European M&A keeps booming as credit stays cheap

LONDON (Reuters) - A fresh burst of takeover activity has broken out across Europe and few see any sign of a let up, as concerns subside about the longevity of the cheap credit underlying many deals.

Private equity firms -- many feeding off buoyant credit markets to fund highly leveraged deals -- are sniffing around again for even larger prey and European chief executives continue to be hungry for takeovers as markets recover.

"European M&A activity reached new highs in 2006 and the trend should continue in 2007 ... The low cost of borrowing leaves room for the arbitrage between debt and equity to continue," ABN AMRO strategists said in a note.

With European Central Bank interest rates at 3.75 percent, firms are being rewarded for putting cash to work.

ABN noted that, at the extreme, a buyer could afford to pay 27 times a company's annual earnings to provide roughly the same return as cash at the rates offered by the ECB.

At the same time, valuations suggest European companies are still not expensive. The average price-to-earnings ratio of the DJ Stoxx 600 .STOXX is 13.5 times forward earnings, below a long-run average of around 15 times.

DEAL LINEUP

Both trade and financial buyers are taking advantage of this apparent disconnect.

Research firm Dealogic says European transactions valued at about $120 billion have been announced since February 26, the day before global markets were shaken by problems in the U.S. lending market, focused on borrowers with poor credit history.

So far this year, deals worth $311 billion involving European targets have been announced in all, slightly below the record levels hit in the first quarter of 2006.

"We have the issue that fundamentals for corporate activity, even with credit spreads widening, still remain strong because the gap between the return on capital and cost of capital remains near high levels," said Mislav Matejka, a European strategist at JPMorgan.

The cost of capital in Europe is estimated at a near-record low 4 to 5 percent, while both company earnings and European stock markets have jumped by almost 50 percent in the last two years.

The lineup of deals is staggering.

Britain's third-biggest bank, Barclays (BARC.L), is in talks on a $80 billion takeover of the biggest Dutch bank, ABN AMRO AAH.AS, for instance, while Imperial Tobacco (IMT.L) has offered $15.3 billion for Franco-Spanish rival Altadis ALT.MC, which rejected that approach saying it was too low.

The surge in takeover activity helped stock markets quickly recover from recent weakness. The pan-European FTSEurofirst 300 index .FTEU3, which fell as much as 8 percent after the sell-off in global stocks began in late February, has since recouped more than half its losses.

Fears of financial contagion spreading from U.S. mortgage problems have eased as banks appeared to have ring-fenced the problem, analysts say. The Federal Reserve on Wednesday further eased borrowing jitters by giving encouragement to expectations of a cut in interest rates.

"Corporate managements appear to be quite confident and that's why we are getting these kinds of takeovers and rumors. There is clearly a lot of money still around and willing to bid for companies," said Stuart Fraser, investment director of European equities at Standard Life Investments.

"What it means is people with the excess cash believe that there are excess returns to be made from taking over things that the equity markets has already re-rated to some extent."

Private equity interest, driven by access to cheap capital, has supported markets, with possible bids for European retailers Sainsbury (SBRY.L) and Alliance Boots AB.L in the pipeline.

RISK

Not everyone is convinced the picture is universally benign for credit and equity markets, however.

Morgan Stanley sees a threat that the problems in the U.S. subprime mortgage market could still develop into a full-blown financial crisis. Much of the risk has been farmed out in securities such as collaterized debt obligations (CDOs).

"There's hundreds of billions of dollars of CDO and derivatives on CDOs, many based on subprime loans, likely to lose a lot of their value," Morgan Stanley European strategist Teun Draaisma said in a recent note.

And Merrill Lynch's chief investment strategist, Richard Bernstein, cautioned about rising U.S. corporate-bond risk premiums: "If this trend continues, it could start to hinder debt-financed takeovers and other more speculative activity."

But for the time being, evidence suggests private equity buyers are having no problem finding willing lenders to back their bids, which may be up to 80 percent debt-funded.

Reports have highlighted the emergence in Europe of so-called covenant-light loans for at least one private equity deal, where lenders forego some of their traditional rights and protection in an effort to increase their returns.

Among corporate borrowers, the volatility in markets has had little lasting impact, either on European companies issuing debt or investor appetite for it.

Debt issuance dried up for a couple of weeks as equities tumbled but normal service had resumed by late last week.

"It is encouraging to see several new deals, it has helped to take the edge of the market and shows it is not closed and the risk appetite tap has not been turned off fully," Tim Barker, head of credit research at Morley Fund Management, said.