It's well known that when companies merge, most of the shareholder value created is likely to go not to the buyer but to the seller. Our extensive experience and ongoing research show that the major cause of this "winner's curse" is the tendency among buyers to materially overestimate the synergies a merger will yield.
We have identified six measures buyers can take to improve their chances. The research _ and measures one through four _ were detailed yesterday in part one of this article. Today we look at measures five and six, and advice on managing the dealmaking process.
5. While managers in about 60% of mergers deliver the planned cost synergies, in about one-quarter of all cases they are overestimated by at least 25%, a miscalculation that can translate into a 5-10% valuation error. As with one-time costs, a firm risks overestimating synergies if it fails to use the available benchmarks as a sanity check.
One European industrial company that acquired another firm, planned for cost savings of 110 million euros from selling, general, and administrative expenses, even though precedents suggested that a range of 25-90 million euros was more realistic. Furthermore, the company neglected to conduct a bottom-up analysis to justify it.
6. Deal teams often make simplistic and optimistic assumptions about how long it will take to capture synergies and how sustainable they will be. As a result, important deal metrics, such as near-term earnings and cash-flow accretion, can end up looking better than they deserve, which leads companies to overestimate the net present value of synergies substantially.
Moreover, many savings, while real, are not perpetual and must be phased out. Often, for example, companies plan to reduce their operating costs by squeezing production capacity and logistics across the merged organisation. But if each merging company is growing quickly in its own right, sloppy incremental analysis might attribute to the merger certain benefits that would have been realised anyway by the companies.
One of our medical-product clients, which had been growing by 10-15% a year, forecast that without a merger it would be using the full capacity of its own plants within three to four years. At that pace, much of the money saved by closing or streamlining plants in the context of a proposed merger couldn't really be expected to last very long, because closed facilities would soon have to be reopened. In general, we believe it is overly optimistic to include the full amount of targeted annual synergies in the "continuing-value" calculation of a net-present-value model.
The problem isn't just properly translating the timing of synergies into present values: bad timing can prevent synergies from occurring at all. Persistent management attention is needed to capture them. We have found evidence that unless synergies are realised within, say, the first full budget year after consolidation, they might be overtaken by subsequent events and wholly fail to materialise. As well, synergies tend to be captured more quickly and efficiently when a transaction closes at the start of the merging companies' annual operational planning and budgeting process.
The companies we studied used various ways to improve their synergy estimates. Involving line managers in problem solving and due diligence improves the quality of estimates and also builds support for post-merger integration initiatives. Synergy analysis also illuminates issues that will shape due diligence, the structure of deals and the negotiations that lead up to them.
One of our clients had its head of operations take the lead in estimating the savings from rationalising manufacturing capacity, distribution networks and suppliers. His knowledge of the unusual manufacturing requirements of a key product line and of looming investment needs at the acquirer's main plant helped improve the estimates. He also learned from a due-diligence interview with the head of operations at the target that it had recently renegotiated its supply contracts and had yet to implement an enterprise resource planning (ERP) system, both facts that made it possible to refine synergy estimates.
All of this helped his employer (the buyer) and ensured that he was prepared to act quickly and decisively to realise savings once the deal closed.
Internal M&A teams should do more to codify and improve their synergy-estimation techniques. Every deal represents a valuable lesson, and some specific procedures make a difference. They include holding a formal post-integration debriefing with the integration and M&A teams (which ideally should overlap), requiring future M&A and integration leaders to review the results of past deals, tracking synergies against the plan for two years, and calculating what the net present value of a transaction turned out to be.
Having said all this, we must sound a note of caution. Companies shouldn't overstate what can really be learned from experience, since not all deals are alike. However, companies with access to reliable data can develop sound benchmarks for estimating realistic synergies and finding insights into the sources and patterns of error in estimating them.
A more comprehensive database would help to resolve other strategic issues _ for instance, whether some synergies are consistently embedded in the acquisition premium paid while others are captured by the acquirer, and whether the stimulating effect of a transaction is necessary to improve the acquirer's stand-alone performance. The answers to the first question will inform price-setting and negotiation strategies; those to the second could lead companies to consider tactics other than acquisitions to raise their performance.
- Scott Christofferson is a consultant and Rob McNish is a principal in McKinsey's Washington, DC office; Diane Sias is a principal in the New Jersey office. A version of this article appeared in 'McKinsey on Finance', Winter 2004, pp. 1-6. 2004 McKinsey & Company. All rights reserved. Additional articles can be found at www.bangkokpost.com/mckinsey/
