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Takeover bids for investors

There are essentially two ways for a company to grow: by investing in and expanding its operations or by acquiring other businesses. The latter commonly seen in publicly traded companies and can have significant implications for different groups of investors and traders. It can generate significant windfalls and create opportunities for some while potentially causing losses and creating unwanted risks for others. 

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Why do takeovers happen?

There’s a range of scenarios, both positive and negative, that could lead to a takeover. The bidder might be looking for growth opportunities, such as by purchasing a similar business in a different market or country, or it might be looking to take advantage of another companies struggles by picking it up on the cheap.

The main aim of a takeover should be to increase the value of the newly combined business, whether it’s through stripping out layers of management, reducing supply costs or simply removing a competitor. There are no guarantees a bid will be successful, and a failed bid could weaken an already embattled company. Some investors seek out struggling companies in the hopes that a takeover bid will emerge and trigger a rally in the share price.

Hostile or friendly

The difference between a friendly and hostile takeover is solely in the manner in which the bid is conducted. In a friendly takeover, the target company’s management and board of directors approve the takeover proposal and help to implement it. However, in a hostile takeover, the management and board of directors of the targeted company oppose the intended takeover. 

Friendly takeovers are far more common and more successful. In the case of a friendly takeover, because both sides have agreed on the terms of the acquisition and have been able to weigh up the costs and benefits of the move, the deal will have the best chance of success. In a hostile takeover, on the other hand, because the management and board of the target company resist the acquisition, they usually do not share any information that is not already publicly available. As a result, the acquiring firm takes a risk and may unwittingly acquire debts or other problems.

Cash or scrip

Bidders can pay for a takeover bid with cash, its own stock (also called scrip) or a combination of the two. The form the offer takes will depend on the circumstances of both companies, with scrip-based offers more common in larger mergers.

How does a takeover affect investors?

The merger of two companies can cause significant volatility in the stock price of the acquiring firm and that of the target firm – assuming both are listed businesses. To make its bid attractive to the shareholders of the target company, the company looking to make an acquisition will usually make an offer that is above the most recent share price. Once the bid is made public, traders will spot an arbitrage opportunity and push the price to around the same level as the offer – or sometimes even higher if there’s a belief that a second bidder will emerge.

Shares in the bidder can move in either direction when the takeover plan is announced. If shareholders believe the merger will create significant value, especially in the short term, the stock may rise, though falls are more common as the market weights up the cost of the bid (especially if it is planning to issue more shares as part of the process). Of course, if the bidder is a very large company taking over a much smaller one, the effect on its share price will be minimal.

Another thing to consider, from the perspective of a shareholder in the target company, is whether the takeover offer represents good value. For instance, an all-cash offer that represents a 20% premium to the recent share price might be highly attractive if the company has been failing to grow but might seem much less attractive if the business is growing quickly. On the other hand, if the takeover involves shares in the bidding company, you should consider the growth prospects of the combined entity and how much value is created by the merger.

Finally, while takeover offers are most often welcome news to shareholders in the target company, they can be disastrous for anyone who has shorted the stock. Traders in that position can expect to face a sizable and likely permanent loss as the share price won’t fall unless doubts arise about the takeover.

Arbitrage risk and rewards

While shareholders are considering a takeover proposal, the company’s stock will likely trade slightly below the offer price (unless another offer is expected). This is what’s known as an arbitrage opportunity and the traders that look to take advantage of it – most often large institutions – are called arbitrageurs.

Say, for instance, Company A has made a $100-per share offer for Company B but while that offer is being considered, the latter’s shares are trading for $98 – in recognition of the fact the deal might fall through. An arbitrageur would buy the shares at $98 and sell them to company A for $100 when the takeover goes ahead, usually a few months down the line. They will have therefore made a 2% profit (excluding fees), which may not sound like much on the surface but could be a considerable return depending on how many shares it owned, especially given the relatively short time-frame and level of risk involved. If a second bidder emerges, these investors would also be in for a more sizeable windfall. Finally, arbitrageurs may also look to maximise their profits by shorting the stock in company A on the expectation the deal will have a negative effect on its share price.

The risk they face, however, is that the deal falls through, which can happen for a variety of reasons, including financing problems, due diligence outcomes, personality clashes and regulatory objections. If that happens, the arbitrageur could be looking at a substantial loss. 

The bottom line on takeovers

While takeovers can be beneficial to investors and traders – especially those that own shares in a target company – there are also risks involved.

Whether you are considering a takeover offer or looking for an arbitrage opportunity, the key is always to do your research: read the takeover documents carefully, keep up to date on the process and consider your options. These may include whether to vote for or against the takeover and whether to sell your shares now or wait for the merger to proceed.

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