As a subdued year on the London stock market comes to an end, Dan Webster (Deputy Head of Investment Banking) looks ahead to what may be in store in 2024.
2023 has not been a vintage year for UK equity capital markets. There have been vanishingly few IPOs, most listed companies have not sought equity capital from investors for either acquisitions or growth, and trading activity generally has been very low. Meanwhile seemingly every week another listed company is acquired by a private bidder. But there are reasons to be more cheerful about 2024, when you consider the problem and its underlying causes.
The dearth of equity market activity has been caused by relentless outflows from UK-focused open ended funds, as investors cut exposure to UK equities in favour of fixed income, global markets or tracker products. In good markets, inflows into such funds drive up stock valuations and fuel activity. But when confidence fractures, investors typically withdraw money from equity funds, forcing fund managers to sell listed assets, pushing down valuations and prompting more selling in a self-reinforcing loop.
Hence in 2023 UK listed companies have had lowly valuations relative to international (particularly US) counterparts and are therefore stuck – unable to issue shares at close to their intrinsic value and lacking confidence that their shareholders would have the capital to support them even if they tried.
The valuation gap has triggered a surge in small and mid cap take-private activity, particularly as the outlook for interest rates has stabilised. Strategic buyers have been particularly active in public bids this year, taking advantage of the UK valuation disparity versus other markets, and offering cash to often reluctant UK shareholders. Private equity, particularly international private equity, has also been bidding for listed companies for the same reasons.
For supporters of London, this is something to be mourned; given the lack of IPOs taking place, the bid activity means that the number of UK listed companies is reducing ever more rapidly.
But there is a silver lining. The accelerating M&A is potentially something of a sugar rush for UK-focused investors. Any investor that holds positions in the UK consumer landscape, for example, may well have had some exposure to Restaurant Group, Lookers, Pendragon, Hotel Chocolat, City Pub Company, Finsbury Foods, SCS, DP Eurasia, Onthemarket or Ten Entertainment, all of whom have either completed or are currently considering different types of take-private transactions. Given a fund manager will hold a limited number of positions, a bid at a 40-50 per cent premium can make a small but important difference to overall fund performance.
On top of this, with cash coming back in from a bid, a fund manager will likely redeploy that capital back into the companies they hold and know best – potentially increasing the underlying value of those positions, and so improving fund performance again. In theory, that should drive relative outperformance versus other benchmarks, which in turn could drive more capital into the funds as investors chase that outperformance. Quite quickly the whole cycle of the negative doom loop can start to corkscrew back the other way, particularly if the wider market is generally feeling more positive about the outlook.
This is obviously only a short-term phenomenon, and it is not exactly a sustainable method of driving a more efficiently priced market or wider equity market activity. And it won’t work if the outflows out of UK equity funds keep continuing regardless of underlying fund performance. But, alongside the significant reforms being considered by the FCA (on listed market regulation) and, probably more importantly, the Treasury (on, amongst other things, driving greater pension exposure to UK listed assets), we could start to see markets getting back to doing what they do best – providing capital efficiently to growing businesses.
Looked at this way, those “predators” taking advantage of UK plc are actually playing a vital role in acting as a “defibrillator” for the capital markets. Clearly, we would like to see companies coming back to the public markets in the medium term, but the recycling of capital that happens following a take-private is a necessary first step to addressing the undervaluation problem. And with the current political impetus for reform to drive change in public markets, the building blocks for a more sustainable recovery are increasingly being built.
Looking out to 2024, IPOs are not going to come back quickly, as very few companies are preparing for a first-half float in London. But we do think wider activity levels in the UK capital markets look set to accelerate markedly, and more strongly than most people dare to think. For the City, and the wider economy, it will be a much-needed boost.