Buying before a takeover is a very shrewd investment
Saturday 12 May 2007
Investors hungry for bumper returns are trying to cash in on the global mergers and acquisition boom by identifying likely candidates for a takeover.
A huge number of firms are being snapped up by wealthy rivals looking to expand their businesses, and powerful private equity giants who can make a fortune by taking them off the stock market.
More than 10,000 deals – worth a total of $2.1 trillion (£1.1 trillion) – have already been struck around the world this year, according to figures compiled by Dealogic. Of this, $163.4bn has been splashed out on just over 1,000 UK companies.
The biggest so far has been the agreed £11bn takeover of chemist chain Alliance Boots, by a consortium led by US private equity firm Kohlberg Kravis Roberts, but observers are expecting plenty more over the coming months.
Shares in mining company Rio Tinto soared this week on the back of speculation that rival BHP Billiton was planning a hostile £50bn bid, while Canadian data company Thomson is in talks to buy news agency Reuters for £8.8bn.
As well as the growth in corporate earnings, and the private equity boom, the current M&A surge is also being fuelled by a stable stock market, a benign economic backdrop and an influx of overseas investors.
"The UK is an extremely open economy that welcomes foreign investors," explains one international financier. "London is also attractive as it's the financial centre of Europe and this makes it a good place in which to do business."
According to financial adviser Justin Modray of Bestinvest, these corporate marriages mean lucrative pay days for people with the foresight – or good fortune – to have invested in the takeover targets.
"A predator wanting a rival has to offer more than its market value and this tends to push up the share price," he explains. "It's not uncommon to see rises of more than 20 per cent on strong rumours, so if you can buy in beforehand you will benefit."
As a result, the hunt is on to find the next takeover target that can provide rich pickings for shareholders.
David Stevenson, who co-manages the Resolution Cartesian UK Opportunities fund, says the two main purchasers of companies – rival corporate names and private equity firms – often have different buying criteria. " Private equity firms prefer financially and operationally bloated companies to which they can take a sharp knife," he says. "They want robust businesses with over-capitalised balance sheets and surplus assets, which can be restructured."
By contrast, companies looking to buy rivals will be focusing on the potential cost synergies involved, which can help them increase future revenues. In addition, this extra cash could eventually be used to finance further acquisitions.
So how can you spot such a target and what attributes should you be looking for? Stevenson believes people need to look across the market rather than focusing on areas such as retailing, which have been such happy hunting grounds in the past.
Housebuilders, power companies and even some bus and rail names, he suggests, could all be potentially lucrative in the long term, as well as firms in more fragmented sectors like building materials and wealth advisers.
"You need to dig deep and look at the financial characteristics of different companies," he adds. "If you can find good cash-generation and plenty of assets there will probably be either a corporate or private equity buyer sniffing around."
For those who lack the necessary experience and knowledge for such exhaustive research, there are other ways to enjoy the benefits of takeover activity, says Modray.
"You can invest through a fund whose manager looks for possible M&A targets as part of their overall strategy," he explains. "It might also be worth putting your money into dedicated private equity investment trusts that focus on unquoted companies."
The funds that are most likely to benefit from takeovers and restructuring are the special-situations portfolios. Among those worth considering is the AXA Framlington UK Select Opportunities fund, run by Nigel Thomas, and the Artemis UK Special Situations fund managed by Derek Stuart.
Regardless of which one you choose, the big question is how long the boom times will last. Optimists point out that while private equity-funded deals have been dominant over the past five years, corporate tie-ups are now on the increase as acquiring firms are now cash-rich after nurturing their balance sheets.
But pessimists argue that the cost of borrowing has shot up on the back of rising interest rates; many of the most attractive targets have already been swallowed up and the valuations of those available have gone up due to strong equity markets.
Roger Noddings, chief investment officer at HSBC Investments, believes the current climate is conducive to more deals. Only when companies start overpaying for assets, will the cycle end.
"M&A activity is predicated on two ingredients: an abundance of cash and cheap stocks," he says. "We've had low interest rates, big improvements to balance sheets and a private equity industry raising billions. There's more to come."
Even so, Mark Dampier, head of research at Hargreaves Lansdown, says there are downsidesparticularly for people who find themselves invested in a predator company, rather than a target. "Many takeovers don't add any value to the acquiring company because they've been bought at the wrong time – and some even end up losing them money because of the deals," he says. "In these cases the share prices of the acquirer can fall, which is bad news for investors. M&A is not a one-way bet."
We asked a number of fund managers which UK-listed companies were likely targets for buyers.
Go-Ahead and National Express
The stock market has become frustrated with Go-Ahead because it has lots of cash on its balance sheet, making it attractive to potential buyers. But the monopoly issues surrounding rail franchises and bus routes are negatives. National Express is bidding for three rail franchises and if it doesn't win them, it will have capital to return.
It's the only listed ports company left – the rest having fallen victim to trade and private equity buyers – but has great visibility, very high margins, good cash generation and high barriers to entry. It's also got a massive land bank of old port land which could be available for redevelopment.
WM Morrison Supermarkets
Fund managers believe Morrisons not only has a better freehold property estate than its rivals. It's also improving operationally after digesting the Safeway deal.
Although water companies have been targets for a long while, the potential of power companies such as National Grid and Centrica, which are asset-intensive, cash-generative and high-yielding, have been generally overlooked.
This is an Irish quarrying company with big operations in the US. Planning restrictions mean that there are huge barriers to entry in this market.
This housebuilder is often spoken about as a potential takeover target and has got one of the largest land banks in the sector. Although its valuation has risen on the back of that, it still offers a high-quality land-bank to a potential buyer.
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