The UK equity market shrank by a record £64bn last year amid a surge in mergers and acquisitions and share buy-backs. The figure equates to over 4% of the London equity market and represents double the rate of equitisation in 2005 and quadruple the figure for 2004.
Indeed de-equitisation is a relatively new phenomenon. Before 2004 there was a tendency for the pool of equity to deepen over time as stock from new issues exceeded the amount being taken out of circulation. The situation is entirely different now.
Why the UK equity market is shrinking
The increasing use of financial engineering to gear up company balance sheets has seen £56bn returned to shareholders via share buy-backs and special dividends last year. Redemptions of B shares by Vodafone retired £8.8bn worth of shares last year. Other significant buy-backs included BP (£8.4bn), Royal Dutch Shell (£2.9bn), Astra Zeneca (£2.2bn) and Anglo American (£2bn).
The other major source of equity market shrinkage was cash takeovers which last year amounted to about £60bn. O2, the mobile phone company was taken over by Spain’s Telefonica for £17.7bn. A Spanish construction company Grupo Ferrovial bid for BAA, the airports operator for £8.75bn. BOC, the industrial gases group, was taken over by its German rival Linde for £8.2bn, while P&O, the ports and ferries company, was bought by Dubai Ports World for £3.9bn.
Meanwhile, a number of smaller companies were taken private by Private Equity houses last year and this year private corporate raiders have raised the bar. A CVC-led consortium of private equity bidders has been coveting J Sainsbury only to break down this week, US corporate raider Nelson Peltz has acquired a small stake in Cadbury Schweppes and Kohlberg Kravis Roberts (KKR) announced a £10bn bid for another high street icon, Alliance Boots. It is possible that the composition of the FTSE 100 will be unrecognisable in five years time.
Last year a record £115bn worth of shares was “retired” and this figure dwarfed the £50bn of new equity introduced to the UK market through initial public offerings and secondary issues. Although de-equitisation is a global phenomenon, the UK market has been more affected than others. Last year the UK equity market’s shrinkage of 4.1% was more than double the equivalent for the US and four times that of Europe.
UK market open to foreign buyers
There are two principal reasons for this. In the first place it is easier for foreign companies to acquire British companies than vice versa. The openness of the UK corporate sector to foreign ownership is extraordinary compared to other mature economies. America will not let foreigners buy airlines, television networks or any business remotely connected with security, while the legal obstacles to acquire companies outside these sensitive sectors can also be onerous. France protects 11 “strategic” sectors, including casinos and food giant Danone. On the other hand, the British government has raised no objections to utilities, airport operators or iconic British brands falling into foreign hands.
The second factor is the explosion of private equity takeovers. Private equity, by some accounts, now employs almost a quarter of the British workforce. The results have been impressive. The most extensive study of the consequences of private equity takeovers has been conducted by the Centre for Private Equity Research at Nottingham University. Over the last 10 years investors in these deals have, on average, made profits 22% above the market index, even after paying the lavish fees of investment bankers and lawyers. More surprising, it shows that employment, after dipping by an average of 5% in the first year of the buy-out, rose by 21% after four years. On top of that productivity almost doubled in that period.
Institutional bias against equity
How do private equity financiers do it? To put it simply, they generate huge profits mainly because they buy companies on the cheap and then find ways of financing them even more cheaply. The real question is how are these operators able to swipe undervalued companies from under the noses of pension funds, insurance companies and other public shareholders? After all, private equity buyers often pay a substantial premium to the stock market valuation.
The answer is straightforward. The companies bought by private equity tend to be undervalued because UK investment institutions, particularly British pension funds, are obeying the orders of regulators who have told them that they have too much money invested in the UK stock market and have instead urged them to put their money in a combination of ultra-safe bond investments.
So as our pension funds have succumbed to the fad of deserting the stock market, many good companies have been sold to private equity companies on the cheap. Meanwhile, as pension funds are encouraged to place their funds in bonds, this depresses interest rates and makes funding for private equity takeovers even cheaper.
And it is not just UK pension funds that are boosting bond markets at the expense of stock markets. The foreign exchange reserves of Asian central banks, which now exceed $3,000bn and oil-producing countries surpluses, adding another $1,000bn are allocating their funds in a similar way.
Private equity investors and large corporations have in turn exploited cheap finance to buy up companies which institutional investors have shied away from.
How the M&A boom affects equity markets
The merger and acquisitions boom has become central to equity valuations. The wave of buy-out money is pushing valuations up. You can get a rough idea to what extent to of the so-called bid premium by comparing the valuations of companies deemed too big to be taken over with the ratings of companies small enough to be a bid target. There has been heady talk of $100bn buy-outs, but the bar has not reached that level yet. The biggest so far is $45bn for the Texan utility TXU from KKR and Texas Pacific and the equity part of that is $30bn. Clearly records are there to be broken, so let’s set the bar at $50bn or £25bn. In the FTSE 100 index there are 17 companies with market capitalisations over £25bn and their weighted average price-earnings ratio is 11.
The weighted average for the rest of the FTSE 100 index, that is companies potentially in a bidder’s grasp, is more than 16. As for the mid-cap FTSE 250 where the bulk of the buy-out activity is in fact concentrated – the weighted average is 18.
So there we have it. As pension funds, Asian central banks and oil surplus economies continue to allocate their funds into bonds and other “guaranteed” assets, interest rates will stay artificially depressed and in doing so the credit markets are underpricing risk. At the same time, the above institutions are eschewing equities, so equities are good value to buyers with access to cheap funds.
Accordingly, the secret to investment success in this environment is to identify a potential bid candidate before fervent bid speculation takes hold. And bid speculation is certainly rife at the moment. In addition to Sainsbury’s, Alliance Boots and Cadbury Schweppes, six other companies have exhibited share price spikes. There have been rumours of a management buy-out of Carphone Warehouse, while SSL International, the company behind Durex condoms and Scholl footcare products was alleged to be a target of an imminent takeover offer. Suspects include Proctor & Gamble, L’Oreal, Johnson & Johnson and of course private equity firms.
Meanwhile, rumours about bids for Whitbread, the leisure group and Scottish & Newcastle refuse to go away. Other iconic British brands that are in the sights of predators include Next and ICI. Some of these situations, like Sainsbury’s, will end in disappointment as partners in a consortium pull out.
Brian Durrant is the Investment Director of The Fleet Street Letter.