* Schroders: Saw substantial upside in Charter
* Saw Melrose management realising this upside
* Melrose shares up 5.0 percent (Adds comment from Charter)
By Adveith Nair
LONDON, Sept 28 (Reuters) - Schroders , the second-biggest investor in Charter International which has agreed to a takeover by U.S. group Colfax , said on Wednesday it was disappointed Melrose had dropped its interest in the British engineer.
Melrose, a manufacturing buyout group which had circled Charter for three months, said on Tuesday it had decided not to make an offer in light of the current weak economic environment, having completed due diligence and agreed terms with its financing banks.
"As long-term shareholders in Charter, we believe there is substantial upside in the company which, in our view, would have been realised over the next three to five years under management by Melrose in a UK listed company," Schroders said.
Melrose had the support of most of Charter's top 10 investors, who thought the company would do a better job of turning Charter around and wanted to participate in any upside in Melrose shares, which have been strong performers this year.
Schroders, which owns about 8.4 percent of Charter, and Aviva, with an 8.7 percent stake, were vocal supporters of the Melrose offer, despite a higher bid from Colfax.
U.S. pumps and valves manufacturer Colfax, 41 percent-owned by billionaire brothers Steven and Mitchell Rales, made an agreed 1.53 billion pounds ($2.4 billion) offer earlier this month, trumping Melrose's 1.43 billion conditional bid.
The offer was a mix of cash and stock, making it unattractive for British equity-focused institutional funds -- which own more than 50 percent of Charter's equity -- as they cannot own U.S. shares.
"We were supportive of the Melrose offer as we never wished to be 'cashed out' of the long-term potential of the Charter businesses today, but to be able to participate in the future upside under the terms of the Melrose offer," Schroders said.
Melrose recently sold Dynacast after nearly doubling its value during six years of ownership and has turned around the fortunes of engineering conglomerate FKI, which it bought in 2008.
"In our view it is disappointing that the opportunity was not taken by the Charter board and its advisors to engage with Melrose and, instead, to solicit alternative approaches -- to the extent of paying an inducement fee to their preferred US suitor," Schroders said.
Charter said it had acted in the interest of shareholders as a whole in securing good value in difficult market conditions.
"It is absolutely right for the board to recommend the Colfax offer," a spokeswoman said. "An offer from Melrose has not materialised in the last three months."
Investec analysts said Melrose's decision to walk away was sensible, in light of current market conditions and the company's aim of maintaining pricing discipline.
Melrose shares were up 5.0 percent at 0900 GMT. ($1 = 0.637 pound) (Reporting by Adveith Nair; Editing by Jon Loades-Carter and Dan Lalor)