1875 Summer 2023 Private Client

1875

DEBT, DEALS AND DISCOUNTS

SEVERN TRENT

IS AN INFLUX OF FOREIGN M&A ACTIVITY ON THE HORIZON?

BOND INTEREST INCREASES

INVESTMENT TRUST DISCOUNTS:

A DOUBLE-EDGED SWORD

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DEBT, DEALS AND DISCOUNTS

ALASTAIR POWER | INVESTMENT RESEARCH MANAGER

As we embark on the second half of 2023, we leave a challenging first half behind and head into what is likely to be another difficult period in financial markets. UK inflation remains stubbornly elevated, interest rates are expected to rise further and the labour market remains tight; all factors behind what many feel is a challenging near-term economic future for the UK. Remembering the inherently forwardlooking nature of financial markets, asset prices have adjusted, downwards unfortunately, to reflect this fact. Provided further nasty inflation-related surprises are not lying in wait, stabilisation of interest rates should see volatility of asset prices decline and markets reframe valuations back in-line with underlying fundamentals, rather than shorter-term expectations of macroeconomic data points.

Progressing further through the year, debt, deals and discounts are three discussion points remaining. The cost of debt and refinancing cycles are expected to have meaningful impacts on corporate profitability and household discretionary spending budgets. Acquisitions are starting to come through in pockets of the UK financial markets on the back of optically attractive valuations; more could be on the cards. Discounts within the investment trust sector reached their widest levels since the financial crisis in April, remaining wide and raising questions around potential bargains on offer.

Amidst the market gyrations of the last eighteen months and subsequent declines in investor confidence, the investment trust sector has seen share price discounts to Net Asset Values (NAV) widen to levels last seen in the financial crisis. At the end of June, the Association of Investment Companies (AIC) reported a weighted average discount of nearly 14% across all UK-listed investment trusts. Some sectors have felt the pain greater than others, most notably Real Estate Investment Trusts (REITs) and Private Equity, where discounts around the 35% mark have become common place. For bargain hunters, the sector looks to be showing opportunities provided comfort can be achieved in the future pathway of reported NAVs. As share prices track these releases, greater resilience in the reported figures over time could see share prices revalue and returns enhanced by discounts narrowing.

The effect of discounts is not limited to the investment trust sector. Listening to UK equity fund managers mention the valuation discount of UK equities to their US counterparts has been a common theme in recent years, with seemingly similar companies holding markedly different valuations based on their country of listing. So wide have these discounts become in both listed equities and listed investment companies, that merger and acquisition activity is becoming apparent and could potentially become a more common theme going forward. In the REIT sector, activity has been notable, with the takeovers of the likes of Civitas Social Housing, Industrials REIT and CT Property Trust all at healthy premiums to prevailing share prices. Yet to feed into the listed equity space, mergers and acquisitions could become a common headline, as

pointed out by one of the leading UK smaller companies fund managers recently, highlighting listed companies trading at a discount to recent valuation multiples seen in private market deals.

With interest rates influencing the cost of debt, headlines have focused on personal debt, mainly in the form of mortgage rates. On a corporate level, rising debt costs have a very real impact, as we see in multiple segments of this issue. With many companies relying on the corporate bond market, coupons on new bond issues are markedly higher than in the zero-interest rate world, sparking concerns around debt refinancing and potential defaults in the lower quality tiers of the high-yield markets. We will take a high-level look at this technical topic later on and see if there are grounds for concern.

Finally, we take a look at another area capturing news headlines for all of the wrong reasons: regulated water utilities. Thames Water, the utility company serving most of London and much of the South East, came under the spotlight for multiple issues from poor operational performance to a debtladen balance sheet and ballooning interest bill on the back of the structure of its debt. In a sector where the disparity between the top and bottom performers is significant, we take a look at Severn Trent, one of three listed names in the sector and a payer of one of the few inflation-linked dividends in the FTSE 100.

As we embark on the second half of 2023, we leave a challenging first half behind and head into what is likely to be another difficult period in financial markets.

SEVERN TRENT

ALASTAIR POWER | INVESTMENT RESEARCH MANAGER

Water utility companies are back in the news headlines, with Thames Water, the utility serving most of London and much of the South East, recently under the spotlight for all the wrong reasons. Poor operational performance, management resignations, a debt-laden balance sheet and a ballooning interest bill due to the structure of its debt profile raised questions around the complexity of the underlying business model.

As with any utility company, understanding the role of the regulator is of utmost importance. The Water Services Regulation Authority, or OFWAT, regulates all UK water and sewage companies. Each year it publishes a report on the performance of all companies falling under its remit, but

most importantly, it sets allowable price increases through distinct five-year blocks or Asset Management Plan (AMP) periods. At the top end of the reported performance tables comes Severn Trent (SVT), one of three listed water utility companies and an inflation-linked dividend payer.

At the core of profitability for regulated water companies comes Regulatory Capital Value (RCV), a measure of the company’s market value plus the value of accumulated capital investment assumed at each price review. Developed for regulatory purposes, its primary use comes in setting price limits for AMPs and assessing the revenues water companies need. Expected to be in the region of 4% of RCV in the financial year 2022/23, the base return provides consistent

revenue with inflation adjustments each year. Away from the base return, Outcome Delivery Incentives (ODIs) provide additional revenue opportunities. Outlined before the upcoming AMP, OFWAT considers deliverables on a common, comparative, and bespoke basis with rewards and penalties administered on performance. These ODIs, on a common basis, include performance metrics such as unplanned outages and leakage, with strong performance rewarded. Comparatively, performance in areas such as supply interruptions and internal sewer flooding are measured relative to other water companies, with top quartile performance rewarded. With strong operational performance rewarded, the likes of Severn Trent have the ability to meaningfully enhance earnings, with £175m earned through ODI rewards in the prior AMP.

Given the large capital base, visibility of future income and expenditure and the highly regulated nature of utility companies, high levels of debt are a consistent theme. Add in a sustainable finance framework and large operational asset base, and the proposition becomes attractive from a debt perspective with a strong investment grade rating from credit agencies. As an indication, SVT’s November 2022 £400m bond issue at a rate of 4.625% was eight times oversubscribed, making it the year’s “most successful sterling company bond,” according to Bloomberg.

The mix of this debt remains of utmost importance for financial sustainability and avoiding potentially ballooning interest expense costs experienced by the likes of Thames

Water through high levels of inflation-linked debt. With just 28% of debt inflation-linked against the sector average of 54%, Severn Trent looks in a strong position relative to peer averages but is still not immune as the effective cost of interest crept higher in the financial year 2022/23 to 6.2%.

For income investors, an inflation-linked income stream is a gold-plated feature. Through the recent AMP, a dividend policy of growth of at least Consumer Price Index (inc. housing) linked to the prior November’s data point. Lasting through to the end of the current AMP in 2025, further guidance regarding the path of future dividends is eagerly awaited.

Research analyst opinions remain divided, with the likes of Goldman Sachs and JP Morgan affirming their “sell/ underweight” recommendations but Société Generale and Morgan Stanley pushing their target prices higher. With business plan submissions for the upcoming AMP expected in October, we will have to wait before forming expectations for the period 2025 through to 2030. In anticipation, a stable financing plan and consistent strong operational performance through the current and past AMP periods look to provide SVT with a strong base going forward.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.

IS AN INFLUX OF FOREIGN M&A ACTIVITY ON THE HORIZON?

In the vast global landscape, the UK stock market has recently been perceived as a region saturated with undervalued, under-loved but often high-quality, cash generative companies. One of the primary reasons behind this has been the lack of interest from domestic equity investors, particular in pension funds which have steadily decreased their equity allocations over time in favour of alternative asset classes such as private equity. Consequently, these companies now trade at substantial valuation discounts compared to their global counterparts, making the UK a hunting ground for

foreign buyers seeking quality companies at attractive prices.

Despite this, over the last few years changing market dynamics have brought about very different environments for UK equities and foreign Mergers and Acquisitions (M&A) activity alike. The years 2020 and 2021 were characterised by a flurry of leveraged takeovers in the UK, fuelled by bullish investor sentiment and the availability of cheap debt. The situation shifted in 2022 as the global economy faced considerable turbulence. Private equity (PE) firms

JAMES EADES | INVESTMENT RESEARCH

had to reassess the prices they were willing to pay for their investments, leading to a slowdown in deal volumes and a decline in the number of announced takeovers of public companies.

In addition to private equity, corporate buyers also hit the brakes on their M&A activities, driven by the necessity to conserve capital and reduce funding risks given an aggressive cycle of rate hikes by the central banks in Europe, the US, and the UK. These actions significantly escalated financing costs for both private equity firms and corporations. Consequently, many investors chose to tighten their capital allocation, adopting a patient approach and waiting for more favourable market conditions to emerge.

Fast forward to the first half of 2023 and activity remained weak in the UK M&A space as macroeconomic headwinds and tighter lending markets continued to take a toll on the volume of deals completed. Private equity deals, which made up nearly 40% of all volumes, focussed on all equity offers for small and mid-sized companies due to financing uncertainty and better management control. Consequently, these companies have been holding record levels of dry powder (cash reserves kept on

This move showcased Blackstone’s ability to deploy some of its accumulated dry powder. The acquisition was made at a price equivalent to the share value about six months ago before a significant sell-off in the sector, making it an enticing prospect for Blackstone while benefiting shareholders too. But the deal may have broader implications for the private equity space, signalling the growth potential perceived by private equity not only in UK real estate but in UK assets as a whole. Furthermore, if Blackstone managed to acquire £700m worth of assets with available cash, it raises questions about the potential impact on other listed property vehicles when market optimism begins to gain momentum, with the potential for further deals of similar if not bigger values.

When considering the future deployment of such dry powder, there are specific areas that appear promising. Particularly noteworthy is the potential for further activity within the Investment Trust sector, specifically REITs and private equity vehicles, both of which are currently experiencing significant discounts to reported Net Asset Value (NAV). Recent data from Winterflood indicates that the average discount to Net Asset Value for the private equity trust sector and UK REIT space stands at around 38% and 19.5%, respectively. These sectors have continued to experience a sector-wide share price decrease in relation to value of the underlying assets, despite strong underlying rental growth, as a concern for investors is the valuation of the trusts’ underlying assets, which are typically based on stock market multiples for comparable listed companies. When markets fall, unlisted assets tend to follow suit, but as there is a lag in the reporting, the impact on NAVs can take months to appear. These concerns have swelled in recent months given considerable increases in interest rates and financing costs.

Despite valuation uncertainty, both sectors may well provide attractive opportunities for those looking to capitalise on depressed valuations even in the face of potentially extended economic headwinds. It is likely that given a higher interest rate environment, patient and selective capital allocation will be key as changing market dynamics may open up new areas of opportunity in some unloved sectors. A continued focus towards smaller and medium-sized acquisitions could also be favoured as smaller entities provide greater flexibility and often lower debt requirement.

hand by a company, venture capital firm or individual to cover future obligations, purchase assets or make acquisitions), with European firms estimated to have around €270bn in reserves by the end of 2022, as they remained patient and vigilant for opportunities on the horizon.

Despite the prevailing market uncertainty, not all companies chose to sit tight and wait. Notably, the US private equity giant Blackstone demonstrated its confidence in the market by recently acquiring the dynamic ‘last mile’ industrial warehouse company, Industrials REIT, for £700m in cash.

While the catalyst for increased PE activity remains unclear, further improvements in macroeconomic indicators could be strongly received, likely providing an inroad for further capital deployment. Flattening and potentially declining interest rates will provide investors with greater transparency on the longer-term financing costs for these vehicles, shedding more light on the returns that could be expected when purchasing the assets.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. The value of investments and any income derived from them may go down as well as up and you could get back less than you invested.

TOPIC OF THE MONTH

BOND INTEREST INCREASES

GREG LODGE | PERFORMANCE & RISK ANALYST

As we readjust to a world of higher interest rates, thoughts are turning to how this will impact debt and refinancing. You will no doubt be acutely aware of this if you are holding a fixed-term mortgage due for renewal in the near future. Debt obligations comfortably taken on when base rates were below 1% are now bearing a substantial increase in interest when the time comes to refinance. In conjunction with lenders, the government has moved to protect homeowners from repossession, such as providing a period of interest-only repayments for struggling borrowers. Conversely, savers will be pleased to see returns on their cash starting to tick up

and investors can find some attractive yields that would previously have only been available from the most distressed debt just a couple of years ago. Articles abound on how this is affecting the housing market, so let us also examine the impact on corporate bonds.

Firstly, it helps to understand why and how companies issue bonds. They may aim to raise capital for an expansion or new project, or to maintain their expenditure. By issuing debt rather than equity, they avoid diluting the ownership of the company. Any company can issue a bond, whereas listing on a stock exchange comes with certain criteria and

regulatory obligations. For this reason, the global bond market is significantly larger than the global equity market. In issuing a bond, a company will enlist the help of a specialist bank. The company’s creditworthiness is determined, and the prospective bond is taken on a roadshow to potential investors. Thus, the coupon is decided, based on likelihood of default and the appetite from investors, and the bond is taken to market.

Following the great financial crisis in 2008/09, interest rates were slashed and remained low until they began to rise again relatively recently. Many bonds were issued in this era as companies sought to capture and lock in the opportunity to borrow at exceptionally low rates. In 2021 when rates were at rock-bottom, the high-yield bond market in the US grew to a record US$1.55tn as issuers took advantage of low borrowing costs. Unsurprisingly, as rates began to climb again in 2022 issuers pulled back somewhat and the market cooled, falling by US$196bn since its peak. Year-to-date, new high-yield issues have been very low, and the market has been driven predominantly by refinancing.

costs has spooked markets and sent its lower ranking bonds into distressed territory, with one issue maturing in May 2026 falling by more than 35 points.

A large-scale sell-off of UK gilts has seen capital values fall, raising yields to levels not seen for a long time, which some investors may find very enticing. As UK gilts are considered the closest thing to a credit ‘risk-free’ investment, investors will demand a premium from corporate bonds to compensate them for the additional risk they are taking. This difference in yield between a comparable gilt and corporate bonds is known as the credit spread. With two-year gilts offering a yield in the region of 5%, investor expectations from corporate bonds are much higher than we have previously seen.

With attractive yields returning, interest from investors has picked up. Bond Exchange Trades Funds (ETFs) across Europe saw net inflows of €4.3bn in May of this year. Similarly, other bond funds also saw strong take-up in the same period. Chief Executive of the Investment Association Chris Cummings said: “Caution was the theme of the month, with Government Bonds seeing strong inflows. This is not surprising given concern about potential global recession and ongoing conflict in Ukraine.”

Demand is strong for quality corporate bonds. This is neatly illustrated by the US$7bn of investor funds chasing a US$750m issue of a perpetual bond from Abu Dhabi Islamic Bank. Initially priced with an attractive 7.25% coupon, the bond nevertheless moved to trade at a 4% premium. Investors were tempted by its low gearing, healthy balance sheet and government backing. Morningstar data shows that in the first quarter of the year sterling corporate bond funds experienced inflows of more than £1bn. There are attractive yields on offer even for cautious investors. Quality government and corporate debt held to maturity could provide yields that were unthinkable in recent years, for comparatively low risk.

A sudden return to normalised interest rates presents challenges to some bond issuers. If they are over-leveraged, refinancing will be difficult. Earnings and margins will be compressed as the new cost of servicing debt jumps. One recent and prominent example is heavily leveraged utilities provider Thames Water. Investors have questioned its capacity to pay back gross borrowing of £15.9bn. More than half of this debt is inflation-linked. Accounts from its parent company show that weighted average interest on this debt has risen from 2.5% to 8.1%. This huge leap in its borrowing

With the twin tail winds of opportunity and caution, fixed interest is undergoing something of a renaissance. Creditworthy issuers are offering attractive yields. In the years following the financial crisis, equities dominated many portfolios. With fixed interest yields so low, and even occasionally negative, a common market acronym was TINA – There Is No Alternative – to describe the predominance of equities in generating returns. That era finally looks to be over. For a sector formerly perceived as staid and low yielding, maybe now is the time to get excited about bonds.

Please note that this communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned. Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.

With attractive yields returning, interest from investors has picked up. Bond Exchange Trades Funds (ETFs) across Europe saw net inflows of €4.3bn in May of this year. Similarly, other bond funds also saw strong take-up in the same period.

INVESTMENT TRUST DISCOUNTS: A DOUBLE-EDGED SWORD

Investment trusts are trading at their widest discounts since 2008. In theory, we now have the ability to go out and buy a quality basket of assets for substantially less than they are worth, but we have to be careful. These discounts have shown no real signs of narrowing, and there is still the potential for further pain in the shortterm.

Before we dive into what makes these investment companies appealing from a long-term perspective, it is worth highlighting some of their key features. Investment trusts invest in a range of companies and infrastructure projects and can have a variety of different objectives that often determine specifically what they buy. For example, an investment trust that focusses on UK equity and aims to generate income will look very different from one that wants to achieve long-term capital growth. Unlike unit trusts, they can borrow money and take on debt in order to invest additional capital. This has the effect of juicing up returns in bull markets but can also provide a serious drag to performance in down markets. Investment trusts are listed vehicles, which is why they can trade at discounts if market sentiment turns on them and people are willing to sell them for less than the value of the underlying assets – the Net Asset Value (NAV).

First, we should examine the debt, or gearing, that many investment trusts have used to provide enhanced returns over the last decade. This is of particular interest, as interest rates are still rising and the cost of refinancing this debt is becoming extortionate, when compared to the price it was issued at. For most of the last decade, the effective use of gearing has seriously benefited many investment trusts. Eurobox, a retail investment trust that specialises in large warehouses in Europe, is over 60% geared and this is part of the reason it was able to return over 23% in 2021. The trust trades at a discount of around 36% today and has had a rough couple of years as interest rates have risen and the return available on near risk-free government bonds has risen in tandem. This increase often forces the value of other income-generating investments down as investors must be compensated for taking the additional risk associated with the investment, as the price of these trusts drops, the yield you can get from investing in them rises. Many commentators believe we are nearing the top of the rate-hiking cycle and, as such, the long-term returns available on property and infrastructure may start to look appealing again.

So, Eurobox’s high-level of debt is by no means the only reason it has struggled and given the emergence of e-commerce and the importance of delivery

infrastructure to the sector, you could be tempted to take advantage of that large discount and see this as a buying opportunity. However, the trust has €500m worth of debt that is due in 2026 and interest rates now seem unlikely to have turned a significant corner by then. Should they remain at current levels, this will put the trust in a situation where it will either have to sell assets in order to pay off its debt, which will significantly reduce its NAV, or refinance the debt on much less favourable terms. Currently it pays 0.95% annually on this debt and, while it is difficult to predict what the payments would be if it chooses to refinance, the figure would be undoubtedly higher. A significant increase in the cost of borrowing could force the sustainability of the trust’s dividend payments to be called into question as it would decrease the trust’s free cash flow. Fears surrounding these eventualities are undoubtedly one of the reasons that the trust is trading at such a large discount. While the debt helped the trust establish itself as a key player in the sector, it is now causing serious headaches for its management team.

retail investors with access to markets that have traditionally only been accessible to large institutional investors or those with a high net worth. HarbourVest Global Private Equity (HVPE), a sort of private equity fund of funds, is currently trading at a discount of over 44%. One of the main reasons for this is that private equity assets are notoriously difficult to value. They do not have the same reporting requirements as publicly traded companies and as such it is only really possible to get accurate valuations when companies fund raise or the holdings are traded on secondary markets. As a result of this, these valuations are often outdated. As the investment trust is exchange traded, investors often try to price in these future write-downs, which is very difficult. Uncertainties regarding valuations can cause discounts to widen, which appears to be the case here. This can create buying opportunities for investors who know where to look but, as ever, there are many other factors that bear considering. For example, while private equity provided excellent returns in the lead-up to the pandemic, it is currently unclear how much of this was dependent on cheap debt and low interest rates.

What these two cases highlight is that while discounts can be enticing, the overall picture is often more complicated. They can offer excellent buying opportunities and provide investors with the opportunity to gain access to quality assets at cheap prices. However, in certain circumstances, it is possible for the discount to tighten as the NAV of the trust moves down towards the share price. It is therefore important that investors have a solid understanding of what is going on under the hood of any trust they are invested in. From interest rates and debt to valuations and investor confidence, there are a variety of reasons that investment companies can trade at a discount. Those who bought investment trusts at big discounts in 2008 will have made excellent returns, but trying to catch a falling knife is often a dangerous game.

Investments and income arising from them can fall as well as rise in value. Past performance and forecasts are not reliable indicators of future results and performance.

Some of the investment trusts that are trading on the largest discounts are those that operate in the private equity market. These trusts are popular as they provide

It is therefore important that investors have a solid understanding of what is going on under the hood of any trust they are invested in. From interest rates and debt to valuations and investor confidence, there are a variety of reasons that investment companies can trade at a discount.