Merger action shimmies into a size-zero outfit

The economic climate is having a profound impact on takeovers. Richard Northedge reports

When the league tables of mergers and acquisitions were published at the start of this month, they showed UK bid activity down 48 per cent compared with the first nine months of 2008. Then Xstrata called off its £40bn offer for mining rival Anglo America and the figures had to be recalculated. If you thought this was a thin year for takeovers, it just got skinny enough to get a job as one of Ralph Lauren's latest digitally enhanced supermodels.

Vincent Flasseur, the deals analyst at Thomson Reuters who compiles these eagerly watched tables, reckons more than £120bn of takeover proposals have been withdrawn this year, with Xstrata the largest.

But on the same day that Xstrata walked away from Anglo, the Spanish-backed consortium bidding for National Express withdrew too. Now eyes are on Kraft's proposed £10bn bid for Cadbury: the US food group has until 9 November to formalise the offer, but last week's strong figures from the British chocolate company could have been enough to make Kraft retreat. And British Airways' long proposed merger with Iberia of Spain has yet to materialise too.

When Mr Flasseur redrew his tables, not only did the value of bids this year fall even further, but Goldman Sachs – Anglo American's adviser – lost its crown as top European investment bank. Morgan Stanley now emerges as advising on more continental bids this year than any other bank, with Credit Suisse overtaking Goldman too.

Takeover activity has been low since the credit crunch made finance harder to find and profits harder to earn. But stock markets have risen nearly 50 per cent since March, meaning brave bidders have valuable paper to offer and reducing the risk of buying a business that is falling in value.

Most companies clearly missed the bottom of the market, however, failing to make opportunistic purchases when prices were cheap. Those that considered bids then may now be worrying that an offer at today's higher prices would be overpaying. But Paul Herman, a partner at corporate finance boutique Cavendish Finance, says: "The markets are now at fair levels. If you've seen the heady days of the dotcom boom and the private-equity-fuelled market of 2006-07, then we've come back to fair prices, but there is still uncertainty in the markets."

That makes would-be bidders much more choosy in their targets, he says. "People are staying away from assets that tick a box and are nice to have rather than must-haves. They are less tolerant of mediocrity. Two or three years ago you could sell an ordinary business doing quite well and get away with it, but now there must be a real reason to buy."

"People are not buying turnover. They want strategic assets," he adds, citing Kraft's bid as being a route into Britain for the US company rather than a wish to buy extra food volume.

Andy Morgan, a corporate finance partner at accountants PricewaterhouseCoopers, echoes the point, saying: "We are seeing a casualty rate higher than in a normal market. The strategic deals with a real compelling rationale still get done but it's the ones where price has been pushed that come a cropper, and I do not think that will change in the next six months."

Uncertain economic prospects are making potential bidders wary. If a company plans to buy another at a premium to its stock market value, the purchaser needs to make better profits to justify the price. That might be achieved by synergy or rationalisation or exceptional growth, but even optimists do not expect the economy to boom in the near future and many fear a double-dip will result in consumption contracting again. "M&A is confidence driven," says Mr Flasseur. "It's not a purely opportunistic exercise."

Buying extra capacity when companies are already not working at full output thus makes no sense and purchasing a business that faces redundancies would result in the buyer incurring heavy expenses on top of the cost of the takeover. Not surprisingly, many companies are still reluctant to bid and some that have made approaches are having second thoughts.

"Deals are falling away," confirms Mr Herman at Cavendish. "And one reason why is the due diligence." This process of investigating the books of the target company has become much more detailed since the credit crunch. "Sometimes this discovery process finds the fit is not as good as they thought it would be. Sometimes there is doubt about the deliverability of third-party funding. The banks that finance many of these large deals are going through their due diligence much more thoroughly."

Mr Morgan adds: "From a bidder's perspective, diligence is undoubtedly more thorough and detailed. At the height of the market, there were quite a few short cuts being taken, but now every aspect is drilled into. That can now be a deal-breaker."

If investment banks have had few takeovers this year they have been kept busy raising capital for companies through rights issues. That has made some of the weaker bid targets less vulnerable but it should have made predators better positioned to pounce. However, instead of giving would-be bidders a war chest, these funds have frequently filled the holes in their own balance sheets and many boards that have only just secured their survival are not yet ready to expand.

But the tough trading during the recession appears to have made many potentially acquisitive companies lose their nerve. If the last takeover they completed before 2007 is still throwing up problems, directors are reluctant to suggest stalking a new target. Even if they did, their shareholders are likely to refuse to support them.

But even boards that did not overpay for companies before the market fell appear unwilling to bid now, and they are certainly loath to enter an auction that drives the takeover price higher. Any hoped-for rival bidders for Cadbury have yet to emerge, and Stagecoach, having declined to enter into an auction for National Express, is now considering a bid at below the level of the collapsed takeover.

Lloyds Bank's acquisition of HBOS may be untypical, but it is a reminder of the danger of bidding for a company without doing detailed due-diligence when the economy can still reveal shocks. With a hostile offer there is not even the scope for studying the target's books and many directors at smaller companies would rather risk missing a takeover opportunity that risk buying a company that turns out to have problems.

"People have less of an appetite for risk," confirms Mr Herman. "This should be a good opportunity to acquire businesses but people are less likely to be looking to take a significant risk." And that prudence is costing the investment banks dearly. Freeman Consulting calculates that global M&A fees are down by 55 per cent this year, cutting the banks' income by more than £7bn. In Europe, the fall in fees is more than 60 per cent and Mr Flasseur reckons the lost fees on the Xstrata deal alone would have been nearly £100m.

The mergers and acquisitions desks of the City's investment banks are one corner of the Square Mile where bonuses may well prove acceptable to government ministers.