Mergers & Acquisitions: Evaluation of Synergies

I purchase companies, split them into small arms, and sell them off; it’s worth more than the whole one of it, explicated by the corporate acquirer, in the movie, Pretty Woman, which displays a company acquired through uncongenial bid and thereon striped-off its assets, entirely disregarding the decades of sweat-work seated by its holders. This is what actually happens in cutthroat environment and therefore a need arises for a guard to take care of the interest from third party interference. To mitigate this problem, there are laws across globe that are in place, dealing with mergers and acquisitions. Hence, one thing stands clear, before doing any number-crunching and other planning; we have to consider if systems are in place to follow the law of the land.

Introduction: 

Mergers & acquisitions has been big part of the corporate world since decades. It deals with conjoining entities for gaining various operational/financial benefits.

From the capital market viewpoint, the promulgation of merger sends a strong message, such that the company is moving forward in the business and probable increase in the market capitalization. The main aim of M&A is to create positive synergy effects in business.

“One plus One makes Three” - this statement represents the main philosophy behind M&A.

The Words 

Merger and Acquisitions are used as synonyms, but they mean slightly different.

Merger: Blend of two or more companies, dealt by offering the stockholders securities in the acquiring company in exchange for the surrender of their stock.

Acquisition: The target company ceases to exist and the acquirer continues to trade its own shares. Acquisitions can be either friendly or unfriendly; it depends on the accordance of the target company.

Synergy: A concept that the value and performance of two companies combined will be greater than the sum of the separate individual parts.

Why Merger and Acquisition ? 

Following would give us clarity on the above:

· Inorganic Growth: Organic is limited to the stand-alone growth of the company, whereas, merger/acquisition leads to immediate growth in size and market capitalisation/valuation.

· Acquiring intellectual capital/technology

· Tax considerations and Overcoming government policies 

· Restructuring the business

· Cost reduction and efficiency leverage

· Capital optimization

To top it all, the overarching reason for a decision on merger and acquisition taken by a company is the synergy it would provide.

Valuation 

The synergy provided by an event of M&A can be calculated on estimating the value of the company to be acquired. There are various methods of doing so; some of them are as follows:

1. Discounted Cash-Flow Analysis:

This method involves discounting the expected future cash flow to the present value in order to derive an estimated value of the company. The terminal value too, is taken into consideration, which is discounted to perpetuity.

2. Assets Based Valuation:

A method wherein valuation is based on the assets and liabilities of the company. It plays an important role where companies have large investments in fixed assets to generate earnings. It is also a sought out approach by companies that are “worth more dead than alive.”

3. Comparable Company Analysis:

The analyst first defines a set of other companies that are similar to the target company. This may include companies within the target’s primary industry or in similar industries.

A company’s enterprise value is the market value of its debt and equity to cash flows, enterprise value to EBITDA, to EBIT and to sales. The equity can also be valued using equity multiples.

Other considerations

· Brand Valuation

· Relative Valuation: Price Earnings Ratios, P/B Ratio, Tobin Q, Price to Sales Ratio

Valuation of combined firm should be greater than the value of companies on stand-alone basis.

Probing Synergies 

Creating value of the enterprise that exceeds the cost of acquisition is the primary objective of the management based on which the market pays-off or punishes the shareholders of a combined company. 

When employed on to valuation and other deal theories, synergy would mean, the companies win, in which the seller receives an acquisition deal premium and the buyer realizes shareholders value. The fundamental and the only palpable justification, which appeals to the owners and management of the company, is the synergy that an M&A would provide and therefore, the centring is on identifying and tracking synergy.

A chiselled and crystal-clear approach to synergies, gives rise in the probability of achieving the objectives. Such an approach would involve:

1. Prototyping-Synergies

Synergy Identification and Validation: For preparing, a deal model the company that is acquiring would need to validate assumptions that are sensitive to the deal. When it comes to an auction process, the amount of information to reveal or not to reveal is completely in the hands of the seller. Hence due diligence is extremely essential to identify and authenticate value drivers. 

To prototype synergies, assumptions are based on information, which is target provided and using public data. The corporate development and finance teams develop these assumptions. Hence, higher the level of detailing in the initial assumptions would be of relevance to negotiate approval process. 

Many companies face challenges when they are approaching diligence in the form of unravelling, what could be wrong with the target company. To overcome this challenge a more efficient approach would be to break down risk areas and important value drivers. 

Prior to realizing synergies from an acquisition, it is essential that the synergy assumptions are identified and validated by the functional units. Once the functional units have ownership of the numbers and the same are verified by experts the credibility of the synergy estimates go up. Synergies are easier to realize if the acquirer has a good understanding of the business, he is acquiring. In general, cost synergies are more successful than revenue synergies. This could be true because cost synergies-reduce headcount, overhead reduction, etc. involve lesser variables and rely less on subjective variables as compared to revenue synergies. 

Companies face possible risks if they don’t validate the synergies with the functional owners. Firstly, inaccurate estimates have a higher chance of occurrence with no validation from functional owners. Secondly, a chance of shortfall in synergy increases once the deal is completed. Hence, vetting these costs and including these numbers in the overall valuation is extremely critical to create a realistic model.

2. Carrying-Out

Challenges of Synergy Realization: The most common reason for acquisitions not realizing their full potential lies in weak execution. This in turn hampers the ability to create shareholder wealth through acquisitions. 

Factors that play a key role in realizing synergies from a deal depend on the type of synergy target. For cost synergies the management’s tone and supervision is critical. The revenue synergies are more about aligning efforts through combination of technical knowledge. 

Transparency: Transparency is extremely essential to maximize synergy realization. The company that is being acquired should have a clear link to its internal and external financial statements. This is important information that stakeholders can use to authenticate value creation. In addition, management’s commitment is extremely essential to the successful creation of synergies. 

Talent Retention: Another essential factor for realizing synergies is the retention of talent that would help maximize the benefits from the integration of the acquirer and the company being acquired. Certain companies use financial incentives to retain certain key members of the firm until the synergy realization is maximized. 

Integration: Certain companies make an error in judgement by delaying integration and underestimating its complexity. To avoid making this error companies should focus on accelerating the transition, prepare for day one and at the same time establish leadership on all levels. More importantly, the company should manage the integration as a business process.

3. Tracking-Synergies

It is simple, if your operating profit is good, then its working well for you. The focus is on tracking if the actual income, sales/gross receipts, and the spending budget and see if that makes sense. More often than not, the first few years’ performance is solid because that is something, which is the near future, and that we have an integration team for, but we really have a hard time tracking it beyond a certain point of time. The bottom line and typically the revenue lag a little bit behind. Usually, we never get the sales synergies as we expect it to be.

Comparing this with the prototyping is the basic that we are to undertake. Companies in present times also track non-financial metrics such as employee and customer retention.

Preeminent practises make us conclude that the success of the deal puts emphasis on:

1. Synergy-tracking

2. Deal-process

3. Measuring Share-holder value

Conclusion 

“Mergers are like speed-dating. There is a short chronology involved in making a vital decision that would lead to union. The company acquired shows off its colours, and you need to differentiate between fascination and a perfect match.”

Leveraging operations, human-resources, and tools that rapidly and accurately track synergies is indispensable to an effective M&A. These elements may not vouch value creation, but without these, a dealmaker’s chance for success diminishes substantially.

Special Thanks to Rohit Gambhir, for co-authoring this article, with us.

This Article was first published in The Financial Bulletin, Money Matters Club, ICFAI Business School.