Defining Synergies in Acquisition Targets

Synergies may be the most powerful way to create value within an acquisition and yet, are still widely misunderstood. A 2012 survey of 352 executives in the United States, Europe and Asia by Bain & Co. found that overestimating synergies was the second most common cause of deal disappointment or difficulty with 55% ranking it as a ‘major’ or ‘very major’ reason (see below).

In the simplest terms, synergies refer to any element of a transaction whereby the new entity is greater than the sum of the individual parts: the ultimate goal of any transaction. But defining those synergies, and estimating them accurately (as the company executives in the Bain survey will attest) is a significant challenge in itself.

The specifics of achievable synergies are unique to every transaction, which is one of the reasons why acquiring companies would be well-advised to bring transaction specialists on board to guide them through the process. That said, broadly speaking, there are three categories in which companies can find these synergies: cost, capital, and revenues.

Cost Synergies

Cost synergies are the quick wins: There are likely to be overlapping costs in transactions of any size. Examples of these duplicate costs include employees (particularly in the HR Department and at the executive level), branch networks (retail branches from both companies in close proximity to one another), distribution and even R&D costs.

Cost synergies are often referred to as ‘run rate’ synergies, meaning that the savings they provide the new firm are recurring. So, to take one deal as an example, the $3.2bn cost synergies aimed for in the 2016 acquisition of SABMiller by AmBev - if achieved - will affect its cost base every year, and not just in the period immediately following the deal.

Capital Synergies

Capital synergies include anything that allows the new entity to improve its balance sheet by reducing working capital and borrowing costs (and using the cash position of one firm against the debt position of the other, for example) and achieving a better return on capital from underutilized assets such as logistical operations.

Capital synergies, although in many cases, more difficult to pin down, can quickly feed into revenue synergies. When Apple purchased Whole Foods Market Inc. in June 2017, it gained several hundred physical stores, which effectively doubled up as distribution channels for its existing online operations and in turn making the stores more productive than they had been.

Revenue Synergies

Revenue synergies, sometimes called ‘soft synergies,’ refer to anywhere the merged entity can enhance the combined revenues through cross-selling of product lines, taking advantage of the presence in new geographies, improved sales channels (for example, e-commerce) and even customer segments.

Companies in the airline industry are renowned for seeking out revenue synergies in acquisitions and the 2016 Alaska Airlines Group acquisition of Virgin America is a case in point. The newly acquired firm could offer more destinations, greater frequency of flights and increased sales distribution channels, giving it considerable cross-selling power.

Valuing the Combined Synergies

Synergies rarely happen without considerable work on the part of the acquiring firm. Even if achievable synergies can be identified before the deal, they’re unlikely to fall into place as soon as the deal closes - explaining at least some of the reason why their financial impact is so often overestimated.

Being realistic with the timeframe for achieving the goals is also crucial for valuing synergies. Timing is everything in integration, with faster integration leading to better savings, all things being equal. The sooner overlapping costs can be cut, the better the cash flow of the combined entity. As much as income statements suggest otherwise, costs aren’t quarterly - they’re daily.

Arriving at an accurate estimation of the achievable synergies in a deal will ultimately allow the acquirer to avoid overpaying for the target - the bane of most unsuccessful transactions. It also gives them the opportunity to be forthright with the target firm about their intentions for their management and their employees, ultimately making for a friendlier acquisition.

The Extra Challenges Created by Cross-Border Transactions

Short-term trends in M&A transactions are common. Over the past 30 years, these have included Japan Inc. on a spending splurge in the United States, the rise of conglomerates, a boom in mobile communications transactions, the dot-com boom, consolidation among giant pharmaceuticals and most recently, a boom in technology-related transactions.

As the trends come and go, one theme is consistent: the inexorable rise of the cross-border transaction. According to Thomson Reuters, cross-border M&A activity totaled $1.3 trillion in 2017. Although the figure is a 10% decrease on the 2016 figure, the long-term trajectory is upward in terms of deal volumes and value.

One of the upshots of the rise in international dealmaking is the growing body of data we have gained on the subject. The cumulative knowledge provided by thousands of these transactions informs future deals. And although the basic tenets of dealmaking are consistent across geographies, there are undoubtedly extra challenges that companies need to be aware of.

A 360-degree view of the target

A recurring problem in cross-border transactions is that they are framed differently to domestic transactions; very often, instead of acquiring a company on its merits, the buyer is buying access to a new market and the growth that market promises. This subtle difference can mean that buyers often don’t know as much about the target company as they should.

In many cases - particularly in smaller deals - accurate data on the target company won’t be readily available. Everything from obtaining historical financial performance and tax returns to outstanding legal cases and contract provisions becomes more difficult as a result. As a result, acquiring this data is often significantly more expensive and time-consuming.

While managers can gain informal knowledge on domestic targets by virtue of being in relatively close proximity, this isn’t an option when the target is in a completely separate jurisdiction. Complete background checks on each of the target’s shareholders and managers are required so that buyers know who they’re buying into as much as what they’re buying into.

The political and regulatory environment

Where’s a tendency to think that political uncertainty exists only in emerging markets, US firms which have been present in the UK since its decision to leave the European Union in June 2016 would probably beg to differ. In less than two years, cross-border transaction volumes in the UK dropped to 2010 levels, thought to be as a result of the political and economic uncertainty generated by Brexit.

The regulatory environment is arguably even more important than the political. For example, calculating the achievable synergies of cutting staff at the target company can only be done by having a solid knowledge of its country’s employment regulations. The employment laws in Europe for example, where unions have a powerful voice, make staff cuts much more expensive than elsewhere, sometimes making large layoffs financially infeasible.

In fact, there are dozens of regulations that need to be understood in full before a transaction should be considered. When creating a checklist of questions, managers at acquiring companies should be asking: Which jurisdiction takes precedence?; How doe the tax code differ to our home country?; and, what are our pensions liabilities if we acquire this company?

Communication trumps cultural differences
Communication is less a factor of due diligence, and more related to the successful integration of the target company into the acquiring company’s operations. Enough has been written about the cultural gap between firms involved in cross-border transactions to fill the Library of Congress, but essentially the majority can be summarized as failures of communication.

Communication doesn’t mean bombarding the newly acquired employees with the company message. Primarily it means asking questions through meetings, workshops and in the case of larger acquisitions, surveys. Establishing open communications will reduce the likelihood of encountering the cultural difficulties for which cross-border transactions are notorious.

Summary

At a time when domestic growth in some industries is sluggish, cross-border diversification can provide a welcome new source of revenue. Growth in the long-tail of cross-border M&A transactions shows that this realm is no longer confined to large corporations and billion-dollar deals: SMEs are also increasingly looking to reap the benefits of globalization.

Acquiring a foreign entity is not a decision that should be taken without proper consideration. Many of the challenges that arise in acquiring a firm in the domestic market are amplified when acquiring abroad. Being cognizant of this is key to overcoming those challenges, and ultimately, to ensure a successful cross-border acquisition.