Brexit and the Private Debt Market

With a decision deadline approaching in late March and Parliament unable to arrive at consensus, Brexit looms large on the financial landscape.  Will there be a crash out with no deal? Will there be a new referendum?  Will there be an extension and a series of smaller deals? Brexit is that classic event that spooks economists, market watchers and financial professionals alike.  So much has been written about it since 2016 that it seems as if the end of the financial world is nigh.

What most writers and prognosticators forget is the market’s ability to discount uncertainty rationally into the price of financial assets.  As much as the EU dislikes Brexit in general, they have no choice but to extend the deadline and allow for an orderly transition, as opposed to a sudden crash out.  While the Brexit overhang does pose event risk in the market around interest rates, stock prices and currency rates, it will likely have only minor impacts on the private debt markets in the US, UK and Western Europe.

Private debt is an alternative asset class that does not react to the same economic variables as public debt or equities.  Private debt, especially those loans tied to middle market companies, are largely illiquid assets that are not traded.  These assets have higher yields to begin with due to credit risk and their inherent illiquidity. Most private debt funds have emerged as a response to banks vacating certain leveraged lending verticals due to regulation.

Private debt has exhibited a high level of stability in its risk adjusted returns over the decades and has become an essential asset class for private equity groups and diversified asset managers.  It has grown dramatically in recent years, as investors have sought yield refuge in credit vehicles.  So will the Brexit deadline restrict the level of Private debt availability in the US or the UK over the near term?  This is unlikely for the following four reasons:

1. Level of dry powder – Debt funds are bursting at the seams with capital. New funds, lacking portfolio baggage, are eager to lend.  New Debt fund formation may slow, but current investment from existing funds will continue.

2. Pricing Upside – Private debt managers are entrepreneurial when pricing risk. Macro Brexit volatility gives them an opportunity to get more upside in pricing. Borrowers with specific Brexit vulnerabilities will likely be credit screened out.

3. Diversified Funding Sources – Most private debt funds are funded through a variety of sources including banks, CLO’s and equity from investors. They have back up liquidity plans in the event of a market dislocation.

4. Central Bank Coordination – The Fed and the European Central Bank are ready to coordinate a response to calm any market disruption based on a variety of worst case stress tests.