Will political uncertainty stifle M&A in 2017?

The pound's post-referendum drop hasn't boosted exports yet, according to recent data, but there is evidence it has helped spur mergers & acquisitions (M&A). The major example of this was SoftBank's £23.4bn purchase of UK microchip designer Arm just weeks after the referendum. While sterling's fall was not the primary reason for the approach and SoftBank said it excluded the Brexit vote from its investment rationale, the impact on the price would have made the deal more compelling for its chief executive Masayoshi Son.

Pound push

Raj Karia, head of corporate, M&A and securities, Europe, Middle East and Asia (EMEA), at law firm Norton Rose Fulbright, said there had been "definite activity as a result of the weakening of sterling", particularly in real estate.

"Deals are being done principally on the basis that they have been looked at for a while and now it is 15 per cent or so cheaper," he said. Mr Karia highlighted one deal he had been working on for a year where the overseas client had now decided to proceed.

"What you don't do is buy something because it is cheap, but rather you buy something because it is good and the reduction in price helps you make a decision," he added.

Mr Karia said the attraction for overseas buyers of UK property in particular was gaining a sterling-denominated yield, especially if the investor's medium-term view of sterling is that it is likely to strengthen and thus create a growing income in their home currency.

Attractive sectors

Besides property, tech is a sector that is likely to benefit from M&A in 2017. One reason for this is that technology companies predominantly generate profit in dollars and when this is translated back into the currently weaker pound, it provides an upward lift. Areas within technology highlighted by several commentators include fintech, something the UK has a strong track record in, as well as battery technology.

Andrew Philbey, regional research manager, M&A, for data provider Dealogic's EMEA region, said professional services, technology, financials, construction, real estate and healthcare were the consistent top-performing sectors in recent years in regards to corporate activity.

The top 10 sectors for M&A by number of deals

Mr Philbey said that since 2013 there had been a huge rise in the number and size of deals in the technology sector. Back in 2013, there were $11.96bn-worth of deals across 331 deals, but this is already at $47.63bn for 2016 (to 30 November) across 428 deals. Interestingly, the number of deals compared with 2015 (441) is still lower, but the value of them is well ahead already ($33.03bn).

He said any company that boasts a significant amount of dollar or euro earnings could also be an attractive target for an acquirer, if you take into account the thrust given to the numbers when translated into pounds. Investors keen to benefit from M&A are also more likely to be lucky if they invest in mid-cap stocks, which several commentators cite as an area ripe for consolidation in 2017.

Uncertainty no barrier

Political uncertainty is undoubtedly at a high point, with Brexit negotiations expected to begin in 2017, Donald Trump to assume the US presidency and elections across Europe. But this doesn't necessarily mean dealmaking will be stifled.

David Hall, managing director of private equity business YFM, said there could be some drivers that make 2017 a vintage year. His company, which runs enterprise investment trusts as well as investments for family offices, recently sold Go Outdoors to JD Sports (JD.) for £137m – or 37 times the original investment it made in 2002.

Mr Hall said 2002-03 and 2009-10 were the "vintage years in which purchases made [later] produced the highest returns". Correlations with those years include major uncertainty, with the future of Britain's relationship with the EU a significant unknown. This lack of clarity echoes, albeit to different levels, the uncertainty post the tech boom in 2002-03 and the fallout of the financial crisis in 2009-10.

Assets that were "very hot", according to Mr Hall, included fintech businesses, which will "stay strong because the UK is the only place in the world where the finance and technology capitals are in the same place, unlike in the US where it is Silicon Valley and Wall Street".

He also expected demand for cyber security businesses to remain strong, although buyers would "have to be prepared to pay the price" and he thought businesses that help companies improve efficiency would be in high demand due to the potential for an economic slowdown.

If there is uncertainty, though, the M&A market needs to be driven by those companies with confidence, a sturdy medium- to long-term view and willingness to deploy capital.

Buoyant balance sheets

While there is the correlation of uncertainty with what Mr Hall calls vintage years for M&A, there isn't such a paucity of capital, which also defined those dates. If there's less capital swishing around, it means those with firepower aren't fighting off as much competition for the targets they are seeking to acquire and prices tend to be less exuberant. But that's not necessarily the case now.

The consensus is that balance sheets are strong and there's a lot of private equity cash waiting on the sidelines, too, which could take advantage of any volatility in prices brought about by market jitters.

Jamie Carter, a fund manager at SW Mitchell Capital, said he was optimistic about the prospects for M&A in 2017 because of the robust nature of corporate balance sheets. "There are 39 per cent of companies that have net cash in the pan-European all-cap market I look at and the average ratio of debt to cash profit is 1.0 times compared with 1.3 times historically," he said.

Mr Carter added that the cost of debt remained relatively cheap and so companies were likely to be compelled to buy in growth rather than spend it on generating it organically.

Karri Vuori, head of M&A at Panmure Gordon, said October was the biggest month for M&A globally and this was largely because the cost of capital was "extremely low". He also suggested balance sheets were strong and that investors were "keen for the money to be put to work to achieve a return" given that cash is "achieving no return".

Jon Kenworthy, partner at global law firm DLA Piper, said there were "plenty of reasons to be optimistic" about M&A.

"Many corporates have money, debt is cheap and equity markets are open for fundraisings by existing listed companies," he said.

He added that many of the factors that drove dealmaking in the past few years remain and it was his view that many companies believe any clarity on the outcome of Brexit negotiations is so far off "there is no point in waiting and so they are making decisions now based on the information available now".

That being said, Mr Karia said that, with the recent rise in long-term interest rates, moves by companies to borrow using bonds might come under pressure if the market demands higher yields from them than at present.

Who might buy?

While the SoftBank purchase of Arm came after a record 10 trillion yen of outbound M&A from Japan, it's not immediately obvious who else might be in the market for a UK company. Data from Dealogic shows US companies spent a whopping $1.18 trillion across 7,009 deals on domestic-based M&A, but only $188.4m across 1,439 overseas deals.

If president-elect Trump does reduce the level of taxes that companies currently have to pay if they repatriate overseas profit, the above data doesn't suggest this would come flooding to the UK.

Interestingly, UK companies are more likely to look abroad for an investment than on home turf. Mr Philbey said domestic M&A was at an all-time low in terms of volume based on their records. "UK companies are not acquiring peers locally but are making outbound acquisitions – and spending a lot of money on buying companies in other countries," he said.

Dealogic data shows UK companies spent just $37.3bn in 2016 (to 30 November) on domestic M&A –only just more than a third of the level seen in 2009 at the height of the financial crisis. A total of $103bn was spent on outbound deals in the same period.

That said, the amount being spent by overseas companies buying UK businesses remains robust at $124bn – which is a decent figure even though it pales in comparison with 2015's $348.7bn, which was particularly inflated thanks to deals such as 'megabrewer' Anheuser-Busch InBev's £79bn purchase of SABMiller.

Some commentators, though, suggested anyone holding a stock that receives a takeover bid from a Chinese company shouldn't hold their breath. The central bank has to sign off transactions of a certain size and there have been reports that the rules could be tightened. The Cambridge-based digital radio and communications company Sepura (SEPU) was recently approached by a Chinese bidder, but one commentator said he would "eat my shorts if that deal goes ahead", largely because of Chinese bureaucracy.

Stick or twist?

Deals, or even speculation about them, tend to spur share prices, but Karri Vuori, head of M&A at Panmure Gordon, suggested investors should be "really careful [with] companies that have a stated acquisition policy but don't have a track record of doing it".

He cited plastics company RPC as one that had been "extremely disciplined" in its approach to buying up other businesses and never paid more than six or seven times earnings for them. But he warned that industry research suggested fewer than half of all M&A deals actually deliver shareholder value. If a share price doesn't respond well to the prospect of a deal, it suggests investors may want to closely scrutinise the terms before accepting it.

Rosie Bullard, portfolio manager at James Hambro & Partners, agreed now was the point in the cycle where management turns to acquisitions to fuel their growth ambitions.

"Watch out for arguments that consolidation and synergies will help drive down costs and preserve corporate strength in a tough environment," she said. "Sometimes it might be true!"

Our pick of the FTSE takeover candidates for 2017

ITV (ITV): 192p

The recent preliminary bid from Twenty-First

Century Fox (US:FOXA) for Sky (SKY) is likely to reignite speculation of a foreign buyout of ITV (ITV). Shares in the Britain's Got Talent broadcaster have tumbled by a quarter in the past year, largely because the EU referendum has fomented uncertainty among advertisers. They now trade at an enticing 10 times broker Liberum's forecast earnings for 2017, and there's a sizeable prospective yield of 5 per cent, not including special dividends. We wouldn't be surprised if a larger media group such as Liberty Global (US:LBTYK) decides to capitalise on ITV's depressed valuation and the current weakness of sterling by tabling a bid for the company. TM

Spire (SPI): 349p

In the past 18 months South African healthcare provider Mediclinic (MDC) has made no secret of its desire to join the London Stock Exchange. After buying a 30 per cent stake in UK hospital operator Spire (SPI) in June last year, the group became a FTSE 100 constituent in February after completing a reverse takeover of London-listed Al Noor – the Dubai-based healthcare company. But with market conditions in the UK so attractive for private healthcare companies, we expect Mediclinic may wish to further its exposure. Spire, therefore, looks like a promising potential takeover target. The UK company has benefited hugely from a rise in NHS referrals and with pressures on Britain's beloved free healthcare service set to increase, we're not surprised that many international companies want to get in on the action. MB

Lok'n Store (LOK): 399p

Lok'n Store (LOK) is cheaper than rivals Safestore and Big Yellow and considerably smaller. The market is growing, but the market is deeply fragmented. Lok'n Store's attraction as a takeover target is simple. Big Yellow's market cap is £1.1bn; Safestore's is £750m, while Lok'nStore's is £100m. This is just the same size as StorageMart, the largest privately owned self-storage operator in the US, which recently paid for 15 sites operated by Big Box in the UK. Furthermore, it stated at the time that this is to be regarded as its launching pad into the UK market (see page 78 for more). JC