Takeover Targets Offer Less Of A Discount As Investors Get Comfortable With Risk

So much for the idea of buying the depressed stocks of takeover targets, where big gaps had emerged between their trading share prices and agreed-upon takeover prices. The gap, or discount, is shrinking fast.

At one point during the recent volatility, the discount averaged about 10%. This created an arbitrage opportunity for investors who believed the takeovers would go through as planned -- and a warning sign for others who believed mergers and acquisitions activity was about to be hit by soured deals, caused by a seized-up market for new debt.

With the rebounding stock market last week, though, many of these discounts have shrivelled to 5% or less, showing that confidence in the debt market is making a strong comeback. Are investors becoming too comfortable with risk?

At its low-point during the recent volatility, the shares of Bell Canada Inc. (BCE) -- it has agreed to a C$52-billion buyout by Ontario Teachers' Pension Plan and private equity players -- were trading at about C$38 each, well below the C$42.75-a-share takeover price. The reason for the discount had to do with the fact that the takeover is to be financed with C$33-billion of new debt at a time when the appetite for new debt issues has deteriorated to a point where no one is sure how the current lineup of M&A activity is going to be financed.

In the worst-case scenario, deals could blow up, even if that means banks are left paying out substantial break fees. There could also be a substantial repricing of the deals. Either way, if there is one high-profile blowup, which could quickly erase the takeover premium that has been built into a particular share price, investors could become worried that another will follow. And then another.

In the case of Bell Canada (formerly called BCE Inc.), investors were particularly nervous because of the massive amount of new debt that would have to be issued. This is, after all, the biggest private-equity buyout deal in history. However, investors appear to be growing more relaxed lately: The shares have since rebounded to C$39.97 as of Friday, or 6.5% below the takeover price. Clearly, big money is now betting that this deal will get done, and at the original price.

The risks of a further deterioration in the credit markets have not evaporated though -- and the problem with the Bell Canada deal is that it is not expected to close until 2008. This leaves many months of uncertainty as investors and central bankers wrestle with financial volatility.

That's why First Data Corp. (FDC), which is being acquired by Kohl-berg Kravis Roberts & Co. in a US$26-billion deal, could be the company to watch. The shares of the electronic commerce company fell 10% below the takeover price of US$34 a share recently. They have since rebounded close to a 52-week high, bringing them to within 4% of the takeover price, and closed on Friday at US$32.80.

The deal received final regulatory approval last week, which means it is on schedule to close by the end of September --well before Bell Canada is expected to make any pronouncements. Should the deal go through as planned, investors will breathe a sigh of relief and discounts will shrink even further. But, despite rebounding share prices, this is by no means a sure thing.