Managers comment on private equity’s activity in UK markets.
In H1 2021 private equity struck the highest number of UK deals in five years.1 With bids for Morrisons and Ultra Electronics being negotiated and Sainsbury's said to be next in line for a takeover approach, there is little sign of private equity’s appetite for UK companies abating.
Private equity firms buying listed companies give shareholders the chance of receiving a premium price today, but this can also remove the opportunity to benefit from longer-term growth. Is private equity’s activity in UK markets an opportunity or a threat for investors and what can they do to benefit from this trend?
“Tomorrow’s value today”
Ed Wielechowski, Manager of Odyssean Investment Trust, said: “Company mergers and corporate takeovers are part of the normal business of stock markets. In some cases, companies can be taken over for a price which materially exceeds the value which the public markets will ever ascribe to a business due to a highly motivated buyer. Sometimes companies are acquired for less than their intrinsic value; each case has its own merits. Sometimes when a business needs to go through a period of restructuring or re-organisation, it can be more easily and quickly executed away from the gaze of public market investors, and quoted shareholders can be given some of tomorrow’s value today in return for not taking on the risk of the restructuring.
“However, if any private equity backed takeover is merely to gear a business up using debt which is currently very easy and cheap to borrow, then it is a long-term threat to quoted markets. Overall, there is little to fear provided that there are enough IPOs of a sufficient quality to counterbalance any takeovers, that existing shareholders achieve a premium to fair value and that key industries and expertise remain in the UK.”
Jonathan Winton, Co-Manager of Fidelity Special Values, said: “We are not against bids by private equity groups and other corporate acquirers if they recognise the true value of individual businesses and pay a fair price. They are typically more willing to take a longer-term view than market participants who can at times be overly pre-occupied by near-term uncertainty. We’re equally happy to take a public stance and vote against a bid if we think the offer undervalues the business (as we recently did with Spire Healthcare). We don’t see this trend as a threat, as the UK market is a large market. We are never short of new investment ideas and have had no issues putting to work the cash released from recent bids.”
Ian Lance, Portfolio Manager of Temple Bar Investment Trust, said: “It is an opportunity. The trend amongst large institutional investors has been to ‘go global’ irrespective of valuations and hence they have been selling one of the cheapest markets in the world, the UK, to buy one of the most expensive, the US. As private equity are interested in absolute returns, this provides them with lots of cheap targets and hence value investors in the UK are likely to see an increasing number of their stocks bid for.”
James Henderson, Co-Portfolio Manager of Lowland Investment Company, Henderson Opportunities Trust and Law Debenture, said: “A number of UK stocks have been on the receiving end of bids this year, particularly from US companies including private equity, and this is a reminder of the value in the UK equity market. The valuation of corporate earnings totally outstrips the long-term cost of debt, and the gap is so large it has to change. This will most likely occur when the cost of long-term debt goes up and the valuation of corporate earnings also goes higher. However, if sound companies are taken over at low valuations it is detrimental to long-term returns from the quoted sector so, in my view, it’s important the current owners of these companies don't allow this happen.”
How can investors benefit?
Ed Wielechowski, Manager of Odyssean Investment Trust, said: “We would never advocate investing in a company only because it may seem to be an interesting takeover candidate for private equity – any investment should be made on its individual merits. However, you can potentially tilt the balance of probabilities in your favour by adding certain negative and positive filters to your investment selection criteria. For example, private equity bidders like market leaders with strong cashflows, which are not generating the levels of sales growth and profit margins that the businesses are capable of. They also like businesses which can add value by consolidating industries, and companies which are asset rich and/or have high barriers to entry. On the flip side, in our direct experience, private equity buyers struggle to acquire companies with large defined benefit pension schemes, significant cyclicality or high capital intensity.”
Jonathan Winton, Co-Manager of Fidelity Special Values, said: “Investors are more likely to benefit from takeover bids if they own attractively valued businesses, or those with desirable technology or innovative products. With Fidelity Special Values, our focus is on attractively valued companies that are ignored or underappreciated by the market. It might be because they are experiencing internal issues or are impacted by headwinds in their sector or the wider economy. The key is that we feel these issues are temporary and our due diligence gives us the conviction that the business will positively change over the medium term. The uncertainty and its impact on the valuation create an opportunity for acquirers who typically take a longer-term view. From an external perspective, Brexit clarity and vaccine progress potentially remove two large areas of uncertainty whereas valuations remain attractive, giving acquirers greater confidence to deploy capital.”
James Henderson, Co-Portfolio Manager of Lowland Investment Company, Henderson Opportunities Trust and Law Debenture, said: “The reason we buy shares in a company is because we believe in the sustainable long-term outlook of the business and think the valuation does not reflect this. These factors may also be why another company will want to buy them. Therefore, our investment process can lead to us being invested in companies that receive approaches. This has been very evident in the last year, but we don’t invest purely on the basis that a company may be taken over.”
What does this trend show about UK businesses?
Ian Lance, Portfolio Manager of Temple Bar Investment Trust, said: “I think it shows us three things. First, that the level of private equity bids is elevated because they are flush with cash and can borrow very cheaply. Second, that the UK is being targeted because it is very cheap – it is at the biggest discount to the MSCI World for fifty years. Thirdly, it shows that the UK is quite friendly to takeovers from a regulatory point of view.”
Ed Wielechowski, Manager of Odyssean Investment Trust, said: “Whilst we do not believe UK listed companies as a whole are undervalued, there are pockets of above average quality companies which are trading at below their intrinsic values. Fundamentally, this drives bid activity.
“The growth in private equity activity demonstrates a number of trends. Firstly investors are seeing more potential value or less competition in buying quoted companies rather than buying assets from another private equity house in a secondary transaction. Secondly it shows the prevalence of ‘dry powder’ capital in private equity funds and the current accommodative debt markets supports their ability to bid for quoted assets; and finally, the level of interest in UK listed companies from US-based private equity companies seems to imply there is a perception that UK quoted companies are attractively valued versus their international peers.”
Jonathan Winton, Co-Manager of Fidelity Special Values, said: “The number of M&A bids we are currently seeing by private equity groups and other corporates highlights how attractive UK companies’ valuations are in an absolute sense, and relative to other geographies and the more expensive parts of the market. Many UK-listed companies are market leaders in their industries with attractive growth potential, and with Brexit in the rear-view mirror, companies and acquirers are more willing to commit to making new investments in the country. These dynamics along with the current availability of capital means we’re likely to see more bids if the valuation discrepancy remains in place.”
Outlook for the UK
James Henderson, Co-Portfolio Manager of Lowland Investment Company, Henderson Opportunities Trust and Law Debenture, said: “In my view, valuations in the UK are too low given the level of long-term interest rates. Additionally, corporate earnings have enjoyed a strong recovery as companies have taken out costs in recent years and now sales are growing. This has resulted in improved profit margins and the extent to which this is happening has led investors to be pleasantly surprised at the level of corporate earnings growth.”
Ian Lance, Portfolio Manager of Temple Bar Investment Trust, said: “The outlook is positive based on two factors. Firstly, the very low starting valuation relative to other markets and, secondly, high exposure to the cheapest sectors such as energy, materials and financials, and low exposure to the most expensive sectors such as technology.”
Ed Wielechowski, Manager of Odyssean Investment Trust, said: “Whilst markets have run hard since the nadir of March 2020 and overall ratings are above long-term averages, we believe that there remain good investment opportunities in the UK equities space. Earnings growth is likely to remain above trend for the medium term due to the recovery of domestic and international economies. We are still able to find companies, typically with international earnings, where this recovery potential has in our view yet to be priced in. Equally, we are finding some interesting reasonably priced growth companies, as the market has been focused on domestic cyclical recovery situations.”
Jonathan Winton, Co-Manager of Fidelity Special Values, said: “The near-term economic outlook is encouraging with Brexit now in the rear-view mirror, most remaining restrictions related to COVID-19 lifted and real-time data suggesting a continued rebound in activity, back to pre-COVID levels in some instances and even ahead in certain areas. The UK is predicted to grow at the fastest pace of the major developed economies providing a good backdrop for UK corporates. UK equities are significantly undervalued compared to global markets, and reasonably valued in absolute terms. While the UK market has looked cheap over the past five years, the key difference in 2021 is that fundamentals on the ground look very good. This backdrop has helped us find attractively valued companies of better quality than would normally be the case, which is reflected in the continued elevated gearing level in Fidelity Special Values.”
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Notes to editors
- Source: KPMG, UK Mid-market PE review, August 2021.
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