Worried about UK small caps? Just look at Peel Hunt's earnings

Lately, the mid-market investment bank Peel Hunt (PEEL) has been banging an ominous drum.

“Our industry has been dramatically hollowed out over the past five, 10 years,” its chief executive Steven Fine told the Financial Times last week. Two days before, the group’s head of research, Charles Hall, painted an even gloomier outlook, claiming in a report that at current levels of IPO and M&A activity, the FTSE Small-Cap index could be on track to disappear by 2028.

At first glance, the data in the report doesn’t exactly back up those dark headlines. Across the main and junior markets, Hall says 13 active bid target situations worth at least £100mn emerged in the first quarter of 2024 – but lists only 12. Among this dozen, both Henderson Eurotrust’s (HNE) proposed merger with its sister fund, Henderson European Focus (HEFT), and the potential takeover of Abrdn European Logistics (ASLI) by an as-yet-unnamed acquirer are included – even though investment trusts are excluded from Hall’s definition of the FTSE Small-Cap index.

Most confusing of all, given the anxiety at the apparent for-sale sign on the London stock market, is the fact that most of the identified deals (by value and number) are all-share transactions involving listed UK buyers. Exclude Nationwide’s cash bid for Virgin Money (VMUK), and four of the five largest deals by value in the period – DS Smith (SMDS)/Mondi (MNDI), Redrow (RDW)/Barratt (BDEV), UKCM (UKCM)/Tritax (BBOX) and the now completed LXI/LondonMetric (LMP) tie-up – are all examples of equity-based domestic consolidation.

Granted, this picture could be muddied slightly if International Paper (US:IP) squeezes out Mondi, albeit the former says it will seek a secondary listing in London if its DS Smith bid is successful. Either way, as things stand, most of the recent flurry in UK share-buying activity will simply combine shareholder registers. Such consolidation may not seem inspiring, especially when it largely involves real estate. But to use an equally uninspiring metaphor, the cash hasn’t left the casino.

However, if a marker of a thriving equity market is the size of its constituents, then the longer-term trajectory is clearly negative. For the Small Cap index (which covers the main market stocks that aren’t big enough for the FTSE 350) the situation is particularly acute because a concurrent rise in FTSE 350 takeovers or de-listings means several more of its number are set for promotion.

According to Peel Hunt, the index was home to around 160 companies (excluding investment trusts) at the end of 2018. Extrapolate recent corporate activity into early 2025, and the tally might dip into double digits. Then, you only need to follow the “inexorable” negative gradient down a few more years – forgetting all the possible permutations in capital markets and monetary policy – and hey presto, the index has disappeared.

Hall lays the blame at some familiar feet. After 34 consecutive months of equity fund outflows, low prices and limited appetite for price discovery have hit valuations across small-to-mid-cap equities. In turn, argues Peel Hunt, this is drawing in acquirers, mindful of management teams’ growing disillusionment at the benefits of a public listing. Throw in acquiescent boards and short-sighted shareholders keen for any bump in values, and you have the recipe for a feeble fire sale.

Does this narrative hold water? Not 100 per cent. For a start, fiduciary duties are meant to compel corporate stewards to create value, not sulk. Management teams and boards might not like the effect of weak valuations on their share-based compensation, but outside of fund management it should be a secondary consideration to the job of running a profitable enterprise.

Second, as we’ve seen, low valuations can act as a spur to intra-market consolidation. In fact, mergers might help to address another issue raised in the report, namely “a recognition that scale and liquidity are increasingly important” for institutional equity owners. As for what constitutes a decent takeover multiple, we should presumably take Barratt’s all-share offer for Redrow – whose directors Peel Hunt is advising – as a reasonable yardstick. Based on an enterprise value of around £2bn, per FactSet, that’s a not-too-rich seven times the five-year average operating profit.

Given it is investment bankers’ job to drum up corporate activity, we should pay attention when the obstacles seem insurmountable. But should we dismiss the doom as a form of special pleading?

After all, Peel Hunt isn’t just the diagnostician. A trading update, also released last week, revealed the grim toll these conditions have wrought on the bank’s income statement. Investors have been told to prepare for a loss in line with consensus forecasts (£2.6mn on a pre-tax basis). Looking forward, “trading volumes remain low” and “equity issuance continues to be subdued”, both of which are expected to persist until the UK economy starts to meaningfully recover “and fund outflows reverse.”

To clarify, Peel Hunt hasn’t been a complete loser from a shrinking market, given its mandates on at least two of the first-quarter mergers. Still, today’s sale is tomorrow’s lost client. That, plus the current mood music, means it would take a plucky investor to spy value in Peel Hunt’s own shares. When management can’t even make the case for mean reversion, then you really are on your own.

Still, Hall and Fine are as one in their prescribed remedy: the reignition of fund flows, which might come from listed companies themselves (via buybacks), pension funds (via shifts in risk allocation), retail investors (via regulatory reform), or overseas buyers (sensing momentum). That, in turn, might inspire new issuers to replenish the market and go public. Fingers crossed.

The harder question is whether an investment bank’s fortunes spell bad times ahead for equity investors. In other words, should we share in Peel Hunt’s pity party, or see it as a bellwether? After all, if the Small Cap index goes, then the FTSE 350 will soon require a rebrand. 

A bit more context

Globally, de-equitisation is a thing. According to analysis by JPMorgan, the world’s supply of public equity is shrinking at its fastest pace in at least a quarter of a century, thanks to a confluence of corporate buybacks, nervous market debutants and tepid equity issuance. The net effect is that share issuance has gone into reverse.

Nor is Hall alone in arguing that redemptions across actively managed funds have punished less visible corners of equity markets. David Einhorn, president at US hedge fund Greenlight Capital, has argued that the rise of passive investing has “fundamentally broken” equities, as index funds pour ever-greater funds into mega-caps, regardless of valuation. “Passive investors have no opinion about value,” he recently told Bloomberg. “They’re going to assume everybody else’s done the work.”

In addition to skewed fundamentals, Einhorn is concerned that passive funds' rise is leading to a breakdown in shareholder accountability, as well as the ability of prospective equity issuers to market their business to potential investors. Others see the expansion of debt markets, private equity and venture capital over recent decades as a greater source of competitive pressure to stock markets, and therefore a bigger blockage to the flow of primary equity issuance.

Long term, this might force private investors into private markets, just as many pension and sovereign wealth funds have done. However, all of this assumes that issuers won’t realise the limits of a leveraged private ownership model and rediscover a preference for equity, or that equity markets in their present (if slowly shrinking) form can’t continue to provide meaningful returns.

At the same time, it seems unwise to bet that passive investing – and all its collateral damage, perceived or real – is about to halt. This week’s speculation, fuelled by both its current and former chief executives, that Shell (SHEL) might quit London as its primary market venue, could simply be a sign that S&P 500-sized multinationals increasingly view surfing the largest force in passive investing as a more efficient move than frantically buying back shares to correct a valuation gap.

Of course, if London’s largest company sets its departure in motion, then we should expect another round of (likely more panicky) extrapolation. Won’t the entire resources complex, or any corporate with the budget to easily absorb the cost of a shift to New York, be tempted to exit, too?

Maybe. Better to park those worries for another day, mindful that periods of stasis and drift invite extrapolation. Markets, fortunately, are often a lot more dynamic. For now though, and with no apologies for any implied cynicism, I present the 20 FTSE Small Cap (non-investment trust) stocks that Peel Hunt presumably sees as most vulnerable to the next surge of M&A frenzy: those with a market cap of at least £100mn, and an enterprise value to operating profit multiple of no more than seven. How many will fall to the sword in 2024?