The Value Investor's Handbook: Introduction to Takeovers

Some of the best opportunities are found in special situations like takeovers

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Jun 24, 2020
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Some of the best investment opportunities are found in special situations like bankruptcies or takeovers, where there are a lot of moving parts and there is a premium to be had for the person who can figure out where the chips will fall when all is said and done.

Today, we’re going to discuss takeovers, how they work, how companies try to stop them from going through and how investors can profit from understanding this process.

How does it work?

Let’s say that company X decides to take over company Y. The board of directors at company X has to make an offer to the shareholders of company Y to buy them out. This can come in the form of cash, i.e. a cash transaction. For example, if company Y’s shares are trading at $40, company X may offer to buy them at $50 apiece - a $10 premium. However, there are other incentives that the buyer may offer the seller, such as equity in the acquiring company (referred to as a stock transaction). If neither making a deal with the company or appealing to its shareholders via cash will work, company X could also start buying shares of the target company in order to conduct a hostile takeover. Once company X has a majority stake in company Y (ie. more than 50%), they are - generally speaking - free to make whatever changes they like.

Defence mechanisms

Not all takeovers are hostile. In many cases, the shareholders of company Y might be happy to sell their shares at a premium. However, there are certainly many instances where the takeover is unfriendly, and in which a struggle for control might arise. For this reason, companies often implement shareholder rights plans, which are also known rather colorfully as "poison pills." There are many different types of poison pills, but their basic mechanism is that they allow shareholders (other than the hostile party) to purchase more shares at a discount to the prevailing market price. A poison pill, if enacted, will dilute the ownership stake of the hostile party.

This forces the takeover company to deal with the board of directors, rather than appealing to the other shareholders directly, and in theory incentivises them to offer a better deal than they otherwise might have done. It should also be noted that in some countries, like the United Kingdom, poison pills are illegal.

The opportunity

Historically, when a takeover is announced, the share price of the acquiring company tends to fall, while the target’s price tends to rise. This is because the acquiring side is usually overpaying (and therefore losing out), while the target is being bought at a premium to its market price. Of course, not all takeovers are a sure thing, and the more uncertain the outcome, the bigger the gap will be between target’s share price and the premium being paid.

Investors like Seth Klarman (Trades, Portfolio), who specialise in these kinds of special situations, make their money by figuring out which deals will go through and which ones won’t. It’s not easy, but you can do very well by doing your homework on this subject.

Disclosure: The author owns no stocks mentioned.

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