and the potential threats they may pose in the future.
One such issue that is worthy of further examination is the continued pre-eminence of bank finance in European economies. The problems surrounding the concept of ‘too-big-to-fail’ are well known, but even when a bank does not find itself in existential difficulty there is always a risk that in the face of market turbulence, lenders may pare back their corporate finance activity in a bid to strengthen their general capital position. Here, rational market behaviour invariably compounds rather than compensates broader economic problems and a ‘credit crunch’ is often the result.
In the EU the present state of the market appears conducive to such a scenario emerging again in the not-too-distant future. This stands in contrast to the situation across the Atlantic. In 2012 US bank intermediation accounted for only one-third (31 percent) of the debt of private non-financial agents (households, the self-employed and non-financial companies), which is less than half the figure for the eurozone (76 percent).
When the going gets tough, US businesses have far greater recourse to market finance in the form of deep capital markets, novel funding institutions such as Business Development Companies and private equity (PE) and venture capital (VC).
Back in Europe, the European Central Bank this year will shine a light on the strength of the region’s banking industry via its ‘Asset Quality Review’. The findings must be suitably robust if the institution is to avoid the widespread derision the European Banking Authority suffered after its stress tests of 2012, in which fundamental weaknesses in certain continental lenders were missed.
If any skeletons are found in Europe’s banking closet (recent turmoil in Portugal and Bulgaria illustrates that such a notion is hardly fanciful) the effect could be chilling on the availability of debt finance across the EU, as banks look to get their own houses in order first and foremost rather than serving the needs of business. Europe must therefore seek to encourage the use of greater forms of market finance by the corporate sector; a diverse financial landscape akin to that which exists in the US would help ensure the funding taps don’t run dry the moment banks begin to wobble.
In fairness, a recent survey by Grant Thornton showed that 79 percent of UK mid-market firms would indeed consider raising finance from non-bank lenders. This behaviour, however, must become more entrenched; sunlight finance rather than shadow banking providing capital to businesses in all seasons. This is the foundation upon which robust macroeconomic growth in the future must be built.
PE and VC can and should play a major part in this process, as the benefits of this active form of company ownership are clear. For example, the British Private Equity & Venture Capital Association’s most recent annual survey of investee companies (conducted by EY) shows that in 2012, under PE ownership, the sample of businesses reviewed (comprising 66 of the largest PE-backed portfolio companies that met defined criteria at the time of acquisition) enjoyed a 29 percent increase in investment, 6.8 percent revenue growth and 2.4 percent productivity growth. All while growing employment by 2 percent.
The challenge is to ensure that legislation coming into force off the back of the financial crisis can catalyse rather than constrict non-bank credit intermediation. Of course, one should emphasise that some of the practices that had become the norm in parts of the financial sector prior to the crash have no place in a well-functioning economy, and warranted urgent attention. This does not, however, detract from the need to create proportionate rules that are based on sound, methodical analysis rather than knee-jerk assessment.
Unfortunately there are a number of cases where such an approach does not appear to have been in evidence. One such example is the Alternative Investment Fund Managers Directive (AIFMD) – the legislation that has regulated PE and VC at EU level since last year – which mandates that all within-scope AIFs must use a depositary to verify ownership of assets. This is a sensible requirement for financial players that trade instruments on a daily basis, but as PE deals with real assets – companies – for the long term, this recital appears unwarranted.
It is often incredibly difficult to convince legislators of the merits of such design, however, as there is invariably an electoral incentive to be had by taking a hard-line on the financial sector. Ultimately it is the small and medium sized business community (to which 90 percent of UK PE and VC investments go) that suffers, as an ever-increasing and often needless burden of compliance inevitably subtracts from the capital that would otherwise be available for investment.
The same can be said for regulation affecting the institutional investors allocating to PE and VC. Whether it is via Solvency II for insurers or CRD IV for banks, if these players are hamstrung with uneconomical capital charges should they decide to invest in equity, they may simply look elsewhere. Again, this would be very damaging at the micro level in the here and now, but also from a macro-prudential perspective moving forward.
Six years after Lehman and the world of finance is getting back on its feet, but risks remain. First, banks cannot and must not remain ‘too-big-to-fail’ but should also not be expected to shoulder the responsibility of supporting entire economies single-handedly; this is not sustainable. PE, VC and other forms of closed-ended funds stand ready to plug this financing gap. They do not pose the same run-risks that can manifest themselves in banking but remain in a position to not only provide much needed capital, but crucial business nous that can help firms expand and grow.
Finally, a poll conducted in 2010 showed 90 percent of PE-backed firms said their parent investment was beneficial to their business, while 85 percent said they would recommend PE to other business leaders. This is a story that should be heard time and again across the UK and EU, but in order to be so it remains of paramount importance that legislators take a balanced, sensible approach to the development of regulation, so that businesses can begin to look beyond the banks for capital. The effect of such a change could be profound for the vitality of the British and European economy in years to come.
Simon Burns is the Public Affairs Manager of the British Private Equity & Venture Capital Association (BVCA). He can be contacted on +44 (0)20 7492 0400 or by email: firstname.lastname@example.org.
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British Private Equity & Venture Capital Association (BVCA)