It’s important to note that some sectors, such as software, will likely see little effect from Brexit regardless of how it plays out. Their attractiveness to PE will depend on their growth rates and the potential value that can be added by transformation or consolidation.
Among sectors likely to be hit by Brexit, we identified four of particular interest to PE firms, as well as several secondary sectors. We chose them mostly because we think they present the greatest opportunities, but also because they illustrate the advantages that PE firms have in competing for these assets, especially in the short term. Most promising are companies that depend heavily on EU trade, workforces, or regulations.
Companies in all of these sectors will face substantial risks at this time of uncertainty and volatility. But PE firms, especially those focused on adding value to operations, are well placed to help them succeed. Corporate buyers, by contrast, are often limited by the pressure to ensure short-term earnings stability. As for the IPO market, the current turbulence will dampen demand for all but the strongest assets.
Industrial Distribution. The distribution industry is highly specialized and depends heavily on the health of its underlying sectors. But as a whole, the industry tends to be resilient in a downturn. Volumes may fall but prices hold up, so margins quickly return as demand returns. That is in contrast to industrial transportation, which has minimal pricing power and high fixed costs, and is ripe for consolidation and vertical integration.
The far bigger risk from Brexit is in the terms of trade, both out of and into the UK. While export-oriented manufacturers will benefit from the fall in sterling, many of them may end up shifting their focus to domestic markets in order to avoid higher tariffs and other barriers. Distributors that specialize in exports could lose significant volume.
Yet even these difficulties in trading could be an opportunity for distributors that elevate their capabilities. Those that do the work to provide seamless access to European markets—by prearranging shipping documentation and other customs tasks—could gain additional business. Over time, clients could see these companies as handling more than just the “tail” of their business. Distributors could become sales partners offering additional expertise, even reaching into new markets with a direct sales force that the client otherwise lacks. With margins perhaps coming under pressure from Brexit, manufacturers’ use of distributors could actually increase.
The distribution sector has already begun to consolidate in order to become more diversified, both within Europe and, most recently, across the Atlantic. PE could hasten this trend, especially for companies that handle specialty products and lack the scale to invest in value-added services.
Private Medical Clinics and Laboratories. By contrast, private medical providers, which exist outside of the National Heath Service, should be quite resilient in the face of macroeconomic weakness. Most of their revenue comes from insurance, which in turn comes largely from employers, not individuals. Patients tend to be highly skilled employees at companies eager to retain them with private medical insurance. In one respect, a recession could actually boost revenue if weakened government finances lead to cutbacks to the NHS and more individuals choose to go outside the system.
Medical tourism accounts for 15% of the sector’s income, largely from countries outside the EU. Many of those countries have dollar-denominated currencies, making UK providers a better value for the money. So the share of overseas patients could grow over the short term. In the longer term, though, overall sector demand could fall off somewhat if Brexit leads to a smaller UK financial services industry.
Brexit will also affect the sector by reducing the flow of skilled labor from other parts of Europe. Private clinics could face a shortage of doctors, dentists, and nurses that forces them to rely more on local contractors. Even less skilled positions, such as hospital porters, could face gaps. Laboratory services such as pathology are in a similar bind.
These pressures will put a premium on operational research methods and advanced staff planning that minimize the drain on resources. Larger clinics have the advantage of more capital and scope to make substantial improvements. They may even be able to improve on the NHS and gain some additional business if the NHS has to outsource more work.
Thanks to stable demand and gains from back-office scale, the private medical sector has been consolidating for some time now. PE can help further consolidation while also investing in capabilities to better manage staffing. Also, many clinics have quite a low return on capital, so PE can impose greater discipline on capital allocation.
Aerospace Manufacturing. The second-largest in the world, the UK aerospace industry is healthy and mature and boasts many sizable publicly listed companies. It serves both military and civilian customers and sells in regions around the globe. Taking advantage of that strong market position, some companies in the sector have been quite acquisitive over the last few years as they diversified their products and services.
The industry benefits from complex and interdependent global supply chains, as well as long lead times on orders. Companies sell to all the major aircraft providers worldwide, and revenues are evenly split between military and civilian customers. With much of their income in foreign currencies, aerospace companies are seeing a short-term gain from Brexit. But some smaller, domestically oriented companies are taking a hit on imported materials, and their share price declines could make them takeover targets for PE.
PE firms could pursue opportunities even with large companies. The long lead times typical of the sector force large companies in particular to maximize return on capital and cash generation. While many of these players have returns of more than 10%, there are several exceptions whose returns are below their cost of capital. Such companies may be reassessing their capital allocation and considering selling some divisions. PE firms could also buy and break up assets that have become unwieldy. And PE’s distinctive capabilities in transformation could help improve productivity and growth more generally.
Employment and Recruitment Services. The recruiting sector has been growing steadily in the past five years, and some large companies have emerged through acquisitions as well. But like distribution, this industry is highly sensitive to the sectors it serves. A general economic slowdown, or even prolonged uncertainty, will cause clients to freeze hiring. Diminished growth in the longer term will affect new hiring volumes and recurring revenues from the management of contractors.
Recruiters for financial services are particularly vulnerable to the final Brexit rules on passporting and the movement of labor. After becoming perhaps the leading global financial center, the City of London could see significant contraction. Not every recruiting hot spot is threatened—information technology and cybersecurity, for example, should be quite resilient. But enough are at risk to put the sector on notice. Likewise, many recruitment companies place EU workers with UK companies. This generates significant recurring revenue, which is now threatened by potential restrictions on the freedom of movement of these employees.
Economic difficulties, however, can create opportunities for private equity. Margins at some of the largest recruitment companies have been quite low, even over the recent boom period. The sector has a flexible labor force with highly variable compensation, so it can shrink quickly to match a falloff in the top line. But a recession could still put several companies into a cash crisis that a PE acquisition could fix.
Private equity could also improve the overall health of the sector by consolidating the market. Many recruiting companies depend on a single industry. With Brexit likely to affect different sectors quite differently, these companies would benefit from a diversified client base or a functional focus. By consolidating the market and building companies that are diversified geographically and by industry, PE could boost the sector’s stability.
Perhaps more important, new Brexit rules on immigration could be an opportunity for PE to build up the recruiting sector’s capabilities. Assuming that the UK economy stays reasonably solid, there will still be a strong demand for talent. As with distribution and the opportunities created by changes in the terms of trade, recruiting companies that step up their capabilities could provide higher-margin value-added services to help clients cut through the new complexity involved in immigration.