The UK companies most attractive to private equity investors

All serious investors with equities in their portfolio should be checking their holdings with one topical thought in mind – since the private equity industry, stuffed with fire power as it is, has its eyes on UK companies, which of my holdings are its outriders likely to pursue?

This thought is much on Bearbull’s mind and Table 1 deals with it. In simplified terms, the table highlights some of the corporate characteristics most likely to attract private equity and quantifies the extent to which holdings in the Bearbull Income Portfolio possess them.

First, a word of clarification; private equity takes several forms – venture capital, infrastructure and real estate, for instance. To a large extent, however, it is synonymous with its biggest component – buyouts, where companies buy established companies that will generate predictable amounts of free cash and whose returns to equity providers can therefore be levered up by financing deals with lots of fixed-cost debt. This is the classic leveraged buyout, and funds specialising in these are prowling around UK plc.

Much like the holdings in the Bearbull portfolio, every private investor’s portfolio will have investments in companies that prompt varying responses from private equity; from barely concealed boredom to instant excitement. So it makes sense to file holdings – even if just mentally – under such headings as ‘rank outsider’ to ‘serious proposition’ and ‘hot favourite’. Apply such intuitive filters and instantly – and in the context of the Bearbull portfolio – companies such as Primary Health Properties (PHP) and Real Estate Credit Investments (RECI) can be shunted to the bottom of the pile, while, say, Pets at Home (PETS) and Victrex (VCT) would rise to the top.

As to why, let’s dig into the detail of Table 1. Since a buyout fund will bring substantial amounts of debt into any deal, the quantity of debt it will acquire is a big factor. But how much debt is ‘too much’ and is all debt created equal? Broadly, debt has two effects on a company. First, it sucks up the liquidity a company needs to run its day-to-day affairs. Second, it lies like a dead weight on the balance sheet with the depressing ability to sink the operation when it comes due for repayment.

Thus, from the perspective of liquidity, Table 1 quantifies the ratio of a group’s net debt to its ‘Ebitda’, an ugly acronym for its cash profit before interest and tax; the more debt relative to Ebitda, the more debt interest sucks up liquidity. There is no absolutely good or bad ratio; that depends on the nature of each company. Utility-like companies such as Primary Health Properties and Williams Companies (US:WMB) can run on a high ratio. For conventional non-financial companies, a ratio above 2.5 times might be a concern. None in the Bearbull portfolio runs on a ratio anywhere near that.

Assessing debt

The dead weight of debt is trickier to assess since the accounting value of a group’s equity tends to be meaningless, so many are the ways it can be manipulated. Hence the table compares debt with the stock market value of equity. Again, companies with the most stable cash flows have the highest ratios, while the non-financial companies all run on ratios no higher than 40 per cent, which – intuitively – seems fine.

Combine high debt levels with lots of short-term debt (due for repayment within 12 months) and private equity might be deterred. No holdings in the Bearbull portfolio meet that criterion. Those whose debt is exclusively short-term – RECI and Henry Boot (BOOT) – don’t have much and are probably of little interest to private equity anyway.

Meanwhile, ample profitability attracts private equity just as it draws in any investor; not that it is an easy quality to encapsulate in a few quick-and-easy metrics (again, accounting quirks are chiefly to blame). That said, there are industrial companies in the Bearbull portfolio that produce wide profit margins and acceptable cash flow returns (flawed though that measure can often be). Step forward Anglo American (AAL), Vesuvius (VSVS) and perhaps even GSK (GSK), as well as Victrex and Pets at Home.

As to five-year growth rates, they look less encouraging among those most likely to interest private equity. The numbers from Anglo American and Pets At Home are the exceptions, but macroeconomic headwinds will blow against both of these in the coming months, especially Anglo American.

At speciality plastics supplier Victrex, growth rates – already contrasting with the group’s glittering past – will take a further drop this year, based on first-half profits released this week. There is no disguising the disappointment of the 14 per cent drop in sales volumes in the half year to end March – despite management’s attempts to do so – and the sharp drop in Victrex’s share price to £15.04 on the day tells its own story. The question is, does that make Victrex more attractive to private equity because in some ways the group is the ideal candidate – fat profit margins even in lean times, next to no debt, products for which demand won’t disappear and a capital-intensive, high-fixed-cost operation. Sure, I am biased – even so, of all the portfolio's holdings, Victrex is the one that looks right up private equity’s street, more so even than Pets at Home, which has been strongly linked to private equity.

All of this means I am little inclined to sell any of the portfolio’s current holdings (see Table 2), even though progress this year has been pedestrian; in the first four months, the portfolio’s value was barely changed compared with a 5 per cent rise from the FTSE All-Share index. Besides, there is the little matter of some £23,000 of cash to invest. As discussed last month (Bearbull, 6 April 2023), the US industrials conglomerate 3M (US:MMM) is worth further research, although (or should that be ‘especially as’) the share price has since sunk to a 12-month low of $100. Even shares in the mighty Coca-Cola (US:KO) yield 3 per cent, and almost 100 stocks within the S&P 500 index of leading US companies yield more than 3.5 per cent. Further work Stateside coming soon.