Sterling is a bargain, if you believe in mean reversion. Since the Brexit referendum vote, it is down more than 15%, and the advent of prime minister Boris Johnson’s government has seen it plunge to new lows against the dollar.
For international investors whose home currency is virtually anything else, assets priced in sterling therefore look ‘cheap’.
Some argue this has fuelled a run of bargain basements buys by private equity firms. Blackstone’s £6bn for Merlin Entertainments, or Advent’s £4bn for Cobham, or Bain’s £3.2bn bid for WPP’s data arm Kantar look like prime examples, and are set to give the leveraged finance market much needed supply in the second half of the year. Hasbro’s £3.3bn purchase of Peppa Pig maker Entertainment One could also count.
Also adding to the UK M&A frenzy are TDR Capital’s bids for BCA Marketplace and Enterprise Inns, though TDR has a more explicit UK focus than some of its international competitors.
But it is not a case of selling the family silver. Unless the sponsors in question believe that FX markets are totally clueless, there’s not much advantage to buying a business for sterling, if it also mainly earns sterling, and will be sold at the end of the investment period for sterling.
If the UK currency bounces during the investment horizon, then, sure, the owners will see a boost from the move, unless they have hedged it out. But just as likely is a further decline in the value of the currency.
UK companies that mainly earn dollars, such as Cobham, stand to benefit from a slide in sterling, if they aren’t hedged. But for a sponsor looking for a buyout deal, this should already be in the price. It’s not a secret from Cobham’s public market investors.
If the smart financial sponsors running buyout funds do believe they have an FX edge over, say, macro funds, and can correctly call the direction of sterling, then there are hundreds of different, easier, cheaper ways to take that view than buying an entire company in a strategically sensitive sector.
They could, for example, buy sterling outright. Or sterling forwards, or derivatives. Or Gilts. Or an index. Any of these could be timed to the second, and entered or exited at will, for low bid-offers and with certainty of execution.
As with most other capital markets, Brexit, if anything, is weighing on UK LBOs.
The provisional capital structure for both Merlin and Cobham are heavy on dollars and euros, a reflection of weak markets for sterling-denominated leveraged credit.
Sterling high yield and leveraged loans had to come at least 75bp back of their euro equivalents, even before euro rates plunged over the summer, reflecting the cost of hedging sterling assets for CLO buyers, and the reluctance of international credit investors to get involved in UK debt while the Brexit outlook remained cloudy.
Domestic UK buyers are still happy to participate in deals they are offered, funding a £440m high yield deal for Entertainment One, and a revived trade from carpet maker Victoria, but for a borrower that has its pick of currencies, offering a sterling tranche just for this buyer base can be expensive.
While LBOs typically try to match currencies to a target company’s requirements, Brexit makes this harder, not easier to achieve — and means that, behind the scenes, there may be more deal-contingent hedging, to make sure that the sponsor’s buyout thesis isn’t eroded by FX moves while waiting for a big deal to go through shareholders and competition authorities. This doesn’t come cheap, even if it can be bundled with the other buyout fees.
Rather than being Brexit-driven, the UK targets in the LBO firing line are simply classic private equity investments — companies that have had a rocky ride in public markets, and may benefit from a turnaround in the shelter of private equity ownership. Better to buy a fixer-upper than a company that’s a stock exchange darling.
The UK has plenty of these companies, and has historically been by far the most active market in Europe for sponsors. Instead of looking for a Brexit bargain hunt, we should ask how big the UK LBO pipeline might have been without the Brexit uncertainty.