* GKN agrees to combine automotive business with Dana
* Part of efforts to fend off takeover by Melrose
* Melrose may be forced to raise bid (Updates with background to the deal and adds quotes)
March 9 (Reuters) - GKN has struck a $6.1 billion deal to merge its automotive business with U.S. company Dana Incorporated in a move by the British engineer to fend off a hostile takeover by turnaround specialist Melrose Industries. FTSE 100-listed GKN said on Friday that it had agreed to combine its Driveline division with the Ohio-based maker of axles and driveshafts in a deal giving GKN shareholders a 47.25 percent stake in the enlarged, U.S.-listed group.
The British company, whose customers include Fiat Chrysler and Volkswagen, will also receive $1.6 billion in cash and $1 billion of GKN's pension deficit will be transferred to the combined business.
It deals a blow to Melrose, which has been pursuing a takeover of GKN since January, when the engineering group spurned its unsolicited cash-and-shares bid that at the time valued GKN at 7.4 billion pounds ($10.2 billion).
Melrose responded by turning hostile and taking its offer directly to GKN's shareholders, putting pressure on the engineer's newly appointed chief executive, Anne Stevens.
The agreement with Dana could now force Melrose to raise its bid.
Shares in GKN edged up 1 percent to 426.2 pence at 1435 GMT in London following the announcement of the Dana deal. That is higher than the level of Melrose's offer, which currently values GKN at about 404 pence-a-share based on Melrose share price, which was up 0.6 percent at 217 pence.
"We might need to revisit our offer, I think that's what the market is telling us," a source close to Melrose said. According to UK rules, Melrose has until March 19 to improve its bid.
Melrose declined to comment.
SHAREHOLDERS TO CHOOSE
The deal with Dana "provides significantly greater value for GKN's shareholders than the Melrose offer," GKN said.
It added that the merger gives Driveline an enterprise value, which includes debt, of $6.1 billion, based on Dana's closing share price of $26.20 on Thursday.
Together with GKN's plan to sell its powder metallurgy business, it will leave the company focused on aerospace, supplying parts to aircraft including the Black Hawk military helicopter and Eurofighter Typhoon.
GKN was left vulnerable to bid approaches after two profit warnings in October and November that were caused by problems at its U.S. aerospace business and sent its share price tumbling.
The British company disclosed on Friday that it was approached by Dana late in 2017 and began talks early this year.
If the deal is successful, Dana will become a UK public limited company, although it will remain headquartered in Ohio and its shares will be traded on the New York Stock Exchange. It will also be led by James Kamsickas, Dana's current CEO.
GKN's shareholders will need to approve the merger, which means they will have to weigh its merits against a Melrose takeover.
That will include considering whether they want to hold a stake in New York-listed Dana or London-listed Melrose.
"Following the (Dana) transaction, GKN shareholders will own 47 percent of a $14 billion revenue, global automotive group and will retain ownership of GKN's outstanding remaining businesses," GKN Chairman Mike Turner said.
The Driveline deal will also deliver annual synergies of $235 million by the end of the third year after the merger completes, the engineer added.
The trustees of GKN's group pension said the arrangements agreed as part of the transaction provide "appropriate mitigation to the schemes."
Credit Suisse and Barclays are advising Dana, while the U.S. company's board is being advised by PJT Partners. GKN is working with JP Morgan, Gleacher Shacklock and UBS. ($1 = 0.7233 pounds) (Reporting by Ben Martin in London and Noor Zainab Hussain Editing by Jason Neely and Keith Weir)