UK companies on hunt for larger deals but shareholder activists encourage boards to keep one eye focused on cost reduction

6 May 2014

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  • UK companies appetite for US$500m plus deals increases
  • Immediate appetite for acquisitions at 26% - 11% lower than it was in October
  • Renewed cost management strategies driven by shareholder activism
  • Re-balancing of M&A investment between emerging vs mature markets

Larger transformational deals look set to increase over the next 12 months, as UK companies place fewer but bigger bets on the table for assets that offer a clear and strategic rationale.

The environment for major transformational acquisitions has strengthened as leverage returns with companies prepared to take measured and bold moves in light of the improving economic conditions, although shareholder activists are influencing boards to focus on short term, lower risk activity - according to EY’s tenth bi-annual Capital confidence barometer, a survey of more than 1,600 senior executives.

UK companies’ intentions to engage in larger deals (greater than US$500m) have risen in six months – 10% to 16% - a sign that plans for transformational acquisitions are accelerating. However, overall appetite for acquisitions at 26% - 11% lower than it was in October – shows that, while there is more of a focus on larger deals, boards are increasingly being encouraged to focus on cost reduction, which is being elevated up the boardroom agenda as a result of shareholder activists.  93% say the boardroom agenda is heavily influenced by shareholder pressure and 38% expect to pursue cost reductions as a result.

Respondents’ expect a significant increase in use of debt to finance acquisitions, with debt usage as a percentage of purchase price up from 33% to 43% over 12 months. Despite record cash balances, advantageous debt financing is spurring the shift from debt to cash.

Jon Hughes, EY’s head of Transaction Advisory Services for UK & Ireland, commented: “Value not volume will be making headlines in the near-future, with prominent large deals part of an emerging trend. What we are seeing now is a level of activity driven by deals that offer a strategic fit to those businesses - companies and boards are opting for quality rather than quantity.

“The interplay of confidence, risk and shareholder action is leading to strategies that seek to balance growth and cost reduction. Pressure for UK companies to grow remains and lessons learned from the global financial crisis mean that closer scrutiny on cost structures and operational efficiency is now the norm and will not be abandoned despite improved economic confidence.“

Companies have been rewarded for consistency, cost-cutting and lack of risk taking and this is now ingrained. Nevertheless growth is returning to the agenda and M&A is one of the tools for achieving this.”

Valuation gap narrows

The gap is contracting between the price companies are willing to pay for assets and underlying valuations. Almost half of respondents believe the valuation gap is now less than 10%, and a vast majority (56%) expect valuation gaps to remain the same or contract over the next year. This will foster an environment in which companies can close larger, strategic deals.

Political instability and risk drives re-balancing of investment destinations

The survey revealed that there are clear signs of geographic rebalancing amongst corportes from emerging towards developed markets. This is shift has been primarily driven by political risk, with 32% of UK respondents believing that increased political instability is the greatest eonomic risk to their business over the nex 6-12 months.

This is closely followed by the tapering of quantitative easing by the Federal Reserve - a particular concern for 23% of UK respondents - reflecting the exposure of UK business and investment to emerging market performance. Conversely, confidence in the Eurozone is surprisingly high and neither inflation nor deflation are seen as significant risks.

Mark Gregory, EY’s Chief Economist and Transaction Partner said, “The overall trend is of a re-balancing of portfolios from emerging towards developed markets as the growth gap narrows and relative risk widens.

“In response, UK companies are shifting capital towards developed markets at a faster rate than the global average, reflecting the improved prospects for key UK markets such as the US and Eurozone. China remains the number one target for UK investment but 52% have increased their focus on non-BRIC emerging markets over the last year.”

The top five global investment destinations for UK companies are China, South Africa, Singapore, UAE and US.

Gregory, adds, “Now, more than ever, is the time for businesses to review their portfolios in their chosen markets in light of the effects of tapering, political instability and slower growth in China. Markets are changing rapidly and what was once an attractive destination to do business may be slipping when compared to more developed markets. Risk has been significantly underpriced by many and the shift towards developed markets helps balance the risk versus reward profile of their portfolios.”

Despite shocks, recovery is resilient

Economic confidence is more resilient than at any time in recent years, with 63% of respondents viewing the economy as improving compared to 43% one year ago. Confidence in all the key financial indicators has increased significantly over the last six months – corporate earnings (63%) short-term market stability (67%), credit availability (62%) and equity valuations/stock market outlook (62%).
Gregory adds, “The pattern is similar to the views on the global economy and reflects a realistic view of economic prospects but also a more resilient outlook – business leaders recognise that there will be volatility but recent events have not dented confidence significantly.”

UK deal-making becomes measured, sensible and selective

Hughes concludes, “The fundamentals for high-value deal-making are very favourable and historically this would have translated into a wave of global M&A. However, companies are increasingly aware of risk, with political instability, unsettled emerging markets and tapering of quantitative easing in the US seen as key economic risks. The complexity of the challenge facing executives today means M&A is more measured, sensible and selective.

“From the businesses we are working with it is clear that they are considering a wide range of deals but are conducting more detailed due diligence to make sure they the deals they are committing to are a strategic fit for the wider business. What we can expect is high-value headline-hitting M&A, given the upsurge in the appetite for much larger deals, as executives look to transformational acquisitions to move the growth needle.”