Three ways to spot the next private equity bid target

So far the main beneficiaries of the private equity boom have been shareholders in mid-cap stocks. But now analysts such as Merrill Lynch and Thomson reckon that "most of the tastiest morsels" have gone from the FTSE 250, with bid fever driving up share prices on any potential candidates to unattractive levels. Large caps, on the other hand, says Merrill Lynch strategist Karen Olney, "are cheaper versus mid-caps than they have been for nearly 20 years" and several FTSE 100 firms are "hiding their true value". These firms, she says, will have to break up to achieve higher valuations, or a private equity buyer may do it for them. And with the vast sums of money available to private equity, no company is safe. Tom Stevenson in The Daily Telegraph says that £1,100bn is waiting to be spent "in the world's biggest takeover spree". But how do you spot a target?

Private equity targets #1: Low debt

In this climate of low interest rates and cheap credit, any company that carries little debt or (as is the case in around 20% of FTSE 100 members) net cash is exposed. That is because a bidder can immediately load it with new borrowing and magnify returns to shareholders.

It's an old but effective trick. Say a firm has net assets of £100m, all funded by equity (shareholders' funds). If operating profits grow over the next 12 months from £5m to £10m, the return on equity improves from 5% to 10%, ie, it doubles. Imagine the same company, financed with £50m of debt, at a finance cost of 8%, and £50m of equity. This time, profit after interest improves from a lowly £1m (since the £5m from the first year is reduced by £4m of interest costs) to £6m (£10m£4m). Thanks purely to gearing, the profit available to equity shareholders has risen a spectacular six times and the return on equity has jumped from 2% (1m/50m) to 12% (6m/50m), despite the fact that the underlying operating profitability is no different.

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Private equity target #2: Strong cash flow

The only problem with loading a company to the eyeballs with debt is that the potentially huge interest bill has to be paid somehow. So following an analysis of European leveraged buyout deals, Lehman Brothers believes that, all other things being equal, high operating cash flows relative to the size of the firm make it more attractive to a bidder, as it means there is plenty of scope to fund those interest payments. Indeed, they conclude that companies valued at less than nine times operating cash flows have a one in eight chance of being acquired.

You can try this test at home using the accounts. If, for example, the operating cash flow (near the top of the cash-flow statement) is £4m; the company is financed with £10m of debt at market value (you can add balance sheet short- and long-term debt to measure this roughly) and £15m of shareholders' funds at market value (the market capitalisation); then the multiple is roughly six times (£25m/£4m), which beats the target.

Private equity target #3: Undervalued assets

From a predator's perspective, strong cash flow needs to be available cheaply. Value for money can be gauged, say Lehman Brothers, by comparing the market value of the business with the value of its fixed assets. Their research indicates that if the ratio is less than two then the chance of the company being a target improves to one in four. You can estimate this by taking the market capitalisation of the company and dividing by the carrying value of fixed assets (shown at the top of the balance sheet).

Buying stocks on bid speculation alone, of course, is not a good long-term investment strategy. Below, we look at some targets that should turn out good buys, whether or not a bid materialises.

Bid targets that should make good buys

If we take Lehman Brothers' two favoured measures of operating cash flow and fixed-asset multiples, then cruise operator Carnival (CCE) and nuclear power group British Energy (BGY) both look attractive bid prospects. British Airways (BAY) also makes the cut, despite Richard Branson's quip that the fastest way to make a million pounds is to start with a billion and then buy an airline. Investors Chronicle points out that were a private equity bidder to value BA on a similar multiple as the one being offered to Spanish peer Iberia, its share price would be up to 50% higher. The main stumbling block to a deal for companies such as BA, or indeed the cash-rich Rolls Royce (RR.L), has tended to be the size of their pension deficits. Of these four, the one we like the look of best is Carnival. Even without a bid, the company is the market leader in its sector, and is a major beneficiary of the "grey pound" as populations in the West age.

Meanwhile, another potential target lies within one of our favourite sectors, mining. Anglo American (AAL) is trading at a discount to the sum of its parts and is also probably small enough not to cause competition issues to any bidder. And even if it doesn't fall prey, if you believe, as we do, that commodity prices will keep rising, the future looks rosy for the group, which trades on a p/e of just under 14.