A $100 Billion Cannon Is Pointed At These Takeover Targets

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Back in 2006, the U.S.economy was growing at a solid clip, thestock market was on the rise, and big investors such as pensionfunds were looking for ways to boost returns. The most appealing destination for these investors was privateequity .

Private equity firms had done very well in previous years and managed to pull in a stunning $700 billion in freshmoney between 2006 and 2008, according toinvestment research firm Triago.

But every silver lining has a cloud, and those same private equity firms are scrambling to keep busy. They promised their clients they would invest all the money within a five-year time frame or give it back to investors. Well, five years have passed, and roughly $100 billion of that money must be invested -- or returned to shareholders -- by the end of thisyear . According to Triago, that's the largest sum that private equity firms have ever had to contemplate returning to investors in any year. 

Thankfully, with the U.S. economy on the mend, these private equity firms now face a more stable economic environment in which to choose their prey. So even as deal-making has cooled in recent weeks after a torrid start to 2013 (highlighted by deals for  H.J. Heinz ( HNZ and  Dell (Nasdaq: DELL) ), you can expect an ample number of high-profile deals before year's end. 

Why should you care? Well as we've stated before, it pays to follow the moves of private equity. It may be  an exclusive playground , but there are ways for regular investors to  profit from their moves.

One way is to monitor thewave of mergers and acquisitions (M&A) activity we'll likely see due to this $100 billion private equity surplus. If you can successfully identify firms that are likely to be targeted, you could reap biggains from thesestocks in short order.

Here are the key items to look for as you track these trends.

1. Robust balance sheets
Many private equity firms like to make a little capital go a long way, so they are attracted to cash-rich, low-debt firms. Using the robustcash balance sheets of theiracquisition targets allows them to secure very strong financing terms with the biglenders thatwill help them pay for any deal. 

2. Big, but not too big
Private equity firms don't like to waste their time on small deals. The relatively smaller payoffs just aren't worth their time. Dell and Heinz fetched more than $20 billion each in theirbuyout offers, which is at the upper end of the range of what a major private equity firm can handle, even if they cobble together a team of co-investors, as firms like Silver Lake Partners like to do. Consider $2 billion to $10 billion to be the sweetspot for any buyout firm.

3. Bloat or synergies
Private equity firms historically target bloated firms that have ample room for cost-cutting. These firms tend to move much more quickly than current management when it comes to reducing headcount and exiting unwanted businesses. However, most companies have been operating in a very lean fashion recently and have little fat to cut.

Instead, look for buyout firms to target candidates that hold a roster of valuable divisions, so the best assets can be sold off piecemeal for the highest price. Or look for targets that represent synergies with assets that are already owned by private equity firms. In such cases, one plus one can equal three, which can set the stage for a robustIPO in a few years' time.

Naming names
There are three key sectors that are always in favor among private equity firms: technology, consumer goods and energy. Let's take a look at the leading candidates in each sector. Here are a dozen technology companies that have at least $300 million in net cash and have market values in the $2-$10 billion range. 

In the consumer sector, private equity firms are likely to focus on companies that are out of favor and can be acquired at a fire-sale price, cleaned up and brought back into the public sphere in a few years' time. That was the playbook for Burger King ( BKW )Hertz Global Holdings ( HTZ and several other consumer-facing companies that were taken private and then eventually brought public again at a higher price.

Yet on this list, most of these high-cash, easily digestible companies are already faring well, which would make them more appealing to strategic buyers (such as rivals) rather than financial buyers (such as private equity firms).

Indeed,analysts have long suggested that companies like  Monster Beverage (Nasdaq: MNST)  might hold great appeal to soft drink makers like  Coca-Cola ( KO )  or  Pepsico ( PEP ) , and recreational equipment maker Polaris Industries (PII)  would make a good fit with firms like  Harley-Davidson (HOG)  or Canada's Bombardier.

In terms of private equity firms, you need to godownstream to struggling retailers that have experienced decliningsales trends and ever-weaker balance sheets. In recent years, private equity firms have targeted struggling retailers such as Talbots and  Coldwater Creek (Nasdaq: CWTR) , and you can expect to see more activity in this segment this year. 

The energy angle
In recent years, oil and gas drillers have largely been bought and sold by strategic buyers. They have not been in the sights of private equity buyers, but these two parties are ideally matched. Many drillers have been forced to sharply reduce capital spending this year due to weak cash flows, yet they are sitting on valuable troves ofreal estate . Private equity firms have a chance to buy some or all of a financially weak driller and perhaps reap considerable profits when industryeconomics improve. As an example, private equity firm  KKR (KKR) is looking to spend up to $1.5 billion  in this industry, according to Bloomberg.

Energy drillers such as  Comstock Resources (CRK)Forest Oil (FST)PDC Energy (Nasdaq: PDCE) , Plains Exploration (PXP)  and  Quicksilver Resources (KWK)  all have generated hugefree cash flow losses in recent years thanks to heavy capital spending -- and they surely could use a boost from private equity firms. 

Risks to Consider:  You should never buy a stock in hopes of a buyout, as many rumored deals never come to pass, and should instead use M&A trends as onefactor among many in your investment research.

Action to Take -->  The key for investors is to track M&A activity. In the past, when one or two players in an industry have received buyout offers, other potential buyers have moved quickly to line up their own targets for fear of missing out on an industry'sconsolidation phase. 

Whenever you read about a buyout, move quickly to assess the valuation metrics sported by various rivals. If those rivals trade for much less than the acquired target (in terms of price-to-sales, price-to-free  cash flow , etc.), then you've just hit on an investment opportunity worth further research.

-- David Sterman

P.S. -- Private equity companies aren't the only way that retail investors can access the previously untouchable private market. In fact, another investment can give you yields of 8%, 10% -- even 12% or higher. For years, this arena has been off-limits to investors like you and me. But thanks to our latest research, we've found a way you can access this underground market. You can learn more by clicking here now.

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.

This article appears in: Investing , Investing Ideas
Referenced Symbols: HTZ , KO , PEP

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David Sterman

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