The Basics:

  • Synergies: the concept
  • Types of synergies
  • A less attractive reality

Before venturing a little deeper into the concept of synergies, it is important to review some basic concepts and mechanisms in market and corporate finance. As the term synergies is closely linked to M&A transactions, let's start with a few reminders about external growth.

1+1 = 3

Just as the objective of a company - from a purely financial point of view - is to maximize the market value of its equity capital in the long term, a growth transaction is not only a way to increase the value of the company's assets, but also to increase the value of its liabilities. In a purely financial - and not industrial - logic, an external growth operation can only be justified if there is a creation of value for the shareholders of the acquiring company. Thus, any complete or partial takeover of a company must be done at a cost - WACC* - lower than the expected returns - CROIC**. Otherwise, there would be a destruction of value. Of course, this is complex to analyze since some exercises can be value-destroying when the following ones compensate for the destruction until value is created. Another way of looking at it - and a little simpler - is to imagine that the cumulative TSR of the acquiring and acquired companies - in case of a merger or acquisition - would be higher than the TSR of the two entities if no operations had taken place. In other words, the objective is to arrive at a result of the type: 1+1=3

In a more academic way, this gives: V(A+B) > V(A) + V(B)

Or V(X) means Value of the company X

This translates then either into an increase in Free Cash Flow : FCF(A+B) > FCF(A) + FCF(B)

*With a similar gearing and beta all else being equal

So, not a change in the gearing - capital structure - of the company, leading to a decrease in the cost of capital - decrease in WACC. This decrease in the WACC is then synonymous with a lower discount rate and therefore with immediate value creation.

*With a similar cumulative FCF, all other things being equal

In summary, an increase in FCF (increase in CROIC) and a change in gearing (decrease in WACC) are the two factors that create value in an external growth operation. We find again the two parts of our Fair Value formula (WACC = CROIC)

The objective is therefore simple. The practice is a little less simple... There is a real asymmetry of information in such operations, but also natural divergences with regard to the terms of the operation. The target company's goal is to sell itself for the highest possible price, while the acquiring company's goal is to buy for the lowest possible price. A divergence on the price, sometimes on the financing and rarely on other terms therefore takes place, as in any sale. Basically, the objective of both companies remains the same: to close the deal - i.e. to find an agreement at an interesting price for both parties. Otherwise, no deal will take place. However, in the case of the sale of a company, there is a strong asymmetry of information between the buyer and the seller. In particular with regard to the financial and operational performance of the target company. This explains why about 25% of external growth operations are aborted each year.

Aside from that, if we go back to our previous formula, V(A+B) > V(A) + V(B), that we consider that V(A) trades at fair value and that V(B) was acquired at fair value - i.e. WACC=CROIC -, our formula implies that there is a world in which A+B would be better performing than A and B operating independently. 

This can be explained by several factors, such as better management on the part of A (the acquiring company), access to new markets, but also by the existence of these famous synergies. This assumption about the acquisition of a target at its fair price may seem pessimistic, but considering the strong information asymmetry and the lack of financial logic that sometimes exists in this type of operation, a company is rarely sold below its fair price. If transactions that make no financial sense or are too risky were not to take place, I think it would be easy to double the number of aborted transactions. If you want to learn more about these subjects, I invite you to read: Rothschild, a bank in power - Chapter 13 or read about the takeover of DFS Group by LVMH.

Synergies:

There is synergy if FCF(A+B) > FCF(A) + FCF(B)

In other words: Sy = FCF(A and C) - FCF(A) - FCF(B)

Synergies are therefore the source of a marginal FCF generated by the takeover of the target. This leads to a comparison between the observed reality (cumulative FCF) and an estimate (what the individual FCF would have been without the transaction). In the case of a merger, there is an operational and legal merger, so the synergies are easier to generate, very strong and fairly rapid. In the case of an acquisition, where each company remains autonomous, synergies are complex to generate and sometimes require the use of ad hoc structures, such as Shared Services Centers (SSC).

Types of synergies:

There are three main types of synergies: revenue, cost and financial synergies.

  • Revenue synergies, Sy (Rev), correspond to an increase in cumulative revenues:

Revenues(A and B) > Revenues(A) + Revenues(B)

They have several origins such as the increase in sales volumes, range effects, or effects on prices (pricing power, competition effect...). In practice, the effects of synergies on revenues are very limited, observed after a certain period of time and obtained after a reorganization that generates costs.

  • Cost synergies, Sy (Cost), correspond to a reduction in costs linked to the operation:

Costs(A and B) < Costs(A) + Costs(B)

This type of synergy is relatively mechanical and plannable: vertical integration savings, elimination of duplication (single headquarters and support function), elimination of inefficient managers, redeployment of R&D, reduction in the number ofThese cost synergies are relatively mechanical and plannable: vertical integration savings, elimination of duplication (single headquarters and support function), elimination of inefficient managers, redeployment of R&D, reduction of overstaffing, etc. The savings can be achieved quickly but require prior restructuring. These cost synergies are actually divided into two: 1) economies of scale 2) economies of scope.

  • Financial synergies, Sy (Fi), correspond to direct financial gains obtained as a result of the operation:

These synergies come from optimizing the group's financial management, renegotiating banking conditions and improving financing conditions. These synergies are not necessarily the easiest to understand for an amateur investor, but they are probably the most tangible, along with the cost synergies.

Synergies are also analyzed in terms of risk. After the operation, the pooling of operations often allows a change in the cost structure. It is possible to achieve a reduction in fixed costs and an increase in margins. In this way, the break even point could be lowered, reducing the operational risk and therefore the Beta of the whole created by the deal (new gearing). The decrease in the economic risk of the group reduces the cost of capital, which leads to an increase in value or allows the absorption of an additional financial risk (linked to a new debt).

The reality of synergies

In practice, synergies are difficult to quantify and are often specific to each deal. Nevertheless, auditors and bankers estimate on average that cost synergies represent 1.2% to 2.4% of cumulative costs and revenue synergies are between 0.5% and 1.5% of cumulative revenues. A statistical method can also be used where an average rate of synergies (as a % of cumulative FCF before the transaction) is obtained by analyzing a benchmark of peers. An empirical approach is also sometimes used. This approach means that the acquirer and the acquired company work together to estimate the amount of expected synergies. This method is time-consuming, laborious and highly uncertain, and is not the most widely applied in practice.

Synergy forecasts must also take into account their progressive release. Indeed, synergies do not appear as soon as the target is acquired. In the investment banking world, when deals are evaluated, a real synergy schedule is set up. It is common for certain synergies to appear only 3 or 4 accounting years after the closing of the deal. This time lag must therefore be taken into account.

  • The run rate: The amount of synergies expected at full speed (100%), i.e. the annual potential of these synergies at cruising speed.
  • The ramp up: The assumption of a gradual increase in synergies to reach the run rate. It is linked to the nature of the combination and the integration plan of the target.

Should synergies be priced?

Finally, there is a last debate related to the pricing of synergies. Every seller wants to sell his asset at the highest possible price, every buyer wants to acquire the same asset at a lower cost. Often, especially since there is a strong asymmetry of information, companies are bought above their fair value. The buyer's objective is therefore to manage the acquired company in such a way that the objectives set by the sellers will be exceeded, thus valuing the company at a higher price than that purchased. In other words, to do better than the sellers hope to do. Obviously, these are not the easiest objectives to achieve, since the business plan of the seller is often already very embellished.

Another way to proceed is for the acquiring company to create numerous synergies, thus transforming a purchase made at the right price into a purchase concluded under the right price. Value will be created even if the acquiring company "only" reproduced the business plan sold by the acquired company.

If the synergies were taken into account in the purchase price, this would give us:

Stand Alone Value of the target

+ Value of the net synergies

+ Premium (expectation of future earnings)

= Transaction Price, projected synergies

And or Stand Alone Value of the target :

Book Value of Equity

+ Valuation Differences (justified)

= Stand Alone Value of the target

+

Acquisition Carrying Amounts (unjustified)(

unjustified as synergies and expectation of future earnings)

= Transaction Price, projected synergies

Rewritten, this gives :

Transaction Price, projected synergies

- Book Value of Equity

- Valuation Differences

= Goodwill

The price paid for the synergies and therefore one of the components of goodwill - as well as the expectation of future earnings normally projected in the business plan - is the price paid for the synergies.

The price paid for synergies and therefore one of the components of goodwill - like the expectation of future gains normally taken into account in the market value of the equity - because they correspond to an expectation of future gains that would be unjustified for the company if it remained isolated - i.e.non-acquired. The objective of the acquiring company is therefore not to pay for the synergies and thus to pay only the Stand Alone value of the target. This is sometimes very complex in practice when faced with a seller who is reluctant to sell his company.

It is for these reasons that we often observe a tendency to overestimate the potential of synergies and underestimate the risk that they will not materialize. The forecasts are optimistic (exaggerated or unrealistic amounts to justify an acquisition price that is too high, ramping up too quickly, insufficient consideration of implementation costs) allowing to justify an acquisition that makes no financial sense - destroying value. However, these value-destroying operations often take place, whether because of the ego of the managers or because of economic interests - for example: higher salary because of a larger post-operation company. Economic interests that a shareholder does not have in this type of operation, which makes sense industrially but not financially. Also certain operations, even if they are not financially meaningful, take place and respond to a strategy of "absorption-spraying" of competitors or "oligopolization" of a sector. These value-destroying operations avoid greater destruction in the long term if nothing is done. When internal growth is no longer sufficient - R&D - and the company enters a phase of maturity or even decline, it may be wise to cut off a hand - or even a finger - to avoid losing an arm... The Adobe - Figma deal can, in my opinion, enter in this category since Adobe paid 20B$ to acquire Figma - 1.21 Figma's TAM*** 2025 (x105 Price-to-Sale 2022). Usually, this type of deal involves drastically smaller amounts, so much so that we rarely hear about it. It is sometimes similar to Venture Capital, which justifies the astronomical amounts paid to buy companies with fragile and uncertain business models - but potentially threatening for the buying companies.

 

*WACC = Weighted Average Cost of Capital

**CROIC = Cash Return On Invested Capital

***TAM = Total Addressable Market