Synergy Trap In Mergers And Acquisitions
With interest rates rising to counter growing inflation and economies in developed countries (the US and Europe) moving to a slowdown/recession, how will the volume of M&A deals get affected? To understand how well the M&A activity evolves forward, let us review the economics of M&A decisions and how the last M&A wave post-COVID worked. Then, in this post, i provide insights on the performance of the recent M&A transactions and a framework that will help shareholders and the board spot bad deals after the announcement.
M&A deals From 2020 to 2022
When i analyzed 250 global M&A transactions (a small sample size) closed after COVID and before the Russian invasion of Ukraine, i got the following results:
- Acquirers underperform their industry peers, with the acquirer stock prices declining on the announcement. Tech giants, including Microsoft and Amazon, who made multi-million dollar acquisitions, witnessed a share price decline in the last 12 months.
- Price matters — Acquirers who paid a higher premium underperformed relative to buyers who paid a lower premium.
- Cash deals performed better than stock deals, primarily when the buyer stock prices declined in the last 12 months. The reason is that stock deals result in higher dilution for the existing shareholders. In addition, because the stock markets were in a bubble in 2021, many buyers paid through stocks because they were overpriced and were ready to pay a higher premium to buy the target.
- Sellers continue to be the beneficiaries of the M&A deal, with their share prices rising post-deal announcement. For instance, when Adani group announced the acquisition of NDTV, the NDTV share price increased from Rs.160 at the end of July to Rs.550 in September. The same happened to Twitter stock when Musk announced his intention to buy the company.
In my view, the buyer’s share price declines during the deal announcement because the shareholders are not confident that the buyer can manage the target business and achieve the synergies required to justify the premium paid. Therefore, the higher the premium paid, the higher the decline in share price at the deal announcement. The main reason behind this decline is that in M&A, the buyer pays the consideration, including the premium for synergies upfront, in contrast to investments in R&D, made in stages. Thus, when the deal closes, the buyer is under pressure to deliver returns on the deal. So when there are delays in realizing synergies, it hurts the deal’s expected NPV.
Synergies Are Not Free
When a buyer acquires a target, ~60% of the target’s value is on its future performance, and the remaining 40% is on improving its current operating performance through cutting costs and improving productivity. Thus, when the buyer pays a premium for synergies, the buyer has to beat the target’s base case. We can calculate the premium at risk by calculating the Shareholder value at risk.
Shareholder Value at risk (SVAR) = premium paid for the acquisition/Market value of the buyer before deal announcement.
SVAR measures the buyer’s value at risk when the buyer does not realize any synergies after the deal closing.
SVAR = Premium (%)*(Value of seller/Value of Buyer)
In the above table, I calculate the buyer’s SVAR for an all-cash deal where the SVAR varies with the deal value and the premium. The greater the premium and the greater the deal size, the greater the SVAR, implying that a higher value is at risk. In cash deals, the buyer shareholders take the entire risk for synergies realization, whereas in stock deals, the buyer and the seller share the risk on synergies.
The stock deals present risk sharing but also pose an asymmetric information problem. According to the target, the buyer issues stocks because it is overvalued and wants to share synergies risk because it is not confident in delivering them. Thus, the buyer is not confident in the deal, thus paying by stock. However, cash deals, either through internal accruals/raising debt, signals buyer confidence in the deal.
Synergies — Cost/Revenues synergies do not come for free and have a financial cost. Thus, when we value synergies, we need to account for the timing and amount of synergies realized along with the incremental expenses required to deliver the synergies. For instance, the buyer values the target and then decides it has to lay off 10% of the target’s workforce to deliver on the cost synergies. If the buyer pays the severance costs after the deal closes, it disrupts the integration resulting in unanticipated shareholder losses. The better alternative is to restructure the target before closing, and the buyer shares these severance costs with the target.
Acquisitions succeed for the buyer when it brings the buyer a competitive advantage. If competitors can replicate the buyer’s benefits from the deal, then the deal should not command a premium. Further, there is a higher risk of competition poaching the target’s best employees during the integration resulting in the delay of synergies realization. Though it has become fashionable to blame deal failures due to cultural clashes, as the buyer has to pay most of the deal value upfront, it should have assessed the effectiveness of integration before signing the deal.
Revenue And Cost Synergies To Justify The Premium
Despite the shortcomings of using EPS accretion/dilution as a metric to justify the deal, many buyers continue to use EPS accretion/dilution as a yardstick to measure the deal’s success. When a buyer with a higher P/E acquires a target with a lower P/E, the deal is accretive irrespective of the deal value. Thus, the better way for the board to justify a deal is to build an earnings model that yields a combination of cost reduction and revenue enhancements that justify the premium paid. Though this model is not a substitute for a DCF valuation, it can help the board to avoid mistakes when evaluating transactions.
To develop the earnings model, let us assume the following:
Target Value before deal announcement = 100
Target earnings = 10
Target P/E = 100/10 = 10
The buyer pays a 10% premium to acquire the target.
Premium paid = 10%*100 = 10
We can rewrite this equation as:
%Premium * Target Value = (%Premium * Target earnings) * (Target P/E) = (10%*10)*10
The equation implies that for the buyer to realize synergies to justify the premium, the target’s earnings need to increase by the premium percentage while the target’s P/E remains unchanged.
The buyer can realize synergies through cost reduction and revenue enhancement.
If the buyer intends to realize synergies through cost reductions,
%Cost synergies = Improvement in pre-tax target earnings/Target Operating cost base
If the target has 10% EBIT and revenues = 100,
%Cost Synergies = 10%*(100*10%)/100*(1–10%) = 10%*(10%/(1–10%)) = 1%
Thus, the buyer needs to achieve a 1% reduction in the target’s operating costs to improve the target’s EBIT, which will justify the premium paid. This cost reduction has to come at the top of the pro-form cost reduction that the target company prepared on its stand-alone business plan.
For a target company with higher EBIT, cost synergies imply higher cost reduction, which is not feasible as the target firm has a lower cost base. Therefore, in such a scenario, cost synergies alone do not justify a higher premium and should incorporate revenue enhancements.
In this case,
%Cost synergies = EBIT%/(1-EBIT%)*(%Premium — %Revenues Synergies)
Buyers can realize cost synergies better than revenue synergies as identifying and eliminating costs like closing down factories and laying off employees is achievable and tangible. Revenue synergies depend on competitive and customer reactions outside the buyer’s control. Generally, buyers look to achieve cost synergies before targeting revenue synergies. This delay in capturing revenue synergies helps competitors protect their clients and attack the buyer’s client base.
Framework For Evaluating Cost/Revenue Synergies
A deal is successful when a proposed combination of cost and revenue synergies exceeds the deal premium.
We characterize acquisitions as:
- The buyer acquires a target with similar capabilities (R&D, Cost structure) and similar market access (Brand, sales force).
- The buyer acquires a target with better capabilities/market access than a target.
- The buyer acquires a target that gives it access to new capabilities/market access.
Point 1 is Scale deals yield better efficiency and give buyers a higher market share. In these deals, the buyer pays the premium for cost synergies.
Point 2 is scope deals where the buyer pays a premium to deliver a combination of cost and revenue synergies.
Point 3 is transformational deals, where buyers pay a premium for revenue synergies.
Any M&A deal should fall under a combination of the above three scenarios.
A buyer acquiring a business with different capabilities/market access cannot claim to realize cost synergies to justify the premium when the additional value comes from revenue enhancements through cost-selling.
In this post, I have tried to capture a framework that helps the buyer’s management and board to evaluate a deal and the premium paid. For any M&A deal, the key question for the buyer is, “How will this deal affect its stock price.”
The business case and valuation model should clearly explain why the newly merged business will result in higher value than when operating independently and how the competitors cannot easily replicate the buyer’s benefits from this deal. In addition, the operating model must reflect the changes the buyer/target needs to make in their leadership, key contracts and the org structure so that employees can achieve the objectives of the business case.