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How do takeovers work and what do they mean for investors?

We take a closer look at exactly how company takeovers work and what it can mean for investors

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Over the past decade, we’ve seen some of the biggest mergers and acquisitions in history. From Microsoft’s deal to buy Activision Blizzard to Amazon’s acquisition of MGM, deal making is a staple on the stock market.

But as we’ve seen with the dizzying back and forth between Elon Musk and Twitter, it’s not always a harmonious union. Sometimes companies are forced into a transaction they don’t support, and that’s when the deal becomes a takeover.

Takeovers happen for lots of different reasons, but typically the main reason is the buyer sees an opportunity. It could be that one company believes another would fill a gap in its operations. Sometimes it’s a competitor. Or, as in the case with Elon Musk and Twitter, it could be a political or ethical statement.

What makes a company a takeover target?

Sometimes, buyers set their sights on companies that are struggling for some reason. That’s because the companies at the bottom of the pecking order within an industry are likely to accept a lower price.

If the company in question is limping along toward bankruptcy, a private equity firm could decide to step in and buy it. In this case, the private equity firm is looking to profit from the sum of the business’ parts by selling them off. This is called asset stripping.

But a company doesn’t have to have one foot in the grave to become a takeover target.

Sometimes a smaller business that is unable to get a seat at the table with the industry leaders is an attractive target. That’s because with a bit more funding and a fresh set of eyes, it might be able to grow into a powerful force within the industry. It’s cheaper to buy and a buyout might be its best option for a recovery.

The trouble is, management and shareholders have to believe that too.

The art of a hostile takeover

In the case of a merger or friendly acquisition, the buyer and seller come to an agreement on a fair price. This is then put to a vote among shareholders, and the company being bought will recommend shareholders say yes.

Shareholders often benefit from a takeover, because the shares are usually bought at a price above what the market’s offering. But much of the potential benefit depends on who’s on the other side of the transaction.

If it’s a private equity firm, management might be concerned about the potential for asset stripping. Even if that’s not the case, it might mean shareholders miss out on the benefits of a recovery. If the company becomes private, the potential to invest is lost.

If it’s a big business stepping in, management might be less willing to hand over the reins. They might believe they can turn the business around without intervention. And in that case, they’ll say it’s not in shareholders’ best interests. If the company in question is absorbed into a larger business, they might be given shares, but the growth from a recovery will be rolled into the wider business’ performance.

If the board turns down the offer, the potential acquirer can try to force the deal through. At this point, it’s ultimately up to shareholders to decide whether a takeover is the best next step.

One way to do this is through a tender offer. The buyer might offer to buy shares in the company for a specified price. This is usually at a price that’s higher than the current share price, in order to incentivise shareholders to sell.

A tender offer normally comes with the caveat that the buyer will only purchase the shares if enough are sold to give them a controlling stake. It’s up to shareholders to decide whether they want to take the offer.

Another option is a proxy fight. Most shares come with voting rights. In a proxy fight, the potential buyer often holds a large, but not majority, share in the company. To circumvent the board, they might try to rally shareholders to vote out members of the board blocking the acquisition.

In these scenarios, shareholders have a lot of power over the direction of the company. But that’s down to voting rights – something not all shares carry. And many shareholders never exercise their right to vote. For those who do, it does offer an element of control.

When Elon Musk began his journey to buy Twitter, it seemed one of these two options could be on the table because the board initially turned its nose up at his advances. But ultimately the two struck a deal, which meant it didn’t come down to a battle for shareholder allegiance.

What can happen next?

With any takeover, hostile or not, the deal comes with binding conditions. Once an agreement has been signed, neither party can walk away without consequences.

But there’s often an element of uncertainty that can keep shares from trading at or near the purchase price until the deal closes. A lot can happen between agreeing to sell a company and actually handing it over. Regulators might block the deal or either party can get cold feet.

Typically, there’s a breakup fee paid by either side if they abandon the deal. Sometimes another company that’s been watching on the side-lines might swoop in with better conditions. If they do, the breakup fee would be owed to the buyer. The opposite is also true. To use the Twitter example again, if Elon Musk walks away now, he’ll owe the little blue bird $1bn.

Some believe Musk dragging his feet over the deal suggests he’s angling for a lower price. This isn’t uncommon. After luxury goods retailer LVMH (Moet Hennessy Louis Vuitton) agreed to buy Tiffany’s, the luxury goods retailer tried to back out of the deal due to the strains caused by the pandemic. Ultimately the two came to an agreement on a lower purchase price.

The potential for the purchase price to slide, or the deal to fall apart altogether is what can keep shares from immediately trading at any premium being offered.

What this means for investors

Mergers and acquisitions can be good for shareholders because they can improve the value of the investment. Whether or not a takeover is the right move for the long-term investment opportunity though, differs greatly and should be considered on a case-by-case basis.

While takeovers tend to dominate the headlines when they’re happening, it’s important not to invest with only this in mind. Even when a deal’s been inked, there’s a risk it won’t go through and investors might be left holding shares in a company they don’t actually want.

It’s important you understand your own preferences and needs before deciding whether or not to hold or make an investment in a takeover target.

Investing in individual companies isn’t right for everyone – it’s higher risk than investing in funds as your investment is dependent on the fate of that company. If the company fails, you risk losing your whole investment. You should make sure you understand the companies you’re investing in, their specific risks, and make sure any shares you own are held as part of a diversified portfolio.

This article isn't personal advice. If you're not sure whether an investment is right for you, seek advice.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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