M&A activity is heating up…

Luke Cummings

Harvest Lane Asset Management

Following on from the recently announced takeover offers for Mantra Group Limited (MTR) and Property Group Limited (PLG) and so too the current tussle for control of Asia Pacific Data Centres (AJD), we thought it was worth revisiting what we look for when trading opportunities in the merger arbitrage space and why we feel it is a strategy worth pursuing.

In our experience, a strategy of merger arbitrage has not only provided us with consistently profitable trades (with a high win rate) but has done so whilst also reducing the overall volatility of our portfolio (when compared to equity markets generally.) It is true however that when takeovers fail, there is the potential for a large loss of capital and hence avoiding these failed trades wherever possible is the key to generating consistently positive returns. Over the 15 plus years that the Harvest Lane team have been trading M&A, our wins have happily far outweighed the losses and by keeping a few key things in mind and adopting a selective and systematic approach, Livewire readers will be well on the way to achieving a similar result.

So, whilst this list is by no means exhaustive, below are some of the key considerations that guide our decision making process when determining whether or not a particular M&A opportunity should be included in our portfolios:

The number of conditions attached to the transaction is generally inversely related to the likelihood of it successfully completing.

When a company announces a takeover, it’s usually accompanied by a number of conditions that when met, lead to the successful completion of the deal. A large number of conditions not only makes the takeover more complex, but also increases the chances of the bidder walking away when one of them is not met. It also increases the chances of you (the investor) underestimating the risk involved in the trade from missing something critical to the success of the deal. Don’t make things more complex than they need to be, preferring takeovers with limited conditions will make your life much easier and no one is going to argue with that.

Cash bids are generally preferred over those transactions where the bidder is paying in shares

There are 2 main forms of consideration that a bidder will generally use when acquiring another company. One is where the bidder offers cash in exchange for each of the target company’s shares. The other is where the bidder offers its own shares as consideration for the bid. Once again, we prefer the cash option for its simplicity. If the acquiring company is offering to pay cash, the value of the bid is essentially fixed and only has the potential to increase (if a further bid is forthcoming).

In the other case i.e. where the bidder is offering to pay using its own shares, the value of the transaction is very much variable and that is because the price of the acquiring company’s shares can change (significantly in some instances) between the time at which the offer is made and when the offer is ultimately completed. If the price of the acquiring company’s shares falls then the value of the target company shares will also fall meaning that as the owner of these shares you may lose money even if the deal successfully completes. In some circumstances you can hedge against these movements (if you are able to short the shares of the acquirer) but if the terms of the deal were to change (such as another bidder entering the mix) the situation would become far more complex in that you now have to assess the probability of each offer proceeding and also whether or not to unwind the (short) hedge that you have in place against the first offer.

Our main aim is to eliminate market risk as much as we can so situations where we are exposed to market fluctuations in the value of our holdings are best avoided. Cash offers are far superior to scrip offers in this respect.

Eventual support from the board and an independent expert is an added benefit

Support from the board of directors of the target company is nice to have but not always needed. In fact, often the initial of absence of board support is what leads to an improved offer at a later stage. Eventually though (ideally after an improved offer) board support is a big plus as it greatly increases the chances of the offer completing successfully. Likewise, the fact that an independent expert initially values the target company at a higher price than is currently being offered by the acquirer usually only strengthens the probability of a higher bid eventuating. However, at some stage we are again hoping for a situation where the independent experts deems the bid ‘fair and reasonable’ or at worst ‘unfair but reasonable’ as once again this is more likely to result in the deal completing. In practice, it is generally the case that the board will only support an offer once the independent expert has deemed it ‘reasonable’ and as such, the two generally go hand in hand.

Additional hidden benefits have the capacity to increase returns

Something that’s often overlooked is the added benefits that are included in some bids. In most cases, this benefit takes the form of the inclusion of fully franked dividend in the transaction proceeds, which for the right shareholders (SMSF’s and other low tax paying vehicles) can significantly increase the realised return on the transaction. There are other instances, where the offer price is linked to an exchange rate or includes a maximum limit on the number of shares that can be tendered into the bid and if this leads to different groups of investors realising different return outcomes (because of their country of domicile, size of their shareholding etc) it may allow other investors (i.e. you) to make lower risk returns than would generally be the case. Often these benefits are not reflected in the target company share price and it therefore worth paying close attention to the specific terms of each bid.

A competing bid that leads to a war

When assessing a potential opportunity, we are not only interested in the terms of the current offer, but also the possibility that one or more competitors will launch a counterbid. In this case, a bidding war becomes a very real possibility and it is very much our ‘Holy Grail’ scenario to have two or more buyers competing to acquire our shares. Some of our best trades have come from a situation where 3 competitors have fought over the assets of one company. You only have to look at takeovers such as Ludowici Group (LDW) or Warrnambool Cheese and Butter (WCB) to see how good these trades can be. Just one such trade a year can be the difference between a good year and a great one.

Contributed by Harvest Lane Asset Management (VIEW LINK)

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Luke Cummings
Chief Investment Officer and Managing Director
Harvest Lane Asset Management

Established by Luke and his partners in 2013, Harvest Lane seeks to generate superior, risk-adjusted returns regardless of prevailing market conditions with a particular focus on ‘corporate events’, including mergers and acquisitions.

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