LONDON: Brexit has claimed another victim: the UK stock market. Three years after the referendum to leave the European Union, the nation’s equity market is shrinking faster than any other major venue globally, according to Citigroup Inc.
The reason? Depressed valuations and low borrowing costs have encouraged listed U.K. firms to pursue the biggest set of buybacks since 2008, fewer companies have gone public amid the uncertainty, and private equity funds and foreign buyers are chasing British acquisitions.
Although contrarians including Citi and London & Capital believe the narrowing of U.K. stock supply could eventually lead to investor inflows and higher returns, the likes of Schroders and Epoch Investment Partners are worried about decreased transparency, elevated shareholder risks as well as growing income inequality since retail investors often lack access to major private deals.
"The big thing that scares me in all of this is that high-quality companies increasingly decide to turn their backs on being public,” said Duncan Lamont, the head of research and analytics at Schroders. "Those investors who focus solely on public markets now have access to a much smaller part of the corporate universe. And a public market investor might end up with lower returns.”
U.K. buybacks are up 9.7% to $45 billion over the past 12 months, the highest level for the period since June 2008, according to data compiled by Bloomberg. Also, lower yields for longer mean firms can keep borrowing cheaply instead of rushing to sell shares and risking falling victim to market volatility.
That U.K. companies are cognizant of this is evidenced by a 57% drop in the value of initial public offerings announced so far this year versus the same period in 2018.
According to Citi, what sets the U.K. de-equitization apart from that of the U.S. market is that whereas the trend is set mostly by buybacks in the latter, it’s foreign buyers driving it in Britain.
With the pound still trading well below its pre-Brexit level against the dollar, deals have taken some big players off the market. Last year’s $39 billion acquisition of Sky by Comcast Corp. and Takeda Pharmaceutical Co.’s $62 billion purchase of Shire Plc alone reduced the public U.K. equity count by 3%, Citi says.
"De-equitization isn’t just about share buybacks. Companies are turning their backs on using the public equity markets to finance themselves,” Robert Buckland, chief global equity strategist at Citigroup, said in a phone interview.
"U.K. is really ripe for de-equitization now. Partly because of Brexit, there’s been a big de-rating of equity against debt. U.K. companies could get picked off by oversees acquirers, which is what has been happening."
While the U.S. stock supply has been shrinking every year since 2011, in the U.K. this trend has become noticeable since 2016. Citi’s Buckland expects the pace of the reduction in British equities to remain at 2-3% per year.
According to Keith Pogson, a senior partner in charge of banking and capital markets at Ernst & Young LLP, the pick-up in U.K.’s M&A activity isn’t unique to the post-Brexit market but is typical for others going through upheaval and increased uncertainty. But this could also mean that British companies will be forced to sell assets at a discount, he said.
"A higher reward premia means a lower price if you’re an issuer because you have to sell it cheaper to get the higher yield,” said Pogson by phone. "That, fundamentally, makes the market less appealing for an issuer.”
The rise in M&A activity is partially driven by the abundance of private-equity capital and reluctance by many U.K. companies to conduct IPOs because of market volatility as well as stringent disclosure and listing procedures.
Such a trend is concerning to Steven Bleiberg, a portfolio manager at the $38-billion Epoch Investment Partners Inc., who says that a privately held firm doesn’t have to disclose as much financial detail as public companies, making the due diligence process challenging and risky.
He says that policy makers might realize that they’ve created too many disincentives for companies to list their shares and ease regulations, reversing the accelerating trend of shrinking equity markets.
Schroders’s Lamont isn’t so optimistic and doesn’t expect this process to stop. Instead, he said asset managers need to find a way to "democratize” client access to private assets.
However, recent instances such as the downfall of star U.K. fund manager Neil Woodford, who plowed his clients’ money into unlisted companies, and record outflows from Natixis-backed H2O Asset Management over concerns about illiquid holdings, show that private investments could come with great risk.
"Investors will ultimately need to diversify their investments into private markets,” said Daniel Kern, chief investment officer at TFC Financial Management in Boston, which oversees about $1 billion."But there’s an important caveat that comes with that, which is private market investments can be riskier and certainly are less liquid.” - Bloomberg
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