Can you profit from merger mania?

With low interest rates meaning easy access to money, bidding wars and hostile approaches are becoming routine, says Alex Ferguson – but how long before the tide turns on takeovers?

There's no shortage of firms willing to splash the cash. Deals worth $1.8trn were announced in the first half of 2006, according to research firm Thomson Financial. The full-year volume is estimated to be more than $3.45trn. That's up from nearly $2.8trn last year and promises to beat the record $3.4trn set in 2000 at the height of the dotcom bubble.

Public company bosses seem happy to fork out serious amounts of money in order to further their empire-building ambitions. This year, we've seen AT&T acquire Bell South for $89bn, Eon bid $57bn for Spain's Endesa and Mittal Steel buy Arcelor for $34bn. Meanwhile, private-equity firms are fighting ever harder for acquisitions as they become embroiled in bidding wars and even make hostile approaches, a rare event in this industry.

What's driving the boom?

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Easy access to money is a big factor. Interest rates remain low by historic standards, even after recent tightening measures by central banks, and the lenders who have flooded the world with so much liquidity show no signs of turning off the tap.

Private-equity firms have ready access to this cheap debt and are also loaded with hard cash from their investors the top five firms have a £38bn war chest that has to be spent by 2010. Public companies have been rediscovering the urge to splurge after several years of using their profits to pay down debt or hand cash back to shareholders. Industries such as oil and mining are at the cash-rich point of their cycle.

With a shortage of organic investments around, many firms are looking to grow by acquisition and to avoid being acquired. Dealmakers also claim markets are undervalued, particularly after the recent slump, making acquisitions attractive.

Is all this a good thing?

There's no doubt that it has given a major fillip to stockmarkets, with takeover speculation helping to boost the price of many shares. For example, British orthopedic specialist Smith & Nephew rose 3.2% in one day recently after Merrill Lynch put out a note saying that private-equity buyers might be interested in the firm. But stockmarkets built on takeover speculation are houses built on sand. What's more important in the long run is how valuable the deals turn out to be.

What does history have to say about that?

That large mergers and acquisitions (M&A) deals have an excellent record of destroying shareholder value. A much-cited McKinsey study in the late nineties concluded that the majority of deals turn out to be counter-productive. The dotcom bubble was particularly costly: it involved nine out of the ten most value-destructive deals in history, costing $500bn in shareholder value, according to research by Collins Stewart Tullett. However, M&A bulls say that the steady build in activity and the fact that solid, old economy firms are involved suggests that this time it's not a bubble and the outcome will be different.

Does that look likely?

The proof of the proverbial pudding is in the eating in other words, whether these deals will be beneficial or destructive won't be clear until we're some way further down the line. But warning signs are beginning to flash.

The average bid premium of around 20% is not high compared to those seen during the height of the dotcom bubble, but the valuations on large deals are ticking up. Mittal is paying an 80% premium to the price at which Arcelor was trading prior to its first bid approach.

The big deal in the mining sector the FalconbridgeIncoPhelps DodgeTeck-ComincoXstrata palaver is just the kind of convoluted bidding war that sees the winner end up as the loser. To recap, Xstrata originally bought a 20% stake in Falconbridge last autumn. Inco then made an agreed offer for Falconbridge, which Teck Cominco followed with a hostile offer for Inco. Phelps Dodge then made an agreed bid for both Inco and Falconbridge, and Xstrata countered with a higher hostile bid for Falconbridge.

The latest offer at time of writing is a sweetened bid from Phelps Dodge that values Falconbridge at a 116% premium to the price at which Xstrata bought its original stake. The aggressive competition between firms such as Goldman Sachs and Macquarie may also see many private-equity buyers overpay for assets.

Are we near the end of the boom yet?

Probably not while money remains cheap and plentiful. Rising interest rates or a reduction in the availability of debt should gradually curb activity, particularly as deals are becoming increasingly debt-loaded. The average private-equity deal involves six times as much debt as earnings, up from 5.5 in 2005, according to Fitch Ratings. Public companies are also gearing up on debt as they compete with the private-equity firms. However, barring major global problems, it looks unlikely that the market will slow sharply before the end of the year. There are signs that the cooler heads in the private-equity business feel they've run out of good targets at good prices and are starting to turn down more deals, but public companies seem happy to pick up any slack in the market.