The ABC of M&As

Every now and again market commentators get hot and bothered over takeovers. Speculation and rumour runs rife as analysts and hacks draw up lists of potential targets. Interest waxes and wanes as the relative merits of various companies are discussed over café lattes at lunchtime and something a little stronger over dinner.

Is it all a waste of time? Possibly, but for the private investor a little knowledge goes a long way. In truth, all listed companies are targets but some are more attractive than others. There's also a fine line between what is termed a takeover, a merger or an acquisition. Often the terms are used interchangeably as two operations are combining to form a single corporation. But there's a world of difference in the way this is achieved.

A difference of terminology

A merger is a friendly process that combines two companies for the greater good of the single entity, as was the case in the proposed MLC, National Mutual merger last year. On the other hand, a takeover is usually hostile, as was the case with AMP's takeover of GIO, while an acquisition means the purchase of an asset of one company by another.

A takeover occurs when a company, the 'bidder', seeks to acquire a controlling interest in another company, the 'target'. A full takeover means 100% of the shares are sought, but sometimes a partial bid is made to acquire a strategic stake in the company that's enough to assume effective control.

Under Australian corporations law an ownership level of 20% triggers a takeover although under the 'creep provision', further small parcels can be acquired above this level over time without making a takeover offer.

Companies on the lookout for potential acquisitions usually do so to help fulfil growth ambitions that can't be fuelled by internal growth - it's often cheaper to buy a new product range than develop one yourself. This may be lazy, especially given the evidence that acquisitions rarely deliver the benefits promised, but it's what happens.

Benefits expected from a takeover include reduced costs by achieving economies of scale, which usually means job losses, or a sharing of resources. These are known in the game as 'synergistic' benefits, the belief that the whole is worth more than the individual parts. Other reasons include:

• Better exploitation of assets;

• Realising the value of under performing assets;

• Cost savings (sharing of head office functions, factory space etc);

• Benefits of changed market perception from expanded group;

• Expansion without duplication or start up costs;

• Diversification of operations;

• ASX listing for an unlisted company - 'a backdoor' listing;

Despite these reasons, extensive studies in the US show that the probability of increasing shareholder wealth through takeovers is low. A summary of dozens of academic studies outlined by McKinsey and Co. show that shareholders of acquired companies are the big winners, receiving an average premium of 20% for friendly mergers and 35% for a hostile takeover. Shareholders of acquiring companies (those parting with the cash) earn very small returns by comparison.

Lessons for investors

For companies, an important part of a successful merger or acquisition is to know how to recoup the 'takeover premium' by identifying real cost savings, sticking with a pre-determined maximum offer price to prevent overbidding and to progress as quickly as possible to full acquisition. Investors should be aware that this is more difficult than it sounds and companies (and shareholders by extension) often find themselves paying over the odds for assets that don't deliver the expected benefits.

As a holder of shares in a company that's been bid for, it's a different story. The key is to wait for the market to play out its game of bluff. Read the documentation from both the 'bidder' and the 'target' company as these outline the arguments for and against the proposal. Have realistic expectations of the premium to market price that the acquirer will pay and look at the bid objectively: Is it a cash or share offer? Do you want to invest in the biding company or sell and use the proceeds elsewhere?

Finally, remember that friendly and hostile takeovers are usually long drawn out affairs. Unless the bidder is already the major shareholder and is mopping up minority stakeholders, the first offer rarely wins. In any event, in the absence of a higher offer, the best time to accept will be just prior to the closing date and after the bid has formally been declared unconditional. This means that shareholders can be assured of receiving the script or cash in the time frame set out in the offer document.

For more on takeovers, head to Takeovers - a practical guide, Part 1 and Part 2.