Debevoise on Brexit: The “No-deal Deal”

It has become common in Britain to argue about whether those who forcefully suggested that a vote to leave the EU would have a very negative effect on the UK economy were wide of the mark.  This argument may be rather pointless and, since the UK has not actually left yet, somewhat premature.  It is also an argument that will be very hard to settle, because measurable economic impacts have a wide variety of underlying causes, and to identify an effect is to beg the question, rather than answer it.  So this week, when Lord O’Neill – prominent pro-EU campaigner and former Goldman Sachs chief economist – said that gloomy predictions for the UK economy were over-blown, his thesis was that stronger than expected growth in the world economy would give the UK a boost.  His view that Britain would be doing even better if it did not have to deal with the uncertainty created by Brexit may be somewhat lost in the headlines.

But it is unarguable that uncertainty continues to prevail after the conclusion of Phase 1 of the Brexit negotiations last year, and that is true just as much for the private equity and venture capital industry as for many other sectors.  From a regulatory perspective (which is not, of course, the only perspective) we are not much closer to knowing how the negotiations will end, and what effect the final deal will have on UK-based financial firms.

It is now generally accepted that the UK will not fall off a cliff when it formally leaves the EU in a little over a year’s time.  It has always been in the interests of both sides to agree to a transitional period, and talks about its terms will soon begin in earnest.  Of course, nothing is yet certain, but it seems most likely that financial services – including the private equity and venture capital marketing passports, which are so important to UK-based private fund managers – will be allowed to continue to operate as usual until at least the end of 2020, if not beyond.  And it looks quite likely that there will be some kind of trade deal between the UK and the rest of the EU after that.

But whether that trade deal will extend to financial services and, therefore, to the marketing passports currently enjoyed by many UK fund managers is much less clear, and recent comments made by highly influential figures in the EU – including France’s President Macron and the EU’s chief negotiator, Michel Barnier – suggest that a deal on financial services may not be on offer.  For some firms that might be a welcome outcome, because it will allow the UK’s regulator more freedom to forge its own path and to dis-apply some of the less sensible EU rules that have been implemented over the last decade.  Others point out, however, that significant helpful changes to the UK’s regulatory regime seem unlikely, and many British firms with a wide base of continental European investors will be obliged to restructure if there is a “no (services) deal” outcome.

The restructuring required is costly, but not prohibitively so for a larger firm, and structures exist which would allow UK firms to keep most of their professionals outside the EU27 whilst getting the benefit of an EU structure.  Despite some recent proposals to strengthen the oversight role of the central European regulator, ESMA, that flexibility seems likely to remain.  The ability for a fund manager to delegate functions to, or take advice from, more expert specialists located elsewhere in the world is fundamental to the European fund model and essential for EU-based investors.

Firms certainly need to make plans for a “no (services) deal” outcome, given the current uncertainty, but workable solutions exist, and the degree to which no deal on financial services would damage the UK private equity and venture capital industry would not be clear for several years.

But the fact that the downside for the UK seems limited, whilst the EU loses regulatory control of an important part of a fund manager’s decision-making structure, may yet prove to hold the key to the ultimate outcome of the negotiations.  At the moment, the prevailing wisdom seems to be that a deal on alternative investment funds would benefit the UK more than the EU.  Yet the benefits to the EU of keeping the UK substantially within the EU’s regulatory purview (especially if the UK can be persuaded to pay for the privilege), probably outweigh any competitive advantage that can be gained by forcing UK firms to operate outside it.  There is no doubt that EU-based investors will continue to invest in UK funds, one way or another, and it would harm the EU to restrict access.  That being so, the EU may decide that it would rather keep control than lose it, and the UK may be willing to cede at least some control in exchange for better access.

Neither the economics nor the politics of that potential compromise are straightforward.  More importantly, perhaps, the debate about the broader (financial) services sector will overshadow any single part of it – so the private equity industry needs to have realistic expectations, given its size.  But private equity is not without influence – far from it – and EU policy-makers may yet prove sympathetic.

This post comes to us from Debevoise & Plimpton. It is based on the firm’s client update, “Brexit: The ‘No-deal Deal’,” dated January 26, 2018, and available here.