In a 'perfect storm', takeovers blast off from the wasteland

Mergers and acquisitions are soaring just as the UK economy turns down. Ben Schneiders looks at what's fuelling the boom and asks if it will last
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The Independent Online

The UK economy may be slowing, oil prices soaring and high street sales slumping, but investment banks don't seem to care. Mergers and acquisitions are booming, and the surge in deals shows no signs of abating either. Already, 2005 is set to be the best year for the buying and selling of companies in the UK since the heady days of the dot-com boom five years ago.

"There's renewed confidence - companies are feeling happy, they are feeling pretty good about life," says Hilary Cook, director of investment strategy at Barclays Stockbrokers. "They are saying we don't need this money for a rainy day: we can buy extra growth."

Analysts point to a variety of reasons, including cheap credit, buoyant share markets - the FTSE 100 recently hit four-year highs - and the growing popularity of private equity vehicles, which are now the biggest M&A players in the UK. While market attention has been concentrated on large moves, such as Pernod Ricard's deal for Allied Domecq - set at $17.8bn (£9.9bn) including debt - and Deutsche Post's proposed acquisition of Exel, most of the action has been in the mid-cap sector.

So far this year, 18 stocks have been removed from the FTSE 250 through changes in control at companies, including, Manchester United and the RAC. That compares with just eight removals in the whole of 2004. Yet this frenzy of activity comes as the outlook for the UK economy weakens and observers warn of the effect of oil prices on world growth. Even Tesco, the hugely successful supermarket, warned last week that the black stuff would hit its profits.

"One of the interesting things about the equity market is that it hasn't been hit by the high oil price," says Robin Woodall, head of core funds at F&C.

Analysts say shares and the economy often move in opposite directions until the economic data becomes so bad that it can't be ignored. "It's common for markets to do very well when the economy is doing badly," says Professor Peter Spencer, adviser to the Item Club, the economic think-tank. He cites a classic example of this in the early 1990s, when the US Federal Reserve slashed interest rates to combat recession. "Suddenly people can get a much higher dividend yield in the stock market than they can elsewhere. The same thing is happening now."

That's the key point: the low US and UK interest rates have created what has been dubbed the "perfect storm" for M&A, and companies, particularly private equity firms, are taking advantage. "The dominant factor is the easy availability of money," says Professor Spencer. The downturn early this decade has also helped, as companies cut costs and rebuilt balance sheets. "They restructured themselves and had money coming out of their ears," says Anais Faraj, a global strategist at Nomura. He adds that after the 2002-03 bear market, the valuations of UK companies also became "very, very cheap".

Another factor is the weaker economic conditions themselves. "Perversely, if the UK is going to slow, it becomes the right time for companies to start buying each other," says Mr Faraj. Takeovers and mergers, he explains, present a quick way of cutting costs.

For investors, the big risk is that the deals get out of hand and there is a repeat of the excesses of the dot-com era. While M&A can be good for the companies being acquired, it can often lead to the destruction of shareholder value for those doing the acquiring.

Philip Isherwood, an analyst at Dresdner Kleinwort Wasserstein, points to an $186bn tie-up in the last boom as an example of what can go wrong. In that deal, internet group AOL used its shares in effect to buy media giant Time Warner, despite its own lack of a track record and unproven earnings potential. The market value of the combined entity has since plummeted.

So far at least, adds Mr Isherwood, the signs are that bid prices have not been too excessive. The average premium paid this year has been 17 per cent above the share price of acquired companies, a month before the deals were announced. This is less than the average since 1995, of 26 per cent, and well below the 39 per cent figure at the height of the dot-com boom. "This year you can see the premiums are lower; normally, when activity goes up, the prices go up as people get carried away," he says. "It would be nice to think the lower premiums are associated with management being more canny."

Yet not everyone is convinced that this boom will be different from any other. While the last one was centred on technology and telecommunications, most M&A speculation this time has concerned the banking, transport, construction and retail sectors - businesses often associated with solid cashflows. Mr Woodall at F&C says deals can quickly snowball. "One company bids for another in a sector and that leads others in the industry to do deals.

"And of course they always say it's a 'strategic deal'; quite often, that's a warning sign."

Mr Faraj says: "You have to watch out for vanity deals." Analysts suggest that eBay's recent $4.1bn bid for Skype may be one where the price is excessive.

Another problem for M&A is that as time passes, it gets harder for acquirers to find good deals. "There's a problem there," says Mr Faraj. "Some say Europe is dead because it's saturated: too much money and too few good assets."

Despite that, most analysts expect the cycle to run for three to five years. As the "perfect storm" rages, it would take a big shift in sentiment for the M&A boom to slow. "The risk would be if there was a big jolt to the economy," says KPMG partner David Elms.

But the big winners so far have been the lawyers, City workers and investment bankers who are expecting bumper bonuses, some thought to be as high as £5m. Last week, Goldman Sachs announced an 84 per cent jump in profits, and Lehman Brothers has also reported strong results. But it remains to be seen if investors will be so lucky.