UK – A shrinking pool of equities

UK equities – this really matters

• Continued M&A – After a lull due to rising interest rates and funding uncertainty, 16 potential transactions of >£100m have been announced YTD and 12 of them are from financial investors.
• Not refilling the hopper – Over the same period, there has been only one IPO of note.  
• In this report we look at the shrinkage in the numbers of companies and market cap of UK equities over the past five years.

There is a problem – There has been considerable de-equitisation of the UK market over a number of years and the pace is accelerating. Reform of the listing requirements and research rules should help, but much more needs to be done to ensure that being listed is seen as an attractive option.

Does it matter?

Undoubtedly yes, for several reasons. The reduction in the listed ecosystem has numerous ramifications in terms of:

• UK economic growth, given that small & midcap companies are generally growing, whereas many of our larger companies are shrinking their workforce.
• Lower attraction of the UK as a listing venue, particularly as many companies leaving the market are in growth sectors.
• Reduction in sector peers and depth of knowledge, which further reduces the attraction of listing in the UK. This is most obvious in the technology sector with the recent departures of Aveva, Avast and Ideagen, and in healthcare with CareTech, Emis, Mediclinic and Vectura leaving.
• Negative impact on a broad range of professional services firms, which is a particular area of expertise and knowledge in the UK. 
• Reduction in corporation tax due to the new ownership structure (eg Asda & Morrisons).
• Reduced importance of UK markets in international indices, resulting in lower attention from international investors.
• Quoted companies generally have conservative balance sheets, enabling greater capability to manage economic shocks and interest rate cycles. The benefit of permanent capital should not be under-estimated.
• There is a change from broad to narrow ownership. 
• Circularity of negativity, whereby valuations are low, liquidity is depressed and companies exit the market as long-term prospects/valuation are not being adequately recognised.

Furthermore, there is a societal benefit of being quoted in terms of the level of scrutiny, both financially and operationally, that is lost as businesses are taken private or subsumed within other companies.

Shrinking UK equity markets

In the current year, 16 offers have already been made for companies with a market cap of >£100m. In the same period, there has only been one IPO of note (CAB Payments). All of the potential departures in the current year are in the small & midcap space, which continues the five-year trend, as shown in the data below.

Figure 1: Number of companies per index

Source: Company accounts, Peel Hunt estimates

Obviously the FTSE 350 has the same total number of companies across each period. However, the shrinkage can clearly be seen in the FTSE Smallcap, which has reduced by 61 companies, or 21% over the past five years.

This could be explained by the big getting bigger, as the overall weighting of the FTSE All-Share is intended to be at least 98% of the market capitalisation of companies available for inclusion (although there are also tests on liquidity, free float and a market cap requirement of >£50m). However, a similar trend can clearly be seen when looking at the FTSE Fledgling, which includes those companies that are too small or illiquid for the FTSE Smallcap. The number of companies in the FTSE Fledgling has reduced by 30, or 28% over the past five years and by 44, or 37% over the past 10 years.

Actually the real picture is worse than this. The overall numbers are helped by a material increase in the amount of funds over the past five years. If these are excluded, there has been a 15% reduction in the number of trading companies in the FTSE 250 over the past five years, with a 25% reduction in the FTSE Smallcap and a 48% reduction in the FTSE Fledgling. 

In case anyone was thinking that this is due partially to some companies moving to AIM – well the AIM All-share has also contracted, with a reduction of 97 companies (12%) over the past five years. 
There is a further issue as the level of market cap available has shrunk. For example, the FTSE All-Share is flat vs five years ago, but the market cap of trading companies in the FTSE All-Share is 16% lower, with the market cap of the FTSE 250 down 28% and the Smallcap down 45%.

All of this shows there is a very clear and real issue that needs to be addressed. Some of this can be attributed to a ‘UK discount’ given the performance of the UK economy, a sharp increase in interest rates and political turbulence. However, in reality, the UK has experienced many of the same issues as other regions and with the perspective of time, this will be seen to be more of a judgement call than reality. Furthermore, the UK has a large number of internationally-focused listed companies, so the real relevance of this point is diluted.

A large part of the issue has been the steady withdrawal of funds from UK-facing portfolios. This has been particularly marked over the past two years, as shown below.

Source: Calastone

This trend means it is not remotely surprising that UK indices have underperformed, given that fund flows are a key driver for share prices. It also drives the perception that the UK is not open for business and depresses valuations, which results in companies being attractive acquisition targets for both corporate and private equity. Furthermore, it makes the UK relatively unattractive to list given the limited funds available to invest in existing businesses, let alone ones seeking to list. 

In conclusion, the UK used to have a thriving UK small & midcap sector, which was the envy of most other leading markets. This position has been materially undermined and squandered, which is to the detriment of UK PLC and the overall attractiveness of the UK as a financial powerhouse. As markets increasingly globalise, there is a clear risk that the relevance of the UK small & midcap market continues to diminish.

What can be done?
We believe the potential changes in the listing rules and Austin Review should improve the relative attraction of the UK market, and Rachel Kent’s Investment Research Review should help to increase coverage. However, in our view, these should be seen as only part of a series of remedies.

Although the UK’s economic performance has been mundane in recent years, this does not explain the torpor in UK equity markets and the steady de-equitization. Other reasons include the loss of growth companies, the relative lack of attention from international investors and the subdued liquidity. All of these issues can be addressed through considering options to enhance the UK as a listing venue.

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