Overestimation of Synergies

Synergy is a peculiar word—depending on the context it either stands for the pipe dreams of management or a hard-nosed rationale for a deal. Often it is a little of both. Consider the following example: A large health services company paid several billion dollars for a more profitable company in a related industry segment. Given its stepped-up investment base, the target's post acquisition after-tax earnings would have had to be about $500 million for the acquirer's return on its investment to approach its cost of capital. The year before the transaction was consummated, the target's earnings were about $225 million. Therefore, it needed to close an earnings gap of more than $275 million through "operating synergies." That meant more than doubling the earnings base. The acquirer's inability to make improvements of this magnitude resulted in destruction of significant shareholder value. In the ensuing three years, market indices rose while the acquirer's returns to its shareholders were actually negative. Clearly in the foregoing case, the estimation of deal benefits became disconnected from reality somewhere along the way. ''The Vision Thing" often underlies such situations, where a visionary CEO's idea of an industry-transforming deal runs straight into the reality of day-to-day business.

Overlooking Problems

Due diligence is a difficult process from which to get good business results. It has an intensive legal and accounting aspect to it that involves large numbers of accountants and lawyers working long hours in unpleasant conditions. There is also a need for secrecy and speed, since leaks can prompt problems with securities regulators, customers, suppliers, and employees. Beyond this, many participants are either inexperienced or not sure what they are looking for. And many people do not want to be the bearer of bad news, especially as the process becomes more frenetic and the CEO and others get more excited about doing the deal. Put it all together and sometimes even major problems, including accounting and legal problems that should have been caught, slip through and blow up, usually in the year after closing.


In the heat of a deal, the acquirer may bid up the price beyond the limits of reasonable valuations. It is all too easy to find benchmarks that justify a higher price or bargain away important nonprice terms that restrict the ability of the acquirer to achieve planned-for savings and growth. Remember the winner's curse: If you are the winner in a bidding war, why did your competitors drop out (bearing in mind that they too may have scratched to find the last penny for their bid!)?

Poor Post-Acquisition Integration

Assuming that the price paid would allow for an acquirer to create value from a deal, there is still another hurdle to clear: implementation. It goes almost without saying that poor implementation can ruin even the best strategy. In M&A situations, the execution of a sound business strategy is made especially difficult by the complex task of integrating two different organizations. Relationships with customers, employers, and suppliers are often disrupted during the process; this disruption may cause damage to the value of the business. Aggressive acquirers often believe they can improve the target's performance by injecting better management talent, but end up chasing much of the talent out. Yet it is this very integration that should yield the returns to make the acquisition pay off. Failure to integrate can be as costly as integrating poorly. Exhibit 7.2 shows a typical losing pattern for unsuccessful merger programs. This death spiral, unfortunately, is all too common.

Exhibit 7.2 Typical Losing Pattern for Acquisitions

Company's returns a re reduced and stock price falls

Candidates are screened or basis of industry and company growth and returns

One or two candidates are rejected on basis ol objective DCF analysis

Frustration sets in; pressures build to cloa deal; DCF analysis is tainted by unrealistic expectations of synergies

Deal is consummated at large premium

Post-acquisitions experience reveals expected synergies are illusory

Company's returns a re reduced and stock price falls

Steps in Successful Mergers and Acquisitions

We can break an acquisition program into the five distinct steps. The process begins with a pre-acquisition phase that involves a self-examination of your company and its industries. And the process ends with a carefully planned post-merger integration that is executed as quickly as possible to capture the premium that was paid for the acquisition.

Do Your Homework

If you have valued your own company and understand the changing structure of your industry and the players in it, then you should have a clear vision of the value-adding approach that will work best. Three avenues to consider are:

1. Strengthen or leverage your core business by gaining access to new customers or customer segments and to complementary or better products and services.

2. Capitalize on functional economies of scale (e.g., in distribution or manufacturing) to cut costs and improve product and service quality.

3. Benefit from technology or skills transfer. Some companies are better at doing certain things than others or have developed unique technologies. If these skills can be applied to larger volumes of business or opportunity, then they can be a source of real value.

When it comes to thinking through synergies, companies at times fail to focus on how revenues will increase or costs will fall. For example, it is tempting to assume that revenues for a new combined company will be the sum of the predecessor companies' sales plus a boost from cross-selling additional products. The reality can be quite different. First, the fact of a merger itself will disrupt customer relationships, leading to loss of business. Second, smart competitors use mergers as a prime opportunity to break into new accounts—including recruiting star salespeople or product specialists. Finally, customers are not shy about asking for price and other concessions in the midst of a merger, which salespeople will be eager to offer for fear of losing the business and getting bad publicity. It is hard to overestimate how much effort is required to deal with such issues, and to underestimate the impact if you do not.

Likewise, on paper, salesforces might be integrated to move more product through the same number of salespeople. Reality in the field might be quite different if the salesforces of the merging companies do not make exactly the same customer calls. For example, it is unlikely that two college textbook companies, one specializing in liberal arts books and the other in scientific texts, can profit from salesforce savings. Salespeople in the two companies actually visit different parts of campus, with little redundancy.

Sometimes value can be gained from skills or technology transfer through the merger. But this approach, while often touted, can be fraught with problems. More often than not, managerial hubris creates overly optimistic self-assessments of skills that can be leveraged. It pays to be skeptical. Probe for the specifics on everything and sort the benefits of possible deals into two categories—the measurable and eminently believable and the conceivable and possibly ephemeral. This way you will at least avoid mixing the two and know what you're counting on to make a deal work.

In parallel with understanding your business strategy and how it may be aided by acquisitions, there are a number of housekeeping/homework tasks that should be addressed before getting involved in a deal.

Housekeeping/homework means identifying the details that are necessary for getting a transaction evaluated and approved (or not) ahead of time. Concretely, this means knowing who in the organization needs to approve a deal as a formal matter. What must go to the board of directors and when? Which types of deals must shareholders approve? Are there any restrictions on types of consideration, issuance of options to an acquired company's employees, or changes to benefit plans? Which regulators will need to be consulted and what are the criteria for deal approval? Are there customer, supplier, employee, or other contracts that contain provisions that would be affected by various types of transactions? What is the company's tax profile—how would it be affected by possible transactions?

Identify and Screen Candidates

Successful acquirers actively screen and cultivate candidates. It may make sense to explain your acquisition criteria to selected investment banks and others that may have special insight or access into potential candidates. However, it is best not to sit back and passively react to investment banking proposals for acquisition candidates. It is much better to develop and actively cultivate your own. Often, if a banker approaches you with a company for sale, odds are that the company is being widely shopped. In this event, you will likely end up paying top dollar to acquire it after a time-pressured evaluation and due diligence process—hardly a prescription for success.

The best approach is to develop a database and set of files on all prospective candidates in your areas of interest. It is likely that you will track many candidates for several years and will want to update your information periodically. You will want to consider publicly held companies, divisions of companies, privately held companies, and foreign as well as domestic companies. You will be aware of many candidates as a result of business strategy work. At this point you may find it useful to winnow the universe of candidates by employing a list of knock-out criteria. Targets that are too large, too small, or heavily connected with unrelated businesses can be quickly eliminated. The end product of this stage should be a set of candidates that have solid businesses; offer potential for revenue and cost synergies; fit culturally so they can be integrated with least disruption; are affordable, and are available (at least possibly) for purchase.

Assess High Potential Candidates in Depth

Once you have narrowed your list of candidates to a handful of realistic possibilities, you will begin the detailed work of valuing each candidate and identifying your strategy for creating value. You will need a plan that more than earns back the purchase price, including a premium that you would have to pay to complete a deal. With takeover premiums running 30 percent to 40 percent and more above the pre-acquisition market values, you will want to be sure the synergies are both large and clearly identified.

When undertaking a detailed evaluation of the remaining candidates, keep in mind the distinction between the value to you and the price you will need to pay. Your obvious objective should be to maximize the former while minimizing the latter. The essential starting point is a clear understanding of the value of the company to you under your ownership. This consists of its standalone value, as operated by current management; likely net synergies from the combination, after taking into account potential lost business from disruption, and transactions costs, such as restructuring charges and deal fees. The more specific you can be in assessing each of these areas, the better prepared you will be for negotiations and subsequent integration.

Standalone value should be looked at from multiple perspectives, including average securities analyst estimates, past performance, and management pronouncements. Likewise, synergies should be categorized and quantified wherever possible. You should also assess how long it will take to capture the synergies. And don't forget about the impact of competitor reactions to your deal that could have a financial impact on the combined firm.

When valuing synergies, you will need to identify not only the synergies that you can obtain, but also those that may accrue to other potential acquirers. If the synergies that you can capture are less than those that can be captured by a competitor, you are likely to lose in a bidding war. Synergies fall into one of three broad categories, as detailed by Bill Pursche:3

1. Universal. Generally available to any logical acquirer with capable management and adequate resources. Examples are economies of scale (such as leveraging the fixed cost of a management information systems department or eliminating redundant senior management) and some exploitable opportunities (raising prices, cutting corporate overhead, and eliminating waste).

2. Endemic. Available to only a few acquirers, typically those in the same industry as the seller. These include economies of scope (broadened geographic coverage) and most exploitable opportunities (redundant sales forces).

3. Unique. Opportunities that can be exploited only by a specific buyer (or seller).

The value to the buyer and seller depends on the type of synergy and who controls it. Universal synergies, since they are widely accessible, usually accrue to the sellers as do unique synergies, if under control of the seller. If the buyer possesses the unique synergy, it may pay a lower price (because there is no competing buyer) and keep most of the value. This is especially the case where the buyer has alternate means of ''monetizing" the capability that does not depend on acquiring a specific target company.

Endemic synergies fall in between, with the buyer and seller potentially sharing the value created as a result of who brings what to the table and the parties' respective negotiating skills and power.

When analyzing synergies, consider restructuring and financial engineering. Assets that are worth more to other owners can be profitably redeployed through liquidations, divestitures, spin-offs, or leveraged buyouts. Hidden asset values, such as overfunded pension plans or underused real

3 W. Pursche, "Building Better Bids: Synergies and Acquisition Prices," Chief Financial Officer USA (1988), pp. 63-64.

estate, can be captured. Finally, alternative financing arrangements, including sale/leaseback arrangements, royalty trusts, partial equity offerings, tracking stock, and contingency payment units, can also create value by better use of tax shelters, reducing the capital base without cutting earnings, or raising funds in an optimal way.

The tax treatment of an M&A transaction can be vitally important to its economics. Moreover, the field is constantly changing, complex, and specific to each jurisdiction and to a company's circumstances. Almost anything that we could write would soon be outdated and incorrect. Our recommendation is that anyone working on M&A transactions establish a good working relationship with tax experts and keep them involved every step of the way.

It is also important to understand the accounting treatment of potential acquisitions, because managements are required to present their results to external parties in accordance with an elaborate set of rules. In Chapter 5, we discussed some of the issues surrounding M&A accounting methods.

Contact, Court, and Negotiate

Eventually, you will be ready to begin contacting your top priority acquisition candidates. This courtship process can be delicate, and may require years until actual combination discussions take place. Many sellers do not want to sell—they have their own plans they believe in and prefer to remain independent. If the target company's financial situation allows it, then there is little that can be done until circumstances change. If the company is publicly traded and has weak defenses, you may want to consider a hostile bid, but this will make the job of finalizing your assessment of the target very difficult and set a poor tone for effective integration after the deal.

The purpose of a discreet courtship process is threefold: to learn more about whether there is a good fit between the companies, to convince the sellers to sell, and, to convince them to sell to you, preferably through exclusive negotiations where you can achieve better price and terms than in a competitive situation.

Once the sellers are at the table, the negotiations begin in earnest. Negotiating carefully and purposefully will help you avoid overpaying and boxing yourself into terms that will make successful post-merger management difficult. Acquirers who fail in an acquisition because they overbid, or because they could not make the acquisition work, often become targets themselves.4

4 See Mark Mitchell and Ken Lehn, ''Do Bad Bidders Become Good Targets?" Working Paper (Washington, DC: Office of Economic Analysis, Securities and Exchange Commission, 1985).

It is important to realize that negotiation is really an art. It depends on your ability to keep your eye calmly on your objectives and interests, while reading and dealing effectively with the other side. Acting and histrionics can play a role. Knowing how and when to leave the table, how to identify and trade off various terms, how to enlarge the total pie—these all matter.

You will also want to be on the lookout for creative ways to handle stumbling blocks. Some of these arise from different perceptions about future prospects and others simply get down to arguing over who will bear risk. In purchases of private companies and divisions, contingent payment structures such as "earnouts" keyed to achieving profit targets can help bridge the gap. At other times, payments tied to customer retention work well. Employee retention can also be an issue, particularly in service businesses; stay-put payments, stock plans and the like can help ensure key staff remain long enough to give the new company a chance to work and be seen as an attractive employer in its own right.

It is easy to be blinded by the "fog of war" and concessions already made can be nearly impossible to reclaim. If you have followed the steps described above, you will be in a good position. You will know clearly what the logic is for a deal, how the companies fit together, and what the economics might look like. You will also know a lot about the target company and its management.

Manage Post-Merger Integration

From a shareholder's perspective, post-merger management (PMM) is a fancy phrase for figuring out how to recoup your investment in a deal. As we discussed earlier, poor post-deal execution causes many mergers to fail. Exhibit 7.3 sets out three broad must-do action areas for top management involved in a merger integration. The approach to executing against each will vary by circumstance.

Exhibit 7.3 Management Must Execute Quickly in Three Areas

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