Valuing Synergies
What is Synergy?
Synergy refers to the additional value created when two companies merge. It’s the enhanced value that would not be achieved by the companies individually but emerges when they combine their resources. This added value can result from increased revenues, decreased costs, or both.
Key Learning Points
- Synergy creates additional value in mergers by enhancing revenues and/or reducing costs beyond what each company could achieve alone
- Types of synergies commonly include revenue and cost synergies
- Investment banking approach to valuing synergies:
- Run-rate synergies are derived from transaction comparables
- Timing and value calculation begins by identifying the initiation point for synergies, followed by inputting projections – including anticipated future growth, with the calculations including a conservative growth outlook, additional discounts for risk, and valuation after taxes
- In an M & A transaction, the present value of synergy is critical in determining the deal’s price cap, influencing financial decisions, and making shareholder value distributions
What is Synergy Valuation?
Synergy valuation is a process to quantify the value of synergy created via the merger of two companies. This process estimates the present value of all possible synergistic benefits, which is then added into the company’s current valuation.
Types of Synergies:
Revenue and cost synergies play a pivotal role in enhancing the value of mergers and acquisitions.
Revenue Synergies:
Revenue synergies emerge through access to new markets and products, enabling companies to tap into fresh revenue streams and customer bases. When companies merge, they gain access to each other’s previously unreachable markets. Utilizing a shared distribution network enables them to expand their market reach. Furthermore, a combined product portfolio facilitates opportunities for up-selling and cross-selling, thereby increasing market share. An example of this is the Lafarge-Holcim merger in 2014, which provided the new entity with:
- The leading global product range in cement, concrete, and aggregates,
- The most comprehensive and diverse geographic coverage,
- An enhanced position to capitalize on growth opportunities in emerging markets and recoveries in developed markets, and
- The capability to bolster unique innovation abilities for developing innovative and sustainable solutions and products.
Cost Synergies – Across Income Statement and Balance Sheet:
Income Statement Synergies: Synergies can be realized in several areas including reductions in the cost of good; sold and selling, general and administrative expense; and streamlined operational expenses; while financial synergies such as lower interest rates and tax synergies, including the ability to offset losses or reduce the overall tax rate, improve the financial health of the merged entity. These synergies lead to immediate cost savings for the entity formed from the merger.
Balance Sheet Synergies: Beyond the income statement, balance sheet synergies include efficiencies in operating working capital and capital expenditures, further contributing to the strategic and financial advantages of the merger. It’s noteworthy that while these synergies may not directly reduce costs, they result in enhanced capital efficiency.
An example of this is the Lafarge-Holcim merger in 2014, which provided the new entity with:
- Synergies in operational optimization and best practices resulting in annual savings of €200mm. Examples include improvements in logistics, distribution, IT, and energy use.
- Procurement synergies, leading to annual savings of €340mm, included cost reductions in overlapping countries and economies of scale from centralized purchasing in certain categories.
- Selling, General, and Administrative (SG&A) synergies achieving annual savings of €250mm.
- Financial savings amounting to an annual rate of €200mm.
- Capital expenditure (capex) synergies with annual savings of €200mm thanks to adopting best practices in maintenance capex and increased efficiency in expansion capex.
- Working capital improvements generating savings of €410mm over three years, attributed to the exchange of best practices.
Access the free download to review excerpts on how different companies disclose the sources of synergies in their deal presentations.
Steps to Value Synergies
Calculating synergies during mergers & acquisitions can be one of the most complex activities due to several moving variables involved. These include the uncertainty of future cashflows, and the significant impact assumptions about the broader market conditions can have on the estimates. The timing of synergies is also an important factor; some cost savings may materialize quickly through downsizing or consolidation, while revenue synergies from cross-selling or market expansion may take years to develop. Further complexities in integration can arise from cultural differences, resistance to change, and misalignment of systems and processes.
However, in investment banking, the present value of synergy is calculated as below:
Step 1: Calculate the run rate synergies
Run-rate synergies are the synergies anticipated to be realized annually in a steady state. This is calculated based on comparable transactions. Following are the steps:
- Identify the relevant transactions in the past 10-15 years
- For each transaction, calculate the run rate synergies as a % of the target’s Last Twelve Months (LTM) revenue
- Calculate the average and median of ‘synergy as a % of LTM revenue’. This is the run-rate synergy multiple
- Multiply this multiple with the target’s LTM revenue
Example:
Imagine a North America-based cement manufacturer is acquiring another major cement company based in the UK, which has operations across Europe, Asia, and the Americas, and boasts an LTM revenue of $2bn.
We have identified five relevant transactions. For each transaction, we calculate the synergy % of LTM revenue as shown on the table below:
Source: Company filings and investor presentations
Run rate synergies are calculated as below, target LTM revenue multiplied by synergy multiple.
Step 2: Determine the Timing of Synergies
When examining comparable transactions, record the timing of their synergy accrual. Conduct a sense check and identify the baseline year for run-rate synergies. It’s advisable to seek an internal perspective from leadership on the starting point, which is generally assumed to be the beginning of the third year.
Example:
For most of the transactions mentioned above, the starting point is the beginning of the third year onwards, which will be used for further illustrative purposes in this example.
Step 3: Calculate the Present Value
In the process of calculating the present value, several assumptions are made:
- Treat all synergies as cash synergies.
- Adopting a conservative approach, it is assumed that synergies will occur on a steady-state basis without any future growth.
- Given that synergies are riskier to realize compared to standard business cash flows, it is recommended to apply an additional discount to the overall transaction’s weighted average cost of capital (WACC). The industry standard for this extra discount is 2%.
- It’s essential to compute the post-tax value using the Marginal Tax Rate (MTR). Apply the target company’s MTR to the synergies earned, under the assumption that these synergies will materialize in the target company. If the synergies are expected on the acquirer’s side, then the acquirer’s MTR should be applied.
Example
- Assume transaction WACC to be 8%, add 2% as additional discount rate, resulting in a 10% overall discount rate used to calculate the present value of synergies.
- Assume synergies to accrue from the third year onwards, they need to be further discounted for two years using the above calculated discount rate.
- Assume 25% as MTR.
Treatment of Present Value of Synergy in M&A:
The present value of synergy is vital in a deal and is added to the target’s equity value. Typically, this figure determines the highest price an acquirer is willing to offer, as paying more would not be financially prudent. Furthermore, the acquirers’ management often aims to preserve this maximum value for their own shareholders, offering just enough to the target’s shareholders to secure the deal.
Conclusion
Valuing synergies is a key factor in mergers and acquisitions, as synergies is the most common driving factor behind any M&A. Key steps include calculating run-rate synergies based on past data and factoring in cash synergies, growth expectations, and discount rates. This valuation critically influences the deal’s price and the value distribution among shareholders of both the target and the acquirer, highlighting its importance in the success of M&A endeavors.