Shielding PE from political risk

Though 2017 was a politically tumultuous one for Europe, 2016 will be remembered as the catalyst that sharpened investors' political awareness. The UK's decision to leave the EU, followed by Hillary Clinton's US presidential election defeat by the more protectionist Donald Trump, were the first in a series of increasingly less predictable political outcomes across western democracies.

While 2017 bucked the trend, with the election of pro-European Emmanuel Macron in France in May, the continued nervousness generated by the Dutch and German election and the unexpected success of the Labour Party in the UK elections were followed by further instability across the continent in October. The particularly troubled month saw the controversial Catalan independence referendum and victories by the conservative and nationalist parties in Austria and the Czech Republic.

Aside from drawing political headlines across the continent, what bonds these events is that they all presented potentially unpredictable scenarios. This fuelled nervousness across all market sectors, pushing both entrepreneurs and financial investors to work relentlessly to refine their risk mitigation strategies and include all possible scenarios within their business plans.

Recently, deal-makers have approached political risks with increased care. "Political due diligence is an important product in order to get a better line of sight on potential issues and opportunities that are coming down the pipe," says Liz Jones, partner at UK private equity house Livingbridge. "While it is rarely definitive, it allows us to triangulate with all the other commercial due diligence work we do to better inform our investment decisions. Having that additional layer of insight into the national – and, in some cases, local – political agenda is a very important tool for us, and allows us to really appreciate the entire landscape prior to making an investment decision."

Adapting to a new environment
Against this backdrop, what was once a niche advisory sub-segment has risen to prominence, leading to changes in the standard contracts between fund managers and advisers. "Until a few years ago, political risk analysis was largely a service related to investments in the emerging markets," says Lizzie Wills, head of investor services at WA Communications. "Now it's front of mind for investors looking at transactions in developed markets too. Because the political environment is more unpredictable, not least because of Brexit, investors have become more aware of the need to understand the political and regulatory landscape alongside more traditional due diligence processes. From being part of ESG advisory, political due diligence is becoming an additional advisory line that investors want to commission separately."

For private equity fund managers it has always been prudent to approach the policy landscape at a portfolio management level, says Livingbridge's Jones. "We always encourage all our businesses to be outward looking, especially where there is a policy element that could impact their operations," she says. "Where appropriate, it remains important, but that isn't always the case."

This said, it is worth noting that political due diligence appears to have moved from a service strictly related to a single deal towards a more portfolio-management-orientated service, according to political risk advisory boutique GK Intelligence. "Increasingly, we have seen portfolio managers coming to us to support them with programmes to mitigate ongoing risks, rather than solely understanding the political environment around a deal," says GK managing director Louise Allen. "The continuation of that risk management support is certainly changing."

Political due diligence is an important product in order to get a better line of sight on potential issues and opportunities that are coming down the pipe" – Liz Jones, Livingbridge

By the same token, Wills says: "Traditionally, we have worked on discrete projects that would take three or four weeks to complete. We would submit our report to investors and that would be the extent of our input with regards to that transaction or asset. However, we've seen a broadening and deepening of our relationship with investors in recent years, having been increasingly asked to offer ongoing support to an asset as a portfolio company with its longer term political strategy. It's no longer a transactional relationship but is increasingly a longer term discussion over how investors are positioning the businesses in their portfolios and their political and communication strategies long term."

This type of analysis aims to explain political dynamics and highlight how it affects the operating environment and reputation of a portfolio business. Advisers initially undertake an in-depth review of all publicly available information about a particular policy area. Subsequently, they approach policy-makers and influencers, such as MPs, members of the House of Lords (in the UK), members of select committees, think tanks and opposition politicians, for primary information on current trends in the policy landscape and future outlooks. They study ministerial speeches, parliamentary questions and select committee evidence that has been submitted in addition to government funding plans, and then merge that information to produce a snapshot of the political environment as it stands. The general aim is to display how investors understand where the policy is likely to develop in the future.

Keeping ahead of uncertainty
Investors need to anticipate future risks and political due diligence advisers provide scenario planning based on a number of outcomes. They suggest the best strategies to protect revenues and the reputation of a business. The goal is to prepare a business for all potential consequences of changes in regulation or legislation.

Examples, in the current political climate, are hypersensitive issues such as national security, economic competitiveness, foreign investments, trade policies and job security. "Portfolio companies can be affected by political developments at different levels, particularly those that rely on governments for revenues," says Allen. "With Brexit, all portfolio companies need to understand the potential risks and opportunities." Private providers of public services and companies subject to an overarching regulatory framework have been particularly affected by the recent political uncertainty.

Brexit is the most eminent case in point, but other events have also become poignant, most recently the Catalan referendum. "Referenda are reflective of the wider political uncertainty that exists," says Allen. "They are often a way for the government to engage and affect voters in a way that is quite simple to understand. But the political issue is often larger and more complex than the question stated on the ballot paper. Understanding the political environment around that referendum – what is driving that and how an asset or a portfolio company can operate in that environment – is critical."

It is all about understanding the risk and, indeed, opportunities arising from the political and regulatory environment. "What we do is to look at all potential implications of that event," Allen says. "It is a very research-led strategy, hard analytical digital data combined with soft data that we get from intelligence from interviews. Referenda are a symptom of this disaffection and uncertainty, as much as they are a cause of it."

The political environment has increasingly become an evolving and moving picture, and investors need to refine their risk management to identify opportunities among the upcoming obstacles. With the Brexit negotiations creeping into their next stage, it is likely that political due diligence providers will be an integral part of the private equity landscape into 2018 and beyond.

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