Synergies refer to expected cost savings, growth opportunities, and other financial benefits that occur as a result of the combination of two companies. A correct estimation of synergies is needed to produce a successful transaction. The combination of two entities will not create value if the value of synergies is zero or negative. The synergy from a merger or an acquisition is the value of the combined entity minus the fair value of the two firms as separate entities. The fair value is the true or intrinsic value of the entity exclusive of any element of value arising from the expectation of a merger or acquisition. The gain in value of the combined entity is the present value of the synergy cash flows.
The size and degree of likelihood of realizing potential synergies plays an important role in framing the purchase price of acquisition. Due to their critical role in valuation and potential to make or break a deal, investment bankers need to understand the nature and magnitude of the expected synergies carefully. The buy-side team (investment bankers on acquirer side) must ensure that the synergies are accurately reflected in the financial model and M&A analysis, as well as in communication to the investors and markets.
Synergies arise from the increase in size of expected future cash flows (the additional cash flows resulting from the combination of assets). The additional cash flow for a given year may arise from:
Revenue synergies refer to the enhanced sales growth opportunities presented by the combination of businesses. A typical revenue synergy is the acquirer’s ability to sell the target’s products through its own distribution channels without cannibalizing existing acquirer or target sales i.e. The post merger combined entity is expected to sell more than the two merged firms separately (selling the same products to more clients, more products to the existing client base, or both). Also, revenue synergies occur as the combined entity may get a larger market share that enables it to raise the price of its products. Another revenue synergy occurs when the acquirer leverages the target’s technology, geography presence, or know-how to enhance or expand its existing product or service offerings.
Revenue synergies tend to be more speculative than cost synergies. As a result, valuation and M&A analysis typically incorporate conservative assumptions regarding revenue synergies.
Cost synergies, which are easily quantifiable, tend to have a higher likelihood of success than revenue synergies. Cost synergies are also rewarded by the markets via stock price appreciation. Typical cost synergies include headcount reduction, consolidation of overlapping facilities, and the ability to buy key inputs at lower rates due to increased purchasing power. Increased size of the acquirer provides for economies of scale i.e. larger companies are able to produce and sell more units at a lower cost per unit than smaller competitors.
Decrease in operating costs as a result of the combination (2+2=3): Reduction in overhead expenses (discounts for raw material purchase due to increase in quantity) and economies in marketing and distribution generally lead to an improvement in cost of goods sold and selling and general and administrative expenses.
Decrease in the capital requirements of the combined entity: Capital requirements are the new investments required in working capital and fixed assets. For example, after a merger, the combined entity may be able to use its combined assets more efficiently by cross-using factories on a regional basis.
Likelihood and Timing of Synergies Realization
The business combination will project various benefits, some of which have a very high likelihood of success while others may be long shots. For example, the likelihood that the administrative costs associated with the target’s board of directors can be eliminated is about 100%. Conversely, achieving certain sales goals against stiff competition is probably far less definite. These differences must be noted and allowed for in the forecast.
The timing of synergies realization is very important. The successful and timely delivery of expected synergies is extremely important for the acquirer. Failure to achieve the synergies can result in share price decline as well as weakened support for future acquisitions from shareholders, creditors and rating agencies. A McKinsey study points out – ‘Unless synergies are realized within, say, the first full budget year after consolidation, they might be overtaken by subsequent events and wholly fail to materialize.’
The net present value of synergies can then be valued with the usual discounted-cash-flow model.
Source: Para 18.5, Investment Banking: The Dream Begins (www.theiBbook.com)
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