De-equitisation and the opportunity for investors

De-equitisation and the opportunity for investors

Equity finance, the process of raising capital through the issue of shares, provides an important source of long-term funding for businesses. Unlike debt there is no fixed cost of servicing interest and in return ‘shareholders’ receive dividends together with the opportunity for capital growth in an asset class which historically has provided the best real returns after inflation. The benefit of equity should not be under-estimated as it provides permanent capital, enabling businesses to invest for the long-term whilst providing a greater ability to manage economic shocks and interest rate cycles. Companies that are listed (quoted on a stock exchange) generally have a further advantage due to the ability to quickly raise additional capital, whilst providing shareholders with an independent pricing mechanism and liquidity. This became evident in 2020 when UK listed businesses raised £42 billion3 of new equity as the Covid lockdowns temporarily closed many businesses, particularly those operating in the leisure and transport sectors. 

Despite the advantages of being quoted, the number of companies listed, both in the UK and overseas, has significantly reduced over recent years, leading to the term “de-equitisation”, or the disappearance of companies from the public market. For example, the number of companies on AIM has more than halved from a peak of c.1,700 in 2007 to less than 800 today. A similar trend has been experienced in the US, with the number of companies on the NYSE declining from around 5,500 in 2000 to the current figure of less than 2,5004.

The UK equity market is currently failing in its role of providing finance to the next generation of businesses and the drivers behind de-equitisation include:

1. Accounting standards

New accounting rules for pension funds have forced companies to account for pension deficits and recognise the liability on their balance sheet. This encouraged trustees to become more risk-averse and reduce their equity exposure in favour of liability-matching bonds. According to think tank New Financial5, UK pension funds have reduced their equity allocation from 73% in 1997 to 27% in 2021, whilst the allocation to bonds has quadrupled to 56%. Over the same period UK pension funds have cut their exposure to UK equities from 53% to just 6% with the trend accelerated by the decision in 1997 by the then Chancellor, Gordon Brown, to remove the 20% tax credit on dividends from UK companies.

2. Share buybacks

Since the Global Financial Crisis an artificially low interest rate environment has encouraged businesses to buy their own stock for cancellation and use a form of financial engineering, replacing debt with equity, to grow earnings per share (EPS). As an example, since 2016 the annual value of share buybacks in the UK has increased seven-fold to over $70 billion2 in 2022, reflecting a change in shareholder attitude towards debt and growing frustration amongst management teams with their valuations.

3. Private Equity

The availability of cheap debt has fuelled a bonanza in Private Equity (PE). According to the McKinsey Global Private Markets Review the industry’s assets under management reached $11.7 trillion in June 2023 and this helped fund £13.7 billion of UK PE backed take-privates in 20227. Although this figure is lower than the £30 billion of take-privates in 2021, PE firms are estimated to be sitting on a record $3.7 trillion of ‘dry powder’ – capital that has been raised but has yet to be deployed.

4. Onerous regulatory requirements

Finally, modest valuations combined with the burden of increasingly onerous regulatory requirements has discouraged entrepreneurs from seeking a stock market listing. For example, in 8 months to 31 August 2023 there have been 11 initial public offering (IPOs) on AIM raising £50 million and this compares to the peak in 2006, when almost £10 billion was raised through 462 new issues3, albeit a number of these were of dubious quality.

Although the retirement of listed shares through takeovers or buybacks continues to exceed the issuance of new shares, there are reasons for optimism and these are highlighted below.

1. Valuation differential

Until recently the UK economy has been considered a “backwater” and uninvestable by many global asset allocators following the decision to leave the EU combined with political upheaval and rising inflation. As a result, domestic stocks have been shunned and this has created an estimated 42% valuation discountto global equities8. This discount should narrow as political stability returns and domestic inflation follows a similar, albeit delayed path, to other developed countries. Ultimately, the stock market is cyclical and when confidence returns this will drive inflows, supporting new issues.

2. Resilient economy and slowing inflation

The UK economy has proved more resilient than previously estimated and the fear of a recession has faded. In September, the Office for National Statistics (ONS) revised UK GDP, adding 1.7% or £40 billion to the size of the UK economy, indicating the country recovered much faster from the Covid pandemic than previously reported. More recently, the rate of annual growth in earnings has exceeded the Consumer Price Index (CPI) and after almost two years of wages failing to keep up with inflation, household living standards are now rising. Consumer confidence is likely to be further boosted by the recent decision by the Bank of England not to raise interest rates following 14 consecutive interest rate increases from 0.1% in December 2021 to 5.25% in August 2023.

3. Dynamic and maturing market

AIM is a dynamic market and it is the quality, rather than number of companies, that is key. Post the dot-com boom there were a significant number of early stage or speculative IPOs, which have either developed to become highly successful and profitable businesses or delisted as their business model failed. As an illustration, it is estimated that in 2006 less than 25% of the companies listed on AIM were profitable, whereas today the figure is over 75%, due in part, to survivorship bias.

4. Normalisation of interest rates will make PE less attractive

The current stock market downturn is likely to produce bargains for PE. But this time around there’s more PE money chasing a reduced number of investment opportunities. Furthermore, following a ‘normalisation’ in interest rates, the returns from highly leveraged PE may be less attractive than in the past as it is unlikely that financing conditions will be as favourable as in recent years.

5. Higher interest rates will reduce pension fund liabilities

For the past 15 years, the majority of the UK’s defined benefit pension schemes have reported deficits due to low interest rates. However, the sharp rise in interest rates has left most with a surplus. In June 2023 there were 4,652 schemes in surplus and 479 in deficit, compared with three years ago when 2,282 schemes were in surplus and 3,168 in deficit, according to the Pension Protection Fund. This should enable a significant number of businesses to stop making further pension contributions to defined benefit schemes, freeing capital for increased investment and enhanced returns for shareholders.

6. Government initiatives

The Mansion House reforms announced on 10 July 2023 by the Exchequer, Jeremy Hunt, are designed to encourage pension funds to invest in private companies, including AIM listed businesses. The largest defined contribution pension schemes have reached an agreement to allocate at least 5% of their assets to unlisted equities by 2030. To meet this commitment, it is likely that pension schemes will allocate additional funds towards AIM due to the higher level of liquidity and pricing transparency associated with public markets. Assuming 10% of this increased allocation is channelled into AIM companies, this implies an incremental £5 billion into AIM, offsetting the outflows over recent years.

The government could provide further support by re-introducing accelerated CGT or taper relief for investors in domestic businesses to encourage and reward long-term investment. Further reform could also be made to the accessibility of analyst research to stimulate inflows into small and mid-cap companies. The UK has adopted the EU’s MIFID II directive, which includes the requirement for asset managers to pay separately for investment research. Post Brexit the UK has an exemption on businesses valued below £200 million and this should be extended to at least £1 billion as investment research generates interest in stocks and helps companies reach and maintain appropriate valuations. This creates a healthy ecosystem that is attractive to new businesses seeking to list, leading to greater innovation, growth and employment.

In the lead-up to the UK general election there has been speculation the Conservative manifesto may include the “aspiration” to abolish Inheritance Tax (IHT). The residence nil rate IHT band was introduced post the 2015 general election as a vote winner, enabling married couples to effectively pass up to £1m to their children, free from IHT if the family home is included. Whilst we recognise the punitive nature of IHT and the £325,000 nil-rate IHT band has not increased since 2009, we believe it is unlikely there will a fundamental change to IHT due to the “levelling-up” agenda and the need for fiscal responsibility due to an estimated £132 billion government deficit in 2023/249.

Conversely, there have been rumours a Labour Government would abolish Business Relief. This would further undermine equities as withdrawing support from AIM would have a devastating impact upon UK smaller companies. Moreover, the benefit would be marginal, as over the last 5 years the cost of Business Relief has remained broadly static at c.£800 million per annum, equating to just 0.03% of GDP10.

Sources:

Whitman AIM IHT Portfolio  – 30/09/2023
2 Numis Indices – 30/09/2023
3 London Stock Exchange
4 McKinsey & Company, Reports of corporates’ demise have been greatly exaggerated, October 2021
5 New Financial, Unlocking the capital in capital markets, March 2023
6 Janus Henderson Global dividend Index, May 23
7 Pitchbook April 2023
8 Saxo, UK equities offer high expected returns for the bold investor
9 Office for Budget Responsibility, Economic and fiscal outlook, March 2023
10  HMRC Non-structural tax relief statistics, January 2023

Disclaimer: Although Whitman uses all reasonable skill and care in compiling this report, no warranty is given as to its accuracy or completeness. The opinions expressed accurately reflect the views of Whitman at the date of this document based on our views at such time regarding market conditions and other factors, may depend upon assumptions or projections that may not prove to be correct, and are subject to change. The opinions stated are honestly held, they are not guarantees and should not be relied upon.

The value of investments may fall as well as rise and your capital is at risk. Information on past performance, where given, is not necessarily a guide to future performance. We strongly recommend that you seek professional advice before you consider making investments is such securities. AIM has less stringent rules and AIM company shares may be less liquid than those companies listed on the London Stock Exchange.

Current tax rules and the available tax reliefs offered on investments into AIM-quoted stocks may change at any time, and there is a considerable risk that if the legislation changed in respect of these tax reliefs, then those stocks that no longer qualified for such reliefs would be subject to heavy selling pressure, potentially leading to significant investment losses.

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