Takeovers: Is it the late 90s all over again?

Fuelled by cheap credit, money is pouring into takeover deals. The question now is whether 'we are at the top of a hill' or 'looking over the edge of a cliff'
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The Independent Online

The signs are getting difficult to ignore. Nearly every day, it seems, news breaks of another mega-takeover that will in a stroke change the face of an industry. Bankers talk of a "new paradigm" to explain company valuations out of line with any historical point of reference. Stock markets are rapidly approaching all-time highs and in some places, such as America, surpassing them.

Insider trading is rampant, with one in four deals in the UK preceded by suspicious activity. Remuneration for executives and hotshot investors has reached ludicrous proportions, leading to increasingly loud questions about just how much longer this can go on.

Sound familiar? "There was a real feeding frenzy in the late Nineties," says Piers de Montfort, head of UK investment banking at Credit Suisse. "If you weren't growing, buying, consolidating, you were vulnerable. That market was as close to out of control as I have ever seen. I don't see that this time. It's more controlled now, and the markets continue to reward sensible, strategic transactions."

Last month was the busiest ever for mergers and acquisitions, with nearly $650bn (£330bn) in deals announced. That pushed the total value to $1.9 trillion so far this year. "M&A is dominating my life," says one exasperated banker.

The €71bn (£48bn) takeover battle between Barclays and a group led by Royal Bank of Scotland for ABN Amro, the Dutch bank, is the largest ever in the global sector. Alliance Boots, which agreed to be purchased for £11.1bn by private equity giant Kohlberg Kravis Roberts (KKR) last month, is Europe's largest leveraged buyout. Other big deals include the €12.1bn proposal for tobacco group Altadis by buyout groups CVC and PAI, Thomson's £8.7bn media deal for Reuters, and AstraZeneca's recent $15.2bn pharmaceuticals purchase of MedImmune in America. Takeovers this year amount to more than half of all of those announced in the record year of 2000, when $3.3 trillion worth of acquisitions took place.

It's an unsettling comparison. To be fair, there were different factors at work then. The frenzy of the late 1990s and 2000 was fed by the overwhelming urge felt by companies to get in on the new internet economy. Establishing a beachhead on the web and securing "traffic" took precedence over stodgy old concerns like turnover and profits. The result was a wave of logic-defying deals on a scale not seen before or since.

When investors finally stopped to consider what Alan Greenspan, the former head of the US Federal Reserve, described as the "irrational exuberance" of the time, the fallout was horrendous. A rash of bankruptcies followed. Companies spent the next several years unwinding the deals they had done and paying back billions. Jobs were lost. In the US, the centre of the action, a mild recession ensued.

But fear not: this time, we are told, it is different. "We are at the top of the hill rather than a mountain, and the hill isn't particularly steep or strenuous," says one banker.

"In the late 90s, when it got near the end, we knew we were looking over the edge of a cliff."

Such statements are made, of course, with the benefit of hindsight. But most observers agree that the majority of the deals being struck today make much more sense strategically, even if the final price paid is questionable.

After all, if Warren Buffett, the world's second-richest man, is ready to get it on the act, it can't be all bad. At his annual shareholder meeting earlier this month, the ukelele-playing Oracle of Omaha said he would "love" to splash out $40bn to $60bn on a company. He explained: "The entire world is definitely on our radar screen and we hope to be on its... The cash is coming in faster than the ideas."

So why the rash of deals now? Perhaps more important than any other factor is the benign credit environment. Despite four hikes in less than a year, UK interest rates remain near historic lows and the chance of a return to the double-digit levels of the early 1990s is virtually nil. That has fomented nearly a decade of strong economic growth. It also means that debt used to fund takeovers is cheap and plentiful.

"Interest rates now vary within a very small band. Fifteen years ago, everybody - the UK, the US, Europe - had their own monetary policy. The market had not yet come to terms with global monetary policy," says Mr Montfort. "The environment today is much more stable and we are not seeing anything that is likely to change that. With greater predictability, buyers are getting more comfortable with medium-term trends, and are doing deals that are braver."

In other words, when corporate chieftains look out to the horizon, they see smooth seas. Globalisation is credited with increasing the predictability and growth of industries, such as mining, that in the past were subject to the cyclical nature of more limited markets.

That sense of security, combined with balance sheets brimming with cash and the willingness of lenders to grant unheard- of amounts of debt, has given executives the confidence to make bold moves. So deals that have been simmering for years - Rupert Murdoch's $5bn pass at Dow Jones in America, and Thomson's bid for Reuters -- are finally coming to fruition.

"There's a bit of uncertainty about how long this will last, so a lot of things that were meant to happen in the autumn, people have put forward. It's bird-in-the-hand type stuff," explains another banker.

There are also more buyers. Private equity firms - investment groups that raise pools of money to buy companies, restructure them and then sell on - raised a record $210bn last year and are slated to capture another $250bn this year, according to research firm Private Equity Intelligence. That's nearly four times the amount they had at their disposal just five years ago. These groups accounted for one-fifth of all the deals done in 2006.

Yet worrying signs are cropping up, especially the debt packages used by private equity to buy companies. Traditionally, loans were studded with conditions that acted as an early-warning system. This would be triggered when a business tripped up. In the worst case, banks could take control of a business that fell foul of its covenants.

Fierce competition among banks for these deals, however, has made them increasingly supine. So-called "covenant-lite" agreements that do away with many of the old conditions are now common. Such is the level of demand that some buyout firms have begun to demand big interest rate reductions even after the financing terms have been signed off.

KKR and Goldman Sachs did this recently in a $3bn refinancing of Kion, a forklift company they had purchased. The reduction on one loan of 50 basis points and of 75 basis points on another meant tens of millions less in annual payments. The firms won the decreases even though they had already agreed to higher rates. Despite the much harsher terms for the banks, both loans were vastly oversubscribed.

"Private equity firms are taking advantage of ferocious demand to push through pricing reductions and structural changes unimaginable 12 months ago," explains Fenton Burgin, head of the debt advisory group at Close Brothers. "Conventional principles of credit analysis appear to have been suspended in some instances."

Consider the purchase of Alliance Boots. If KKR and Stefano Pessina, deputy chairman of the chemist, pull it off, the £11.1bn takeover will be the largest yet by private equity in Europe. KKR and Mr Pessina have said they will pay £2.6bn between them out of the total £12bn they need to finance the deal and leave some money left over for investment. The remaining £9.4bn will be sold to institutional investors, which will be offered no voting rights for taking on more than 80 per cent of the risk. Few foresee any problems in attracting enough investors.

There's also the case of Gartmore. Hellman & Friedman, the US buyout firm, acquired the fund manager for £522m - £180m of its own cash, plus £342m of debt - last year. That deal closed in September, and now, just eight months later, it has put the finishing touches on a refinancing of the entire £522m price tag. This has allowed Hellman & Friedman to recoup all of the £180m it paid to take over the business, in effect reducing its risk to zero while maintaining its ownership.

Such large debt loads leave little room for manoeuvre if a company runs into trouble, raising fears that some acquired firms are being set up for failure. "We'll see a lot of these deals go south if the markets slip away and a recession bites. All that debt around [companies'] necks will become a noose," warns one banker.

However, the pervading sense in the market is that Rumsfeldian "known unknowns" which could throw the current run off course, such as global interest rate changes and hiccups in economic growth, have been minimised. Investors are more worried about "unknown unknowns" - macro-economic shocks, a war or natural disasters.

This was the concern that came up repeatedly over cocktails at a gathering last week of London hedge fund managers at Claridge's Hotel in Mayfair. Perhaps no other sector has benefited more from the market's performance, or would be better placed to opine about its future. The world's top 25 managers, for example, made an average of $570m each last year - more than double the figure for the year before. As an industry, they now control more than $1.5 trillion around the world.

Increasingly, they are also jumping on the M&A bandwagon by taking much larger stakes in companies or buying them outright. Last month Dresdner Kleinwort formed a new group to begin selling M&A ideas direct to hedge funds. Six months ago, such deals would only have been brought to private equity firms or corporate clients.

Yet at the reception last week, there seemed an implicit acknowledgement in the money men's conversation that these indeed are the good times, and the days are numbered. "This can't go on for ever. It's got crazy," said one. "The prices people are paying now will mean a lot of pain later. That's just the cyclicality of business. I would be surprised if it didn't end up that way."

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