At the time of writing, it looked like US private equity firm Kohlberg Kravis Roberts (KKR) would succeed in its bid for Smart Metering Systems (SMS). Under the original terms of the takeover offer, shareholders in SMS were to receive 955p a share in cash, which implied an enterprise value of around £1.4bn. It was pitched at a 40 per cent premium to SMS’s closing price on the last trading day prior to the offer, but it was 8 per cent adrift of the Glasgow-based company’s market high point in September 2021. It was also opposed by the target company’s founders.
At the end of last year, KKR closed its second global impact fund, dedicating the $2.8bn (£2.21bn) raised to investments that tap into “sustainability-related trends with macro tailwinds”. The evolving energy transition obviously falls within this category, as does SMS’s expertise in electricity meters and utility-grade storage batteries.
There may be another kind of transition at play in M&A activity: a factor which could increasingly drive takeover activity is that companies with technological shortfalls in certain key areas might seek strategic acquisitions in response to the ongoing digital transition. It may be a more straightforward and cost-effective option to acquire digital capabilities in areas such as artificial intelligence and cybersecurity rather than developing them in-house.
The rationale for the KKR approach is not difficult to appreciate, but it did come towards the end of a year in which global private equity deal-making waned due to uncertainties over the cost of capital. Private equity exits also dried up through the year, but that could change rapidly when interest rates click into reverse. The succession of rate rises made the valuation process for target companies far more challenging – buyers and sellers couldn’t agree on prices. Therefore, the overriding consideration now is the extent to which central banks pare back interest rates this year – and the speed at which they do so.
According to The Telegraph, if the SMS deal closes, KKR will owe it partly to the influence of arbitrage hedge funds. These types of funds seek to exploit deal spreads in transactions. Some funds engage primarily in fixed-income arbitrage, sometimes erroneously conflated with hedging activities, one of the few strategies that is positively correlated with interest rates.
Other fund managers may opt for merger arbitrage which relies on price discrepancies – ergo the arbitrage spread – in M&A deals. The spread comes about because once a deal is announced, the share price of the target company usually settles below the acquirer’s bid price for a period. This reflects risks linked to the completion of the deal. These could range from antitrust issues to the time value of money from when the deal is announced to when it’s completed.
If an M&A offer is scrip-based, then you can exploit arbitrage opportunities by acquiring stakes in both the offeror and target companies. As the closure date approaches and the deal makes it past various impediments, the target company’s share price normally converges on the bidder’s offer price – therein lies the opportunity.
Although these strategies aren’t necessarily the preserve of institutional investors, they come with unique risks. If you’re tempted to pursue merger arbitrage opportunities, then you will need to weigh up the offer price, the spread, together with any regulatory issues and the possibility that the bid will be rejected by either the target or acquiring companies’ shareholders. You will also need to gauge whether the target company is likely to attract rival bids. And if you’re trying to assess which companies could be subject to a bid approach, it’s worth keeping in mind that shareholder activism is increasingly a deterministic factor in M&A deals.
Despite the fall-away from the prior year, private equity acquisitions accounted for 20 per cent of worldwide M&A deal activity in 2023 and activity increased sequentially from the third to the fourth quarters, according to S&P Global Market Intelligence. The question is whether volumes will tick-up through the remainder of 2024?
Merger arbitrage opportunities tend to increase as equity valuations rise, a point worth considering given the historical and relative discounts on offer in the UK market. As interest rates appear to have peaked, we might realistically expect an increase in M&A activity through the remainder of the year. Although, it’s difficult to say what impact the prospect of upcoming elections both here and in the US will have on deal-making, particularly given prospective changes to the tax regime on this side of the Atlantic. Concerns on this front could precipitate a spike in deal volumes ahead of any potential changes, assuming improved clarity of the trajectory of interest rates – fertile ground given the potential spreads on offer.
