Synergies

What are “Synergies”?

Synergies can occur when two companies are combined, and their pooled assets and resources may create greater value together than on an individual standalone basis. Synergies can be in various forms, including operational, financial and tax synergies. In most transactions, cost savings can be the most important and easily quantifiable synergies.

When do Synergies Occur?

• When companies merge or are combined, the two newly pooled sets of resources will begin to operate as one unified company and this can provide efficiencies (or synergies) rather than running two independent standalone businesses. The most common synergies are cost synergies following a transaction. The most immediate cost synergies can come from merging into a single head office and moving from two companies into a single corporate with just one CEO, finance director, HR team etc.
• Post deal, the realization of sales synergies is also possible. When Pepsi Cola merged with Frito-Lay and became PepsiCo in 1965 it created company that sold both beverages and snacks. This meant that both types of products could be distributed in the same transport system – a cost synergy. It also enabled the Sales divisions to be combined so customers (such as convenience stores) could buy snacks as well as beverages from one vendor – a sales synergy. A well-developed distribution network can be used by the combined entity post-deal company and this should achieve higher sales figures than on a standalone basis. If a merger is between two complimentary products, this can create a more attractive product selection which will appeal to both current and new customers.

How to Value Synergies?

The potential synergies are typically estimated using a multiple or it can be valued using a DCF approach. Listed companies often provide guidance on how much they are targeting in synergies. This can then be compared to the premium being paid to assess the value creation in a deal.

Types of Synergies

Let’s look at each type of synergy in more detail:

• Cost Synergies
• Financial Synergies
• Revenue Synergies

Types of Synergies – Cost Synergies

Cost synergies are the most common types of synergies. When two companies combine, their pooled resources can create efficiencies that reduce costs. For example, combining distribution networks can lead to cost savings.

Cost savings are also the easiest synergies to achieve post M&A. Once a deal has been done, units and divisions can be closed or sold which will reduce costs for the combined company. There may be costs associated with cost synergies, such as redundancy payments or the early termination (and possibly penalties) for contracts and other operational issues. However, these costs are usually one-off and result in larger, longer-term savings.

Types of Synergies – Financial Synergies

Financial synergies can include tax benefits, improved access to capital, and better financial management. A newly merged company may be able to access more favorable financing rates as it is larger and may have acquired more assets to use as collateral. Financing support may well be provided by the same firm that advised and facilitated the merger. Financial Synergies often result in lower costs of capital and improved financial performance.

Types of Synergies – Revenue Synergies

These occur when the combined entity can achieve higher sales figures than the standalone companies. For instance, leveraging a well-developed distribution network can lead to increased sales. Often companies can lean towards a merger as they can recognize the revenue synergies of operating as a single unit.

However, they can take longer to achieve as are reliant on the customer base approving of the merger and choosing to maintain or increase existing contracts with the newly merged company.

Synergy Examples

Example of Cost Synergy

An example of cost synergy is when two businesses merge and have two departments that do the same thing. A typical cost synergy from a merger would be closing one of the company headquarters, making staff redundant and closing any facilities which are outside the core operations of the new company By cutting departments in these areas, costs are reduced.

An Example of a Positive (Successful) Synergy

A positive synergy example is ABB buying Baldor Electrics. ABB had past losses that could be carried forward to reduce future tax, but they had no chance of using them within the allotted time frame. Buying Baldor allowed ABB to use up the losses before they expired, creating value for the newly merged company.

An Example of a Negative Synergy

The most common example of a  negative synergy is when the total premium paid for a company exceeds the value of synergies. If the premium paid for the company ends up being higher than initially hoped for, then it can be hard to create a similar value from the planned synergies. This can leave the newly-combined company being worth less than the previous two independently operating  companies.

Alternatively, the M&A deal may have gone to plan but afterwards synergies prove harder to achieve. If sales fall post deal then it can be deemed a negative synergy.

Estimating Synergies Using a DCF Approach

One way of estimating synergies is valuing them using a DCF approach. Under the DCF approach, synergies are then compared to the premium being paid to assess value creation in a deal. This forecasting approach will rely on the analysts financial modeling skills and creating a realistic timeframe and scenario for cost savings.

Comparing Premium Vs. Synergies

Analysts can start by comparing the share price pre-deal (or the unaffected share price) with the offer price. If the buyers are prepared to pay a premium, it is often for the synergies that can potentially be earned via the deal. Analysts, therefore, compare the present value of the synergies earned to the premium paid. An acquirer’s ideal situation is that the present value of synergies should be greater than the premium paid.

Calculating the Present Value of Synergies

There are several factors to be considered when calculating the value of synergies to ensure it is as accurate as possible:

Discount Rate:

When calculating the present value of synergies, it is important to use a discount rate higher than the weighted average cost of capital (WACC) to account for risk of synergies. This is because the WACC accounts for a company that already has ongoing sales and costs. On the other hand, the synergies do not yet exist within the company as they must be instigated. If and then they do occur, they may be lower than estimated. The higher discount rate helps in accounting for such risk.

Timing of Cash Flows:

Some synergies may occur at the start of the year and some at the end. Analysts should assume that synergy cash flows occur at a mid-year point to help even out the timing of the synergies.

Perpetual Growth of Synergies:

Since the synergies will occur only once we assume the synergies’ perpetual growth as 0% as the majority are likely to be one-off savings.

Calculating Premium Vs. Synergies:

Let us understand this with an example. Here is the information on an M&A deal:

In this example, the offer price of $24.75 a share is higher than the unaffected share price, indicating the buyers are paying a premium for the synergies. This is a 22.4% premium on the unaffected share price.

So let’s calculate the value given to the existing shareholders. The calculation involves multiplying the difference between the offer share price and the unaffected share price with the number of shares.

The value or premium paid to sell shareholders works out at $906. Now, let us calculate the remaining value for the buyer by subtracting this number from the present value of synergies.

Based on the calculations above, this looks like an attractive deal for the buyers. The present value of synergies is substantially higher than the premium paid. This excess value allows buyers to enjoy a good portion of the synergies.

Download the free Financial Edge template and test yourself with the calculations.

Sources of Synergies

When comparing two transactions with similar synergies, the sources of synergies help in determining which transaction justifies a higher premium.

Here is an example of two deals. The “run rate” refers to the ongoing annual synergy expectation after incurring M&A integration costs. What we need to look at is which of the two deals justifies a higher premium?

As a first step, let us assess the risks in each of the two deals.

Cost Synergies: cost synergies indicate that costs will come down after the transaction. Since they are within the control of the company, they are perceived as low risk.

Percentage at the Target Level: in Deal A, all the synergies are at the target level. Since they are at the target level, it is reasonable for the target shareholders to expect to get paid a premium for this as they are providing the synergies.

However, in Deal B, only half are at the target level, thus reducing the premium justifiable to target shareholders.

Revenue Synergies: revenue synergies imply that the company expects to sell more in the future as a unified company. However, these potential synergies are much higher perceived risks as the growth of revenues is outside the company’s control. Therefore, it does not make sense to pay the target shareholders a premium for these synergies.

Cost of Capital Synergies: these are perceived as low risk because again they are within the company’s control. We can assume that the buyer is bringing this low cost of capital. Therefore, the target does not expect to get paid for this.

Thus, we can conclude that Deal A justifies the higher premium more than Deal B as it is able to deliver more (low risk) synergies at the target level.

Modeling Synergies in an M&A Model

Synergies can be modeled in an M&A model by estimating annual synergy cash flows using past transactions and metrics (such as synergies as a percentage of sales or SG&A expenses). The value of synergies can be also estimated using discounted cash flows (DCFs) or multiples.

Examples of Ways to Estimate M&A Synergies

M&A synergies can be estimated using past transactions and metrics such as synergies as a percentage of sales or SG&A expenses. Additionally, the value of synergies can be estimated using discounted cash flows (DCFs) or multiples. When modelling M&A transactions it is helpful to use several methods to forecast synergies to ensure the assumptions within all metrics. Management will typically provide some guidance on expected synergies if it is a listed company transaction and analysts must take a view on whether the target is achievable and also comparable with past deals.

Hard vs. Soft M&A Synergies

Hard synergies are tangible and quantifiable, such as cost savings from eliminating duplicate departments.  Whereas soft synergies are intangible and harder to quantify, such as improved customer satisfaction or brand value. Both can be modeled in an M&A model, with soft synergies often influenced by the success of the initial integration of the companies.

Risks to Synergies

The risks to synergies include overestimating the value of synergies, cannibalization in revenue synergies, and failing to achieve cost savings. Additionally, uncertainties in synergy cash flows can lead to value destruction if the premium paid exceeds the value of synergies. It is important that analysts consider all scenarios and also factor in market conditions and competitor performance when building synergies within an M&A model.

Conclusion

Synergies play a crucial role in mergers and acquisitions, providing significant value-creation opportunities when two companies combine their resources. The most common types of synergies include cost, financial, and revenue synergies, each contributing to enhanced efficiency, improved financial performance, and increased sales.

Additional Resources 

Present Value Of Synergies 

Synergies in a DCF 

Valuing Synergies