Thursday, July 17, 2014

Valuing Synergies

It has been a banner year for mergers.  Currently, Reynolds American is seeking to acquire Lorillard, Inc.  Comcast and Time Warner are trying to combine.  Meanwhile, Time Warner is rejecting an offer from 21st Century Fox.  And, of course, we've seen a wave of Pharma mergers recently.   As we've mentioned, the maximum premium a bidder should pay for a target is the net present value of the deal. Of course if you pay this amount, you are giving away all your expected value. Bargaining is the key to the division of gains.   But today's post is not on bargaining but on synergies, generally a large component of the NPV and unfortunately, often overestimated.  Because of their importance, we have written frequently about valuing synergies (See, for example, Synergies and Anticipating the Competition).  

There are three basic types of synergies: revenue enhancement, cost reduction and financial synergies.  Revenue enhancement derives from expanded market power, the ability to expand markets, and the ability to increase prices.  Cost reductions come from economies of scale, eliminating duplicative positions, tax reductions and increased power in bargaining for supplies.  Financial synergies are controversial.  In theory, they derive as the new firm is better able to bargain for financing, reducing the cost of capital.  While this is possible, there are many dangers in estimating financial synergies. (See, PE Magic).

Here are just a few of the many things to keep in mind when estimating and valuing synergies:

1) Synergies are often over-estimated.  Ask yourself why these synergies exist and why no one else has exploited them.

2) If there is disagreement among the executive team as to the amount of synergies, consider tying compensation to their realization.  That simple technique can have a sobering impact on the magnitude of estimates.

3) Remember you are not operating in a vacuum.  Consider how the competition will react.  (See Synergies and Anticipating the Competition).

4) Value synergies at a rate commensurate with their risk.  Safer, more certain, synergies can be discounted at a lower rate.

5) Don't forget point (1) or Warren Buffet's parable of unresponsive Toads kissed by managerial princes.  (Acquisition Returns and Unresponsive Toads).

Happy Hunting,


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