Value at Work: Britain’s Much Maligned Private Equity Push

What is going on with all these private equity deals? That is a question we have seen repeatedly this summer, as financial commentators we follow grapple with the increasing number of UK-listed shares bought out by large investors that have made a business out of taking companies private. As we write, a group of investors is making a widely discussed bid for Morrison’s, and industry researchers report several dozen other deals have been proposed or completed this year. With the number of UK-listed companies shrinking accordingly, several commentators we follow have concluded UK markets are in ill health and will likely struggle to compete with other nations for new listings unless something changes. Some have lauded the government’s proposals to reform listing rules in hopes of enticing more Technology companies to list in London, and perhaps that will indeed prove beneficial. Yet we think there is a much simpler explanation for the buyout spree, one that doesn’t reflect poorly on UK markets.

That explanation: UK markets are heavy on value-orientated companies, and private equity investors are the ultimate value investors. Value-orientated companies tend to carry relatively lower price-to-earnings ratios and more debt, making them more sensitive to economic conditions. They tend to return more money to shareholders via dividends and share buybacks and invest less in growth-orientated endeavours. By contrast, growth-orientated companies generally have higher valuation metrics like price-to-earnings ratios and focus on re-investing profits into the core business to expand over time and capitalise on long-term technological trends, making their profits relatively less sensitive to economic ups and downs, according to our research.

Technology and e-commerce companies are classic growth-orientated shares, whilst Energy, Materials, Financials, Utilities and Consumer Staples sit primarily in the value category. The MSCI UK Investible Markets Index (IMI), a broad index covering 99% of UK-listed firms by market capitalisation, devotes over half its market capitalisation to those five value sectors, versus just 2.7% for Information Technology.^[i] (Market capitalisation refers to the value, in pounds, of all outstanding shares.) Many of the private equity firms’ buyout targets mentioned in this summer’s coverage are in these old-line industries as well as the MSCI UK IMI Value Index. That isn’t an airtight categorisation, as many of the criteria separating growth and value are qualitative rather than quantitative, but we do think it illustrates the broader point.

Investors who specialise in value-orientated shares are typically looking to buy companies valued (in their view) too cheaply relative to their underlying assets or future earnings potential. The goal, as summarised by Benjamin Graham and other legendary value investors throughout history, is to buy the company when it is troubled and therefore cheap, hold it as management turns the business around, then sell at a nice profit. Fisher Investments’ founder, Executive Chairman and Co-Chief Investment Officer, Ken Fisher, also wrote at length about this tactic in his 1984 book, Super Stocks.

This is also generally the goal of private equity investors. They have long had a bad reputation as corporate raiders that buy familiar businesses, load them up with debt, make workers redundant and leave them as hollowed-out shells of their former selves. When Debenham’s went out of business earlier this year, we saw several commentators pin the blame on the three years the company spent in private equity ownership in the mid-2000s. Like most widely held views in the financial world, there are some examples of businesses going bankrupt under private equity ownership, and we think this is likely how their nefarious reputation came about. But in many of those cases, those bankruptcies happened not because the private owners ran the business into the ground or stripped its assets, but because a recession struck before the turnaround was complete, upending it. We recall this happening with a number of American retailers in the deep 2007 – 2009 recession, for example. In other cases, the turnaround plans have proven too ambitious and unable to save a terminally ill business. Yet if destruction and bankruptcy were the norm, private equity would likely have died out long ago for not delivering a profit. In many cases, the business does eventually return to public markets, revitalised and ready to face the future.

Rather than view private equity’s forays into the UK as a dark omen, we think a different view is more accurate: Investors wouldn’t be snapping up UK companies if they didn’t see promising businesses operating in one of the world’s freest economies with some of the world’s finest thinkers and workers. Nor would they be doing so if they perceived Brexit and the related trade and labour disruptions as an insurmountable problem—in our view, this is a case of international investors voluntarily making a strong statement about Britain’s economic future and putting big money behind it. Moreover, by taking these companies private, they free up shareholders’ capital, making more funds available to invest in new companies. That could very well foster the development of more Technology and Tech-related companies, abetting the UK’s ongoing economic evolution.

Perhaps that evolution will increase the UK’s weighting in growth-orientated companies in the future. But even if Britain remains value-heavy, it doesn’t mean UK markets are inferior or destined always to trail the rest of the world. Growth isn’t inherently better or worse than value—just different. Growth-orientated shares have led in recent years, but value has had plenty of turns in the spotlight over time. According to our research, value’s best returns arrive just after bear markets (typically deep, lasting declines of -20% or worse with an identifiable fundamental cause), when they are most attractive to bargain hunters and can reap easy returns off a very depressed base. When that day arrives, we think there will likely be plenty of ripe opportunities for individual investors to deploy the same tactics the private equity crowd is using today.