The UK market has potential to catch up with Europe in terms of M&A activity. Here, one firm sets out its approach to exploit the market when it wakes up.

A chill was cast over UK mergers and acquisitions just after the Brexit vote on 23 June. International and UK investors were cautious. Nevertheless, investors have since confirmed their strong interest in the UK, where M&A has lagged the rest of the world, so the author of this article argues, and there are opportunities as it catches up. The author is Philippe Lecoq, co-manager of the Edmond de Rothschild UK Synergy fund. The views of guest authors are most welcome; the editors do not necessarily share all views of outside contributors and invite readers to respond.

The capacity for risk assets to rebound took everyone by surprise and equity markets returned to pre-referendum levels within a month. Action from the Bank of England and a very rapid return to political stability after the vote helped the UK market outperform European markets over the summer. And although it is still too early to assess Brexit’s economic impact, the fact that economic surveys remained upbeat after such a political shock is rather reassuring news and suggests a recession could be avoided.

A good example is the acquisition of ARM Holdings by Japan’s SoftBank barely three weeks after the vote. Cambridge-based ARM has the largest capitalisation in London’s listed high tech sector and is a leader in mobile phone processors. Its microchips are used in most smartphones. The bid was priced at a 43 per cent premium to the 15 July close, a very interesting proposition in our view, which explains why we sold the remainder of our position on the day the news broke. 

What we need is a little more currency stability
Whilst Brexit is a source of volatility, the M&A market is still showing positive signs, in particular with the pound as weak as it is. This could, in fact, prove beneficial as sterling’s sharp decline offers up some interesting opportunities for foreign predators while giving UK firms a strong competitive edge. Some bid targets will now look very cheap, which could trigger opportunistic bids insofar as companies still look attractive.  

Many sectors in the UK could see further consolidation so investors should take advantage of cheaper stock options while they still can. The UK market underperformed the rest of Europe between 2012 and 2015 and only this year is the UK starting to recover, which means stocks are still trading at a major discount. There have been outflows in UK equity markets for the last three years but that trend could reverse. Even so, the asset class is underweighted by many asset allocators. Maybe what we need is a little more stability as far as the currency is concerned before investors are willing to jump in.

The market offers many targets
The utilities sector will be a hotbed of M&A activity. Such deals would be much easier in the UK than in Continental Europe. Water companies in particular remain very attractive in terms of cash generation, visibility and dividend payments due to the regulation of the business. Severn Trent, Pennon and United Utilities are domestic players, but their businesses have very stable and predictable activity. Also, a little bit of inflation could be good news for the sector since the price of water is linked to the consumer price index. They are perfect targets for investors looking for yield. We also like the hotel sector and hold Intercontinental. 

The wave of M&A in the asset management sector is likely to continue as competition increases and margins decrease. Midsize companies must grow and achieve scale. Elsewhere, Deutsche Bank may sell its AM division to get cash. Within financials we are cautious on banks and the level of profitability. A number of banks are having to raise capital and look weak, although many European banks have built good capital buffers. 

Telecoms companies: look at content players
The media sector is a good place to be currently. ITV, which owns several internationally-popular TV shows and is the UK’s leading audiovisual group with a 46 per cent market share, and Sky are attractive targets for telecoms companies like US giant Liberty Global that are hungry for additional content. It boasts a very strong and rapidly expanding content offering, a big advantage which could appeal to certain UK or US distributors. The trend for telecoms companies to purchase content players is likely to continue, as they have to offer more and more to subscribers. 

Elsewhere, semiconductors is a sector that looks very attractive. Industrials, especially oil and gas equipment, could be attractive as the sector is relatively unconsolidated (Weir Group, for example). Aircraft and defence is another area which could see targets from bigger US names and possibly from within the UK. With some companies operating in a niche market, their technologies could be interesting for big companies. 

Another interesting target is Meggitt, which makes components for the defence, petrochemical and aerospace industries. The sector is still very fragmented. Sterling’s fall was initially damaging for the firm but it makes 35 per cent of sales in the growing defence sector in US dollars and should see sales rise. The recent stake taken by the activist hedge fund Elliot Capital, a specialist in identifying bid targets, reinforces the probability of a takeover.

The UK market has the potential to become the most active within Europe in terms of M&A. Our investment approach allows us to exploit this opportunity and to create investor value. The sleeping beauty could awaken soon.