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 guises, including operational, financial, and tax synergies. In most transactions, cost savings can be the most important and easily quantifiable synergies.

The most common are cost synergies as the two sets of resources provide efficiencies when operated as one rather than independent standalone businesses. Furthermore, the realization of sales synergies is also possible. For instance, a well-developed distribution network can be used by the combined entity post-deal and should achieve higher sales figures than on a standalone basis.

The potential synergies can be estimated using a multiple or it can be valued using a DCF approach. This can then be compared to the premium being paid to assess value creation in a deal.

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.

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 paying 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 make 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 risky 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 have to be instigated. Even if 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 synergies’ timing. 

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 is higher than the unaffected share price, indicating the buyers are paying a premium for the synergies.

First, let us 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 to 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.

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. Here, the “run rate” refers to the ongoing annual synergy expectation after incurring M&A integration costs. 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. 

The 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, reducing the premium justifiable to target shareholders. 

Revenue Synergies: revenue synergies imply that the company expects to sell more. However, these 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.