Featherstone Time to brush up those takeover skills

Tony Featherstone advises directors to sharpen their skills ahead of a likely rise in mergers and acquisitions this year.

Directors of listed companies should brush up their takeover skills. More mergers and acquisitions (M&As) are likely this financial year if the global economic recovery is sustained. Smaller companies with depressed valuations following the financial crisis will be prey for cashed-up rivals.

More boards will be asked to approve acquisitions at a time of persistent high market volatility. Directors are right to be wary. Fears of a double-dip recession in the US and contagion from European debt problems are growing. Having survived the financial crisis, boards will want to ensure an acquisition does not over-gear their company and make it vulnerable to another financial shock.

The long-term record of creating value through takeovers is hardly inspiring. Various studies show more than half of all takeovers destroy value for the acquiring company’s shareholders. Companies can pay too much, overestimate acquisition benefits, be slow to capture synergies or struggle with cultural clashes. They end up making themselves vulnerable to takeover.

Boards defending takeover advances also face many challenges. They may believe their company is worth much more than an acquirer is willing to pay. But many small listed Australian companies are stuck in a “graveyard” – too small for fund managers to invest in, too illiquid for stockbroking firms and too risky for retail investors. In the absence of a short or medium-term catalyst to re-rate the share price, the most prudent action for boards is recommending the offer.

Arguably the biggest risk boards face is succumbing to takeover hype. There is nothing like a few takeovers to spur companies into action on the acquisitions front. One can imagine more CEOs pleading with their board to approve a transaction or risk “missing the boat and paying much more for the asset next year”.

Directors will need to be clear about how the takeover fits corporate strategy and whether the acquisition is in shareholders’ best interests. They must be sure executive remuneration packages are structured to incentivise sound acquisitions.

Several newspaper stories have forecast a takeover boom in the next 12 months. Some investment bankers are also talking up M&As – not surprising given the $7.8 billion in equity capital market issuance in the first half of this year was the lowest half-year volume in seven years, Dealogic research shows. Another source of investment banking fees – initial public offers (IPOs) – is still in the doldrums.

Perspective on takeovers is needed. There has been a noticeable increase in takeover offers this year, though many have been for smaller industrial companies. Inbound cross-border M&A activity worth $15 billion (for announced deals) in the first half was at a two-year low, according to an Australian Financial Review report. About $10 billion of that was for the rejected Macarthur Coal deal and Transurban bid. The amount of completed M&A is still low.

The main argument for more takeover activity is large listed companies needing to invest more of the $110 billion they raised last year to repair balance sheets. Having too much money parked in cash will weigh on equity returns. Paying off debt and reducing interest costs will not create the same returns as astute acquisitions. But cash returns will look attractive for companies that overpay for assets and produce low or negative returns for shareholders.

Other options such as giving excess cash back to shareholders through special dividends may make more sense than rushed acquisitions.

Another argument for takeover activity – a lower Australian dollar against the Greenback – also needs scrutiny.

Certainly, an Australian dollar near or below US80 cents would make purchases of Australian assets more attractive for some foreign bidders. Several takeover attempts this year have been from offshore companies. Parity between the Australian and US dollars seems unlikely; so does a sharply lower Australian currency given this economy is still among the Western world’s strongest and commodity prices are underpinned by Asian economic growth.

A third takeover argument – renewed activity from private equity firms – is unconvincing. Many private equity firms are still sitting on assets bought a few years ago that are not able to achieve a sufficient valuation through an IPO due to equity market weakness.

It is unclear whether superannuation funds will commit large slabs of new money to private equity firms in the short term. More private equity activity is likely in trade sales and for acquisitions of smaller listed companies.

Of course, a stronger recovery in the global economy and a sluggish sharemarket could unleash more takeover attempts.

In the meantime, boards should maintain a wary approach to acquisitions, be clear on director duties during takeovers and resist M&A hype.