MBA 101- Basics of Synergy in a M&A Transaction
By Paul Chameli,
The increased prominence of Private Equity investors and their valuation approach has created a simplified approach to business valuation in the marketplace. Once extensively grounded in a detailed consideration of discount rates, future assumptions about cash flow projections, and appropriate assumptions regarding terminal values, conventional valuation tends to be more focused on valuation multiples of EBITDA (Earnings Before Interest Taxes Depreciation and Amortization). While perhaps adopting this approach to valuation is better for purposes of efficiency, this mindset has the effect of causing sellers and even their investment bankers to take their eye off a critical element of financial theory that can have significant impact to valuation – synergy opportunity. When synergy opportunities exist for a strategic buyer of a Target – or a financial investor that has an existing portfolio company for which the Target can be affixed – the Target has higher intrinsic value to the strategic buyer. As a result, the strategic buyer can in theory pay more to acquire the Target since the benefits are higher than the reported earnings of the Target.
Considering this clear benefit, Sellers and their investment bankers should focus on developing a synergy hypothesis that can be communicated to potential buyers and financial investors. While sophisticated buyers and investors are acutely aware of, and actively seek out these synergy opportunities when pursuing targets, demonstrating to the buyer universe that the Seller is aware of synergy potential will establish the expectation that the benefits of these synergies be inherent in the valuation of the Company.
This write-up is a refresher on common categories of synergy that are available to, and form the basis of, M&A motivation and value creation.
The most common synergy opportunity sought by strategic buyers in an M&A transaction is the opportunity for cross-selling. This is a generally well-understood synergy opportunity, but not one as often communicated by Sellers to Buyer candidates. Cross-selling is, as the name implies, the ability to sell the Buyer’s product to the Target’s customer and vice versa. A strategic buyer will often consider if there are “bundling” opportunities, or the ability to package up multiple logically adjacent products in one package and as a result offer a value proposition to the customer in terms of overall value and perhaps better pricing.
Another common associated synergy with cross-selling is the ability for a sales person with a customer relationship to manage a greater number of products with that one particular customer. So, for example, a pharmaceutical salesman for Pfizer visits a Doctor to present product. As that salesman is walking out the door, a salesman for Merck Pharmaceutical walks in to see the same Doctor. If Pfizer and Merck were to combine, the first salesman could in theory handle both product lines and either rationalize or repurpose the other salesman.
Related to the above, but a big enough consideration to warrant its own category, is synergy achieved by localized presence. Because or cultural differences and customs, it may be difficult for an American company to sell product into Germany, or vice versa, without a local on the ground to “vouch” for the foreign company. Because customers tend to buy product from local country personnel, the acquisition of a Target with established local distribution and a local brand is viewed as an opportunity to achieve sales that the Company would not otherwise achieve without the local presence.
New Distribution Channels
Further related to cross-selling is the opportunity for a Buyer or Target to achieve access to a new distribution channel through a combination. Often employed by consumer oriented industries but increasingly employed in other sectors, this motivation gives the Buyer or Target another medium for which to sell product. For example, a brick and mortar retailer that acquires a company focused on e-commerce, or vice versa, has the clear motivation to capitalize on multiple forms of purchasing behavior. In the industrial application, a combination may give one company that has exclusively sold through independent sales representatives (“ISR”) access to a catalog or network of stocking distributors to sell their product, while at the same time allowing the Buyer to access new channels themselves through the ISR network of the Target.
Operational Cost Savings
A significant driver of M&A in the 1980’s, due in large part to bloated middle management ranks, the idea of synergy from significant operational cost savings has largely dissipated in recent decades. Some of this is the result of the fact that many companies operate much leaner than they did in the 1980’s, the fact that technology has already created a lot of those savings, but also because M&A strategists have learned their lesson from the disasters of 1980’s combinations. In those days, large holding companies attempted to overlay a common operational infrastructure over a number of companies, many of them in unrelated industries. Remember Beatrice? Companies like this would establish a common platform for all of its companies, including accounting, customer service, purchasing, etc. This didn’t work as well once business managers learned that operational functionality needs to be tailored for the uniqueness of a business. Most strategic buyers nowadays acknowledge that the operational back office gives the organization a solid backbone for success and that it has to be tailored.
With all of that being said, there are operational cost savings that are commonly sought by strategic buyers – but these are smart strategies that don’t disrupt the operational fabric of the Company. We most typically see strategic buyers attempt to reduce costs through greater purchasing power with vendors or suppliers. Insurance and raw material purchase savings, for example, are achievable when buying in bigger volumes.
While offshoring to a low-cost country (“LCC”) has been over the past 20 years the biggest operational synergy, a focus on domestic manufacturing in recent years has created a series of new and interesting synergy opportunities, including commercialization of new technologies, domestic production capabilities, ability to capitalize on Buy America credits, and ability to capitalize on excess capacity.
A benefit possessed by a smaller and more nimble organization is its ability to quickly evaluate, commercialize, and integrate new emerging technology into its organization. While larger strategic buyers certainly have the resources to acquire these sort of technologies, they are often not as agile in their integration. For this reason, we often see the expertise in these new technologies as a compelling synergy opportunity for strategic buyers.
While facility consolidation had been a common synergy opportunity, in this environment of limited production assets in the United States we see more often that strategic buyers seek opportunities to push more production into acquired facilities. Or often a strategic buyer who has a history of outsourcing non-core production will seek to preserve the margin loss by moving the production to the acquired Target. While vertical integration has questionable merit in most industries, it can be a synergy benefit that otherwise justifies an acquisition or can enable for higher pricing.
While the benefits of this have been debated for many years, vertical integration is a possible synergy category for strategic buyers. Vertical integration, owning either a supplier or a customer, is generally an attractive investment for operations managers who worry about managing the cost of their production supply or want to ensure that they don’t lose a customer. While that seems like a great rationale from an operations strategy, the availability of benefits from a financial perspective are generally absent so long as there is an ability to continue to do business with the customer or supplier. If a company can continue to sell product to a customer, what benefit is there to owning the customer – the only benefit is to prevent a competitor from selling to the customer. In that case, however, the company can simply lower its pricing to stave off the competitor. For these reasons, vertical integration is less common in most industries. That being said, there are certain industries for which vertical integration is deemed to be an attractive synergy from a strategic perspective. For example, controlling the only supplier of a required production technique or product can put a company in an advantageous position relative to its competitors. Or in the case of a foreign company that wants to do business in a country but needs local content (for example, to be compliant with “Buy America” provisions), the acquisition of a customer can have clear benefits that would be otherwise unachievable.
The benefits associated with synergy analysis and presentation are clearly valuable. In a recent example monitored by EdgePoint, Wabtec (NYSE:WAB) has proposed to acquire GE Transportation Systems for 13.5x the reported TTM EBITDA of GE Transportation Systems. This value was in excess of the multiple for which Wabtec was trading at that time, and from an objective standard a high value for a cyclical business. However, after taking into account all of the cross-selling and operational synergies, Wabtec calculated the synergy-adjusted multiple to be 9.5x and was able to justify the high purchase price as a result. In essence, the synergy opportunity translated into higher value for the shareholders of GE Transportation Systems.
In a transaction recently managed by EdgePoint, the presentation of synergy opportunities to the buyer universe significantly increased the valuation multiple. The Target, broke financial covenants on its loans and was pressured by their lender to liquidate or monetize the investment. Conventional multiples for companies such as the Target were approximately 6.0x EBITDA at that time, which would have resulted in a valuation that just barely covered the debt balance (wiping out all shareholder investment). The presentation of the above synergy opportunities and contribution margin to a strategic buyer, as well as the competitive process managed by EdgePoint, drove valuation multiples to a level almost twice that amount.
Considering the clear motivation, Sellers with a mind on highest value for their Company should prepare themselves and their investment banker for synergistic pricing by accumulating and documenting the synergy opportunities with potential strategic buyers and be ready to present those ideas as part of the sale process.