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Understanding Synergy in Mergers and Acquisition

Mergers and Acquisition (M&A) is one of subject areas in ACCA Advanced Financial Management (AFM) exam. Many academic studies showed the intention of an M&A deal is come from the belief of synergy arisen from it.

From the real world, it wouldn’t be unfair to assume that the mergers and acquisitions have been on a rise with an exceptional growth of capitalism. We’ve seen the world’s largest mergers and acquisitions in the last two decades.

When one entity acquires a majority shareholder in another, it is called an acquisition. Joining of two “equal” entities is termed a merger. In the practical world though, acquisitions are also often painted as a merger of two equals.

Synergy in Mergers and Acquisitions

The prime reason for the mergers and acquisitions is business growth. That growth can be achieved in different ways of business operations, and it can be summed up with a single word known as synergy.

“When two or more entities join hands to achieve growth results that individually could not be achieved is called synergy”

In terms of market value, let’s say two entities X and Y join to form Z, then

Market value of Z > Market value of X + Market Value of Y

If the combined effect, let’s say, the new market value of the joint business is the same as the sum of the two individual businesses, then there exists no synergy. Synergy effects can be evaluated in true terms if we know the types of mergers and acquisitions.

Depending on the nature of the merger or acquisition, we can then identify the reasons behind the move and whether the purpose has been achieved or not. In a practical world, three types of businesses can come together to form a new entity through a merger or acquisition:

  • Horizontal Integration: It happens when two entities in the same line of businesses combine. For example, Cisco’s acquisition of Broadsoft

  • Vertical Integration: It results when an entity acquires or merges with a business in the same line of business but at a different level. E.g. H.J. Heinz and Kraft Foods Merger

  • Conglomerate: when two entities in different business areas join together.

If two unrelated businesses are joining hands then the synergy effects will be different from those in a horizontal merger. Businesses join together for different reasons, business competition being the prime driver behind such moves.

Along with the different types of mergers, the motive behind the move can help understand the synergy effects. Some of the most common reasons for M&A’s are:

  • The Increased Market share that means more business power and control

  • Economies of Scale

  • Technological needs e.g. Cisco investing in Broadsoft

  • Acquiring a new customer database

  • Opportunities for Big Data, e.g. Facebook’s acquisition of Whatsapp

In the modern business world where technology is dominating any business form, the reasons such as technological acquisition, reach to big data and reducing competition are more common than the others.

Many merger and acquisition attempts face regulatory authorities questioning though. Authorities for business competition and monopoly watch have increasingly become tougher on attempts to reduce market competition. However, any reason or motive behind a merger would want business growth through synergy effects.

Importantly, synergy effects cannot be achieved automatically. It requires substantial efforts and planning to achieve shared goals. In fact, the biggest challenge becomes achieving synergy through combined efforts.

Types of Synergy

Businesses aim to achieve combined or synergy advantages in several ways, such as gaining access to valuable customer data, increased market share, and so on. We can categorize these synergy effects into three broad categories.

1. Cost Synergy

2. Revenue Synergy and

3. Financial Synergy

Cost Synergy

Perhaps the biggest contributor to achieving synergy is reduction in the costs from joint operations. Tech-based modern firms are spending their largest portion of revenues on research and development. A merger like vertical integration can save a lot of money for both entities joining hands.

For example, Cisco invested in Broadsoft for their cloud technologies. Facebook wanted to improve their messaging technologies through integration with Whatsapp.

Corporate tax relief is another cost driver that often attracts acquisitions and mergers. With two international entities joining, the double taxation treaties become the deciding factor on where to pay the group taxes.

Large corporations have often been accused of using this trick to avoid heavy amounts of corporate taxes. All modern tech giants have been using this method to avoid taxes in low tax rate countries.

For example, Google has been avoiding high corporate taxes in the UK by repatriating profits through a subsidiary in Ireland.

Economies of scales through combined operations and reduced operating costs also play a big role in cost reductions. Operating inefficiencies cause a higher cost of production that result in low competitive prices. Complimenting resources create efficient process from procurement to production and supply chain management. Similar operating facilities can save costs of production or can be used to increase market share.

For example, H. J. Heinz invested in Kraft foods, Exxon and Mobile merger, the two industry leaders joining.

Both horizontal and vertical integrations often result in employee layoffs. That is perhaps the only cost reduction driver which is often considered negative. Conversely, experienced management in one entity can offer valuable expertise to another. Human capital after all is the most precious asset on any firm’s balance sheet. Cost reductions in a newly merged entity can also be acquired through reducing costs in marketing, finances, and asset management.

Revenue Synergy

If the merger or acquisition remains successful, revenue synergy can be achieved in all form of M&A’s that we listed above. Increased market share and access to a larger customer base result in larger revenue streams.

Conglomerate mergers are more likely to see the revenue synergy then Horizontal and vertical integrations. A diversified portfolio of products, with enhanced economies of scale, efficient production, and a larger brand label is more likely to attract more revenue than individual entities.

Both Vertical and horizontal integrations offer critical challenges to reap the revenue synergy rewards. Cost reduction actions can be decided in short time e.g. employee layoff, but increased revenue generation requires time.

Both cost and revenue synergy resources often overlap, however, the implementation of plans is substantially different. The new management needs to consider critical factors to harness full revenue synergy rewards:

Cross Selling: Perhaps the first strategy to decide on which main products to keep for the new brand for the combines existing customer base. This decision also includes the decision of supplementary or by-products and co-branding decisions.

Geographical Expansions: This plan would require decisions on entry to the new markets often new international markets. Decisions on salesforce, local suppliers, and product pricing decisions in the new geographical locations.

Product Portfolio: This strategic decision will involve critical planning around co-branding, selection of product portfolio to sell, and rebranding policies. Conglomerates often keep selling diversified products, as that is their prime objective of a merger or acquisition. The decision becomes trickier with vertical integrations faced with a choice of similar products and branding options.

Optimized sales force and marketing plans, clear objectives on new products or existing portfolio selection, and revenue management can help achieve the desired goals.

Financial Synergy

Financial synergy effects from any merger or acquisition would depend on the success of the whole plan. Combining financial resources would merely gain any financial advantages.

These effects start from purchase offers of the merger or acquisition. Sources of financing supporting the merger or acquisition, available combined cash balances, and leverage of the entities all impact the financial synergy.

Financial synergy in the longer-term would depend on the success of cost and revenue synergies. If the strategic plans for cost reductions, operational efficiencies, market expansion, branding, and revenue management are successful then new company’s stocks are sure to rise. Some of the key financial advantages with a merger and acquisition include:

  • Leverage: Businesses fund their projects with heavy borrowings from banks, which affect their leverage ratios. Combined cash balances and debt ratios can improve the combined leverage that can enable access to new financing options.

  • The Bootstrap Effect: When an entity with a higher Price to Earnings ratio acquires one with a lower P/E ratio the combined P/E ratio goes up. The acquiring entity can increase its overall value through this tactic known as bootstrapping.

  • Share Prices: successful mergers and acquisitions are a sure hit in stock markets. Positive market signals from a successful merger would increase the share prices of the new entity. A combined increased Goodwill on the balance sheet will also play an important role in increased share prices.

  • Surplus Cash: Two large entities with adequate cash balances combining will surely result in surplus cash balances. That can help the new entity fund new projects, dividends, or pay off bank debts.

Mergers and acquisitions require careful planning and even more efforts to implement the plan. Change management with newly combined resources cannot be achieved overnight.

Real World Example

Facebook acquired the text messaging app Whatsapp for a staggering amount of $ 21.8 billion. At that time Whatsapp reported a net loss of $ 230 million. Facebook was eyeing the large mobile user base of Whatsapp, which makes it a classic example of vertical integration.

Ever since the merger, the social media giant Facebook has enjoyed increased share price values, increased market share, increased customer base, and technological gains. One of the prime reasons behind the merger was acquiring Whatsapp messaging in mobile system which was the underdeveloped area in Facebook business. Facebook acquisition of the loss-making Whatsapp is one of the finest examples of achieving synergy effects that alone for each entity would not have been possible.

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