Economies of scale have always been at the forefront of the goals of an organization and in today’s cutthroat competition, organizations are going all out to over par competitors. It is not unusual for a company to pursue a merger or acquisition as a growth strategy. Most of the M&A transactions are justified by the value of synergy created. In this article, we will discuss the concept of synergy, benefits, factors affecting pricing with a conclusion that synergy calculated is seldom delivered in acquisition due to lack of planning, lack of management foresight, and the inability to overcome practical challenges. Synergy is the value created after combining two individual entities, which is not possible while operating individually. Two firms can merge to form one company that is capable of being more productive, cost-effective, and is able to eliminate redundant processes than two individual firms working independently. Basically, a firm usually creates synergies in two forms i.e. operating and financial. Operating synergies is an efficiency gain attained through vertical and horizontal mergers. It basically includes both economies of scale and economies of scope. While the financial synergies help in enhancing the financial metrics of the company in need by having better access to capital via merger. As companies always welcome synergies, but there are no free lunches and these benefits do not come without a cost to them. Before getting into any deal transaction, cost and pricing analysis is most critical in the whole process. In simple terms, synergy is the difference in net worth of both firms before and post-merger or we can simply state:
Synergy = NPV of Combined Company + PremiumWhile evaluating the value of synergy, analysts generally focus on the benefits however they tend to ignore the hidden cost and incremental investment before realizing post-merger returns. Ignorance of these costs leads to overvaluation of target firm leading to lower value through synergy in reality. One should always keep in mind below mentioned factors before conducting a pricing analysis.
a) Assumptions are taken for making forecasts should be critically reviewed.
b) Probability of different scenarios like optimistic, pessimistic, and realistic should be done through Monte Carlo simulation.
c) Timing of the deal should be taken into consideration while evaluating the prospect of the deal.
It is not a hidden fact that two-thirds of the merger deals fail to deliver their own terms. At the same time, we cannot become skeptical about the successful deals because we have great examples like Vodafone- Mannesman, Exxon- Mobile Corp, Glaxo-SmithKline, and AOL- Time Warner acquisition, etc. However, to make any deal successful, an analyst should make realistic estimates taking into account all costs and issues associated with combined entity encompassing strategic vision, system integration, and operating strategy.