Jeremy Warner's Outlook: Does Boots takeover signal top of the market, or is it just the start of something bigger still?

Boots sets a new valuation benchmark

Each morning, our business news list here at The Independent carries a round up of interesting looking or market moving stories which have been in other newspapers but have not been reported on our pages. The idea is to assess whether any of them might be worth following up.

Most days some of them will be, but perhaps the more remarkable feature of the modern day business "scoop" is quite how many of them are incapable of being either confirmed or taken forward. Instead, the "follow up" list is comprised of a bewildering array of essentially speculative takeover stories, most of them involving this, that or the other private equity house considering a bid for this, that or the other company.

Some of these stories will score a direct hit, in that they will force a statement from the company confirming it has received an approach. But the majority are simply left fallow.

There is nothing particularly new about this phenomenon. All periods of merger mania are characterised by a similar outbreak of speculative reporting. What makes the current rash of it different, however, is that the great bulk of it involves financial buyers. The beauty of these stories is that as written, most of them are almost certainly true.

Without knowing it to be the case, I could for instance write that private equity is or has been considering a break-up bid for Pearson and be pretty certain of its veracity. I'm not saying that the stories are made up; many of them are no doubt well informed. But the sheer weight of money that has flowed into private equity means that for any credible target there will almost certainly be a team - and in all probability several - working away somewhere on whether the numbers can be made to add up.

That doesn't mean a bid is going to be made, so congratulations to Simon Wolfson, chief executive of Next, for giving the speculators a bloody nose by selling £3.7m of stock in the company at a bid-inflated price. Since he would not have been allowed to deal if there had been an approach, it was his way of saying "sorry guys, but as far as we are concerned, there is no bid".

What is the significance of all this takeover tittle tattle? Some of it is undoubtedly for the purpose of insider dealing and market manipulation, some for the equally sinister purpose of destabalising the share register so that if there is a bid, a large part of the stock is held by hedge funds with a vested interest in short-term gain. This makes the company easier to buy at a price which may not reflect its long-term value.

Yet perhaps the most pertinent question is whether speculative activity on the current scale marks the final blow-off of the bull market. Merger mania is as good a sign as any of the top of the cycle. With corporate profits booming, credit cheap and easy, and confidence high, the temptation to go corporate shopping is hard to resist. Invariably, the merger cycle peaks just in time for the next big downturn.

Many will therefore see the private equity acquisition of Alliance Boots, the largest leveraged buyout yet attempted on European soil, as the deal too far, top of the market froth that signals the beginning of the end.

As I will argue, in fact the correct way of looking at the present boom is precisely the reverse. The Alliance Boots deal will open the floodgates to a rash of similar, copycat takeovers of major, publicly quoted companies.

Some of the detail behind this thinking I'll explain in the following note. Yet here it might pay to make some more general observations about the present wave of merger mania. According to research conducted in US stock markets, M&A activity tends to follow a predictable pattern over a ten-year cycle. On average, around 8 per cent of the stock market is traded via M&A each year. Yet the average fluctuates between a trough of around 3 per cent and and a peak of 13 per cent.

What's happening at the moment might seem like a mania, but in fact it is not disproportionate by historic standards and is still quite some distance from the peak seen in past cycles. In absolute terms the numbers are high. In the first quarter, according to new figures from Dealogic, a record $1,000bn of takeovers were completed globally. Yet as a proportion of total stock market value, this is not high. There are also some powerful structural changes that imply a step change in M&A activity.

One of these is the rise of private equity, which has similarities to the leveraged buyout boom of the 1980s (that particular mania ended very badly indeed) but is actually a little bit different. Even at the height of the LBO fever of the 1980s, it was virtually impossible to do cash deals in the tens of billions. Today, these transactions are becoming commonplace. Nor would it have been possible to apply leverage at multiples as high as 7 times ebitda. Finally there is a growing number of cross-border deals - again something which wouldn't have happened in past cycles.

Some observers will see these phenomena as a sign of dangerous levels of exuberance in markets. My hunch is that they signal the reverse. Despite recent volatility, there's no reason yet to think asset prices are about to fall off a cliff. To the contrary, what's happening is that as the perceived risk in markets declines, private equity buyers are prepared to accept lower rates of return and therefore pay higher valuations. Some of the evidence for this lies in the Boots transaction.

Boots sets a new valuation benchmark

Alliance Boots is the first FTSE 100 company to fall to private equity. OK, so the £10bn deal is not yet done and there's still room for mishaps. It is for instance possible, though unlikely, that the deal could be referred to the Competition Commission, as KKR is also part of the consortium bidding for J Sainsbury. The lawyers are going to have to work hard to make this combination in ownership acceptable to regulators.

There have also already been a number of private equity-type deals in the FTSE involving overseas trade buyers, including BAA, P&O and Corus. All the same, this is the first takeover in the FTSE by a single private equity house, and as such it marks a watershed.

By allowing KKR in to examine the books, Sir Nigel Rudd and his board have all but run up the white flag and formally agreed the deal. Some will continue to tut tut, for this is certainly a brilliant transaction for Stefano Pessina, the deputy chairman.

Under the terms of the deal, Mr Pessina's 15 per cent stake in the company is worth around £1.5bn. Of this he has committed to put around £1bn back into the equity of the refinanced company. Assuming debt leverage of around two times the equity, Mr Pessina therefore realises £500m in cash from the transaction and at the same time ends up an even larger shareholder in Alliance Boots than he was before. That's the power of leverage for you.

Yet at £10.40 a share, it is also an extraordinarily full price for other shareholders too. At 22 times consensus earnings for this year and 12.8 times ebitda, it is hard to argue that the board has undersold the company.

When Boots was merged with Mr Pessina's Alliance Unichem just 18 months ago, the combined company was valued at just £6bn. Today it is being sold for more than £10bn. Try arguing with that.

Even taking account of the tax advantages enjoyed by leverage, KKR is setting a new benchmark for private equity with this price. So much so that it is hard to figure out quite how it makes the numbers stack up.

Even doing quite radical things with the company, such as selling or closing the manufacturing side, or exiting retail, it is impossible to see how KKR can achieve the 20 per cent rates of return traditionally demanded by private equity investors.

The answer, I would suggest, is that KKR is already reconciled to not achieving them. Instead, KKR and its investors are accepting the likelihood of much more normalreturns. If that's what private equity has resigned itself to as the targets get bigger and pricier, then we can expect a lot more activity yet.

j.warner@independent.co.uk