Only one place to start. The situation in Ukraine is evolving fast, with market risks taking shape. Whether the IMF/EU can find the money to keep Ukraine afloat is a moot point, given the threat of conflict. However, Ukraine’s troubles aren’t over even if loans and peace materialize. The Eurozone crisis has made us all too familiar with the IMF’s terms & conditions, which will place extra strain on an already fragile economy.
A deep Ukrainian recession and even default shouldn’t escalate into a broader markets crisis. Russian, Italian and Austrian banks own a large proportion of Ukrainian debt, but the amounts aren’t material to their domestic banking systems. It is Russia’s ‘involvement’ and its potential isolation that makes this incendiary. There is clearly a limit to how much the UK and other western powers can do without harming their own interests. Nevertheless, Russian markets and companies exposed to the region felt the backlash yesterday as investors reacted to the threat of sanctions, capital outflows and closed gas pipelines, along with a further weakened rouble and higher interest rates. Russian equities lost $58bn on Monday– more than one Sochi – with a mild recovery this morning as Russian border troops returned to barracks. For the 20 or so Russian companies with loan deals in the pipeline, this is a nervous time. Europe also faces interrupted wheat supply from the Ukrainian breadbasket and an unfriendly hand on the tap supplying 20% of its gas – considerably higher in some countries. European governments will be thankful for the mild winter.
However, what really raises the stakes is the potential impact of this turmoil on fragile emerging markets, already suffering from 22 weeks of capital outflows. Investors were reassessing emerging market risk-reward before they took losses in Ukraine and Russia and reconsidered threats in interlinked Eastern Europe. An emerging market crisis that was serious, but contained, is at risk of becoming systemic should the Ukrainian situation escalate. Central bank liquidity heavily buffers the UK and other developed markets – with the potential for more from the ECB and continued support from the MPC, albeit with a less unified front of late. However, much of the discussion at Davos concerned how we move the global economy from austerity to growth via freer trade and increasing confidence. Talk of conflict, sanctions and reduced co-operation would represent a step back for the global recovery.
Crisis puts spotlight on…
Global equity markets are volatile. The FTSE 100 lost 1.5% yesterday, making this back today as tensions eased. UK businesses exposed to Ukraine and Russia, through local assets and customers, and heavy purchasers of wheat and gas are of chief concern. European utility companies with Russian assets look particularly exposed. Higher gas prices will help European and UK North Sea suppliers and perhaps release more US LPG; however, exporting gas from Russia could be problematic if the crisis escalates and currency translation for those reporting in sterling and euros becomes harsher as the rouble weakens. Emerging market exposures in general remain in focus in UK markets. So far, in Q1, 20% of UK profit warnings have cited the strength of sterling against mainly emerging market currencies. This compares with an average of around 4% citing adverse exchange rates in previous quarters. It’s increasingly clear that investing in emerging markets remains a risky business for UK companies. However, given the potential of rapid growth markets, companies may consider it a risk worth taking, so long as they can control costs through periods of political, demand and currency volatility.
Exit through the data room
It is a truth universally acknowledged that a private equity house in possession of a four-year investment is in want of an exit. However, a lack of options has left Europe’s private equity holding a record number of investments. Never in the history of modern private equity have we seen this level of overhang. The way the industry clears this backlog of portfolio assets is critical to its future. PE houses need to double the rate of exits to reduce hold periods back to optimum.
Helpfully, global & UK IPO markets have picked up, reaching their highest level of activity since the financial crisis in 2013 and going great guns so far in 2014. Valuations, in many cases in Q1, have raised eyebrows – funds clearly have deep pools. As trade buyers also return to the market, many companies are running dual processes. The leap in business investment in the UK Q4 GDP figures mirrors the increased confidence we’re seeing in M&A markets. All of which adds up to a much-improved outlook – geopolitical jitters withstanding. However, the PE industry shouldn’t assume an easy exit ride in this next stage of the cycle. Investors should establish exit plans 18 months before marketing begins to put the vendor in a position of strength.
Secondary debt market booms in 2013, more to come in 2014?
Europe’s secondary loan market was certainly set up for sellers in 2013, as they took full advantage of the coincidence of a scarcity of primary issues and ample liquidity. Portfolio sales were a regular feature, with US funds active buyers. Trading volume was around $90bn compared to $66.11bn in 2012, according to Thomson Reuters LPC. By December, 30.42% of Western Europe’s leveraged loans were quoted over par against 8.34% in Dec 2012.
Expectations for 2014 are more of the same. Liquidity is still relatively high, yields are low across other European asset classes and primary issuance remains flat. Rising stressed and distressed debt prices will also encourage banks to bite the bullet on underperformers – more so once the Asset Quality Review (AQR) bank stress tests get going in Europe. However, recent significant overnight falls in loan pricing shows the market retains the capacity to shock.