Sources of Operating Synergy
Operating synergies are those synergies that allow firms to increase their operating income, increase growth or both. We would categorize operating synergies into four types:
- Economies of scale that may arise from the merger, allowing the combined firm to become more cost-efficient and profitable.
- Greater pricing power from reduced competition and higher market share, which should result in higher margins and operating income.
- Combination of different functional strengths, as would be the case when a firm with strong marketing skills acquires a firm with a good product line
- Higher growth in new or existing markets, arising from the combination of the two firms. This would be case when a US consumer products firm acquires an emerging market firm, with an established distribution network and brand name recognition, and uses these strengths to increase sales of its products.
Operating synergies can affect margins and growth, and through these the value of the firms involved in the merger or acquisition.
Sources of Financial Synergy
With financial synergies, the payoff can take the form of either higher cash flows or a lower cost of capital (discount rate). Included are the following:
- A combination of a firm with excess cash, or cash slack, (and limited project opportunities) and a firm with high-return projects (and limited cash) can yield a payoff in terms of higher value for the combined firm. The increase in value comes from the projects that were taken with the excess cash that otherwise would not have been taken. This synergy is likely to show up most often when large firms acquire smaller firms, or when publicly traded firms acquire private businesses.
- Debt capacity can increase, because when two firms combine, their earnings and cash flows may become more stable and predictable. This, in turn, allows them to borrow more than they could have as individual entities, which creates a tax benefit for the combined firm. This tax benefit can either be shown as higher cash flows, or take the form of a lower cost of capital for the combined firm.
- Tax benefits can arise either from the acquisition taking advantage of tax laws or from the use of net operating losses to shelter income. Thus, a profitable firm that acquires a money-losing firm may be able to use the net operating losses of the latter to reduce its tax burden. Alternatively, a firm that is able to increase its depreciation charges after an acquisition will save in taxes, and increase its value.
Clearly, there is potential for synergy in many mergers. The more important issues are whether that synergy can be valued and, if so, how to value it.
Empirical Evidence on Synergy
Synergy is a stated motive in many mergers and acquisitions. Bhide (1993) examined the motives behind 77 acquisitions in 1985 and 1986, and reported that operating synergy was the primary motive in one-third of these takeovers. A number of studies examine whether synergy exists and, if it does, how much it is worth. If synergy is perceived to exist in a takeover, the value of the combined firm should be greater than the sum of the values of the bidding and target firms, operating independently.
V(AB) > V(A) + V(B)
V(AB) = Value of a firm created by combining A and B (Synergy)
V(A) = Value of firm A, operating independently
V(B) = Value of firm B, operating independently
Studies of stock returns around merger announcements generally conclude that the value of the combined firm does increase in most takeovers and that the increase is significant. Bradley, Desai, and Kim (1988) examined a sample of 236 inter-firms tender offers between 1963 and 1984 and reported that the combined value of the target and bidder firms increased 7.48% ($117 million in 1984 dollars), on average, on the announcement of the merger.
This result has to be interpreted with caution, however, since the increase in the value of the combined firm after a merger is also consistent with a number of other hypotheses explaining acquisitions, including under valuation and a change in corporate control. It is thus a weak test of the synergy hypothesis. The existence of synergy generally implies that the combined firm will become more profitable or grow at a faster rate after the merger than will the firms operating separately. A stronger test of synergy is to evaluate whether merged firms improve their performance (profitability and growth) relative to their competitors, after takeovers. On this test, as we show later in this chapter, many mergers fail.