By Shristi Achar A and Johann M Cherian
(Reuters) - Even as higher costs of borrowing continue to choke dealmaking, fund managers and bankers believe smaller UK-listed firms remain attractive to private equity players flush with unspent funds of nearly a trillion dollars.
Central banks have been battling high prices by hiking borrowing costs for more than a year now and market participants expect the Bank of England to lift the benchmark rate to over 5%.
While this has put pressure on dealmaking overall, Britain has recently witnessed multiple proposals for takeovers including Network International Holdings, Hyve Group and Medica Group.
Among the most talked deals was the takeover of veterinary drugmaker Dechra Pharmaceuticals by Swedish private equity (PE) firm EQT, which is now near completion at 4.46 billion pounds ($5.57 billion).
The companies in discussion are largely small- to mid-sized, making them achievable targets, as opposed to firms listed on the FTSE 100. Market analysts believe higher interest rates may not be a wall high enough to halt PE dealmaking entirely in the UK.
One of the contributing factors for PE firms' abundance of cash, or "dry powder", is the continued buildup of uninvested capital during the pandemic, according to fund managers.
Globally, the availability of unspent funds is estimated to be around $2.5 trillion as of May, according to data provider Preqin, with about $922 billion earmarked solely for buyouts.
"Private equity houses have had reasonably strong balance sheets through COVID in the past 2 to 3 years. So, there is money in the system looking for returns," said Richard Bullas, portfolio manager for Martin Currie UK Equity team with Franklin Templeton.
During the first five months of 2023, nine listed firms on the London Stock Exchange were approached by PE firms, exceeding the number of targets in the same time period last year, according to Refinitiv data.
Since then, central banks have hiked interest rates, with borrowing costs in the United States and the UK at more than four times when compared with the levels in May 2022.
The nine takeover approaches in the UK by PE firms this year have a potential aggregate deal value exceeding $8 billion, which is more than half the value of PE deals for each of 2021 and 2022.
However, some of the proposals have also been taken off the table, like Apollo Global Management's bid for John Wood Group, but not before the PE firm submitted five separate bids to take over the oil services provider.
"PE funds have significant 'dry powder' and a robust pipeline of deals, so we expect to see selective deals get done in 2023 ... there will be a continued overall slowdown in momentum for the rest of the year compared to prior years," Kirshlen Moodley, head of UK advisory for BNP Paribas, said.
The other side of the coin is valuations of UK equities also took a severe beating in 2022, with investors wary of a looming recession as major central banks raised rates at a pace not seen in years.
In 2022, the FTSE Small Cap index and mid-cap FTSE 250 index fell nearly 16% and 20%, respectively, marking the worst performance since the 2008 financial crisis.
In terms of valuations, the mid-cap index is trading at 11.4x forward earnings, while the small-cap index is at 10.2x.
The valuations are less compared with their U.S. and European counterparts. The S&P 400 mid-cap index is trading at 13.6x forward earnings, while the STOXX Europe Mid 200 index is at 13.2x.
Among those out shopping for firms, many seem attracted to these lower valuations of small- and mid-cap firms.
"The UK stands out as being undervalued, in particular, down the small- and mid-cap end," Bullas said.
"And that valuation opportunity at the moment is being taken advantage of by overseas capital looking for the best return and risk-adjusted opportunities, and the UK is one that's relatively low risk on a global scale."
Though firms listed on the smaller UK indexes are more domestically focused than their larger counterparts, analysts point out that nearly half of their revenue is from their international presence, making them an even more attractive purchase for PE firms.
"When you look at the FTSE 250 and the 100, these are global companies. They may be listed here in the UK, but their revenue is quite global and diversified, with revenue pools in the U.S. and across Europe," Moodley said.
($1 = 0.8010 pounds)
(Reporting by Johann M Cherian and Shristi Achar A in Bengaluru; Editing by Shounak Dasgupta)