Better ways to play the merger mania; Big takeovers get all the attention, but demergers have a far better record of releasing value

August 2, 2013 6:28 pm

Better ways to play the merger mania

By Jonathan Eley

Big takeovers are back in the news, but what is the best way to profit from them? Mega mergers are back. This week, advertising groups Omnicom and Publicis announced a $35bn tie-up. Just a day or two earlier, Irish pharmaceuticals group Elan ended a long courtship by recommending a takeover by Perrigo. Closer to home, engineering group Invensys has recommended an offer from France’s Schneider Electric. The re-emergence of M&A has been long predicted, and there have been several false starts. Companies are sitting on big cash piles, having restructured and refinanced in the wake of the credit crunch, and that money is earning only nugatory returns in cash and other short-term instruments. The global economic recovery might still be slow and uneven, but there are now at least some tangible signs that it is heading in the right direction, giving chief executives the confidence to deploy some of that cash. Valuations in the US might be looking a bit stretched, but elsewhere in the world – especially in many parts of Europe – they are broadly reasonable.Is this good news for investors? There’s a mountain of academic evidence that takeovers destroy value for shareholders in the bidding company, and that the hubris of senior managers leads them to overestimate the benefits of combining one company with another.

If you want a practical example, look no further thanRio Tinto’s disastrous $38bn takeover of Alcan in 2007, which was followed by a dividend cut, a $15bn rights issue, a $10-11bn write-off – and a change of chief executive.

On the other hand, takeovers are a sign of growing confidence, and institutions generally have to reinvest whatever cash takeovers generate in other shares, which boosts the broader market.

And for a private investor, a conventional cash takeover offer should be manna from heaven. You wake up one morning to find you’ve been offered a fat premium and no dealing costs to sell your shares. The only downside is that you might incur a capital gains tax liability on the profits, or face a conundrum when it comes to reinvesting them. Both are nice problems to have.

Alas, not all takeovers are of this particular ilk. The lower end of the stock market has been prone to stingy “take private” deals, where a dominant shareholder grows frustrated with poor share-price performance and offers to buy out other shareholders at a miserly price. The minority holders generally accept, through gritted teeth, because the alternative – owning shares in an unlisted company controlled by a majority shareholder – is so unpalatable. Morson, a recruitment company, was taken private in just such a fashion last year.

And then there’s the “nil-premium merger of equals”. This is the structure to be used for the Omnicom/Publicis deal, and it was also the basis of Glencore’s takeover of Xstrata. These are often used for big deals because the accounting treatment (“pooling of interests”) avoids the creation of large amounts of goodwill on the balance sheet of the combined company, which might one day need to be written down if the deal doesn’t work out.

But nil-premium mergers are not so clear-cut for shareholders. It’s more difficult to evaluate whether you’re getting a fair deal or not; the prices of the two companies move all the time. If the deal involves an overseas company, you might end up with shares in an entity that’s based somewhere else (as happened when Carnival and P&O Princess merged).

In a conventional takeover, you get your cash, and all the practical difficulties of integrating two complex businesses are somebody else’s problem. With a merger, you are exposed to all that ongoing risk. Long-term shareholders in Invensys know this only too well. The company was created from the £9.4bn merger of industrial conglomerates BTR and Siebe in 1999. That transaction was followed by years of restructuring and refinancing. Some 14 years later, the Schneider bid values Invensys at £3.4bn.

Picking individual takeover targets is notoriously difficult, too. Plenty of companies have been “bid targets” for years but languish on low share-price valuations while they await a suitor. You can leave the job of picking takeover targets to a fund manager – not that I know of any funds with such a precise mandate – but the strategy is essentially the same. You are buying something largely in the hope that one day someone else will buy it off you for more. It’s less investment and more speculation.

Two other strategies spring to mind. One is to buy a small or mid-cap fund. That’s because smaller companies are more likely to be taken over, and any bid is more likely to be a straight cash takeover. While you wait, you’re also exposed to a segment of the market that’s on a roll. Since I last wrote about the FTSE 250’s outperformance (and predicted it would continue) it has put on another 23 per cent, against 12 per cent for the FTSE 100. The mid-cap index is full of housebuilders, which are being boosted by the government’s hare-brained lending schemes, and seems set to go on outperforming.

Another option is to buy a special situations fund, like the Fidelity UK Special Situations or the M&G Recovery fund. These funds don’t just chase takeovers; they look for any circumstance in which there might be a catalyst for hidden value to be realised.

One way for that to happen is via the corporate transaction that never gets the attention it deserves – the demerger. Here’s a back-of-a-fag-packet example: the oldCarphone Warehouse was worth £1.7bn immediately before it demerged TalkTalk in March 2010. The two now have a combined value of £3.71bn, an increase of 118 per cent. The FTSE All Share has risen just 20 per cent over the same time. And another: Cookson’s market value was £1.79bn in December. The combined worth of its two successors, Alent and Vesuvius, is £2.17bn, an increase of 21 per cent against a 12 per cent gain in the All Share. Big takeovers get all the attention, but demergers have a far better record of releasing value.