UK: Keep calm while GDP carries on rising

Alice Murray
02 April 2014

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On the surface, the UK economy appears to be moving from strength to strength with GDP expected to hit pre-recession peaks. But what does all this good news mean for the asset class? Alice Murray reports

The British Chambers of Commerce (BCC) announced in mid-March that it expected UK GDP to reach pre-2007 levels by this summer, a quarter earlier than originally expected. Furthermore, the outlook for 2015 has also been bumped up, with GDP increasing from an expected 2.4% to 2.5%, and is predicted to remain stable – holding onto this rate throughout 2016.

Matters of great interest
The immediate impact of this optimism will, of course, be the long-awaited rise in interest rates, which has been at a record low of 0.5% for the past five years. The BCC has predicted that the rates are likely to rise in Q3 2015, but will only be nudged up to 0.75%, and will step up incrementally by 0.25% each quarter until it reaches 1.5% in H2 2016. However, it would appear that the BCC's outlook is conservative, as the wider consensus around the base rate is that it will rise to 1% in Q3 2014, and then up to 2-2.5% in the following 12 months.

The question on many private equity practitioners' minds will be the impact of the rate rise on outstanding debt held by portfolio companies. According to Gary Edwards of Investec's growth and acquisition finance team, the levels of restructuring seen in 2013 (which accounted for more than 80% of debt transactions across Europe) are likely to continue throughout 2014 in anticipation of the increase: "Private equity will need to deal with debt structures before the [interest] rate increases."

Steady going
The sense of confidence and enthusiasm for the UK economy has been grabbing headlines for several months. However, according to a recent report by KPMG, there were fewer domestic and cross-border M&A deals during 2013 than even 2012 or 2011. This means that despite GDP improvements, in terms of M&A activity, the number of deals recorded in 2013 was the lowest level since records began in 1987. When looking solely at private equity activity over recent years, average aggregate deal volumes for early-stage, expansion and buyout transactions have remained stable. According to unquote" data, in 2012, the monthly average of these deals was 42.4. This monthly average deal volume figure dropped slightly to 41.4 in 2013. So far in 2014, the year started with a bang, with deal volume coming in at 45, although this slipped to 34 deals in February.

So, while UK businesses are more confident today, and household consumption is on the rise (one of the key reasons for bumping up GDP forecasts), overall M&A volumes are depressingly low, and rather than bucking the trend and investing against the cycle, from early-stage to buyout, the asset class is recording steadily shrinking deal volumes.

Edwards believes the expected rise in interest rates will create more optimism, making the UK "an emotional economy". He predicts that after the second increase, when interest rates reach 2-2.5%, the confidence and belief in the UK economy will turn into conviction. "This conviction brings emotional behaviours when making decisions over the next 12 months."

This dogmatic stance towards the UK is likely to generate more deal activity. However, the attractive company valuations enjoyed by the asset class in recent years will quickly fall away and GPs must ensure a disciplined approach to new investment as competition for quality assets is set to soar.