This article was taken from the Summer issue of the 1875. To subscribe to our investment publications, please visit www.redmayne.co.uk/publications.
In the vast global landscape, the UK stock market has recently been perceived as a region saturated with undervalued, under-loved but often high-quality, cash generative companies. One of the primary reasons for this has been the lack of interest from domestic equity investors, particularly in pension funds which have steadily decreased their equity allocations over time in favour of alternative asset classes such as private equity (PE). Consequently, these companies now trade at substantial valuation discounts compared to their global counterparts, making the UK a hunting ground for foreign buyers seeking quality companies at attractive prices.
Despite this, changing market dynamics over the last few years have brought about very different environments for UK equities and foreign mergers and acquisitions (M&A) activity alike. The years 2020 and 2021 were characterised by a flurry of leveraged takeovers in the UK, fuelled by bullish investor sentiment and the availability of cheap debt. The situation shifted in 2022 as the global economy faced considerable turbulence. Private equity firms had to reassess the prices they were willing to pay for their investments, leading to a slowdown in deal volumes and a decline in the number of announced takeovers of public companies.
In addition to private equity, corporate buyers also hit the brakes on their M&A activities, driven by the necessity to conserve capital and reduce funding risks given an aggressive cycle of rate hikes by the central banks in Europe, the US, and the UK. These actions significantly escalated financing costs for both private equity firms and corporations. Consequently, many investors chose to tighten their capital allocation, adopting a patient approach and waiting for more favourable market conditions to emerge.
Fast forward to the first half of 2023 and activity remained weak in the UK M&A space as macroeconomic headwinds and tighter lending markets continued to take a toll on the volume of deals completed. Private equity deals, which made up nearly 40% of all volumes, focused on all equity offers for small and mid-sized companies due to financing uncertainty and better management control. Consequently, these companies have been holding record levels of dry powder (cash reserves kept on hand by a company, venture capital firm or individual to cover future obligations, purchase assets or make acquisitions), with European firms estimated to have around €270bn in reserves by the end of 2022, as they remained patient and vigilant for opportunities on the horizon.
Despite the prevailing market uncertainty, not all companies chose to sit tight and wait. Notably, the US private equity giant Blackstone demonstrated its confidence in the market by recently acquiring the dynamic ‘last mile’ industrial warehouse company, Industrials REIT, for £700m in cash. This move showcased Blackstone’s ability to deploy some of its accumulated dry powder. The acquisition was made at a price equivalent to the share value about six months ago before a significant sell-off in the sector, making it an enticing prospect for Blackstone while benefiting shareholders too.
But the deal may have broader implications for the private equity space, signalling the growth potential perceived by private equity not only in UK real estate but in UK assets as a whole. Furthermore, if Blackstone managed to acquire £700m worth of assets with available cash, it raises questions about the potential impact on other listed property vehicles when market optimism begins to gain momentum, with the potential for further deals of similar, if not larger, values.
When considering the future deployment of such dry powder, there are specific areas that appear promising. Particularly noteworthy is the potential for further activity within the Investment Trust sector, specifically REITs and private equity vehicles, both of which are currently experiencing significant discounts to reported net asset value (NAV). Recent data from Winterflood indicates that the average discount to net asset value for the private equity trust sector and UK REIT space stands at around 38% and 19.5%, respectively. These sectors have continued to experience a sector-wide share price decrease in relation to value of the underlying assets. Despite strong underlying rental growth, a concern for investors is the valuation of the trusts’ underlying assets which are typically based on stock market multiples for comparable listed companies. When markets fall, unlisted assets tend to follow suit, but as there is a lag in the reporting, the impact on NAVs can take months to appear. These concerns have swelled in recent months given considerable increases in interest rates and financing costs.
Despite valuation uncertainty, both sectors may well provide attractive opportunities for those looking to capitalise on depressed valuations even in the face of potentially extended economic headwinds. It is likely that given a higher interest rate environment, patient and selective capital allocation will be key as changing market dynamics may open up new areas of opportunity in some unloved sectors. A continued focus towards smaller and medium-sized acquisitions could also be favoured as smaller entities provide greater flexibility and often lower debt requirement.
While the catalyst for increased PE activity remains unclear, further improvements in macroeconomic indicators could be strongly received, likely providing an inroad for further capital deployment. Flattening and potentially declining interest rates will provide investors with greater transparency on the longer-term financing costs for these vehicles, shedding more light on the returns that could be expected when purchasing the assets.
Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.