Paradoxical two-track market emerging in UK

Alice Murray
05 June 2014

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Despite the increasingly positive M&A environment enjoyed in the UK thanks to rising confidence and a flood of liquidity in the credit markets, private equity activity levels are diverging between the lower and upper mid-market. Alice Murray reports

When comparing the lower mid-market with the upper mid-market, the average monthly total of buyout and expansion deals in the UK and Ireland are increasingly divided, according to unquote" data. Looking at deals valued at less than €250m, there have been on average 34 transactions per month since January 2013, and just 2.5 per month for deals valued at more than €250m. With differing opinions on where to draw the line between the lower and upper mid-market, even when the barrier is set at €100m, the contrast in activity remains significant, with an average of 32 deals per month below this value range and an average of five per month for the same period above. Clearly, the lower mid-market is the busiest segment.

Stiff upper dip
There are several factors causing the slowdown in the upper mid-market, including the heightened levels of competition, with vast amounts of dry powder sitting in larger funds chasing a scarcity of quality assets. Another reason for the lack of activity in this segment is the strong public markets and firmly open IPO window, now presenting a new form of competition.

"The strong IPO market is becoming a competitor and is more accepted as an exit route, whereas one year ago private equity would have been the more likely buyer of these assets coming to market," says James Ranger, co-head of the acquisition finance mid-market team at Lloyds Bank.

Furthermore, as the UK economic environment continues to move from strength to strength, the gap in price expectations between vendors and buyers has caused a decrease in available assets. "Corporates considering sell-offs are more likely to hold onto divisions for the next 12 months because it will allow them to show more profitability and they expect to achieve better valuations over that period," says Ranger.

Paradoxical activity
What is interesting about the disparity between these two market segments is that dealflow was expected to increase at the larger end thanks to improved credit markets. Lenders – whether traditional or alternative – are paradoxically chasing deals in the upper mid-market, where pricing and terms have become increasingly aggressive, especially for loans worth more than £100m.

However, in the lower mid-market, with loans valued at less than £50m, the competition has been less intense despite the continued strength in deal volume. "The £100m plus ticket segment is by far the most liquid and hottest end of the market where you can find the best terms and pricing. But, this end of the market is housing less activity compared with the lower mid-market. And the lack of deals at this end of the market is only creating more heat as competition steps up," observes Ranger.

Indeed, the prolific rise of unitranche lending has caused terms and pricing for senior debt to become more aggressive, which is now beginning to squeeze these alternative lenders out of the market, says Ranger. This situation has been further exacerbated by the reappearance of mezzanine and the thriving high-yield bond market.

However, before smaller houses wonder if unitranche lenders will move into the lower mid-market as a means of deploying more cash, Ranger points out this segment is still very relationship-focused. "It's a difficult market for new entrants to crack. Furthermore, loans in this segment tend to be less liquid compared to those at the larger end and are often viewed as being more risky."

Fortunately, as the market has undergone rapid changes in the last 18 months, this pace of evolution is likely to speed up further. Says Ranger: "The world is changing very quickly; looking at our pipeline we're seeing an uptick in larger opportunities."