Big mergers, big risks

NEW YORK (Fortune) -- The big currency for M&A isnıt stock or cash, but heady - some worry pollyannaish - optimism about tomorrow. And the $55 billion in mergers announced this morning for targets including Equity Office and Phelps Dodge underscore how bullish Americaıs big buyers are, on everything from office buildings to copper.

Whatıs remarkable about these new deals is that the acquirers are paying big prices at what looks like the top of the market, for assets that are notoriously volatile. If the good times keep rolling, theyıll do fine. But if the normal cycle reasserts itself, if the world hasnıt really changed, the buyers will end up with a wicked hangover.

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A Freeport-McMoran mine in Indonesia

This wave of mergers contrasts sharply with the last M&A boom, which lasted from the late 1990s through 2000, and mostly spelled disaster for buyers and sellers alike. During that period, most of the acquirers were telecom, tech, and Internet players that used their highly-inflated stock as their currency.

This time, the M&A revival is being driven by a new force in the market, private equity. Of the $1.3 trillion in deals announced so far this year, Blackstone, Thomas Lee and the other buyout firms account for $346 billion, or 27%. That compares with $119 billion in private equity deals for the same period last year, according to Thomson Financial.

In no fewer than five of the six biggest transactions announced in 2006, including the HCA, Freescale Semi, and Harrah's deals, the purchaser is a private equity firm. Without the surge in buyout buying, this year would be only middling for M&A. With the charge from the likes of Blackstone and KKR, it promises to rank as the third best ever, if todayıs animal spirits reign till year end, a pretty solid bet.

But private equity firms offer sellers a far different deal from the architects of the last merger boom: They pay not in risky stock, but hard cash. When a purchaser uses 100% cash, its owners take 100% of the risks; when the deal is all or mostly stock, the sellers are taking a big bet on the future success of the deal. The current trend implies that private equity firms, with cash in hand, have a far easier time convincing targets to sell than public companies, which usually want to offer plenty of stock.

Conclusion: The buyers, driven by private equity, are a lot more optimistic about the prospects for the new combinations than the sellers - who apparently would rather cash out than bank their future on the success of an expensive merger.

Take the Equity Office (Charts) deal. Blackstone is paying $20 billion, all in cash provided by the institutions and wealthy individuals whose money it invests. Thatıs a great deal for Office Equity's founder Sam Zell and the other shareholders. Sure, the 14% premium over the stock price a week ago is modest, but the cash is a rare treat.

But how good is the deal for Blackstone? Office buildings have had a great run. The ratio of rental income to the price of buildings, known as the "cap rate," has dropped sharply, meaning that buyers are bidding up the prices of buildings to record levels. It's exactly what happens when investors bid up PEs or bond prices: The future returns from those levels are usually far from fantastic.

So if the world hasnıt changed, either rents must soar or building prices must fall or go flat. Blackstone is taking that bet. Zell and his shareholders wonıt have to share it, thanks to all that cash.

Similarly, Freeport McMoRan's (Charts) bid for Phelps Dodge (Charts) posts two big risks. First, it also involves lot of cash: Freeport is using stock for just 30% of the $25.9 billion. Second, Freeport is paying a big premium. It's offering $6.4 billion, or 33% more, than Phelps Dodge was selling for before the merger was announced.

The market was already expecting big things from Phelps Dodge, chiefly because copper prices at over $3 a pound sit well above historic levels, even though they've dropped recently. To make the deal pay for its shareholders, Freeport must generate the big earnings the market was already expecting from Phelps, earnings that are highly dependent on high copper prices. But it must also earn a double-digit return on the premium of over $6 billion by cutting overhead, selling more products to the same customers, or otherwise producing synergies.

That's a tall order. But because of the big cash component, almost all of the risk rests with the Freeport folks. So the bull market in optimism is back. Youıve got to give the private equity people credit: They're betting cash that it isnıt mostly bull.

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