Private equity – opportunity or threat to portfolios?

6 September 2021

UK private equity deals hit a five-year high in the first half of this year, amid growing investor confidence. But how might this affect quoted portfolios and how can investors benefit? 

According to KPMG’s latest data, 785 deals were completed with a combined value of £73.7 billion between January and June, up 61% on the same period of 2020.

With bids for Morrisons and Ultra Electronics being negotiated and Sainsbury’s said to be next in line for a takeover approach, appetite for UK companies shows no signs of slowing.

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.”

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 the UK is home to pockets of “above average quality companies” which are trading at below their intrinsic values, helping to drive bid activity.

He commented: “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. 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.”

However, investment experts warned that low valuations could be detrimental to the market.

Henderson cautioned: “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 to happen.”

Jonathan Winton, co-manager of Fidelity Special Values, commented: “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. 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.”

How can investors benefit?

According to Ed Wielechowski, manager of Odyssean Investment Trust, while investors should not consider companies simply because they seem to be an interesting takeover candidate, they can potentially tilt the balance of probabilities in their favour.

Wielechowski explained: “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, private equity buyers struggle to acquire companies with large defined benefit pension schemes, significant cyclicality or high capital intensity.”

Winton 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.

“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.”

Looking ahead, investment experts expect the outlook to remain positive thanks to earnings growth and growing economic confidence.

According to Wielechowski, earnings growth is likely to remain above trend for the medium term due to the recovery of domestic and international economies and there are companies, typically with international earnings, where this recovery potential has yet to be priced in.

Winton added: “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.”

Professional Paraplanner