Importance Score: 65 / 100 🔴
Private Equity Eyes UK Smaller Companies: A Buying Opportunity?
Fund managers suggest that investors should pay close attention to why private equity firms are acquiring undervalued UK smaller companies. The UK’s listed smaller companies are increasingly facing takeover bids, as attractive share prices and subdued investor interest present private equity buyers with opportunities to extract value. The current lack of strong positive sentiment from larger investors may create avenues for smaller investors to capitalize, according to Abbie Glennie, co-manager of Abrdn UK Smaller Companies Fund and the Abrdn UK Smaller Companies Growth Trust.
The Valuation Disconnect
Glennie stated, “These discounts reflect the negative sentiment that we’ve seen towards UK smaller companies in recent times. While it’s true that the sector has faced a challenging period – with underperformance and stricter regulation – ultimately, negative sentiment is just that: sentiment.”
Ken Wotton, of Gresham House’s Strategic Equity Capital, noted that the typical premium offered in small-cap acquisitions, compared to undisturbed share prices over the past 18 months, exceeds 50 percent.
This indicates that acquirers see inherent worth in UK small caps that investors may be overlooking.
“The UK is trading at multi-decade discounts relative to global equities,” stated Wotton. “The smaller you go, the greater the discount becomes when comparing smaller and larger companies.”
UK Small Caps: Undervalued?
Data from Aberdeen suggests that UK smaller companies are significantly undervalued based on 12-month forward price-to-earnings ratios compared to their ten-year average.
Aberdeen reports that this undervaluation extends globally, with small caps trading at discounts: European small caps at a 28 percent discount, US small caps at a 26.9 percent discount, and Japanese firms 19.4 percent lower.
However, the trend might be shifting for UK small caps. After a strong performance in the past month, they are trading at a 14.6 percent discount to their ten-year average. In March, the discount for UK small caps was the widest among major markets at 23.4 percent.
This recent uptick could indicate that investors are finally acknowledging a series of buyouts and significant investments.
The tech, media, and telecom sectors have experienced the most takeover activity, with the consumer goods and retail sectors also seeing increased interest.
Glennie added, “Confidence in the US ‘mega caps’ has waned, and investors are exploring ways to reduce their exposure. Consequently, interest in other asset classes is rising.”
“Within the UK, there’s a more favorable outlook toward domestically focused UK companies than we’ve seen in many years. This could be beneficial for UK smaller companies.”
“While we haven’t yet observed a significant shift in sentiment toward UK smaller companies and inflows into the asset class, the groundwork for a recovery is being laid.”
Compared to private market valuations, small caps in public markets trade at discounts of approximately 30 percent. According to Wotton, these discounts sometimes reach 50 percent.
“This situation creates a substantial arbitrage opportunity between private markets, international markets, and UK small caps,” Wotton explained.
This price gap attracts potential buyers, contributing to increased takeover activity in the sector.
Wotton noted that potential acquirers range from US and European private equity firms to strategic buyers from the UK, Europe, and the US.
“While the buyers vary, the consistent factor is the valuations of the companies being acquired,” Wotton emphasized.
Implications of Takeovers for Small Caps
As long as UK small caps remain broadly undervalued, they will likely continue to be takeover targets.
“I anticipate continued high levels of takeover activity,” Wotton told This is Money.
“Any change will depend on either an increase in valuations in the UK small-cap sector or a decrease in valuations in other areas.”
Wotton added, “The ongoing takeovers at a premium clearly indicate existing valuation opportunities.”
However, concerns persist that the UK small-cap market is gradually being depleted by private equity acquisitions and delistings. The decline in UK IPO activity further exacerbates the precarious condition of the small-cap market.
Some firms are bucking this trend, such as the listing of a new British bitcoin holding company by Smarter Web Company, but such occurrences are rare.
Last year, Peel Hunt suggested that the FTSE SmallCap index could vanish by 2028 if current trends persist.
Although this scenario might be extreme, Wotton observes little indication that investors are changing their stance on small caps.
He stated, “Over the past couple of years, I’ve been expecting this elevated level of takeover activity to highlight this valuation discrepancy and draw more capital back into the UK small-cap market.”
“Instead, we’ve witnessed consistent month-on-month outflows from UK funds.”
Strategies for Profiting from UK Smaller Companies
Fund managers can actively prevent their holdings from succumbing to opportunistic takeovers, according to Wotton.
Strategic Equity Capital, the investment trust managed by Wotton, focuses on the long-term financial health of its investments, aiming to “ignore short-term market sentiment” and “concentrate on high-quality companies trading at appealing valuations.”
Additionally, Wotton emphasizes the importance of Strategic Equity Capital’s readiness and willingness to actively engage with the companies in which they invest.
According to Wotton, Strategic Equity Capital intentionally acquires larger stakes in businesses, as this empowers them to proactively collaborate with those companies.
He clarified, “We draw a distinct line between activism – which we don’t engage in – and constructive active engagement, which we actively pursue.”
“This entails working with management teams and boards, contributing to critical issues that we believe significantly impact shareholder value. These include business strategy, capital allocation, board composition, and aligning management incentives with long-term shareholder value.”
He adds that engagement enables them to connect companies with valuable individuals or firms, further “supporting value creation and adding value ourselves along the way.”
The ultimate goal is to improve small-cap valuations, deterring private equity firms from acquiring them at a discount.
However, this strategy can also help to fend off unwanted takeover attempts.
He adds, “Given the prevalence of takeover approaches, some of which are opportunistic due to low valuations, the last thing a management team or board wants is for someone to offer a 30 percent premium over a depressed share price, leading shareholders to capitulate and sell the company.”
“When we hold a significant stake, we potentially have the ability to prevent that from happening, and we have done so in several instances.”
“As a board, maintaining open and supportive communication with an investor signals that, as long as you are pursuing the right course of action aligned with our shared vision, we won’t succumb to such offers.”