Uncertainty thanks to Brexit may have curbed merger and acquisition activity in the UK, but the tumbling value of sterling means once the UK has exited the EU, the country’s top firms will be wide open to foreign takeovers – especially big exporters.
Sterling has been in relentless decline against the US dollar and euro over the last 10 years, but this has been accelerated since the Brexit vote, falling a further 12%.
Many expected cheap sterling to initiate a wave of US-funded takeovers of the UK’s top firms. But, so far, this has not occurred with 2017 activity well below a record 2016.
Merger and acquisition (M&A) activity is generally driven by two major factors: liquidity and confidence. Liquidity is unquestionably high with corporates harbouring large cash deposits earning negative real interest rates, while borrowing costs are low and opportunities to invest cash are diminishing.
However, uncertainty from Brexit in the UK and the Trump administration in the US, has reduced confidence which is slowing M&A activity, especially in the UK.
The uncertainty is such a factor that it has overshadowed sterling’s decline. Since 2007 it has fallen around 35% against the US dollar and 25% against the euro with the Brexit vote accounting for around 12% of it. Surely that must make the UK an attractive and vulnerable target for US business in particular?
However, many UK-located businesses have significant overseas earnings, which automatically translate back into higher sterling denominated earnings and an increased business valuation. In effect, the stock market has already adjusted valuations for this affect, which partly explains why the FTSE 100 is at record levels.
So non-sterling earnings are no more attractive than before Brexit. What is more attractive is UK manufacturing and service production, which has increased its competitiveness against overseas-based businesses. So the element of UK value added in a car would be cheaper to produce, which is beneficial provided the car is sold overseas. If sold in the UK at UK prices then the more expensive overseas element will drive up costs and reduce profit.
Traditionally the UK has been seen as a low cost producer with flexible labour to access the EU market. Investment has flowed into the country with that end in mind. However, uncertainty as to whether that situation will persist beyond Brexit, has dampened M&A and investment enthusiasm.
Once uncertainty clears the prime targets are likely to be big consumer brands and UK-based services and manufacturing which sell into overseas markets. Big consumer brands have the advantage of being robust during the merger process in retaining market share and offering significant future cost savings. Though, often the enormous profitability of major brands allows management inefficiencies to develop.
An acquisition within the same markets allows rationalisation of functional, regional and head office management structures. A combined business only needs one of each.
We have seen a recent short-lived attempt by Kraft Heinz to buy dual-listed Unilever, which many have viewed as underperforming both in terms of growth and shareholder returns. The benefits would have been cost-cutting, greater combined buying power, and negotiating power with a highly consolidated grocery retail sector. Unilever is making some attempt to improve shareholder returns, but it is not out of the woods yet. CEO Paul Polman knows he has work to do with investors as Unilever remains ‘in play’.
We have also seen US-based PPG attempting to buy underperforming AkzoNobel, a Dutch-based paints business and owner of the Dulux brand among others. Again cost-cutting and a split of the industrial from consumer paints divisions would have occurred.
Both Unilever and AkzoNobel have major UK production facilities and sales. However, Dutch corporate governance issues made both companies difficult to acquire, despite attractive bids. The same cannot be said for most UK-listed businesses where corporate governance is generally high due to consolidated institutional investors who can act together to ensure shareholder interests are to the fore.
Brexit uncertainty will eventually be resolved and M&A activity will resume in the UK unless there is a significant surge in sterling. Leaving the EU with no trade deal will make the UK less attractive due to the likely tariffs which will dampen trade and lose any cost efficiencies.
Assuming there is a trade deal, then owners of big brands and UK-based manufacturing and service production are likely to be principle targets for M&A. However, buyers still have to generate significant integration benefits to pay for the likely substantial bid premium. PPG bid 50% more than the AkzoNobel undisturbed share price and still failed to win control.
Weak sterling does not resolve the common problem of paying too much for a business, although it does help.
John Colley is professor of practice in the strategy and international business group at Warwick Business School, and a former MD of a FTSE 100 company.