Victoria Stevens

The bittersweet taste of company takeovers

Victoria Stevens

Seeing a portfolio holding succumb to a takeover approach can be bittersweet for a fund manager, sparking a range of emotions ranging from vindication to frustration. It is, however, an experience that we are increasingly familiar with in our team. Since we began managing the Liontrust Special Situations Fund in 2005, we have seen 66 companies exit the Fund; a third of these have been the result of takeovers.


In July, NEX Group was the latest to join this list. We sold the stock out of portfolios ahead of the expected completion of a takeover by CME Group, the US operator of futures and options exchanges. With shares in NEX Group trading at or around the implied bid level from CME, and CME’s offer being approximately 50% comprised of its own shares, it made sense for us to exit the position rather than wait for the deal to complete.


This month, we have seen another holding fall prey to an acquirer as ION’s purchase of Fidessa Group was finalised. On this occasion, since the offer is all cash we were happy to wait for the deal to complete before receiving proceeds.


Fidessa is unlikely to be the last portfolio takeover we see in 2018; Shire, another fund holding, is currently the subject of a bid from Japan’s Takeda Pharmaceutical which has been recommended by Shire’s board and looks likely to proceed.

Victoria Stevens: The bittersweet taste of company takeovers

Why Economic Advantage can be attractive to acquirers

As investors in our funds will know, our investment process is all about finding companies with three core types of intangible asset: intellectual property (IP), recurring revenues and distribution networks. We seek out these assets because they are difficult to replicate; the theory being that they can confer an enduring competitive advantage, as high profitability cannot be eroded away by copy-cat market entrants. This sustained profitability should then surprise the market – which more usually assumes that excess returns will revert to more normal levels over time – and lead to share price gains.


It is precisely because these assets are so hard to replicate organically that they often appeal to corporate acquirers. The only way to get hold of these assets is often to acquire the company that owns them. This concept is probably most intuitive in the case of intellectual property. If a company possesses IP that is protected via a patent, there really is little way to legally gain ownership of that technology or knowledge without buying the company.


The core intangible assets we look for are not only durable and hard-to-replicate, but also carry little risk of migration away from the parent company. This contrasts with another key type of intangible asset – human capital.  Businesses reliant on human capital may be able to incentivise key personnel to stay put using various financial enticements, but at the end of the day they have little ability to stop them leaving for a competitor.


Is a takeover approach always a positive development?

We invest in companies in the expectation that their Economic Advantage will eventually be recognised through share price appreciation, but we cannot predict the pace at which this will occur.


In theory, it might seem that we should be relatively agnostic as to whether a positive share price return occurs gradually over time or is catalysed through a takeover of that company. Or, perhaps more intuitively, it might seem that a takeover would be preferable given that it can crystallise a sharp investment gain over a relatively short time period.


However, things are not always this straight-forward. In fact, the eye-catching premiums at which takeover offers are pitched can sometimes give a misleading perception of the attractions to shareholders. If we assume markets are efficient and share prices reflect all publicly available information, then any time a bidder is willing to pay an amount 30% higher than the market clearing price, it should seem a ‘no-brainer’ to accept it. However, we know that in reality markets are inefficient and this is a fundamental building block of the case for active management.


We invest in companies precisely because we think their share prices underappreciate their long-term prospects. So the simple fact that a premium is being offered doesn’t mean all investors should welcome it.


Assessing the merits of a bid

Upon receipt of a bid, the first thing we need to do is evaluate how the implied business valuation matches against our assessment of the company’s long-term potential worth. If it is in the same ball-park, then taking the short term takeover premium boost could prove very attractive. If an offer level is significantly below our assessment of a company’s value, then the bid is clearly less welcome.


We are all used to board statements proclaiming that unwelcome bid approaches “significantly undervalue the company’s prospects”, or similar, and while this seems a knee-jerk response in many cases, it can also be very true.


This is particularly the case when the bidder is acting in an opportunistic manner, taking advantage of market turmoil or company-specific short-term setbacks which have knocked a share price disproportionately.


Another reason a bid may undervalue a company is due to the short-termism which can sometimes be evident in stockmarkets. If a company is investing heavily for future growth, this can depress short-term earnings and restrict the share price. However, if one were to either strip out this investment and normalise the earnings or evaluate the assets that are being accumulated, then one might be able to justify a much higher target share price. Often the market overlooks the long term value of strategic assets because they are focused on the short term earnings potential of a business.


If such a takeover succeeds, then it can be very frustrating for us as shareholders.


Many combinations will have sound strategic foundations

Equally, there are many reasons why an acquirer might be willing to match or exceed a company’s potential as a publicly-owned entity.


The opportunity to strip out duplicated costs such as personnel, office space and the costs of maintaining a public listing is one of the most obvious benefits and post-deal one of the first goals will often be to achieve the ‘low-hanging fruit’ of cost synergies.


If two companies have highly-complementary assets, then it also makes sense to combine forces: the value of the whole should, in this scenario, exceed the value of the two stand-alone entities. An improved product or service offering can then be promoted (‘cross-sold’ or ‘up-sold’) to the combined customer bases. A company that possesses a unique strategic asset in a particular market will be particularly attractive to acquirers in a dominant position in an adjacent market for exactly this reason. This is what we have seen with ION Trading’s takeover approach for Fidessa Group.


Fidessa is a trading software company which originally received a bid from Swiss banking software group Temenos a few months ago. However, news of the bid flushed out two other potential buyers, one of which – ION – subsequently sealed a deal at a premium to the Temenos offer. It’s interesting because Fidessa has a dominant market position in trading software for equities as an asset class, and has been investing heavily to build a franchise in derivatives trading as well. Meanwhile, the acquirer ION already has a market leading derivatives position – so a combination of the two looks an obvious fit.


Takeovers can offer welcome vindication of stock picks

From a practical perspective, we always have a pipeline of potential investments we are monitoring in order to verify their possession of Economic Advantage, but we don’t always have room for them in our portfolios. When one of our stock picks prematurely matures in the form of a takeover, we can view it as an opportunity to promote one of our pipeline stocks at the other end of the investment lifecycle. Stocks being taken out by acquirers is therefore less a necessary evil, and more of a pleasant by-product of our investment style and welcome vindication of some of our stock picks.


If the Funds sees another 20+ holdings bought out over the next 13 years, it is more likely this will be sweet than bitter for unitholders.

For a comprehensive list of common financial words and terms, see our glossary here.


Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Some of the Funds managed by the Economic Advantage team invest primarily in smaller companies and companies traded on the Alternative Investment Market.  These stocks may be less liquid and the price swings greater than those in, for example, larger companies. The performance of the GF UK Growth Fund may differ from the performance of the UK Growth Fund and will be lower than its corresponding Master Fund due to additional fees and expenses.


This content should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Thursday, August 30, 2018, 11:31 AM