Deal or no deal, there's a lot more uncertainty to come
As the UK's withdrawal from the EU reaches its apparent "endgame", will Brexit finally test the extraordinary resilience of the M&A market in Western Europe?
The increasingly febrile atmosphere surrounding Brexit as it moves into its apparent "endgame" ought to be enough to unsettle even the steadiest of nerves.
The UK government is struggling to gain parliamentary support for a deal to proceed. This period of high uncertainty looks set to continue for weeks, if not months, with further turbulence promised if and when the next crucial stage of negotiations on trade begin.
M&A thrives in times of certainty that, at least, is the accepted wisdom. So it would be fair to assume that the transactions market, at least in the UK and the rest of Europe, and perhaps more widely, ought also to be suffering a period of intense jitters.
Yet, for now, there is scarce evidence of that happening, and little sign that, in the 18 months since the surprise referendum result that set the UK on its journey out of the EU, M&A activity has been dampened.
Admittedly we did see investment activity quieten down in the first few months after the highly divisive vote. It soon resumed, however, not least as some investors took advantage of a plunge in the value of the pound to hunt for cheaper UK assets.
However, it has not all been about opportunistic buying. There have been plenty of deals done for good, old-fashioned strategic reasons and at high prices look no further than the recent takeover of Sky by Comcast for proof.
The truth is dealmaking in Western Europe has been on the climb in 2018, and in the year to date actually stands 40% higher than at the same time last year, in value terms, although volumes of deals have declined by 14%.
Meanwhile the UK remains the second most-active market for inbound cross-border deals.
Also, in the first ten months of 2018 the UK was the third most-active outbound investor, after the U.S. and Japan. UK companies have particularly been targeting deals in Germany, although it is unclear to what extent such deals are being driven by Brexit. Our belief is that most are the result of more normal pressures on companies to reorganise their operations for greater efficiency and seek opportunities for growth in a low-growth environment.
Overall, however, the picture is clear. The resilience of the M&A market has been formidable to date.
The wider risk landscape
Part of the explanation for that could lie in the fact that investors are operating in the middle of a much wider, fast changing and increasingly complex risk landscape, where Brexit is just one of many risks. It is in this environment that investors are now having to assess and execute potential transactions.
In the last few years, three areas of risk have particularly come to the fore.
Political risk has been elevated at a time when disparate forces are at play from the unpredictable politics of the Trump White House through to the rise of populist movements across Europe. For now at least it seems that the political and policy landscape in many countries is becoming less stable and much harder to predict.
Then there is `change of law' risk. Brexit is a prime example, representing the biggest change of law to hit the UK and the rest of Europe in many decades. Rarely have M&A investors had to grapple with this issue in the recent past, although the allocation of risk arising from a change in law has been a common feature in many long-term project financing deals for some time.
Finally, there is the march towards greater protectionism, seen most acutely in the increasingly hostile trade war between the U.S. and China as the recalibration of economic power from West to East is fought out through tariffs.
The UK is also contemplating tougher restrictions on foreign direct investment; Germany is already imposing stricter controls, France is thinking of following suit and Chinese investors are increasingly worried about the controls being exerted by the Committee on Foreign Investment in the U.S. Throw in sanctions as well, and it is clear that protectionist risks and the impact of assertive economic foreign policies are rising rapidly.
We are seeing a growing number of transactions where these dynamics are affecting the structuring and execution of deals and it is clear that plotting M&A strategies and deciding which markets to prioritise are becoming more complex tasks.
"For now, there is little sign that, in the 18 months since the surprise referendum result, M&A activity has been dampened."
One very worrying aspect remains in all this many companies are being slow to tackle risks, and it's something we are seeing particularly in the context of Brexit. Issues such as regulatory equivalence, free trade arrangements and WTO rules have scarcely been on the radar of boardrooms before. Now they are right at the top of the risk agenda although many have yet to respond.
Some sectors are ahead of the game by force of circumstance: financial services, pharmaceuticals and aviation, for example. However, despite the obvious uncertainties around currency movements, stock market volatility, supply chains and regulation, many companies are leaving their planning to the last minute, waiting to see if the politicians can eventually provide some certainty around which to make important strategic decisions.
That's an issue that has been highlighted by some of the UK's leading industry organisations, one releasing a troubling survey in September suggesting that almost two-thirds of UK companies have yet to assess the risks of Brexit. More recently, the Bank of England Governor, Mark Carney, has warned that few UK companies are prepared for a no-deal scenario despite the growing likelihood this is where the UK may be on 29 March.
When they finally do they are quite likely to find the task all-consuming, as the big investment banks have done. If so, they are unlikely to have much spare management capacity to think about transactions and may even conclude that a period of increasing stress is hardly the time for heroic strategic moves on the M&A front.
"Many companies are being slow to tackle risks, and it's something we are seeing particularly in the context of Brexit."
More volatility likely
We are seeing these factors come to the fore as the UK government wrestles to get its withdrawal agreement through Parliament. We expect to see the currency and stock markets react quite violently as the time shrinks in which to get a deal in place for the 29 March 2019 exit deadline.
Will that provide openings for further opportunistic buying? Possibly, but it remains to be seen and could easily go the other way.
Recent market movements suggest that the prospect of a hard Brexit where the UK crashes out of the EU with no deal has not yet been fully priced in. The worry remains that a super-hard Brexit could quite quickly plunge the UK into a recession, one that might easily spill into other parts of Europe and, by extension, hit investor confidence more widely.
If the outcome is more positive and a deal is given the green light by the UK Parliament, that does not spell the end of the uncertainty.
Instead it marks the start of the next, vital stage of the Brexit process as the two sides move into a transition phase of at least 21 months, during which they try to agree the terms of a new trading arrangement between the UK and the EU27. That process is likely to be just as fraught.
Only at the end of that phase are we likely to see companies turn their attention to doing transactions that are directly and more strategically in response to the reality of Brexit. For most there will be no done deal until the shape of the new trading arrangement is finally known.
In the meantime, there are changes that buyers should consider now on transactions where the target has UK operations, including diligence on the target's Brexit contingency planning and Brexit-related warranty cover. Sellers, on the other hand, will be looking to avoid liability for the, as yet largely unknown, impact of Brexit.
It all adds up to a very volatile outlook.
While Brexit may not be the dynamic that brings this record-breaking period of M&A growth to an end, it looks certain to pose a big test for investors' nerves in the weeks and months ahead.