Perspektywy

Why are UK takeovers on the up again?

Once-in-a-lifetime valuations plus copious cash held by private equity firms sparked record takeover activity in the UK equity market in 2020 and 2021.

The level of private equity dry powder (i.e. cash that had been committed by investors but had yet to be allocated to a specific investment) hit a new high of $3.4 trillion at the end of 2021, waiting to be invested as opportunities arose.

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However, as the volatile macroeconomic environment began to intensify in 2022 and affect the public markets, private equity firms began to reappraise the prices they were willing to pay for their investments. As such deal volumes slowed, and consequently the number of announced takeovers of public companies also fell.

Away from private equity, corporate buyers also took a pause on merger & acquisition (M&A) activity, driven by the need to conserve capital and decrease funding risk given the expectation of a higher interest rate environment.

But could things be picking up again? After a slow start to the year, there have now been 25 completed or pending takeovers in the UK equity market, which compares to 18 deals in the same period in 2021 (source: Refinitiv, as at 31 July 2022). Private investment firms account for ~52% of the total takeover approaches seen so far this year.

The overall focus among all buyers appears to be companies in the real estate and transportation/infrastructure/logistics sectors, while companies in sectors such as healthcare and retail have been bid for the least.       

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While corporates and private investment firms are being cautiously selective in their purchases, we have long argued that the UK equity market’s wide price-to-earnings discount relative to its global peers, combined with a weak currency, presents a significant opportunity particularly for international corporates and financial institutions.

UK equities have been trading at an increasingly wide price-to-earnings discount relative to global equities ever since around the time of the 2016 Brexit vote:

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Meanwhile, sterling has depreciated by c.18% relative to the US dollar during that same period:

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A combination of pent-up demand from the Covid-19 pandemic, global supply shortages, the exacerbation of food and energy inflation from Russia’s invasion of Ukraine and negative wage growth has led to a sell-off this year in risk assets such as equities. There are also concerns about the impact this environment will have on the level of consumption.

Despite the UK equity market’s defensive characteristics, global outflows from Equity UK, Equity UK income and Equity UK Small & Mid Cap for the first seven months of 2022 were £17.8 billion according to data from Refinitiv/Lipper Global.

The consequence of this, combined with fund managers holding more cash, has been the severe dislocation between some companies’ positive underlying fundamentals and their low stock market valuations. These may catch the eye of private investment firms and other bidders if this dynamic continues.

Which areas of the UK market may still be vulnerable to takeover?

As public equity investors we believe the stock market is a discounting mechanism and that in the long run a company’s fair value should eventually be realised. While we do not centre our investment cases on the potential for bid activity to occur, we recognise that there are times when market dislocations present opportunities for external buyers to close the valuation gap.

As mentioned earlier, the real estate sector appears to be one area that buyers are focusing their attention on in this higher inflationary environment (real assets act as an inflation hedge). Businesses with freehold asset bases that are trading at significant discounts to their net asset values means that you get future growth for “free”.

Comparing these valuations to where recent transactions have been priced at is also important for public equity investors in determining their attractiveness.

In addition, companies operating in sectors where occupier demand has the potential to drive rental growth (due to long term structural trends such as population growth) are likely to also be attractive takeover candidates.

While investors have been wary of unprofitable businesses, particularly those where visibility on when profits will be generated is poor, unprofitable businesses shouldn’t all be tarred with the same brush.

For example, take loss-making technology and healthcare companies whose valuation multiples have contracted severely but have high gross margins. They may also have key performance indicators (KPIs) moving in an upward trajectory, near term visibility on when profits will be generated and a combination of a net cash balance sheet and low cash burn (the rate at which a company spends its cash reserves).

Such companies may also be attractive takeover candidates in this environment. Competitors could potentially absorb these businesses and leverage their existing sales & marketing capacity to drive growth and profitability faster, whilst private investment firms could bolt them onto existing portfolio companies to generate synergies.

Our private equity colleagues seem to agree. Paul Lamacraft, Schroders Capital, said “We have certainly seen an increase in the number of public companies that are trading on attractive multiples and that could therefore fit with a scale up/buy & build strategy under private equity ownership.

"With a five-year plus investment horizon, taking a longer term view and expanding platform businesses through bolt-on acquisitions can open up new products, services and geographies.

"Acquiring such complementary businesses from the listed markets at lower valuations while public markets investors are nervous makes a lot of sense for the right company. Alternatively, acquiring a high quality platform company on which to build into the future can be equally attractive for private equity investors with dry powder to deploy."

Given current market sentiment, and for reasons stated above, we think there is a good chance of bid activity continuing in 2022.