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A $100 Billion Cannon Is Pointed At These Takeover Targets

David Sterman

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

Private equity firms had done very well in previous years and managed to pull in a stunning $700 billion in fresh money between 2006 and 2008, according to investment 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 this year. 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 (HNZand Dell (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 the wave 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 big gains from these stocks 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 robust cash balance sheets of their acquisition targets allows them to secure very strong financing terms with the big lenders that will 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 their buyout 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 sweet spot 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 robust IPO 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 forBurger King (BKW)Hertz Global Holdings (HTZand 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 (MNST) might hold great appeal to soft drink makers like Coca-Cola (KO) or Pepsico (PEP), and recreational equipment makerPolaris 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 go downstream to struggling retailers that have experienced declining sales trends and ever-weaker balance sheets. In recent years, private equity firms have targeted struggling retailers such as Talbots and Coldwater Creek (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 of real estate. Private equity firms have a chance to buy some or all of a financially weak driller and perhaps reap considerable profits when industry economics 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 (PDCE),Plains Exploration (PXPand Quicksilver Resources (KWKall have generated huge free 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 one factor 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's consolidation 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.

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