Flurry of M&A activity provides boost for UK managers

Healthy balance sheets and the strength of the dollar drive merger and aquisition activity, with European companies targeted by North American buyers

UK equity fund managers are expecting to receive a welcome performance kick from M&A activity as the current wave of takeovers shows no signs of abating.

The low cost of financing coupled with a stronger dollar has led many managers to expect bids for the companies they hold, especially from bidders across the pond. The dollar is already 4.8% higher against sterling this year and 11% up on the euro.

Three-quarters of European investors expect to see an increase in M&A by mid-2011, according to a survey by IntraLinks and Mergermarket. Optimism in the US is even greater, with 91% of those surveyed forecasting a rise in M&A.

Managers also highlight $112bn of leveraged loans and high yield bonds mature in 2014 / 2015. This is by far the highest annual amount expected for the next seven years, and dwarfs the $3bn seen this year.

While a number of global deals have already taken place, there is continued evidence of more activity to come, as shown by BHP Billiton’s recent hostile bid for Potash, and BA identifying 12 merger targets last week.

“You are seeing a lot of mergers and spin-offs, and companies trying to restructure in the face of very tough market conditions. It is a fat opportunity set in a tough environment where people need to consolidate,” says Ken Kinsey-Quick, the head of multi-manager alternatives at Thames River.

European corporate earnings are as much as 40% below their peak, leading many buyers to see strong upside in target companies.

Two companies held in Liontrust’s First Growth fund have already been involved in M&A this year and co-managers Anthony Cross and Julian Fosh expect more to follow.

First Growth held 1.4% in Chloride, which was the subject of rival bids from ABB and Emerson Electric in June. Missouri-based Emerson trumped ABB, with a 375p offer at a 79% premium to Chloride’s share price.

Next Fifteen, and Reckitt Benckiser, which bought SSL International, are other First Growth stocks that have been involved in M&A activity since the start of the credit crunch.

“We are interested in characteristics that produce robust and sustainable businesses such as intellectual property, strong distribution and high recurring income,” Cross says.

“Companies over £1bn with these attributes could be the kind of businesses US dollar-denominated rivals look for. The dollar’s strength against the pound and euro has added weight to the argument for M&A.

“If cash on the US rivals’ balance sheets is earning very little, then M&A deals using cash can look attractive. We would expect more over time.”

The potential for an increase in M&A has led Threadneedle co-heads of UK equities Leigh Harrison and Simon Brazier to turn their attention to the small- and mid-cap space.

Harrison says: “We are keen to find more opportunities in the mid- and small-cap area, but most are domestic-oriented so have a low growth outlook. This makes it tricky but M&A could mean a complete revaluation of the market.

“We are trawling through these markets as we think this is where the biggest opportunities are.”

Neil Veitch, manager of SVM Asset Management’s UK Opportunities fund, is also convinced US companies are on the hunt for solid companies with international footprints and strong margins.

Three such firms Veitch’s fund has held – Gulfsands Petroleum, Intec and International Power – have all received bids from international suitors.

However, he is not predicting an upturn in M&A simply because of the strength of the dollar, “though this is the cherry on top for US buyers,” he says.

Charles Kirwan-Taylor, chief executive of RAB Capital, says the fact banks have closed down 80% of their internal desks involved in M&A as they have reined in risk since the financial crisis, provides another boost.

Chief executives are dusting off company strategies after putting corporate ambitions on hold during the financial crisis, he says.

“There is an amount of backed-up ambition to be flushed through the system, and chief executives are looking at a dramatically different pricing environment now.

“What in 2007 might have cost them twice as much to buy as they were willing to pay, may now cost half as much.”

Richard Watts, manager of Old Mutual Asset Managers’ UK Select Mid Cap fund, says M&A did not pick up in the first half of 2010 because CEOs acted cautiously as Europe’s sovereign debt crisis exploded. But he says July and August were some of the busiest months on record, and he expects more bids during the rest of 2010.

UK and European companies are as likely as those in the US to table offers, he says.
Their debt to equity levels have fallen by about one-third between the end of 2008 and the start of this year, leaving them well placed to snap up rivals.

“The levels you see now are consistent with the levels in the UK in 2004 to 2006, when there was a lot of M&A,” he says.

“Corporate profitability bounced back very strongly in the first half of 2009 and many companies have repaired balance sheets with rights issues and fund raisings.”

Companies that cannot grow earnings organically in the anaemic growth conditions in the West could choose M&A to expand instead, Watts says.

He mentions Babcock buying VT Group as an example of strategic M&A, and Travis Perkins’ takeover of BSS as a cost-saving merger of their complementary operations.

 “If you have spare cash your options are to increase dividend payments, do share buybacks or conduct acquisitions. I would expect to see all three,” Watts says.

 “Dividend payments typically grow in line with profits, so companies can still be building excess cash and can afford to spend money.”

However, not all managers believe M&A activity will happen in the volumes many expect.

Leonard Charlton, manager of Dalton Strategic Partnership’s MST European fund, says: “We all came into this year thinking we would have a lot more M&A, but the reality is the initial thesis was simply incorrect.

“Corporates have been very conservative in their deployment of capital, which is why you have record non-financial corporate cash balances now.”