The average valuation of takeover candidates suggests thinning reward-to-risk

William Hester, CFA
June 2007
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"Buyout Bingo." "Merger Monday." At the point a trend in the market is identified with constant alliterations, it's probably about to stop working. That term "Buyout Bingo" came across the newswires recently - an apt description of the popular strategy of building a portfolio of stocks with "takeover characteristics" and then sitting back in hopes of seeing them purchased at a premium by private equity investors.

For the broader market, the pace of private equity deals has fueled the argument that stocks represent reasonable values. The recent rise in stock prices has been helped in some part by the message that investors are taking from the number of private equity deals. Increased private equity activity must be signaling that stocks are fairly valued, the argument goes, and not until the pace of takeovers drops will stocks be overvalued.

Both of these arguments may be unreliable. Waiting for a collapse in the rate of private equity deals as an indicator to reduce stock market exposure could prove too late to avoid a downturn. The number of deals may slow, especially if borrowing rates continue higher. But the pace of deals could roll over, rather than collapse, and the deals may increasingly reflect non-economic factors that have little to do with valuation. That's Warren Buffett's take on the subject. Speaking at last month's Berkshire Hathaway shareholder meeting he pointed out that there is a tremendous incentive for private equity managers to force money into new deals, value or no value. "If you have a $20 billion fund and charge a 2% fee on it, you earn $400 million a year. You can't start another fund with a straight face until you get that money invested." So the pace of activity may depend equally on those that allocate the investments and on the providers of capital. Buffett added, "It may be some time before disillusion sets in for the people supplying the money for these deals."

If the future rate of change in the pace of private equity deals turns out to be subtle, and it is partly driven by factors other than investment opportunities, then the more important question for equity investors is whether the expected long-term return from investing in potential takeover candidates is attractive. If the universe of stocks that private equity investors pick through lacks value, it will be difficult to argue that the broader market offers better opportunities. One way of doing this is by looking at the investment value of the typical takeover candidate.

Takeover Candidates

Over the last few years, the strategy of buying a portfolio of likely takeover candidates has worked well. Holding a portfolio of stocks with buy-out characteristics - including low debt, high cash flow per share, and a price tag that is manageable for private investors - has returned 9 percent a year over the last 6 years versus the S&P's 5 percent return. Most of the outperformance of the strategy has occurred during the last few years, as investors have increasingly chased takeover candidates in hopes of capturing buyout premiums.

The chart below shows the result of this enthusiasm. It is the ratio of the average enterprise value to earnings before interest, taxes, depreciation, and amortization (EBITDA) for potential takeover candidates. Enterprise value includes both equity and debt, so it represents a likely purchase price to a private buyer. Earnings before interest, taxes, depreciation, and amortization is a proxy for cash flow. The benchmark was kept simple, and includes stocks with market values between $2 and $30 billion, low debt, and then ranked by cash flow per share.

As the chart shows, the price of the average buyout candidate relative to its cash flow has been rising over the last three years. Last month the average multiple jumped to 9.5, up from 8.3 a year earlier. That makes the average buyout candidate almost 15% more expensive relative to its cash flows versus a year ago. Takeover candidates are 40 percent more expensive relative to cash flows than they were four years ago. The average cash flow yield has fallen to 10 percent from 15 percent during that time period.

This upward trend in multiples may help explain why the average deal premium has been trending lower. The average deal premium was 28 percent in 2006, according to Bloomberg data. It's fallen to 23 percent this year. In May, the average deal premium was 19.5 percent, the lowest average premium since February of 2006. Private equity investors are paying smaller buyout premiums for companies as the overall price tag on takeover candidates relative to cash flows has soared.

The pick-up in the number of private equity deals beginning a few years ago was rooted in better conditions. The universe of attractive takeover stocks had average cash flow yields of 15 percent and borrowing rates were rock bottom. But the argument that the current pace of private equity deals provides evidence that stocks are fairly valued needs to be reconsidered. Current deal flow alone can't be an indicator of investment opportunity because it is too clouded by factors outside of valuation. And it's becoming increasingly difficult to argue that, on average, the universe of potential candidates to take private represents attractive value.

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The foregoing comments represent the general investment analysis and economic views of the Advisor, and are provided solely for the purpose of information, instruction and discourse.

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