Asset manager playbook
As the dust settles following the UK referendum vote on 23 June, Theresa May, the new UK prime minister has been clear: “Brexit means Brexit”.
The stark reality of the challenge has started to sink in and with uncertainty around the UK economy, the Bank of England has reduced interest rates to an unprecedented 0.25% and launched further quantitative easing measures. Delivering a stable post-Brexit environment both for the UK and the other 27 members will be a complex and difficult task but vital to ensure long-term financial stability.
Like all sectors of the UK economy, the asset management industry – including traditional players, real estate managers, infrastructure managers, hedge funds and private equity funds – is coming to terms with the surprise result. In the immediate aftermath, the industry has managed the inevitable market volatility with agility and resilience. Three short-term priorities have prevailed: managing the market, communicating with clients and reassuring staff.
While there remain questions concerning the UK’s longer-term economic prospects and the risk that further political uncertainty across the EU will disrupt financial markets and investor confidence, the industry has been calm and measured. We are not seeing knee-jerk reactions. Managers must rebalance holdings and portfolios to reflect current and future scenarios.
There has been a market hit, with redemptions, outflows and gating of commercial property funds. Much of this is likely to have been sentiment-driven and a result of the recent intense market volatility, and some issues seem to have attracted excessive media attention. Our discussions with the industry have highlighted that some corporate relocations and new fund establishments may actually have been been ‘business-as-usual’ decisions and indirectly ascribed to Brexit. In addition, while uncertainty remains and there is a longer-term risk to future flows, Brexit is seen to have created new market opportunities and even a ‘post-Brexit bounce’.
Aside from managing the market, the other short-term focus has been on communicating with clients to minimise the risk of client loss and reassuring EU nationals working in the UK and visa versa. The key message is business as usual.
Once the UK serves notice of its wish to leave the EU under the terms of article 50 of the Treaty of Lisbon, the negotiation process may take up to two years, although there is scope for it to take longer. Looking to the medium and longer-term, it is too early to gauge political sentiment and make a call on the outcome of the negotiations.
However, since it looks unlikely that article 50 will be triggered before the end of 2016, it appears that the horizon will remain unclear. The sheer scale of what needs to be done – not only in terms of exit but also in relation to concurrent negotiations with non-EU countries and achieving third country equivalence – is immense. As we have seen with other bilateral agreements, this could take years to conclude.
The most critical issues facing the industry are access to the EU market and talent. Passporting is on the agenda across the whole financial services sector and the asset management industry is no different. The outcome will be critical and will drive both the industry as a whole and the responses of individual firms. In the interim, we do not anticipate change in the regulatory environment, especially if the UK is required to prove ‘equivalence’ as a third country for passporting purposes.
Many asset managers doing business across Europe already have EU fund structures and operational footprints in Dublin or Luxembourg, but changes may be required to continue to access EU markets. It is crucial that firms update their pre-vote plans to reflect new eventualities and assess the longer-term implications.
It may not be possible to make firm decisions on legal structures and the location of funds, management companies, portfolio management teams or distribution functions until the model for exit is confirmed. These are not decisions to be made in haste and repented at leisure. These are complex issues so planning, agility and, optionality, are key. Those who plan will be better prepared to make informed decisions when the situation becomes clearer. We also believe that this assessment is likely to identify a number of ‘no regret’ actions that can be pursued in the interim before clarity is achieved.
Operational issues – such as the impact on technology and data privacy, broker relationships, trading venues, depository and custodian arrangements – as well as any changes required to financial disclosures, reporting or covenant arrangements, also need to be considered in the short to medium term.
Finally, such planning activity will help firms to successfully galvanise, educate and lobby regulators and industry bodies to ensure individual interests are protected, there is clarity on the value of the overall industry, and business as usual operations can continue in the meantime.
Will UK asset management survive?
The UK is currently one of the largest markets for asset management. It has exceptional breadth and depth and will remain a key location irrespective of the outcome of negotiations. While some firms may look to transfer operations outside the UK, an exodus is not envisaged and it is expected to continue as a financial services and asset management hub. Not only does it have heritage, expertise and time-zone benefits, there remains a sizeable and growing need for asset and wealth management services as the UK pension shortfall and savings deficit continue to increase.
“Schemes that have experienced a deterioration in funding are likely be further away from any planned future de-risking. While some may be tempted to consider taking the opportunity to re-risk investment strategy to capitalise on new market opportunities, for most it will not be the time to increase money at risk… Again, calm and measured planning will be key”
However, Brexit will add to the challenges the industry has been facing: increasing competition, regulatory scrutiny, changing client needs and expectations, the shift from active to passive, and the increasing appetite for solutions. Leaving the EU will add an additional dimension to these challenges and could increase the pressure on margins. I anticipate that we will see more consolidation as players seek economies of scale or to acquire capabilities and access to new channels, geographies and client segments. Players are likely to look for more cost flexibility to provide downside protection should it be required and at the same time look to the raft of new opportunities for growth.
How will Brexit affect pensions?
As with the asset management industry, Brexit will inevitably impact the pensions sector. The short-term impact has been a worsening of the funding position for most UK defined benefit (DB) pension schemes and the consequences for trustee valuations, employer covenant and cash funding are high on the agenda. Further market volatility can be expected when article 50 is triggered. We now have negative real yields on AA-rated corporate bonds, which are the key driver in valuing pension liabilities for accounting and regulatory capital. Yields have continued to fall since the referendum – from 3% to 2.3% between 23 June and 31 July, according to the main index, while medium-term retail price inflation is running at 2.9%. This means pension liabilities will have risen by 10-15%, and this is unlikely to have been fully met by increases in asset values, except for those well hedged on interest rates.
Investment risk management is also high on the agenda. Schemes that have experienced a deterioration in funding are likely be further away from any planned future de-risking. While some may be tempted to consider taking the opportunity to re-risk investment strategy to capitalise on new market opportunities, for most it will not be the time to increase money at risk. Instead, we expect most to revisit journey planning and considering de-risking and tightening risk budgets. Again, calm and measured planning will be key.
For defined contribution (DC) schemes, the impact on individual pots is wide-ranging and potentially confusing. Early communication could help encourage engagement and personal reviews. Scheme members approaching retirement are likely to be concerned about the potential impact on annuity rates and their retirement income and may need additional support. Sponsors and trustees may also consider revisiting the underlying default fund(s) and have a clear understanding of equity exposure and other protection triggers. They will also need to consider the potential impact of Brexit on underlying DC providers, asset managers and specific funds and how this could feed through the scheme over the medium term.
In terms of pension laws, as with the broader asset management industry, given that most EU pension rules are embedded in UK legislation, we do not anticipate these will simply fall away. While there may be the opportunity for some changes in perceived problem areas such as in the protection of employment on the transfer of undertakings (TUPE) regulations, and equality, timing could be an issue given the volume of legal amendments required to clear parliament in the near term to achieve Brexit.
The referendum result took many by surprise and there will inevitably be a prolonged period of uncertainty. While knee-jerk reactions are ill advised, planning will be critical to ensure that the possible impacts of different scenarios can be worked through, ‘no regret’ actions identified and sufficient optionality built in to respond to the evolving landscape.
Ian Smith is partner, investment management, KPMG UK