Podcast transcript: How the PE complex can navigate Brexit right now

28 min approx | 4 February 2021

Winna Brown

Today, I’m joined by Sally Jones, leader of our Trade Strategy practice in London. Sally’s primary focus is advising companies on the implications of Brexit and, specifically, how to operate in the post-Brexit world. Sally, I’m really excited to have you on the podcast. Thank you so much for joining.

Sally Jones

Thank you for having me.

Brown

Well, so before we dive into the discussion, I mean, Brexit has been a topic of much debate and speculation since June 2016, when the UK asked its electorate whether they should remain a member of the European Union. I know I’m not the only person to have been quite shocked by the result of that referendum, and in fact, I can very clearly remember exactly where I was when those results were announced. Since then, it’s been four long years of negotiation and lack of clarity, all culminating on 24 December 2020, Christmas Eve, when an agreement between Britain and the EU was finally reached. So Sally, are you able to maybe share with us what happened since Christmas Eve, and that historic moment when the Brexit agreement was finally secured?

Jones

So, the announcement was made on Christmas Eve, but we didn’t have any details. They let us have Christmas Day off and then published all 1,246 glorious pages on Boxing Day, i.e., 26 December 2020. 

Brown

How nice.

Jones

Oh yes! That was a deal that went live on New Year’s Eve, i.e., 31 December 2020, at 11:00 p.m. The deal has still not been ratified, but that’s not a huge concern as both sides are treating it basically as a formality. A bigger concern is the fact that businesses and governments have six days to absorb all the detail and some critical aspects, like, the final version of the UK’s border operating model, that was published four hours before the deal went live. That gave businesses no time to react.

Brown

Wow! Were the details anticipated? Did people know what was coming, or was it all just brand new?

Jones

Some details were anticipated. Some were brand new. So that made it really difficult for a business to decide how to proceed. I’ll give you a real-life example. Rules of origin — now, rules of origin are turgid, boring and complicated and it’s easiest for non-trade people to think of them, best as being anti-avoidance. So, imagine just for a moment, a scenario where I want to sell my products to you. You’re in the US and I’m in the UK and there’s, for the sake of argument, a 10% tariff. And I think to myself, that the UK’s got a trade deal with Canada that reduces tariffs to 0%. The US has got a trade deal with Canada that reduces tariffs to 0%. Why don’t I sell my products to a friend in Canada, who can then send them on to you with no tariffs? Bingo! Now, that’s not how life works. In that scenario, unless my friend in Canada has done something substantial to change the product, then the authorities in the US will look straight through my friend and just treat it exactly as if I’d transferred my products directly to you. 

Rules of origin tell us all, when something substantial has been done. But there are a dozen or so different measures of substance, and they vary from product to product, service to service, sector to sector and country to country. That’s the kind of detail that wasn’t published in advance. So, we knew that there were going to be rules of origin. We just didn’t know what any of them would look like, which made it incredibly difficult for companies to prepare because they just didn’t know which tests they were going to have to apply.

Brown

Got it. Ok and alright. So, if I just try and take that and think of it in terms of private equity and I think about the two sides of private equity, — you know, broadly you’ve got their investees and secondly, you’ve got the top of the house — the rules that you just described now feels to me like it would greatly impact investees, so the companies. So, when I think about a company’s private equity backed and try to deal with these trade-related topics and the new rules that were coming out, how did these companies actually react on 1 January? I mean, on 1 January, most of the world’s shut down, but yet there’s a whole different set of rules, a different playbook they have to play by. What did they do?

Jones

It varied honestly from sector to sector. So, perhaps, unsurprisingly, the people who had to deal with Brexit change, first, were the people who moved goods that can’t be stockpiled. So, that’s perishable goods like agri-food. I don’t know if you’ve seen in the press, the fisher fleets have had real trouble moving their fish from the UK to the EU and vice versa. You can’t stockpile fish; you have to place it on the market within six days of it being caught. Or it can be fast fashion. Some of our fashion stores have a six-week turn around on stock plans — the clothes that are in a store now are completely different from the clothes lines that were there six weeks ago. It can be things that are made bespoke like spectacles or contact lenses, or the kind of stuff that’s done specifically to a prescription. That can’t be stockpiled or can be repaired. So, if I break something like a piece of technological equipment, oftentimes it won’t be repaired in the UK. It will be repaired somewhere else. And that “somewhere else” would involve a border crossing, and that’s holding up things like repairs. Those goods flows were the ones that struggled straight off and in some ways, they were lucky because freight volumes were significantly down during the same period last year. And they, in fact, still haven’t recovered to the level we would expect, based on prior years. This is mostly because people have been stockpiling, which meant that the worst impacts of Brexit, the keys of truck queues, some of us were fearing didn’t come to pass. But though that lack of queues of trucks is not a good thing, it means that goods aren’t even getting to the borders in the first instance. And that’s a real problem for anyone who’s trying to get hold of anything that’s coming across a border. In some ways, and I’m being a little bit tongue in cheek here, but in a lot of ways, goods movements have got it good compared to services. And the reason I say that is that the impact for goods is more paperwork, more costs and potentially tariffs if you can’t get into the right rules of origin position. But, those things are just doing the kind of inverted commerce things with my fingers, which you can’t see because it’s a sound recording, but it’s just cost. And for sure, there’ll be some transactions which are no longer profitable. It might take place, but basically, trade can continue. Services, which have virtually nothing in the trade deal to help them, can face a situation where it becomes unlawful to trade. Not just more expensive, but actually unlawful. And because those aren’t getting delayed at the border, they’re just not happening at all, but they’re not really getting the same level of attention.

Brown

So, when you say services, you mean people kind of going over borders to deliver these services, or do you even mean virtually delivering?

Jones

Oh, it can be both. So, when you’re looking at services, you have to answer three questions. The first question is, can I still lawfully, under the domestic statute of the country I wish to provide my services in, provide those services? And sometimes, the answer is yes. So, for unregulated services, like training provision or a treatment, oftentimes is yes. But for regulated services, oftentimes, the answer is just a flat no. You may no longer lawfully provide your services in our country from the UK. So, that’s question number one. 

Question number two is, alright, I can provide my services lawfully. Can I physically get myself into that country to deliver my services? And that’s another two-part question. The first is do I need a visa to physically travel to that country. And the answer on visas is that basically, you’re allowed in for visits for 90 days out of any rolling 180-day period, but that visit includes holidays as well. So, that’s come as a nasty shock to companies. They didn’t realize that they were going to have to track how many days of holiday their staff is spending in Europe as well as how many days of business they were spending in Europe. But then again, the ancillary question to that one is, do I need a work permit to do the business I want to do in Europe? And oftentimes, the answer is yes. The definition of work activities that can be performed without a work permit is pretty scant. They are basically ancillary activities, like training courses or attending a conference, not your day-to-day job. Many people are now finding that in a COVID-19 world, post-COVID-19 world, I should say, they may well not be able to physically go to the country they want to go to without a visa, without a work permit and those things are expensive and difficult to obtain. 

The third question you have to ask them is, having worked out that I can provide my services, but I can’t deliver them in person, can I deliver them remotely, as you say? And that is also sadly not a straightforward answer because that involves data flowing from the EU and the UK, and we don’t yet have certainty that that data can continue to flow in four months’ time. The commission needs to grant the UK an adequacy decision in order for that to happen. It hasn’t yet done so. When I’m feeling optimistic, I hope that it will, but certain things on the UK statute books make that difficult. It is possible that just as the US doesn’t have an adequacy decision, neither too with the UK, it puts the companies into a whole new world of pain.

Brown

Wow! Ok, that is a lot to unpack. 

Jones

Isn’t it?

Brown

And I guess just a couple of thoughts, I mean, there are many thoughts that are coming to mind, but I guess I’m thinking how are firms dealing with this? I mean, there’s been, up to now, you know, people moving freely between the UK and Europe for the longest time working on projects or business and I think about private equity that are very focused on value creation and moving their people to different locations where their investees are headquartered. So, we’re saying they won’t be able to do that, and they can’t work remotely; so, what does that mean? Do you have to engage in-country only?

Jones

Potentially, yes. I think we’ll see a lot more of that in-country engagement going forward. There are provisions that allow intercompany transfers for a period of up to three years, but no longer than three years, and again, the definition of intercompany transfer is pretty narrow. It’s wholly impossible to imagine just how different the world is going to look like once COVID-19 restrictions have been lifted and we are into this world where the end of free movement of people will fundamentally change the way Europeans and British nationals do business together. 

Brown

Wow! So, do you think that the difference then could manifest itself or one of the solutions, I should say, would be where maybe the UK headquartered companies, or private equity companies, would set up a European operation and then have its people flow freely among European countries and just really kind of almost have a physical separation between both sides of their businesses?

Jones

Yes, we are seeing that kind of physical separation is starting to be discussed in earnest among a number of different companies now. So, that kind of people movement point is one that we’re seeing coming up. We also see pressure for that physical separation to take place because of regulatory reasons. So, to give you a real-life example, one of my clients makes electrical equipment. They are in people’s homes and they have gone to an awful lot of time and trouble to prepare their business for Brexit in terms of customs procedures and supply chain, but the thing that they’d not taken into account is that if you make electrical equipment in people’s homes, there are very strict EU directives that basically say, and I am paraphrasing a bit here, but what they basically say is don’t burn down people’s homes, don’t electrocute people and if you do either of those two things then we want an entity with proper substance in the EU that we can punish for your negligence. And for my particular client, when they looked through the rules, they realized that although they had some EU subsidiaries, none of them had enough substance to meet the requirements of those EU directives. So with a handful of months to go, they had to suddenly decide where within the EU they were going to put more substance because, without that regulatory commission, they couldn’t lawfully sell their products into the EU anymore; where they were going to put that substance, what substance they were going to put in, which regulator they were going to approach to check that they were doing sufficient; which people they were going to move into Europe or recruit into alternative positions; how they were going to update their IT systems; how they were going to inform their customers of the changes; how it was going to impact on their transfer pricing because, all of a sudden, you’ve now got a lot more tax activity taking place in Europe than had been before; and get it all signed off and do all of that by 31 December. It was an absolute uphill scramble to get that done. And so, that’s a real-life example, quite separate from people movements, but where the business model required fundamental change just to keep trading.

Brown

Wow! Ok, and how many companies in your experience – because obviously, you’ve been dealing with a lot of companies – how many companies have actually woken up to fundamental changes that they’re going to have to implement in order to continue to do business?

Jones

It’s a mixed bag, I think. So British businesses, unsurprisingly, were quite aware for quite a long time that change was coming. Admittedly, they didn’t know exactly what change was coming, but quite a lot of them took the approach of planning for the worst even though they hoped for the best. European businesses, I think, were probably a little bit less prepared, and that wasn’t insensible of them because, oftentimes, the approach that they took was that the UK was a relatively small part of their overall European sales, and they would wait to see what happened before they made expensive decisions — a similar approach actually from US businesses. But the end result of that wait and see position is that some people got lucky. Their facts and circumstances meant that they could continue to trade in a relatively undisrupted way, but the ones that do have disruption, I think, it has come to their attention pretty strongly now, whether it’s not really being able to access 0 tariffs or having delays in their supply chain when they just can’t get stuff across the border or a realization that actually they’re not going to be able to trade lawfully in the way that they’d wanted to, but in the past with people moving between countries freely. Those are the kind of things where people have started to really wake up now.

Brown

And I can see and paint the picture of how this is impacting or starting to impact all of the different, you know, companies in different sectors, especially those as you said, who have goods that they are trying to transfer or, to your point about the electrical example, if we kind of shift that and think about private equity and we think about the top of the house, you know, so financial services. How are we finding the rules impacting the financial services sector? I mean, my understanding at the moment is that there’s still a lack of clarity around the rules that will govern that sector.

Jones

Yes, that’s right. So, we’ve got in the trade deal. It is a commitment by both sides to set out a framework for future cooperation. That framework is to be set out by March 2021. That will include the equivalence decisions, which the EU has yet to make. So, to recap, the EU had made temporary equivalents decisions in respect of clearing and central securities depositories, recognizing the importance of the existing UK infrastructure for EU markets and hence financial stability risk. But it hadn’t otherwise made any other equivalence decisions or taken any steps to smoothen the transition for financial services. And, of course, not all financial services are covered by equivalence in any case. So, the honest answer for financial services is that it was quite the cliff edge because of the intensely regulated nature of the sector most businesses had already planned for no-deal anyhow, and we’ve seen moves of private equity in banks and insurers out of the UK to European markets precisely for that reason. So, we haven’t seen the same level of disruption in financial services as elsewhere because they’d already bitten the bullet and got themselves ready.

Brown

But the sheer fact, I guess, of moving and having a presence in the EU has given them leeway while this, the rules are being clarified?

Jones

Correct

Brown

So, they can keep operating undisrupted.

Jones

Correct. Absolutely.

Brown

Ok and then if we think about deal electivity and M&A activity, if I think about it going forward and if you have any a UK-only deal, it was previously, I guess, referred to the European Commission for approvals. Now, I guess, the approvals are going to be sought with the Competition and Markets Authority in the UK. What do you think the UK agency will have as a policy? Do you think they’re going to adopt a more protectionist stance, or are they going to be focused on attracting more foreign investment into the UK? Because it sounds like right now, the UK is in a bit of trouble in the sense that a lot of people are leaving the UK.

Jones

Well, it’s interesting you say that very timely question because yesterday UNCTAD published its global investment trade monitor and it showed a massive fall in foreign direct investments in the UK for 2020 compared to 2019. When I say massive, I mean it fell to zero. It fell off a cliff. 

Brown

Wow!

Jones

The investment into the UK from foreign investors just tanked. So, based on that, I think that on the whole, the UK is going to want to adopt measures that attract FDI; I think it has to. But equally, there are a handful of places where policies may not be as leaning towards attractiveness as opposed to protectionism as you might think. So, a couple of points — first is there’s been some speculation over the British Corporation Tax rate. We are currently 19%. It may go up basically to help fill the holes in the coffers caused by COVID-19. And the other thing just to flag is the National Security and Investment Bill. This legislation could give retrospective powers to the Government in respect of takeovers, which subsequently turn out not to be in the national interests for a whole raft of different reasons. That’s attracted a certain amount of concern among investors who fear that they will either divest something that turns out that they shouldn’t have divested in that way or that they’ll buy something that they shouldn’t have bought in that way and that that retrospective nature may come back to bite them. We’re seeing some fairly intense lobbying efforts in some courses of business, pointing out just how damaging that could be for UK attractiveness. 

Brown

So, just to understand that fully, you’re saying a deal that was potentially previously approved by the European Commission is now subject to retrospective unraveling by the UK Competition and Markets Authority? Is that what you’re saying?

Jones

Sorry no, Winna. I’ve been really misleading you there. What I’m saying is that there will be a five-year lookback period but only with respect to deals that are taking place from now onwards. 

Brown

Got it.

Jones

So, you could sell a business now and find, in five years, up to five years’ time, that there was an issue. But no, if it were five years ago from now, you’d be fine.

Brown

Ok, got it. But still, that, to your point, causes a great deal of uncertainty because you can enter into a transaction today, not knowing if, in four years’ time, someone will rule against the transaction and unravel it.

Jones

Yes, that’s exactly the point.

Brown

Wow! Ok. That is pretty significant. 

Jones

It is.

Brown

When is there going to be clarity around these rules?

Jones

So, the draft legislation has been published. It’s currently going through the UK parliamentary process. 

Brown

Which could take a while.

Jones

Could take a while.

Brown

And in the meantime, I’m sure that companies and investors are making alternative arrangements. They are looking for different countries in which they can transact and find the next deal.

Jones

Yes. I think that’s probably right. And whether investors continue to see UK assets as being a good investment is going to depend entirely on whether they’re seen as valued as attractive. Many of the aspects made the UK attractive before remaining in place. Of course, we still have a solid legal regime, stability, a very low corruption index, you know, an educated workforce, etc. All of those things are still in place, and I think part of that is reflected by the fact that the sterling has pretty much held steady against both the dollar and indeed strengthened slightly against the euro since the start of the year. But, the effect of Brexit on the economy is expected to emerge much more slowly, but to be permanent. So, the UK’s economy’s estimation will be 5% smaller over the next 15 years than it would have been without Brexit. That’s two times bigger than the overall impact of COVID-19. 

Brown

That is very significant. And then, thinking about that and taking, you know, thinking about the UK economy and the attractiveness, and the very important aspect of the PE life cycle is exit strategies. I’ve noticed there’s been a few announcements of late, where prominent UK-based private equity-backed companies are actually seeking to list in the US. Now do you think this is a coincidence? Or do you think perhaps Brexit has had an impact on the attractiveness of the London stock exchange?

Jones

Well, I would have said coincidence until a recent German report I was reading that said that the US has now become the most attractive G7 location. It was the UK — the UK is still second — but maybe that’s playing into it a little bit. We’ve got reasonably small numbers of course. So it’s hard to say whether it is just outliers or an emerging trend, because the listing regime itself shouldn’t be impacted by Brexit. But whether Brexit has made the overall attractiveness of the UK fall, is a different matter altogether, I guess. I think that’s one that we’ll just have to keep an eye on.

Brown

That’s interesting. When you look into your crystal ball, how are you seeing the next couple of years unfolding for the UK?

Jones

I think we’re going to see a period of disruption that will come in waves between now and Easter 2021. So, we’ve spoken about the issues with goods that are being picked up now. I do think regulatory is going to come to the forefront, people mobility will come to the forefront a bit later, when COVID-19 travel restrictions will ease a little, and we’ve got this data point still to worry about. But I do think that by Easter, or maybe in April or May, we’ll know the lay of the land because the immediate disruption will have settled. Then I think the question will become — is the shape of my UK business right for the brave new world or not? And for some businesses, the answer will be actually yes! That we’ve done a lot better than we thought we would’ve, particularly relative to our competitors. For other businesses, it will be no — we need to take steps now to either move activities out of the UK and into Europe or the other way around; or out of Europe altogether, depending on what’s going on; or look at new markets; or look at new ways of trading. And I think that will be the way that the next 12 months after that will play out. It will be looking at right-sizing, resizing and reshaping the UK-based activities that every business is undertaking.

Brown

So let me ask you this. If I think about a private equity firm and I think about the top of the house, and I think about the companies that it invests in, what advice would you give, you know, to those at the head of the PE complex, as they think about investing and creating value at their portfolio companies. What advice would you give to help them navigate through the post-Brexit era and of course, the inevitable question will be — what will you give? What advice would you give to those companies, that are trying to operate, expand and grow?

Jones

So, for the top of the house, I think the time has come to pay more attention than you otherwise would do, to how your portfolio companies are trading. The risk is that value could erode pretty quickly without you really noticing, if you haven’t got your eye on the ball. And again, a number of companies that we speak to in this space are taking a much more active stance with their investees right now, than they normally would do. And the investing companies get that. They understand why it’s happening and they’re very open in many cases. For the investee companies themselves, we’ve got five pieces of advice that will actually apply to any change situation, and to Brexit in particular. The first is, make sure you’ve got a response team in place with senior people on it, who you can contact if you need to during the night or weekends, especially if something’s gone a bit rough. And make sure they are senior enough and that they can make decisions without having to refer. That’s point number one. Point number two is to keep communicating. You can’t over-communicate with your customers, your suppliers and your workforce right now. If you’re going to have a delay, speak to your customer as soon as possible, so that they understand and can take their own steps. Keep talking to your suppliers because they may have alternatives that they wouldn’t think to raise with you, unless you’ve got open communication lines. You cannot over-communicate in times of change. The third is the point around data. If you’ve got data flowing from the EU to the UK, do keep an eye on whether there’s going to be a need for some pretty rapid changes to your contract terms or your internal governance, to stay on top of how to legally let your data flow. Not just because the sizes of the fines are enormous, if you get it wrong. So, it might not be top of your likelihood list, but it would be pretty impactful if it were to happen to you. The fourth is your cost base. Your cost base is going to change. It’s going to go up and you have to decide what you’re going to do about that. And your choices are basically absorbing it yourself and accepting the fact that margins will be eroded, pass it on to your customers or push it back on your suppliers. And those are really your only three choices. Which of those is right for you will depend on your product and how elastic its price is, what your competitors are doing and how thin your margins are already. But being on top of your cost base so you can turn off unprofitable trades, is going to be really important. And then the fifth and the final point is to make sure you understand the new regulation — whether it’s new labeling, new disclosures, new authorizations, new licenses, or a new subsidiary you need to put into Europe. The faster you get on top of that, the quicker you’ll be able to resume normal trade.

Brown

Sally, thanks so much for your time today and for the really great insights and words of advice. Even though there’s an agreement in place, it sounds like there’s much to learn, more details, and practicalities to work out, as the world gets used to life after Brexit. A clear message here is that private equity complexes who get ahead of navigating the changes we just discussed, will likely be more successful in the long run.