Surprise! It’s a Takeover!

Last week Microsoft announced that it was acquiring LinkedIn. This news sent LinkedIn ($LKND) shares soaring more than 40% in one day. If you happened to be holding LinkedIn shares that day, congratulations! You probably made some money!

Let’s take a look at mergers and acquisitions (AKA M&A) and what they mean to the average investor.

First of all, mergers and acquisitions usually come as a surprise. Sometimes companies actively seek a buyer (hello Yahoo!), but most often the news of a merger comes suddenly, so it is hard to plan for.

Mergers tend to be the combination of equal companies. There are usually efficiencies to be gained from a merger of two companies, so mergers are often cheered by investors.

Acquisitions differ from mergers by the fact that one firm is usually large, and it buys out and swallows a smaller company.

The key benefit for shareholders is something called a ‘control premium’. In order for one company to take over another, a premium is usually paid over the current value of the company. This premium exists because firms believe the merged entity will unlock untapped potential.

And the current shareholders get the benefit of that control premium.

Control premiums vary. For a ‘merger of equals’ the premium tends to be lower. For acquisitions of companies with important intellectual property, the premium can be quite high.

So what does this mean to you? Holding the shares of a company that is part of a merger or acquisition can be immensely profitable. But it is also extremely difficult to plan for.

There are people who invest by trying to target potential takeovers. Smaller independent companies are always popular takeover targets for big conglomerates. Annie’s Organics and Gillette are two recent examples of this kind of takeover.

Battered stocks can also be prime takeover targets because it can be a great way for strong companies to expand their reach by buying cheap, distressed competitors.

Think of popular small companies or distressed companies that might be a good fit for larger, more diverse competitors. Or look at companies that could be targets of big companies with deep pockets (what do you think Microsoft could be shopping for next?).

Also, when sentiment turns bearish (ie. investors anticipate slowing growth in the market) M&A activity can provide focus for companies and a way to boost lagging stock prices. So in a slow market like we have today, you may see increased M&A activity with companies seeking to boost value by swallowing other companies.

Targeting potential mergers is not a strategy in itself, but if you like a company as an investment, thinking about it’s takeover prospects can help you make an investment decision. A takeover could be a nice surprise for your portfolio!

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