Why you should steer clear of M&A

Mergers and acquisitions (M&A)are back. So much so that, as Reuters notes, the global total deal value for August of $200bn is only $77bn short of the record set in 1999. A string of deals has hit the market, featuring headline-grabbing names such as BHP, Hewlett Packard, and HSBC. This all sounds pretty exciting "predators" stalk "targets", while "white knights" and "poison pills" are deployed but that may not be of any real use to investors.

What is M&A?

In a merger two sets of shareholders are persuaded to get together to create a newly combined firm. However, most of today's big deals are acquisitions. Here, one firm agrees (in a friendly acquisition) or attempts (in a hostile takeover) to gain control of another by buying a minimum of 50% +1 of its voting shares from existing shareholders. Pure cash is often offered, or a mixture of cash and shares. Once any deal is announced plenty can go wrong a target's board of directors may fend off a hostile bid by persuading their shareholders not to accept. In Britain competition authorities can block any deal.

Why bother?

A firm can usually grow more cheaply "organically", using its own profits and cash flows. So why go to the expense and hassle of buying a rival? After all, as the FT's Lex column puts it, "the latest crop of deals has some of the tell-tale signs of danger: high ego, high price and over-confidence". Yet there are perceived advantages. It's a fast way to propel a firm up, say, the FTSE 100 (which, like many indices, ranks firms on pure size market capitalisation). For some CEOs there's the satisfaction of knocking out a rival. It also uses up any surplus cash a firm's shareholders may want to spend and it generates fees for investment banks (who naturally favour deals).

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Above all, it's exciting far more so than the daily grind of running a steady business and creates a sense of buzz. Some optimists even see it as a sign that the stockmarket has turned a corner (see below). It's a pity then that, as the FT notes, "history suggests a disconcertingly large portion" of M&A activity never delivers shareholder value. Why? Because buying a business is a lot easier than running and integrating it. And many firms overpay for targets because the seller has the upper hand they really know what's "under the bonnet".

Can M&A make me money?

There are several ways for a retail investor to play M&A however, tempting as the press can make them sound, we'd avoid them all.

1. Buy a target (and short the predator).

Given that targets tend to get a share-price boost once the market twigs they might get bought, the trick is to buy shares in potential targets. Better still, given that most deals fail to add value, why not short a prospective predator at the same time? You could easily set up a down bet via a spread-betting broker (see Moneyweek.com/spread-betting). However, as Robert Prechter notes on Marketoracle.co.uk, "picking and choosing takeover targets can be a tricky game. Most individual investors simply don't have the expertise to make the right bets". And get a short spread bet wrong and losses can rack up fast.

2. Buy an M&A boutique.

A less risky option is to buy shares in a listed advisory firm, such as Evercore Partners (NYSE: EVR). This was set up in 1996 and specialises in advising on M&A and other corporate transactions that include public offerings and restructurings. The forward price/earnings ratio to December 2010 is 25 (dropping to nearer 12 in 2011) with a yield of 2.3%. The shares have lost around 35% in the last three months. So one to buy while it's cheap? Perhaps not. With a double dip looming, this M&A boom doesn't look sustainable. So predictions that a big deal pipeline will turn things around for Evercore look optimistic.

3. Buy an initial public offering (IPO)-linked exchange-traded fund.

A slightly different play on the pick up in corporate activity is an IPO fund. The First Trust IPOX-100 Index Fund (NYSE: FPX), for example, gets you exposure to new issues. These have made a huge comeback this year. The ETF avoids the "rabbit out of the gate" problem created by frenzied buying around the IPO date it only buys a stock after seven days. It then holds it until the 1,000th day of trading. The problem? It doesn't deliver. Although the expense ratio is a reasonable 0.6%, so far this year it's done little better than the broader market. The trouble is that globally only 47% of IPOs closed above their offer price in the second quarter, making this a tough place to cherry pick investments even for the professionals.

Is M&A a sign the stockmarket has turned?

It seems unlikely. Indeed, as my colleague David Stevenson has pointed out, spikes in M&A tend to follow market upswings and are often a "harbinger of an overall share pull back". Besides, corporate USA is sitting on around $7.2trn of debt and US firms are carrying four times as much debt as cash. So just like the last one exactly a year ago, the latest M&A flurry may not last long. As evidence mounts of a global double dip, plenty of firms without a compelling reason to do a deal should conserve cash rather than spend it.