The UK has recently established itself as Europe’s number one destination for inbound M&A investment, as foreign buyers increasingly targeted UK firms, partly spurred by the country’s strong recovery from COVID-19 in comparison to its EU counterparts.
However some of the reasons behind the surge in inbound investment were hardly sanguine. These included the plummeting pound, especially against the greenback, and generally lower company valuations that for similar businesses abroad.
Following Liz Truss’ victory in the Conservative leadership election, new Chancellor Kwasi Kwarteng’s mini-budget in late September – which featured sweeping tax cuts – was described as putting the UK on an “unstable” financial trajectory.
This resulted in the pound falling below $1.10 for the first time since 1985, with a drop of 3 per cent the day of the mini-budget representing the currency’s biggest one-day fall since the initial onset of the COVID-19 pandemic in March 2020.
Kwarteng subsequently hinted that further tax cuts were coming, declaring the new government was “just getting started”. This move was characterised by the Labour party as “fanning the flames” of the falling pound and the following Monday the currency fell to an all-time low of $1.03.
In spite of this, the government has, so far, remained steadfast in maintaining that cutting taxes will help drive the growth needed to kickstart the UK economy. This has prompted forecasts that the pound could even fall below parity with both the dollar and the euro.
For both strategic and private equity buyers in the United States, this has created an interesting window of opportunity to make a move on companies they have previously had an eye on.
What is behind the UK’s financial instability?
One of the main factors underpinning the UK’s financial instability and the weakness of the pound is the ongoing energy crisis, as the fallout of Russia’s war in Ukraine pushes oil and gas prices higher. This has led to predictions that both the pound and the euro could be stuck in a “doom loop” of low valuations.
The energy crisis, which has fed directly into the soaring cost of living and skyrocketing rates of inflation, has provided a backdrop to wider turmoil impacting the UK economy. Following the resignation of Boris Johnson as Prime Minister in July, UK politics was paralysed by a protracted race to find the country’s next leader, a race that was ultimately won by Liz Truss against the more establishment candidate, former Chancellor Rishi Sunak.
The death of Queen Elizabeth II just two days after Truss assumed office plunged the government back into a state of inertia for a further ten days. When parliament resumed, Kwarteng delivered his “mini-budget” - a virtually unprecedented series of tax cuts (widely perceived as majorly favouring the UK’s highest earners), backed by huge amounts of borrowing.
With the pound having already fallen to a 37-year-low against the dollar, the budget and Kwarteng’s subsequent promise of further tax cuts to come pushed the currency down to its lowest level against the dollar since the UK moved to the decimal system in 1971.
How will this impact valuations and M&A?
UK company valuations have been largely on a downward trend since the UK left the European Union. Furthermore, with the pound now extremely weak against both the dollar and the euro, overseas buyers would now seem to be in a stronger position than ever to take advantage of the situation.
This is destined to lead to an acceleration in distressed M&A, as buyers pounce to acquire companies (many of whom will be struggling with issues like rising energy bills, degrading consumer sentiment amidst the cost of living crisis and repaying COVID-19-related debts) at low prices.
Given the weakness of the UK economy, however, and the widespread problems facing UK businesses, it seems likely that this distressed M&A will be increasingly driven by overseas buyers, boosted by the relative strength of their currencies in comparison to the flailing pound.
Over recent months, the most pronounced inbound M&A trend has perhaps been an influx of investment from France, as buyers in the UK’s closest EU neighbour pounce on depressed valuations, driven by high inflation, the weak pound and low confidence among UK buyers.
This has led to some major acquisitions by French buyers, including Schneider Electric’s £9.5 billion takeover of Aveva (which had seen its value plummet 23 per cent over the past year) and the acquisition of a 2.5 per cent Vodafone stake by French entrepreneur Xavier Niel.
Commenting on this trend, Citigroup’s Head of UK Investment Andrew Truscott said: “Each of these situations has its own peculiarities and you can’t extrapolate too much, but what you can see is that there is a global recognition that the businesses in the UK are cheap. There is not the liquidity coming into the UK market. It is all cash coming out.”
While France has long been one of the major international acquirers of UK assets, the current level and value of dealmaking points to the opportunities that French buyers are seeing to acquire companies and assets at low valuations. According to data from Refinitiv, 2022’s inbound investment into the UK from France is at its highest volume in at least a decade, while deal value is at its highest since 2013.
What of the US?
Despite the influx of investment from EU nations such as France, the inescapable truth is that the euro is hardly on the up, despite its relative strength in comparison to the pound. One Euro bought 84p in early August and 88p on 1st October. Meanwhile, the US Dollar bought 81p on 1st August and 90p on 1st October. While the major EU economies may currently be more stable than the UK’s, nations on the continent are just as exposed as the UK (if not more so) to major headwinds such as the energy crisis, the war in Ukraine and supply chain disruption.
Since the end of 2021 and the start of the week beginning September 26 2022, the nominal effective exchange rate of the euro depreciated by 16 per cent, while the pound depreciated by 21 per cent over the same period and the yen fell 20 per cent. By contrast, the US dollar’s effective rate has appreciated by 12 per cent.
Arguably, this trend could be accelerated by the ongoing energy and supply chain crises impacting the euro and pound. We have just been reminded of the influence of UK government policy has on the value of sterling. These mostly negative forces have resulted in a scenario where US buyers are very well placed to capitalise on weak UK company valuations and a rock-bottom pound.
Even prior to the pound’s calamitous fall, the US has been the biggest inbound investor in UK businesses. According to the latest government figures, covering 2020, US businesses accounted for the highest value of inbound investment into the UK, with £699.8 billion. With the pound and euro now weaker, and UK company valuations falling accordingly, the US’s share of inbound investment can be expected to grow considerably.
As Tom Braithwaite recently noted in the Financial Times: "The US is the real source of the threat to the UK — not just as a listing destination but as the home of potential acquirers. With the ammunition of a strong dollar, expect American companies to join the French at the UK’s bargain bin.”
Technology companies are centred in the sights of the American buyers. Manysmall to medium private businesses were already being eyed up before the pound began its fall, and large companies were vulnerable to buyouts.
Arizona software behemoth NortonLifeLock bought up anti-virus business Avast Plc in September, whilst US private equity firms Thoma Bravo and GTCR are in the midst of buying cybersecurity companies DarkTrace and GB Group respectively.
Stuart Bedford, Corporate Partner at Linklaters, commented: “If I were a US company that saw a good IP base or a good opportunity to spread my footprint into the UK right now, I’d probably be looking at it thinking it’s a good time to strike. You’d be nuts not to if you are cash-rich.”
What issues are UK firms facing that could heighten distress?
Companies in the UK are also continuing to face a raft of headwinds that put them at risk of serious financial distress over the coming months (if they are not already in a distressed state) and could make them particularly vulnerable to takeovers by foreign buyers.
Perhaps the headline issue facing UK businesses is increasing energy prices as the cost of oil and gas soars amid Russia’s ongoing war in Ukraine. As the UK enters autumn and winter, businesses will be forced to use more energy on heat and lighting, among other things, all while paying higher prices to do so.
While one of the Truss premiership’s first acts was the introduction of a temporary £2,500 energy price cap for businesses (a move that was widely welcomed, with businesses previously not having enjoyed the protection of a price cap), businesses are still paying far more for their energy bills, something that was leading to an uptick in insolvencies even during the summer.
In the construction industry alone, rising energy costs were cited as the key reason behind insolvencies increasing from 313 in June 2022 to 347 in July (as per HM Insolvency Service figures), with rising energy bills seemingly the tipping point for companies already impacted by slowing demand, rising labour costs and supply chain disruption.
During August 2022, the UK recorded its highest number of insolvencies for the year, as 99 companies fell into administration amid soaring energy bills and rising costs. The figure for August 2022 was up 41 per cent compared to the same number a year earlier and brought the total number of UK insolvencies during 2022 to 522 (the construction sector being the worst affected, with 87 administrations in the year to date).
The price cap will limit business energy costs to around £211 per megawatt hour (MWh), nearly half the recent average of over £400 per MWh. However, this is still approximately double the average cost of slightly over £100 per MWh from October 2021 and, for many businesses (particularly small and medium-sized firms in energy-intensive industries such as construction, hospitality and manufacturing), this increase will simply be unsustainable.
Even for bigger firms, rising energy costs could prompt a need for readjustment. JD Wetherspoon, among the biggest operators in the UK’s pub sector, recently announced that it was putting a portfolio of 32 pubs up for sale, a move it openly described as a “commercial decision”, with pubs among those most vulnerable to higher energy bills.
On top of the energy crisis, UK firms are also continuing to contend with supply chain issues, caused by a confluence of factors including a shortage of materials, soaring post-COVID demand and which has now been exacerbated by the effects of the war in Ukraine. To look again at the construction industry, supply chain issues have led to firms paying more for materials, facing longer waits to receive them and, in many cases, losing contracts as project timelines are pushed back.
Companies across the UK are also still navigating the debt burdens they accrued during the pandemic, when thousands of firms took on government-backed loans to help them survive COVID-19 and were enabled to remain solvent due to a temporary ban on creditor insolvency action.
With the repayment on these loans now due and the limits on creditor action lifted, thousands of companies are facing potentially insurmountable debt piles that could lead many to seek a buyer prior to entering insolvency or to succumb to an administration process.
Finally, with consumers facing up to the soaring cost of living (amid rising energy bills and costs for essentials such as fuel and food), UK companies are seeing customers spending less, as households limit their budgets in order to afford the essentials and with consumer confidence set to fall further as the impact of rising energy bills fully hits over the winter.
Conclusion
To quote Ross Michinson of British investment bank Numis, “M&A is being driven by U.K. companies being bid for by overseas companies getting the double benefit of weakened sterling and lowly valued equity markets”. US buyers also benefit from the dollar’s growing strength and the stockpiles of M&A capital they accrued during the pandemic (especially for private equity firms).
While EU buyers are also clearly taking advantage of low UK valuations, the euro’s own struggles and the persistent headwinds across Europe mean that US buyers are particularly well-placed to take advantage of struggling UK firms, many of which could fall deeper into financial distress over the coming months.
The huge economic instability the UK is currently experiencing may prevent a genuine boom in inbound M&A activity. However, the current situation is arguably a unique one, in terms of the strength that US buyers currently possess over struggling UK assets.
With UK firms continuing to lead the way in key sectors such as technology, life sciences, recruitment and wealth management, US buyers find themselves in a situation where they can pick up highly attractive assets at rock-bottom prices and this fact alone seems guaranteed to drive significant transatlantic M&A activity over the coming months.
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