Synergies in mergers and acquisitions:
A critical review and synthesis of the leading
valuation practices
A de Graaf
Department of Management Accounting, University of South Africa
AJ Pienaar
Department of Management Accounting, University of South Africa
Received:
Revised:
Accepted:
April 2012
September 2012
September 2012
SAJAR
Vol 27 No. 1
2013
pp.143 to 180
Research demonstrates that mergers and acquisitions (M&As) of business entities may create
synergies – Igor Ansoff’s “2 + 2 = 5 effect” – but, crucially, that this is by no means guaranteed.
Studies further show that in successful cases, synergies frequently accrue to the target
company’s shareholders only, principally as a result of the payment of outsized M&A premiums
by the acquirer. Remarkably, payment of these premiums is often justified by a mere notion of
synergy. These factors, together with a void in the literature, and the significant amounts
invested in M&As, create a critical need for a comprehensive description of superior ways of
valuing M&A synergies before committing to a transaction. This study aims to make a
contribution in this regard by classifying certain practices as leading valuation practices by
means of a critical literature review, and by synthesising these into the following logical
groupings: (1) practices part of the overall M&A process, affecting synergy valuation; (2)
practices with a universal application in valuing M&A synergy; and (3) valuation practices
linked to specific origins of synergy. The origins of synergy explored in this study include: scale
economies; economies of scope; managerial efficiencies; economies of the capital market;
economies in innovative activity; and other more contentious origins, including tax savings, and
market power. Certain valuation practices are also recommended, where appropriate. Research
in this area is relevant because any enhancement in the accuracy of M&A synergy valuation ex
ante should improve the selection of worthwhile M&A targets. Better choices in this area may
then represent a positive step towards sustainable business practice.
KEY WORDS
Synergy; valuation; mergers and acquisitions; efficiencies; merger control; leading practices
Contact
[email protected]
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INTRODUCTION
From early times, humankind has been searching for phenomena with a combined effect
greater than the sum of the parts – a synergy effect. The ancient Greeks named it
sunergos, with the broad meaning of “working together” (Concise Oxford English
Dictionary, 2009: 1460).
A synergy effect may exist through auspicious circumstance or by design. It is not
unique to any specific science and has been successfully identified in several fields,
ranging from engineering to anthropology, and later the business world. The term
synergy was first applied in a business context by Maslow (1964) and Ansoff (1965).
In his book Corporate Strategy, Ansoff (1965) proposed a meaningful framework for
the evaluation of merger and acquisition (M&A1) synergy by encouraging the use of
factors that are unique to individual firms. With this insight, Ansoff eloquently captures
the inherent qualities of synergy when describing it as the:
“2 + 2 = 5” effect (1965:72).
Interestingly, the Soviet Government used the same expression as propaganda in the
first Five-Year Plan (implemented in 1928). Here the expression conveyed the
aspiration to complete this plan in four years, not five, and certainly also contained
veiled suggestions that communist ideology was superior (Posner, 2003). Against this
backdrop, Ansoff, probably unwittingly, alludes to the darker side of synergy and its
elusive nature.
Every year large sums of money are invested in M&As, yet evidence suggests that only
some of these transactions realise synergy. Various studies, including those by Bradley,
Desai and Kim (1988), and KPMG (2001) have demonstrated that while M&As can
lead to synergy this is by no means guaranteed. In fact, many acquisitions fail to
generate synergy (Sirower and Sahni, 2006) and a large proportion is later divested (as
described in a seminal paper by Porter, 1987; and Kaplan and Weisbach, 1992).
In cases where synergies are created, studies show that they frequently accrue only to
the target company’s shareholders, principally as a result of the payment of outsized
M&A premiums by the acquirer (Sirower and Sahni, 2006). The payment of an
acquisition premium, which in some cases may even exceed 100 percent of the preannouncement market capitalisation of the target company, is frequently justified by a
mere notion of synergy in the specific case (Porter, 1987), often without specifics
(Devine, 2002), detailed supporting calculations (Sirower, 1997), or a proper roadmap
for its realisation.
The danger with vague notions of M&A synergy is that they can and frequently do
disguise other transaction motives. Such motives may include hubris, where vanity
induces managers to overpay, quite unconsciously, for a target company (Roll, 1986);
1
Due to their frequent appearance in this paper and to ease readability, use is made of the informal
acronyms “M&A” for “merger and acquisition” and “M&As” for “mergers and acquisitions”. In
addition, when referring to “merger” (including the plural) it is meant to include the term “acquisition”
(or its plural) and vice versa.
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“managerialism”, where managers purposefully overpay for a target company in order
to extend their own reach at the expense of the shareholders (Seth, Song and Pettit,
2000:387); and even the allure of owning a prestige brand, as illustrated by the
comments of Ratan Tata, the chairman of the Indian Tata group, who described the
chance to own the Jaguar automotive brand as “irresistible” (The Economist, 2011b).
An added concern is that some mergers not only fail to generate synergy but actually
destroy value. Linn and Rozeff’s anergy hypothesis (1985) describes circumstances that
could result in the destruction of value. Likewise, Prahalad and Bettis (1986) argue that
value may be destroyed when resources are removed from the areas of operation that
management knows best.
Obviously, the high failure rate of mergers creates a significant problem. Given the
large number of mergers to date, what lessons can be drawn with the benefit of
hindsight? A popular thesis, especially in earlier years of research, posits a direct link
between the level of relatedness (strategic fit or otherwise) of entities involved in a
merger, and the level of synergies. Scholars have found it very tempting to prove this
thesis for it would both remove an important stumbling block to the realisation of M&A
synergy and offer a means to engineer successful M&As in advance. Since many
scholars, including Ansoff (1965) and Gaughan (2007), credit the existence of certain
types of synergy to the effect of efficiencies (these include scale economies, which
could only be shared by entities with overlap in products or services), logic dictates that
there should be some truth in this thesis.
Unfortunately, research in this area offers little consensus. Studies have applied
different methodologies and definitions of relatedness, but have nonetheless produced
conflicting findings. Certain papers have found that M&As involving related entities
create more value (Singh and Montgomery, 1987; Shelton, 1988), but other papers have
not found any observable correlations between relatedness and value creation
(Lubatkin, 1987; Seth, 1990). Unfortunately, on this matter, current research leaves the
door ajar.
Although the outcome in this area is inconclusive, it suggests that relatedness may play
a role in the level of M&A synergies and that other factors may be relevant as well. In
the final analysis, research indicates that M&A synergy frequently fails to materialise
because of one or several of the following factors: improper engineering of the merger;
using equivocal notions of synergy as a disguise for other transaction motives;
overpaying for the acquisition; and underestimating the differences between the
merging entities, such as cultural differences.
The culmination of these factors, combined with the void in the current body of
knowledge, creates a pressing need for research into superior ways of valuing M&A
synergies – before committing to a transaction. (This implies an ex ante perspective.)
Ideally, best practices should be identified here. Unfortunately, few documented best
practices – identified through the study of “best-in-class” organisations, with
corroborating evidence of superior performance (as prescribed by Szwejczewski, 2008)
– exist in the valuation of M&A synergy. Yet, critical analysis of the existing body of
knowledge does allow for the identification of leading practices – a more conservatively
named precursor to best practice. The burden of proof is less stringent when classifying
A de Graaf & AJ Pienaar
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a practice as a leading practice: demonstrable proof of superior performance is not
required, but the practice should display inherent merits, which, on a balance of
probabilities, should lead to effectiveness. Preferably, but not necessarily, a leading
practice is one that has been implemented by a respected organisation. These arguments
make a clear case for the use of this nomenclature in this study. Further, to avoid
perpetuating an unfortunate trend, this choice has been partly motivated by a desire to
avoid the term “best practice”, which is frequently misused in business literature.
BACKGROUND
In view of the multitude of concepts appearing in the study of M&A synergy, it is
necessary to provide some contextual background. Concepts warranting an introduction
are: (1) a classification and definition of synergy; (2) the origins of synergy, specifically
efficiencies; and (3) merger control.
Numerous levels of classification of M&A synergy have been used throughout the
literature. To avoid the overlaps that frequently occur, in this study a simple
classification of either cost or revenue synergies has been followed, where possible.
Still, several authors have attempted a more descriptive definition of M&A synergy.
Copeland and Weston (1983) provide a sensible definition with clear links to an income
approach to valuation, based on discounted cash flow. According to this definition,
M&A synergy exists when the net present value of the cash flow of the combination of
two assets is greater than the sum of the net present values of the cash flows of the
assets independently. Because the net present value of an asset on its own will already
incorporate assumptions about future growth and related cash flows when applying
discounted cash flow models, it is important to read this definition within the
qualification offered by Sirower (1997): synergy should represent increases in cash
flows beyond those which were originally expected.
A further related matter is the origins of synergy, including efficiencies. Several authors
(including Ansoff, 1965; Chatterjee, 1986;2 and Gaughan, 2007) credit the existence of
cost synergies to efficiencies), and the existence of revenue synergies to the effects of
collusion and market power (Chatterjee, 1986).
De la Mano identifies two main types of efficiencies: static efficiencies and dynamic
efficiencies, and describes these in a 2002 publication. Static efficiencies register at a
given point in time, through the use of existing resource prices, existing technologies
and the current level of knowledge. Dynamic efficiencies lead to improvements in the
available technology, or the discovery of new products or processes that will expand the
frontiers of production (otherwise known as innovation efficiencies.)
Since certain efficiencies (serving as the origin of M&A synergy) imply a level of
relatedness between entities,3 and given the inability of research to demonstrate a clear
2
This paper is one of the most frequently cited papers on the topic of “synergy” based on an ISI Web
of Knowledge search (Thomson Reuters, 2012).
3
Such as scale economies, discussed infra, which could only be shared by entities with an overlap in
products or services.
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link between the relatedness of entities and the level of M&A synergies, the argument
in this paper is that relatedness between entities should be considered, not as a
guarantee of M&A synergy, but rather as a qualifier – indicating that a certain origin of
synergy is to be evaluated for a specific case.
The final related concept is merger control, which is the regulatory procedure whereby
M&As are reviewed under competition law. Merger control regimes exist in most
developed countries; its intention: to make some altruistic impression on a typical
uncompromising M&A landscape. Merger control is not always successful in this
endeavour. Arguably, there have been cases where interjection has done more harm
than good (Oinonen, 2010). Nonetheless, the successful navigation of merger control is
often critical in the ability to close M&As (Laing, Gómez and Burke, 2007).
It is well known that mergers regularly have an anti-competitive effect, but in several
regions and countries, including Europe, the United States and South Africa, if it can be
proven that M&A efficiency gains outweigh the anti-competitive nature of the
transaction, the government bodies concerned may approve the transaction (Laing et al.,
2007). Synergies are therefore frequently studied indirectly as part of merger control,
through its connection with efficiencies. Merger control studies include, amongst
others, a legal perspective.
This paper capitalises on this opportunity. However, this paper has an international
scope and therefore only refers to publications in merger control in a specific region or
country to gain additional insight and perspective – not to explore the letter of the law
or procedure, which is a specialist area and may diverge in different countries.
Lessons could be drawn from the comprehensively researched area of European merger
control, for example, where there is increasing emphasis on a definition of synergy as
formulated by Farrel and Shapiro (1990, 2001). This definition of synergy focuses on
assets that are both hard to trade and merger-specific. Based on this definition, De la
Mano explains that, in cases where each firm could have achieved certain efficiencies
unilaterally, such as scale economies that could also be achieved through the firm’s own
expansion, those efficiencies are classified as “non-synergy efficiencies” (2002:45). In
cases where a merger may lead to a reduction in the time needed to obtain certain
economies of scale, it may yet qualify as synergy by the same definition (De la Mano,
2002).
Mindful of the divergent motivation behind merger control, in cases of “non-synergy
efficiencies”, one should ask an important question: if the synergies are not unique and
could be achieved by other potential bidders as well, will these synergies not already be
largely factored into the asking price for the entity, with the result that no synergies will
remain for the bidder? This question should be addressed further when considering the
maximum amount that a specific bidder could offer for a target company (discussed
infra).
The following sections describe the research objectives and method; the literature
review, critique and recommendations; and conclusions.
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RESEARCH OBJECTIVES AND METHOD
This study aims to make an original research contribution by pursuing the following
objectives:
a)
Document the origins of M&A synergy and concomitant conditions to provide a
necessary context.
b) Evaluate documented and proposed practices4 in valuing M&A synergy ex ante,
and from these, identify leading practices on the basis of Copeland and Weston’s
(1983) definition of synergy.
c) Recommend new practices in valuing M&A synergy ex ante, where appropriate.
d) Uniquely and comprehensively synthesise the leading practices in valuing M&A
synergy ex ante.
The paper aims to achieve the research objectives through a study and critical review of
the literature.
Relevant literature, providing data for the research, was identified from several sources,
including peer-reviewed papers in reputable journals, books, surveys and publications
by consulting firms offering M&A transactional advisory services, articles in
periodicals, and company reports.
The literature included in this review was published mainly in the field of economic and
management sciences, but relevant publications in the field of jurisprudence and other
areas were also considered. A literature network was constructed in order to structure
and facilitate the process (as described by Hesse, 1974 and 1980).
REVIEW, CRITIQUE AND RECOMMENDATIONS
The following literature review is structured according to the functional areas of the
various valuation practices. Valuation practices may be best suited to either the overall
approach to M&As, may have universal application, or may relate to a particular origin
of synergy. The origins of synergy considered in the final instance include: scale
economies; economies of scope; managerial efficiencies; economies of the capital
market; economies in innovative activity; and certain more contentious origins,5
including tax savings and market power.
4
In the interest of conciseness, when referring to “practices” the term may also refer to its smaller
building blocks, consisting of techniques and methods.
5
The inclusion of such origins in this paper is for the sake of completeness only and is not to be read as
a condoning of M&As where such origins are the principle motivators. The pursuit of M&A synergy is
only recommended in cases where its origins are ethically responsible, legal and in compliance with
relevant regulations. (The international scope of this study makes a study of specific laws and
regulations impractical.) Ethical concerns are beyond the scope of this study.
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The overall approach to M&As
This section highlights practices linked to the overall approach to a merger, which has
been shown to affect the synergy realised ex post. In the interests of improved accuracy
these practices should also be considered when valuing M&A synergy ex ante.
Based on a survey of big international deals concluded in the later 1990s, KPMG (2001)
set out to identify practices that were common to mergers that created value. (The seven
key practices identified are described in Exhibit 1.)
The KPMG study (2001) reflects the general need to identify common denominators in
success. The study adequately controlled for variables affecting the measurement of
merger success; evidence of successful practical implementation is implicit, but the
employed methodology is subject to both observer and correlation biases. Observer bias
will always exist in studies performed by firms offering M&A advisory services, but the
qualification of “independent” in the post-deal assessment activity, for instance, may
offer additional evidence of bias. Moreover, a later study by Mckinsey & Co. (2010),
discussed infra, refutes the practice of process management – where this is not
supplemented by additional measures.
Regardless of the shortcomings mentioned and when read in conjunction with the
practices described infra, two key practises identified in the KPMG study (2001) could,
in essence, still be described as leading practices. These are: (1) early action and (2) the
implementation, not of an individual key practice, but rather of a number of key
practices. The KPMG survey further supports this conclusion, indicating a 67 percent
success rate for mergers implementing seven of the key practices, versus a much lower
success rate of 18 percent, where four or fewer key practices were implemented.
Exhibit 1: Seven key M&A processes (KPMG, 2001)
1.
Early action
2.
Main board leadership
3.
Pre bid value assessment
4.
Formal transaction process plan setting out clear roles and responsibilities
5.
Process manager involved throughout
6.
Process manager empowered with wide ranging role
7.
Independent assessment of post deal implementation
Kode, Ford and Sutherland describe the most significant practices, labelled “best
practices” (2003:23), which help to realise M&A synergies ex post, based on a critical
review of the literature of twenty authors. These are listed as (1) adequate planning for
the integration of the acquisition; (2) establishing proper incentive tools; and (3) the
linking of the acquisition premium to anticipated synergies.
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Based on their research design, Kode et al. (2003) judged the significance of each
practice purely on the basis of a count of the number of authors recommending each
practice within the finite sample – thereby neglecting the qualitative arguments in the
content. However, in spite of the shortcomings in their research design, further
corroborating evidence exists. The importance of merger integration is also highlighted
by McKinsey & Co. (2010) and is discussed infra. Incentives and rewards, if designed
with goal congruence in mind, should in principle be able to improve the management
of the merger process, which will indirectly support some of the other leading practices
identified.
Finally, the setting of a maximum bid price, linked to the anticipated synergies, has
inherent merit. The numerous opening arguments favouring the valuation of M&A
synergy ex ante also apply here. A maximum bid price will help to prevent the accrual
of synergies only to the target company’s shareholders. Other publications not included
in the review by Kode et al. (2003), including those by Albo and Henderson (1989), and
McKinsey & Co. (2005), have convincingly demonstrated that it is a leading practice to
establish a maximum bid price based on Equation (1) below.
Σ(MVt , P) ≤ Σ(IVt , SVt)
… (1)
where:
MVt
P
IVt
=
=
=
SVt
=
Σ(IVt , SVt)
=
Fair market value of the target entity on the offer date
Premium paid by the bidder
Intrinsic value of the target entity on the offer date, viewed
independently from any M&A and calculated using a method based
on discounted cash flow
The value on the offer date of specific synergies available in a
merger between the target and bidder entities in question
Maximum bid price
In their frequently cited paper on synergy (Thomson Reuters, 2012), Larsson and
Finkelstein (1999), applied a case survey method – tested through further empirical
study – to identify the factors critical in the realisation of M&A synergy. According to
this survey, proper organisational integration is the single most significant element in
explaining synergy realisation.
A detailed survey by McKinsey & Co. (2010) further highlights the risk of neglecting to
plan for integration during the early stages of a merger, revealing M&A failure rates in
excess of 65% when following traditional integration practices. These traditional
practices prescribe the use of checklists and process management, with a focus on risk
avoidance (elsewhere claimed to be best practices).
Instead, McKinsey & Co. (2010) recommend a new approach to integration – starting in
the initial phases of the merger. This updated integration approach prescribes, firstly,
the use of corporate culture as a merger screening criterion. If the cultures are found to
be compatible, detailed ways of reconciling them are identified. Secondly, the focus is
on ways of integrating the disparate sales forces.
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This new approach to integration recommended by McKinsey & Co. (2010) has
inherent merits, especially because it focuses on the key concerns of M&A
professionals as highlighted in a detailed survey. However, its study is subject to the
usual observer bias and the said survey is perhaps not fully representative of merger
activity worldwide, since only M&A professionals in the United States were included.
Its recent publication date precludes evidence of successful practical implementation.
The recommended approach therefore warrants only a tentative classification as a
leading practice.
Practices with universal application
Several proposed practices in valuing M&A synergy ex ante are not exclusive to the
valuation of a specific origin of synergy, such as a specific type of efficiency, but rather
form part of a basic toolkit to be customised and drawn from for every assignment, and
then used to measure a host of cost or revenue synergies.
McKinsey & Co. (2005) recommend an overall structured approach in valuing cost
synergies. This approach, the “outside-in approach” (2005:447), begins with an external
picture of the larger industry within which the companies operate and then delves
deeper into the specifics of the companies. This approach prescribes a four-step process:
(1) develop an industry-specific business system; (2) develop a baseline for costs as if
the two companies had remained independent, making sure that the baseline cost is
consistent with the intrinsic valuations; (3) estimate the synergies for each cost category
based on the expertise of experienced line managers, with most of the insider
information provided by the target company’s management team through a due
diligence request; and (4) compare aggregate improvements with margin and capital
efficiency benchmarks for the industry to judge whether the estimates are realistic.
The “outside-in approach” has merit, not only for what it prescribes, but also for what it
prevents. The approach avoids the common simplification employed in practice,
whereby an assumption is made that a weaker entity’s margins will automatically
improve to a level close to those of the stronger entity, by emphasising comparison with
industry benchmarks. This merit is unfortunately also a double-edged sword: emphasis
on industry benchmarks may downplay the uniqueness of every merger and will further
be less effective in countries with fewer so-called, “pure-play companies”, such as
South Africa. However, McKinsey & Co. claim superior M&A success for their clients
(2010). This was not independently verified, but the continued growth of this consulting
company’s M&A advisory business offers little reason to contest this statement. The
“outside-in approach” therefore permits classification as a leading practice.
Evans and Bishop, in their book exploring ways to build value in companies through
M&As (2001), described three key variables that drive synergy value. These variables
are: (1) the size of the synergy benefit, (2) the timing of the benefits, and (3) the
likelihood that it will be achieved. These variables also point to the use of a standard
toolkit, which is then customised based on the unique circumstances of the case.
In a suggestion that should preferably be read within the guidelines on the other leading
practices described here, Evans and Bishop (2001) recommend that the first variable,
namely the size of the benefits, be quantified using a valuation method based on
discounted cash flow, but that a conservative approach should be adopted and the
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benefits rigorously questioned. Building on the foundations of the key scholars, Miller
and Modigliani (1958, 1961), and Jensen (1986, 1988), a method based on discounted
cash flow may be one of the few available methods6 to value the variable “SVt” in
Equation (1). This method also has clear links to Copeland and Weston’s definition of
synergy (1983).
The second variable, namely the timing of benefits, logically trails the first and will be
associated with the period in which the various projected cash flows are included.
Evans and Bishop (2001) again advocate the application of a conservative attitude and
they further stress the importance of meeting the (ex ante) projected timetable in order
to achieve the (ex post) synergy value. In corroboration, observation by McKinsey &
Co. (2005) indicates that synergies that are not realised within the first full budget year
following the merger are often not realised at all. Since a valuation method based on
discounted cash flow is well-suited to these unique circumstances, its use in valuing
M&A synergy permits classification as a leading practice. Furthermore, based on the
arguments made here and the proven difficulty in realising M&A synergies ex post, it is
prudent to classify an appraiser’s conservative outlook in valuing M&A synergies as a
leading practice.
Finally, a few techniques are available to assess the third variable, namely the
likelihood of success. These include a Monte Carlo simulation, which is discussed infra.
Aswath Damodaran, a professor of Finance, described an overall process in valuing
M&A synergy (2005) using a method based on discounted cash flow (refer to
Exhibit 2). First of all, the method applied in the overall process is promising due to its
classification as a leading practice, as already demonstrated. Additionally, the overall
process is sensible and contains logical steps. Against this, the process contains some
generalisations and no evidence of actual application by a reputable organisation could
be demonstrated. Accordingly, the overall process described by Damodaran (2005) can
only receive a conditional recommendation as a leading practice.
Caveats to be considered here include: consideration of other leading practices with
universal application described in this paper, specifically including McKinsey & Co.’s
outside-in approach (2005), and further consideration of leading practices in assessing
specific origins of synergy (linked to step 3.1 in Exhibit 2), as described infra.
6
In the absence of identical or similar assets in an active market – typical of specific synergies – an
appraiser cannot mark-to-market and therefore has to rely on methods that mark-to-model.
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Exhibit 2: Valuing M&A synergy: an overall process based on discounted cash flow
(Damodaran, 2005:6-8)
1.
Quantify the intrinsic value of the entities involved in the merger independently, by discounting
expected cash flows of each firm, using the weighted average cost of capital (WACC) for that firm.
2.
Estimate the value of the combined firm, without synergy, by adding the two separate values obtained
in step 1.
3.
Estimate the value of the combined firm with synergy, by applying further steps:
Incorporate the effects of synergy into the expected cash flows of the combined entity, by incorporating
inter alia:
a.
A higher growth rate in revenues.
b.
Higher margins, because of scale economies.
c.
Lower taxes, because of tax benefits.
3.2
Incorporate the effects of financial synergy into the discount rate of the combined entity and calculate
an adjusted WACC for the combined entity.
3.3
Calculate the present value of the combined expected cash flows including synergy by discounting at
the adjusted WACC.
4.
Subtract the determined value in step 2 from the value in step 3.3, to obtain the total value of synergy
(as part of the maximum bid price).
Monte Carlo simulation was developed out of the need to solve complex problems
incorporating a high degree of uncertainty. This type of simulation has a proven track
record in many disciplines and has further been recommended for several business
applications. For instance, Hertz recommended its use as an aid to capital investment
appraisal, as long ago as 1964. Hertz (1964) further described superior results using the
Monte Carlo simulation in dealing with uncertainty, when compared to other
techniques, such as game theory, selected probabilities, and three-level estimates.
However, apart from Evans and Bishop (2001), and Boer (1999), no other authors
linking this technique directly to the process of quantifying synergy value could be
identified.
Nonetheless, even with little evidence of success in this area, the inherent strength of
Monte Carlo simulation in highlighting risks and potential outcomes makes it well
suited to valuing M&A synergy – an area frequently exposed to a large degree of
uncertainty. This warrants recommending the use of Monte Carlo simulation in these
circumstances, especially when used in conjunction with other leading practices.
A more recent development by three Italian academics, Malagoli, Magni and Mastroleo
(2007), advocates the use of an expert system and fuzzy logic to indicate the valuecreation potential of an acquisition target. In this publication the Italian academics
explain that such an expert system is intended to replicate the reasoning of human
experts using fuzzy logic, a reasoning framework aimed at formalising human beings’
innate ability to think about complex problems and vague concepts. The proposed
system makes use of twenty-nine explicit drivers (which could be expanded) to predict
value-creation potential, including economies of scale and complementarities. Malagoli
et al. (2007) further explain how a rating could be transposed into a price for a target
company.
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This is an interesting approach and in many ways may be suggestive of the way
forward. However, the output of any model is highly dependent on the quality of the
inputs, which in this case must be provided by experts. Consequently, fuzzy logic is
unlikely ever to replace experts, but may, in future, offer valuable assistance. Because
of the early stage of its development and unproven track record, the use of such a
system cannot yet be classified as a leading practice.
Other synergy origins and the practices that could be linked directly to them (if any) are
reviewed separately infra.
Scale economies in production
Scale economies in production, in simplified terms, relate to a decrease in the average
unit cost as the scale of operations increases.
Scale economies in production are especially relevant to capital-intensive
manufacturing firms, with the continued growth of large multinational companies cited
as proof (Gaughan, 2007). Consequently, such economies can only serve as an origin of
synergy as defined by Copeland and Weston (1983) in product-concentric mergers and
in cases of horizontal integration, where an entity moves from a low level of output to a
higher level of output (and demand).
However, scale economies do not increase linearly with an increase in scale; there is a
level of scale where the economies are maximised, above which a firm starts to realise
diseconomies of scale. A concept known as “minimum efficient scale” represents the
minimum scale of a plant where all scale economies are fully utilised and if the scale is
increased beyond this point, the long run average cost curve will move upwards due to
diseconomies of scale, or will remain flat where returns to scale provide a more
constant benefit (Camesasca, 2000). Returns to scale are closely associated with the
underlying production technology, with more efficient technology generally being
available at higher levels of output (De la Mano, 2002).
According to De la Mano (2002), European merger control will generally only consider
arguments of scale economies in production as a rebuttal against an otherwise anticompetitive merger, in cases where it is likely to result in the reduction of selling prices.
(Here De la Mano, 2002, argues that a reduction in variable cost will normally reduce
selling prices in the short term, whereas a reduction in fixed costs will occasionally
reduce selling prices, but only in the long term.) Moreover, as discussed supra, this
efficiency will only be considered here if benefits are merger-specific; this efficiency is
normally considered to meet the further requirements of being verifiable and
quantifiable (De la Mano, 2002).
Although the intention in merger control is different, certain lessons could still be
drawn from these considerations for purposes of valuing M&A synergy. Scale
economies do not have to be merger-specific in order to generate synergy, but if not,
there is an increased possibility of overpaying for the acquisition (therefore, consider
the maximum bid price in Equation [1]). The fact that merger control seldom objects to
its verifiability and quantifiability supports the notion that it should be possible to
accurately value scale economies in production ex ante.
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Additionally, when analysing scale economies in production to be realised through a
merger, a clear differentiation should be made between benefits realised in the short
term and those realised over a longer term.
According to De la Mano (2002), the most convincing case for short-term benefits is
that of declining markets where the market has over-capacity. Here a merger will allow
the combined entity to close one plant and operate the other at a level that allows for
scale economies, but only if product similarity and production techniques permit.
Subject to specific circumstances, this situation may well provide a benefit that could
not have been achieved unilaterally by each firm, through its own expansion, instead of
a merger, and may thus avoid further classification as a “non-synergy efficiency” (De la
Mano, 2002:45).
De la Mano (2002) further argues that long-term benefits are realised through the
coordination of the combined entity’s future capital investments, by allowing for
production levels closer to the minimum efficient scale or by utilising returns to scale,
not through the merging of existing facilities. (It is generally too costly to merge
existing, separate plants.) Only in cases where a merger will shorten a timeframe,
compared to the entity’s unilateral expansion in lieu of a merger, will this benefit avoid
classification as a “non-synergy efficiency” (De la Mano, 2002:45).
A further, detailed exploration of the origins of scale economies in production is beyond
the scope of this study, but a merger could allow for a shortening in the timeframe to
increased scale, which in turn, could allow for inter alia: the distribution of high initial
fixed cost over a larger output (such as design and development costs of a new
automobile, where platforms could be shared); an increase in dimension, with the
benefit of operating costs increasing at a proportionately lower rate; economies of
specialisation (such as the purchase of a specialised piece of equipment with lower
operating costs); economies of massed reserves accruing to a larger firm (such as
proportionately fewer spare parts to be held when operating a greater line of identical
machines); superior methods of organising production; and the learning effect
(Camesasca, 2000).
Likewise, origins of diseconomies of scale in production following a merger could
include: the law of diminishing returns as originally formulated in the 18th century by
R.J. Turgot, who observed that applying additional labour to a fixed surface area of
agricultural land offered diminishing returns (as described by Hutchison, 2010); factor
limitations (Pratten, 1988), such as the limited supply of labour available to a merged
entity from the surrounding area; and a longer chain of management (Camesasca,
2000).
Scale economies in production could be estimated using either econometric, survivor or
engineering approaches. In this respect, a study of scale economies in production by
MacPhee and Peterson (1990) in the flour milling, cheese and fluid milk industries
revealed similar results for all three approaches. In opposition, Pratten (1988), and
Hochn, Langenfeld, Meschi and Waverman (1999), argue that an engineering approach
offers more reliable results. (No papers favouring another approach could be found.)
Econometric approaches, including multiple regression techniques, are subject to
limitations, which include: difficulty in obtaining comprehensive, dependable data; and
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problems associated with analysing plants built at different times (Camesasca, 2000).
Next, a survivor approach claim that only entities with the most efficient plants of a
certain size will survive and that eventually all plants in the industry should approach
the same size (Camesasca, 2000). The limitations of this approach include: observation
bias by the observer and the effect of time on survival patterns (Camesasca, 2000). The
econometric and survivor approaches are thus exposed to limitations and do not
demonstrate superior results. Hence, these approaches cannot be classified as leading
practices.
For an engineering approach, engineers are the obvious contributors, but estimates are
also occasionally provided by economists, accountants and managers. Camesasca
(2000) described a benefit of the engineering approach, namely that it permits the
estimate of scale economies, while keeping the other current conditions constant (such
as quality, input price and skill level). However, Camesasca (2000) also cautioned that
this approach contains a margin of error. For the engineering approach, knowledge is
often assembled using questionnaires or studies, which, according to Camesasca (2000),
are often compared to comparative figures belonging to alternative plant design.
When assessing the various approaches to estimating scale economies, an exception
cannot be made for engineering estimates on the grounds of their exposure to a margin
of error, since all approaches will be exposed in this manner. Therefore, based on the
supporting arguments in the literature, the use of engineering estimates to assess scale
economies in production may be classified as a leading practice in this context.
Pratten (1988) offered the most comprehensive summary of expected scale economies
to date. (The results are shown in Exhibit 3.) In this summary, Pratten consolidates the
results of numerous earlier studies which estimated scale economies for different
branches of manufacturing industry in the UK and then European Community (1988),
using predominately engineering estimates. As an indicator of possible savings from
scale economies, Exhibit 3 shows the cost gradient (in percent) at half minimum
efficient scale. (A greater percentage here will indicate a greater potential for scale
economies.)
Using the summary in Exhibit 3 as a source of reference, a further valuation practice
may be recommended, as follows: a reasonability test may be performed by comparing
the results achieved using an engineering approach for a specific case with the reference
information contained in the exhibit. Notice that the cost gradients and remarks in
Exhibit 3 relate to possible scale economies in both production and non-production
areas. As explained infra, in the following subsection, controversy exists regarding the
reliability of estimates in scale economies in non-production areas. As a result, the
summary included in Exhibit 3 may offer only a rough indication of possible scale
economies. Moreover, since evidence suggests that scale economies in production may
change over time and may differ between countries, a comparison between this set of
information and a separate engineering estimate may well show up differences.
Nonetheless, the argument here is that value may be added by seeking an explanation
for significant differences.
Some notes on the interpretation of the indicated cost gradients in Exhibit 3 may be in
order. The visual relationship between the long-run average cost per unit and the level
of output frequently offers a close fit to a second-order polynomial curve (this curve
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closely resembles a parabola). Consequently, a second-order polynomial curve could be
used as a trend line to predict the average cost per unit at full minimum efficient scale,
based on the indicated cost gradient at half the minimum efficient scale.
Exhibit 3: Summary of scale economies available to different branches of the
manufacturing industry, ranked by the size of the average expected scale
economies (source: Pratten, 1988)
NACE
Code
Branch
Cost
gradient at
half MES
(percent)
Remarks on economies of scale (EOS)
35
Motor vehicles
6–9
36
Other transport
8 – 20
25
Chemical industry
2,5 – 15
26
22
33
32
5 – 10
>6
3–6
3 – 10
5 – 15
Substantial EOS at product level and for development costs.
5 – 15
Substantial EOS at product level and for development costs.
8 – 36
Particularly high EOS in the printing of books; substantial
EOS in paper mills.
Substantial EOS in cement and flat glass production.
31
Man-made fibres
Metals
Office machinery
Mechanical
engineering
Electrical
engineering
Instrument
engineering
Paper, printing and
publishing
Non-metallic
mineral products
Metal articles
Very substantial EOS in production and in development
costs.
Variable EOS: very substantial in aircraft development
costs; small for cycles and shipbuilding.
Substantial EOS in production processes. In pharmaceutical
products, R&D is an important source of EOS.
Substantial EOS in general.
Substantial EOS in general for production processes.
Substantial EOS at product level.
Substantial EOS in production, but limited at firm level.
48
Rubber and plastics
5 – 10
(castings)
3–6
41-42
Drink and tobacco
1–6
41-42
Food
3,5 – 21
49
Other
manufacturing
n.a.
43
Textile industry
46
Timber and wood
10
(carpets)
n.a.
45
Footwear and
clothing
Leather and leather
goods
34
37
47
24
44
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>6
1
(footwear)
n.a.
EOS substantial in production, but lower at plant level.
EOS possible at product and production level; moderate
EOS in tyre manufacture; small EOS at plant level for
rubber and moulded plastic articles.
Substantial EOS in marketing; moderate EOS in breweries;
small EOS at cigarette plant level.
Considerable EOS at the level of individual plant;
considerable EOS in marketing and distribution.
No clear EOS for plants in this sector. Possible EOS from
specialisation and from increase in length of production
runs.
Possible EOS from specialisation and from increase in
length of production runs.
No clear EOS for plants in this sector. Possible EOS from
specialisation and from increase in length of production
runs.
Possible EOS from specialisation and from increase in
length of production runs; small EOS at plant level.
Small EOS.
157
Removal of redundancies
A common source of M&A cost synergy (as defined by Copeland and Weston, 1983) is
the removal of redundancies, mainly in areas other than production, such as redundant
personnel, office space, and accounting and auditing services.
According to De la Mano (2002), European merger control generally only considers the
argument that redundancies have been removed as part of an efficiency defence in cases
where this is likely to result in the reduction of selling prices. This benefit generally
meets the further requirements of merger-specificity, verifiability and quantifiability
(De la Mano, 2002). This suggests that the removal of redundancies may readily lead to
cost synergy and that it should be possible to accurately value scale economies in
production ex ante.
Calculating the basic savings resulting from the removal of redundancies is relatively
straightforward. However, the effect of hidden factors (such as impact on morale, the
cost of integration, and the impact of the success or failure of the integration) may be
considerable, but has received very little attention from researchers (Cleich, Kierans and
Hasselbach, 2010).
A leading practice in estimating the saving from removal of redundancies in M&A
would therefore have to move beyond a mere assessment of the various areas that may
be affected and a basic discounted cash flow estimation incorporating the cost savings.
Since current research in this area is limited, one could propose that a new valuation
practice be considered. It is therefore recommended that the basic practice be
supplemented by additional procedures, including specific consideration of practices
linked to the overall approach to M&A, as described supra – particularly, the leading
practice recommended by McKinsey & Co. (2010) whereby culture is considered as a
screening criterion, with a further detailed focus on ways of integrating sections, and the
number of key processes implemented for the merger, as described by KPMG (2010).
A recommended practice may further account for the effect of significant uncertainty on
the likelihood of success by performing a Monte Carlo simulation.
Scale economies in non-production areas
Another related matter to be considered here is scale economies in non-production
areas, such as in the areas of management, marketing, distribution, and research and
development.
Here the emphasis shifts from the removal of redundancies to an approach where the
existing and future cost of the activities could be spread over a greater level of output.
In this way the average total cost per unit is reduced (as opposed to average production
cost per unit, which is the relevant indicator under scale economies in production).
De la Mano (2002) supplies examples of how a merger could lead to scale economies in
non-production areas. These include: the creation of a single, consolidated brand in
order to save on advertising expenditures; obtaining greater advertising media discounts
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(discounts are frequently linked to advertising volume); combining the sales forces or
distribution networks; and making better use of an unsaturated distribution channel.
According to Camesasca (2000), European merger control generally only considers
arguments of scale economies in non-production areas as part of an efficiency defence
in cases where these are likely to be substantial. However, Camesasca also emphasises
that this efficiency is normally difficult to verify and quantify, and is not considered
where it merely represents a pecuniary efficiency, where wealth is transferred from an
outside entity to the proposed merged entity. (Advertising entities, for example, often
have discriminatory pricing policies and may offer improved pricing to a larger merged
firm, with higher advertising volume.) This efficiency may represent a cost synergy
(even if it represents a pecuniary efficiency), but merger control treatment suggests that
it may be difficult to quantify accurately.
The scale economies in non-production areas could be estimated using the now-familiar
econometric, survivor and engineering approaches. As in the case of scale economies in
production, Pratten (1988), and Hochn et al. (1999), argue that an engineering approach
offers more reliable results. Conversely, for scale economies of this type, MacPhee and
Peterson (1990) highlight both the complexity and the disagreement surrounding the
quantification of scale economies in non-production areas, choosing to avoid this area
completely in their empirical study. Camesasca (2000) further cautions against the use
of the engineering approach in this area, stressing its non-exhaustive nature when
applied to non-production areas.
As a result of the controversy in the literature, no specific practice could be classified as
a leading practice in estimating the scale economies in non-production areas.
Furthermore, due to the intricacy of this area, no new practice could be proposed.
Economies of scope
In cases where entities participate in different, but complementary pursuits, economies
of scope could be generated where it is less expensive for a single merged entity to
perform two activities than for two specialised firms to perform them individually
(Camesasca, 2000).
Consequently, economies of scope can only serve as an origin of synergy (as
formulated by Copeland and Weston, 1983) in cases of vertical integration, where a
merged entity may then control (to various degrees) the raw materials, the
manufacturing, or the retailers. Accordingly, a single entity frequently produces all the
products for which economies of scope exist (Camesasca, 2000).
A detailed exploration of the origins of economies of scope is beyond the scope of this
study. However, Camesasca (2000) describes certain conditions that could serve, inter
alia, as the origin of economies of scope where their benefits are achieved through a
merger: higher transaction costs where activities are performed by disparate entities
(transaction costs include the cost of concluding an agreement and the cost of ensuring
compliance, and are typically high when dealing with specialised products, long-term
contracts and in several other circumstances); sensitivity to the timing of supplies (for
example when operating a just-in-time inventory system); opportunities to obtain
market power (this may be against merger control regulations and is discussed
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159
separately infra); and high taxes or governmental price control (a firm could vertically
integrate in order to avoid these, provided there are no legislative constraints).
De la Mano (2002) highlights the typical treatment by European merger control, as
follows. Merger control normally does consider this efficiency in a rebuttal argument,
unless a primary motive seems to be the pursuit of market power or tax savings. With
proper intent, it tends to be merger-specific and may lower prices to the benefit of
consumers in the short term. Only in cases where products are technically
complementary, is it relatively easy to verify. This suggests that economies of scope
may lead to cost synergy, but that this may be difficult to value accurately.
No specific valuation practices could be linked directly to this origin of synergy, but in
this case an appraiser may have to consider the costs of vertical integration, such as
higher legal fees to comply with merger control regulations.
Managerial efficiencies
A merger may allow for the replacement of underperforming managers with more
successful managers, which may serve as the origin of M&A synergy through either
improved efficiency or a reduction in internal inefficiency – commonly known as
“Xinefficiency” (Camesasca, 2000:144).
In this context, efficiency is usually linked to a reduction in suboptimal decisions and
therefore points to better decision making, with its numerous related benefits. Still,
management may underperform for a multitude of reasons and new management will
not always improve on this. In fact, a merger could exacerbate some causes of
inefficiency, for example by increasing organisational complexity (Camesasca, 2000).
According to De la Mano (2002), European merger control often does not consider
arguments of managerial efficiencies as part of an efficiency defence. The reasoning
includes measurement difficulties and the argument that managerial skill is freely
available through contract and is seldom unique to a specific buyer (De la Mano, 2002).
This suggests that managerial efficiencies may lead to synergies only in exceptional
cases, and that they may be difficult to quantify ex ante. Furthermore, should a merger
allow for improved managerial efficiency where several bidders exist, this benefit may
be fully factored into the final offer price, leaving little or no synergy benefit to the
acquirer.
No specific valuation practices could be linked directly to this origin of synergy, but an
appraiser may have to consider its implementation cost, such as severance packages and
the cost of induction training for new management, including lost time.
Economies of the capital market
According to Camesasca (2000), a merger could lead to increased corporate size, which
in turn, could lead to economies when raising capital through common stock issue or
borrowing. Economies in the capital market, if realised, could then serve as an origin of
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synergy (as defined by Copeland and Weston, 1983), which would then often be
classified as financial synergy – a form of cost synergy.
But why would investors accept lower returns from larger entities?
Numerous sources link the size of an entity to its ability to survive, and therefore its
underlying risk. For example, Camesasca (2000) explain that a larger entity may display
lower variation in earnings, thereby affecting its ability to survive events like a price
war or the loss of a significant customer. Standard and Poor’s, a prominent ratings
agency, concede that there is a strong positive correlation between an entity’s size and
its survival rate (2010). In the same publication, the agency indicates that size is
beneficial in many cases owing to more extensive diversification and significant
resilience as a result of the large number of employees (which could influence the
entity’s fate in case of distress), the extensive exposure of banks (which often promotes
longer commitment) and more extensive ancillary assets (which could be sold). A very
large private entity may even become systemically important, prompting crisis-driven
bailout packages from governments in certain cases7.
Directly linked to the size of an entity is the concept known as a “small-stock
premium”. This premium is frequently incorporated as part of the estimated rate of
return on ordinary equity (PricewaterhouseCoopers, 2010), when calculated on the basis
of the dominant Capital Asset Pricing Model (as originally developed by Sharpe, 1964).
A small-stock premium therefore serves to increase the discount rate for smaller entities
– to a varying degree – to reflect increased risk, thereby suppressing the discounted cash
flow value of such entities. The notion of a small-stock premium is not universally
accepted, however, but supporting arguments include the inability of the standard
Capital Asset Pricing Model to describe the higher observed returns (albeit erratic) from
small companies (Fama and French, 2004).
In the case of leveraged entities a discount rate also typically incorporates the after-tax
rate of return on debt. This cost of debt, in turn, is frequently linked to a credit rating
that is normally determined directly by the provider of debt, such as a bank, or where
the debt is not provided by such an intermediary, a credit ratings agency.
Ratings agencies have come in for severe criticism in recent years for their role in the
latest financial crisis, including inappropriate ratings given to mortgage-backed
securities, and the conflict of interest inherent in their business models – whereby the
issuer of debt also pays for the rating. Even so, it is essential in some cases that a
separate entity should determine a credit rating and ratings agencies continue to play a
pivotal role here. In determining a credit rating these agencies consider both business
and financial risk, where attention is paid to several factors, including the size of an
entity. (Though, Standard & Poor’s (2010) emphasise that a demonstrable market
advantage is more important than outright size.)
7
A prime example is the backing given by the U.S. government to several businesses during the global
financial crisis that started in 2008, including the federal takeover of Fannie Mae and Freddie Mac by
the U.S. Treasury in 2008. Government backing to systemically important private businesses is not
guaranteed, however, as illustrated by the collapse of Lehman Brothers, a large U.S. investment bank,
also in 2008.
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It follows that, in the case of a merger, the impact on the combined entity’s cost of debt
will be determined by the effect of the merger (including increased size and market
advantage) on the combined entity’s business and financial risk.
According to De la Mano (2002), European merger control normally only considers
arguments of economies of the capital market as part of an efficiency defence in cases
where a merger will lead to access to new, less costly possibilities in raising capital and
the merged entity’s demand for capital increases. (If the demand for capital does not
increase, any savings will merely represent a pecuniary transfer of wealth from the
providers of capital to the merged entity, and will then not be considered.)
This suggests that economies of the capital market may readily result in cost synergy
(even if this is due to a pecuniary benefit) and that it should be possible to accurately
value this benefit ex ante.
Many writings, including those by Gaughan (2007) and McKinsey & Co. (2005), label
financial synergies as a questionable motive for any M&A. One type of merger – a
conglomerate merger – is sometimes justified on the basis of economies in the capital
market.
As part of their theory of why firms merge and then divest, Fluck and Lynch (1998)
predict that financial synergy allows a conglomerate merger to temporarily extract value
from marginally profitable projects by allowing access to finance, which would
otherwise have been unavailable. In their theory, the presence of the marginally
profitable projects further explains why conglomerates are often less valuable than less
diversified firms. This argument further supports the notion that economies in the
capital market will have a low value, at best.
A further argument is that the acquiring entity is frequently the dominant contributor to
economies of the capital market (with notable exceptions). Bidders should therefore be
wary of incorporating the full benefit of such synergy into the bid price, for this would
leave no benefit to the acquiring entity’s shareholders and thereby benefit only the nondominant party. The acquiring entity should also be wary of the impact of the
acquisition on overall credit risk and the resulting impact on the cost of debt.
Except for a link to a practice with universal application as recommended by
Damodaran (2005), which received only tentative classification as a leading practice
supra, no other dedicated practices in quantifying the value of financial synergy could
be identified in the literature.
However, a suggested practice could be inferred from documented practices in
calculating discount rates, to supplement the approach recommended by Damodaran
(2005), as follows: subject to the aforementioned provisos, incorporate the effect of
financial synergy into the overall process described by Damodaran (2005, step 3.2
indicated in Exhibit 2). As demonstrated, economies in the capital market will
principally affect the discount rate through the effect on the small-stock premium (if
employed, then part of the required rate of return on ordinary equity) and the combined
entity’s credit rating (affecting the after-tax rate of return on debt).
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Economies in innovative activities
“Innovate or perish”. This title by Lewis Branscomb (2006), professor emeritus at
Harvard University, aptly describes the choice offered to many a business in the modern
economy.
Innovative activity features “new methods”, it is “original” and often “advanced” (New
Oxford American Dictionary, 2005).
Joseph Schumpeter, one of the foremost theoreticians of entrepreneurship, offered early
insights into technological innovation – a matter closely related to entrepreneurship.
This keen perception included a description of five major types of innovation: (1) a new
product, (2) a new method of production, (3) a new market, (4) a new source of raw
material, and (5) a new organisation of an industry, such as a monopoly8 (Schumpeter,
1934:50).
A later paper on technology valuation by Schuh, Klapper and Haag (2008) reveals the
increasing importance of technological innovation: in the early 1980s, up to 75 percent
of the market values of most business entities comprised tangible assets, whereas this
figure plummeted to only 25 percent by 2005 – the balance being filled by intangible
assets, including technology and other products of innovative activity.
According to De la Mano (2002), M&A synergies stemming from innovative activity
could be substantial, especially where competition is mainly in the field of innovation,
rather than price. Importantly, benefits may accrue to any business where technology
enables an increase in competitiveness or product differentiation – thus, not only in
high-tech industries (Reilly and Schweihs, 1999).
Transformational synergy, a form of M&A revenue synergy, could also be grouped
under this category. Mckinsey & Co. (2010) describe transformational synergies as a
major potential source of synergy, but one that is often overlooked. Moreover, in the
same publication, the consulting firm credits this form of synergy to new capabilities,
such as the cross-fertilisation of product portfolios.
Against this, Camesasca (2000) warns that the benefits of innovative activity often
prove to be highly elusive. It may also be very difficult to promote innovative activity
within a company by using a specific method or system. Indeed, numerous attempts
have been made to address this, including brand new lines of study such as Design
Management.
Furthermore, McKinsey & Co. (2005) emphasise that synergies are often the result of
the acquisition of a specific technology or product – not just any innovative activity.
Consequently, the emphasis in this section falls mainly on the practices applied to
valuing the M&A synergy resulting from the acquisition of a target company for its
technology-related intangible assets.
8
The effect of market power and its interaction with innovative activity are discussed infra, in a later
subsection.
A de Graaf & AJ Pienaar
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In this instance, little additional insight could be gained by studying practices employed
in merger control. According to De la Mano (2002), claimed benefits are normally only
considered in an efficiency defence for mergers in industries with a short lifespan that
involve a high level of technology and a rapidly expanding demand. Furthermore, De la
Mano adds that, because of the difficulty of verifying claims, benefits are usually
assessed on the basis of “an educated guess, [offered] on a case-by-case basis”
(2002:17). However, additional reliance is placed on arguments where independent
sources are able to confirm the claims.
Merger control treatment and previous arguments therefore suggest that economies in
innovative activity may lead to substantial synergy in some cases, but that this is subject
to a high degree of uncertainty (therefore warranting a particularly high level of
conservatism by the appraiser). Moreover, it is suggested that these economies are
difficult to value accurately.
When applying valuation methodologies or models, the results will depend to a large
extent on the quality of inputs. This is especially true of innovation and technologies,
which is a specialist area and subject to a high degree of uncertainty. (A proper
understanding of the environment is therefore required.) It is beyond the scope of this
paper to address the technology and innovation environments comprehensively;
however, a few key issues are addressed in this section, including an evaluation of
certain practices that may be used to value technology-related intangible assets, which
in turn, may provide a stepping stone to valuing the M&A synergy obtained through a
technology.
According to Camesasca (2000), some origins of economies in innovative activity relate
to the removal of redundancies in research and development, and scale economies also
occur in this area (these were addressed supra, as part of non-production areas).
Thus, within the ambit of this research, other economies in innovative activity in a
merger may still serve as the origin of synergy. These include: (1) gaining access to
external technology, which may in turn extend technology options or hasten the
commercialisation of a technology (Boer, 1999); (2) the absorption of technology “freeriders”9 (Camesasca, 2000); and (3) gaining access to core technology-enabling patents,
allowing the levy of licensing fees, or legal action against infringers10 (The Economist,
2011a).
When considering the first possibility, recall that an option includes the right, but not
the obligation, to perform certain actions. Technology options, within the context of a
merger, include the following: the option of pairing technologies, the option to
accelerate a project, and additional options created through the interaction of a
technology (or portfolio of technologies, acquired through a merger) with an existing
research and development portfolio. These technology options could be priced using a
9
Inadequate protection of intellectual property rights and reverse engineering may result in knowledge
easily flowing to competitors, thereby creating a “free-riding” problem (Camesasca, 2000). In recent
years, several technology companies, including the Samsung Group and Apple Inc., were party to both
claims and accusations of patent and intellectual property “free-riding”.
10
Recent years saw renewed patent-wars in the information and communication technology industry; at
its apex, the technology-enabling patents of smartphones and computer tablets.
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real-options approach, which in turn, may be based on binomial option pricing models
or the much-lauded Black-Scholes formula11 (Black and Scholes, 1973).
A condition for the successful use of real-options pricing based on the Black-Scholes
model is that it should be possible to abandon a project before significant financial
investment is required (Van Putten and MacMillan, 2004). Fortuitously, this condition
is often met when valuing technology options, since the acquisition price for a company
owning a targeted technology frequently represents only a small proportion of the total
cost of commercialising the technology (Boer, 1999).
The weakness of the real-options approach is its sensitivity to changes in all variables,
including the inputs relating to volatility and the length of time to maturity. (This could
be overcome to an extent, using sensitivity analysis.) The strengths of this approach
include its recognition of the benefits of variability (Benaroch and Kauffman, 1999),
which is often downplayed in discounted cash flow analysis.
A real-options approach, based on the Black-Scholes formula, has been successfully
applied by several companies in the pricing of technology options, such as Merck &
Co., Inc. – one of the largest healthcare companies in the world – as highlighted by
Boer (1999), and Benaroch and Kauffman (1999), on the basis of a description by its
then Chief Executive Officer.
The appropriate use of a real-options approach, based on the Black-Scholes formula,
may therefore be classified as a leading practice in valuing technology options, as part
of the valuation of M&A synergy.
The first possibility also implies that gaining access to external technology may hasten
the commercialisation of a technology or product already in development. This could
affect numerous variables considered in forward-looking models dedicated to valuing a
single technology. The variables that may be affected include: probability weightings;
the timing of discounted cash flows; and certain factors, such as a technology readiness
factor. Forward-looking models and methods dedicated to valuing a single technology
include the Risk Weighted Enterprise Model (Boer, 1999), and the Technology Balance
Methodology, developed by the Fraunhofer Institute for Production Technology (as
described by Schuh et al., 2008).
Pertaining to the first model, the Risk Weighted Enterprise Model considers the
development life cycle of a technology as well as the possible results of successful
commercialisation; then, taking cognisance of these factors, the net present value of
projected cash flows is determined using a discounted cash flow approach, with
outcome-probabilities allocated for each possible stage of its life cycle (Boer, 1999).
The variables incorporated into the Risk Weighted Enterprise Model and its overall
approach seem wise in view of the high amount of uncertainty inherent to the process of
valuing a technology. The model is further based on other practices already classified
as leading practices, including a method based on discounted cash flow, but is naturally
11
The Black-Scholes formula was demonstrated to be general enough to be applied to a wide range of
business decisions where flexibility is a key factor, including the flexibility of physical capital
investment (The Nobel Foundation, 1997) and the pricing of technology options (Boer, 1999).
A de Graaf & AJ Pienaar
165
also exposed to weaknesses, such as a high level of subjectivity and a margin of error.
Successful implementation is claimed by Boer (1999), but it was not possible to verify
this claim independently.
Consequently, the use of the Risk Weighted Enterprise Model (Boer, 1999), as
described, warrants tentative recommendation as a practice in valuing M&A synergy,
but should preferably be combined with other leading practices (with Monte Carlo
simulation recommended as well).
The second Technology Balance Methodology is a more recent attempt at valuing a
single technology and employs a comparable approach to the previous model, but adds
a few intricacies of its own. This methodology also estimates future cash flows over an
entire life cycle, but considers two additional factors: a technology readiness factor and
a prognosis adjustment factor (Schuh et al., 2008).
The Technology Balance Methodology’s strength lies in its merging of several highquality techniques. Weaknesses include: a methodology chosen in part to find favour in
financial reporting circles (as such, applying a concept of value in use, as described by
the International Accounting Standards Board), highly subjective inputs, sensitivity to
changes in all variables, and the possibility of duplicating the risk probability
weightings in the expected cash flow and technology readiness factors. (The effect of
these weaknesses could be limited, to an extent, through sensitivity analysis.) Further
technical weaknesses include the assumption that the technology readiness factor could
be estimated simply by applying a linear scale to a more complex environment, and the
subjective estimation of the prognosis adjustment factor for an entity with little prior
experience (where it would be estimated without any basis). Furthermore, no evidence
of successful practical implementation could be identified.
Owing to the numerous weaknesses that have not yet been disproved, the Technology
Balance Methodology cannot currently be recommended as a practice in valuing M&A
synergy.
No specific practices to address the second and third origin of synergy (the absorption
of technology “free-riders” and gaining access to core technology-enabling patents,
respectively) could be identified in publications in the economic sciences.
In some cases, innovative output of a business is measured through a count of the
number of patents or the number of staff involved in research and development, or even
reference to the annual research and development expenditure. Camesasca (2000)
sensibly labels these as limited and warns against certain erroneous assumptions,
including the assumption of a direct link between these factors and innovative outputs
(there is an indirect link, at best), and further, the assumption that all inputs are
homogeneous in their effect. Use of these methods is therefore not recommended.
In addition, Eccles, Lanes and Wilson (1999) recommend that revenue synergies
(thereby implicating the inclusion of certain economies in innovative activity) should be
quantified, but that this should not be included in setting the maximum bid price (refer
to Equation [1]). This practice was followed by Morgan Stanley in quantifying the
acquisition price for AirTouch Communications (Vodafone Group, 2009), for example.
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Nevertheless, this approach should not be followed in all cases as an appraiser’s degree
of certainty should determine whether, and by how much, revenue synergy is included
as part of the maximum bid price. It suggests, however, that there is ample reason to be
conservative.
Savings in taxation
Savings in taxation resulting from M&As will depend on the tax legislation of the
countries involved, but according to Eccles et al. (1999), these savings should not be a
dominant motivator for a merger.
Moreover, tax legislation frequently prevents the utilisation of benefits, which might
otherwise include the utilisation (or faster utilisation) of income taxation losses, by
offsetting the taxable income of one entity against the assessed loss of the other; or a
saving in tax generated through an increase in the tax values of the assets of the
acquired firm, without paying capital gains taxes (Camesasca, 2000). (The international
scope of this study makes more detailed descriptions impractical.)
Although savings in taxation merely represent a pecuniary efficiency, whereby the
wealth of the government is transferred to the merged entity (De la Mano, 2002), such
gains could still result in an improvement in the net present value of cash flow of the
combined entity, when compared to that of the individual firms, thereby meeting
Copeland and Weston’s definition of synergy (1983).
No dedicated leading practices in valuing this origin of synergy could be identified.
This could be explained by one of several possible reasons, including: its controversial
nature; varying tax treatment in a multitude of countries; and a strong regulators’ focus,
demotivating voluntary disclosure by companies.
However, for the sake of completeness, a general practice could be suggested as
follows. First, make use of a taxation specialist, with appropriate knowledge of tax
matters in all affected territories, to assist with legal tax engineering and tax structuring
of the transaction. Eccles et al. (1999) explain that tax engineering pursues a lower
combined tax rate for the merged entities, when compared with the blended tax rates of
the unilateral companies. Tax structuring, in turn, strives to lower once-off tax costs, for
example from transfer duties and capital gains tax from the change of ownership, and
further attempts to carry forward any assessed tax losses. A second recommended step
is to obtain guidelines and estimates of tax savings from the tax specialist, and
incorporate these into a discounted cash flow model to determine the value of M&A
synergy from this source.
Market power
According to De la Mano (2002), market power is the ability to maintain prices above
competitive levels for a significant period of time. Market power may lead to collusive
synergy (a form of revenue synergy), according to Chatterjee (1986).
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Throughout history, several monopolies, syndicates and cartels have acquired market
power in many markets, including the salt, coal and steel markets – often with
debilitating effects on the welfare of consumers and competitors.
In recent decades, however, anti-competitive legislation largely curtailed those mergers
motivated mainly by market power (Camesasca, 2000; McKinsey & Co., 2005) – with
notable exceptions. In cases where it does exist, within the constraints of merger
control, it could nonetheless represent a significant synergy benefit (Chatterjee, 1986)
and must therefore be considered in the interests of completeness, for the purposes of
this review.
Camesasca (2000) states that both vertical and horizontal mergers may lead to increased
market power.
In the case of a vertical merger, a supplier of a key industry production input may
merge with another entity closer to the end-consumer in the supply chain, for example,
and then discriminate against competitors in its pricing of the input.
On the other hand, certain circumstances will motivate the pursuit of market power
through a horizontal merger, including a market facing falling demand (resulting in
excess capacity with the risk of a reduction in prices), and a local market exposed to a
higher possibility of entry by foreign competitors (with the risk of a fall in prices).
Economic and management sciences publications did not yield much information on
valuing M&A synergy from market power. This is logical, as regulators wish to limit
increases in market power and companies seek to expedite merger approval, few
companies would voluntarily disclose practices in this area.
Coincidentally, this strong focus by regulators resulted in an extensive study of this
phenomenon within merger control. For the sake of completeness, crucial insight may
therefore be obtained through a study of the practices employed in merger control to
measure the potential for, and effect of, market power generated through M&A.
European merger control utilises two dominant parameters to deduce a merger’s
potential for increased market power. These parameters are: the existing market shares
of the entities, and the overall market concentration (De la Mano, 2002). Mergers
seemingly motivated by market power could be classified as anti-competitive,
especially where a combined market share would exceed 25 percent (De la Mano,
2002:28).
In addition, European merger control considers the characteristics and nature of
competition in a market (Camesasca, 2000). Here, for instance, dominance is often
presumed for an entity with a large market share in a mature market, but not routinely
so for an entity with a similarly large market share in a high growth, technology-driven
market – as this may be short-lived12 (Camesasca, 2000).
12
Although in some cases it may be longer-lived, as in the case of Apple Inc., for example, a company
that held a dominant position in several technology-driven areas for quite a number of years. (But, even
for this titan of the technology industry, dominance now seems to be dwindling.)
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In U.S. merger control a foremost indicator of market power is the HerfindahlHirschman Index. This index applies a formula which considers both the number of
firms in a market and market shares. The index further places a greater weight on
concentrated market shares.
The United States Department of Justice (no date) describes the calculation of the
Herfindahl-Hirschman Index as follows: (1) the market share of each firm (or in the
case of a highly segmented market, the 50 largest entities) competing in the market is
identified; (2) each of these market shares is squared; and (3) the resulting numbers are
then summed.13 Market shares are typically calculated on the basis of specific firm’s
current share of the total market in terms of sales or capacity (Camesasca, 2000).
The United States Department of Justice (no date) further describes the following key
points on the index: between 1000 and 1800 points (suggesting a moderately
concentrated market), and points in excess of 1800 (indicative of a concentrated
market). In cases where the market has an index rating above 1800 points, prior to a
merger, it is already deemed to be concentrated. If the index rating increases by more
than 100 points following a merger, this will trigger market power concerns and will
probably be challenged in U.S. merger control. According to Camesasca (2000),
mitigating circumstances would be considered in such a case, such as potential new
entrants and the barriers to entry.
Merger control in both the European and U.S. milieus further emphasises the
importance of properly defining the market. According to Camesasca (2000), the
Europeans consider the “functionable interchangeability” (89) of a product or service;
to them a market should therefore encompass all products and services that are
interchangeable to a sufficient degree in its price, usage and consumer preference. In
defining a market, the U.S. Merger Guidelines also address the concept of substitution
between products, services and area. The United States Department of Justice (no date)
explains that the market should be expanded as long as a consumer would switch to a
substitute product, service, or geographical area in the event of a 5 to 10 percent
permanent relative increase in selling prices. If the consumer would not switch to a
substitute, this would indicate the limit of the defined market.
In the face of dominant market power, various merger efficiencies may still positively
affect certain groups protected by the competition law of a country. Possibly motivated
by the Schumpeterian process of “creative destruction” (1942:313-318) – where an old
economy must sometimes be sacrificed in the interest of a new, more efficient state –
and as introduced in the background to this study, the relevant bodies responsible for
merger control frequently consider an efficiency defence, in rebuttal against an
otherwise anti-competitive merger. If this defence is successful, the merger may still be
allowed, or be allowed with certain conditions.
13
To illustrate, assume a specific market consists of five firms each with a current market share of
20 percent before a merger. In this case the resulting Herfindahl-Hirschman Index would equal 2000
points (202 + 202 + 202 + 202 + 202). An ex ante projection may indicate that, following the merger of
two of these firms, the market would consist of four firms, three with a 20 percent share each, and a
single firm with a market share of 40 percent. In this case the resulting index would equal 2800 points
(402 + 202 + 202 + 202), thereby increasing the index by 800 points.
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Further, as described by De la Mano (2002), market power not only has the potential to
positively affect a merger in terms of synergy, it also has its drawbacks.
In a negative sense, despite the obvious, market power could also be the cause of
inefficiencies, thereby reducing overall M&A synergy. According to De la Mano, these
include two types: (1) an increase in managerial inefficiency, due to an increase in the
size and complexity of the merged organisation; and (2) a reduction in innovation
efficiency, for example in technology-driven industries where there is a “winner takes
all race” (2002:13). Here, a merged entity with increased market power could have less
incentive to innovate, as further innovation could help destroy the old, dominant
industry and help in the creation of a new one14. A frequently cited survey on the topic
of “synergy” (Thomson Reuters, 2012) by Chandy and Tellis (1998) supports this view.
Here, Chandy and Tellis find that one critical indicator of success in far-reaching
innovation is a firm’s “willingness to cannibalize” (1998:474) its own investments.
From the literature there does not seem to be any universal, direct measure to estimate
the expected increase in selling prices from an increase in market power. However,
based on these insights, the following methodology could be suggested in valuing M&A
synergy from market power ex ante. An appraiser, preferably through the involvement
of a specialist adviser in competition law (who may already be assisting in mergercontrol matters), should collectively consider four factors.
First, consider the likely effect of the merger on market power and the probable reaction
of merger control in the relevant territories. (If market power will be significantly
affected, the merger is unlikely to be approved by merger control.)
Second, if the merger is likely to be approved, but there is still a possibility of an
increase in market power, then the effect on market power should be determined using
the same measures applied in merger control (including estimates of market shares and
market concentration, and a calculation of a Herfindahl-Hirschman Index for a properly
defined market, as described).
Third, based on these estimates of an increase in market power, the likely effect on
selling prices should be estimated (mainly by the management of both entities, through
a due diligence investigation) and included in a valuation model based on discounted
cash flow. Here the advice of McKinsey & Co. (2005) should be heeded: estimates of
pricing power and market shares should be formulated to be “consistent with market
growth and competitive reality” (450).
Finally, consider potential negative implications and incorporate them into a discounted
cash flow model (specifically, the cost and effect of conditions likely to be specified by
merger control, and the effects of increased market power on managerial efficiency and
innovative efficiency).
14
To illustrate, consider the recent demise of the once-dominant Eastman Kodak Company, which filed
for bankruptcy in 2012. According to Forbes (2012), Kodak and its subsidiaries failed by asking the
wrong marketing question – even though the company invented the first digital camera in 1975, it held
back the marketing of the new technology for fear of hurting its then lucrative film business.
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Other related matters
The process of negotiating the final amount to be paid for a merger (and synergy) treads
the grey area between “art and science” (see Howard Raïffa, 1982), and incorporates
many intangible components.
Although a detailed analysis is again beyond the scope of this study, the results of a
negotiation regarding the price of a merger will directly affect the eventual purchase
price. As demonstrated, this in turn may affect the value of synergy realised in a
merger.
According to Reynolds, Simintiras and Vlachou (2003), the main categories of interest
in the extensive research into international business negotiations are: (1) character traits
of the individual negotiators; (2) cultural impact; (3) environmental and organisational
circumstances; (4) the negotiation situation as such; and (5) the outcome of the
negotiation.
Due to their important role, negotiators are frequently held in high regard. But Raïffa
clearly dispels one common misperception: “[Negotiators] certainly weren’t satisfying
the prescriptive ideals of ‘rational economic man’” (1982:4).
Recent trends in East-West foreign direct investment15 make the character traits of the
individual negotiators and cultural impact particularly topical. For instance, a successful
negotiation with Chinese needs to be conducted in a manner that is acceptable in
Chinese culture, according to a study by Hong Seng Woo (1999). The same study
revealed that a western negotiator should avoid misunderstanding through proper
knowledge of unique concepts, including the importance of status, trust and friendship,
the workings of a Guanxi network (a personalised network of influence), patience, and
Chinese protocols (1999:313).
To add a few more examples, U.S. negotiators are often described as forthright and
direct; European negotiators as reserved and conceited. The intent here is not to
stereotype. However, improved understanding should be sought by paying proper
attention to the nuances of negotiation.
Certain direct links could be made between negotiation and the process of valuing
M&A synergy. Relating to the individual candidate, KPMG (2001) recommends the
appointment of a process manager in the dual-role of price negotiator and deal assessor.
Other factors to consider include Chatterjee’s call for the distribution of synergy gains
according to bargaining leverage afforded by each entity’s respective contribution of
resources (1986). In a technology context, Boer adds that when two technologies are
brought together, the majority of the value will “polarize” (1999:312) in the direction of
dominance. Here, dominance could be an enabling technology or a dominant
commercial position.
15
Where companies in the East, such as China and India, make direct investments in the equity of
companies in the developed West, such as Europe or the U.S.
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CONCLUSION
First of all, it has to be admitted that this study offers no panacea for the difficulty of
accurately valuing M&A synergy ex ante. Further studies must be undertaken, including
numerous case-studies of best-in-class organisations in order to identify best practices.
It must also be remembered that leading and best practices change over time. A further
critical review and synthesis, taking cognisance of new developments, will therefore be
required in future. Due to its focus on M&As, the scope of this study excluded joint
ventures, licensing and industrial partnerships. These are nonetheless valid avenues for
extracting synergy and should form part of separate research.
Future research could also expand the knowledge of “best practice parenting”.
According to this area of study, investors are demanding that companies demonstrate
their superior parenting of subsidiaries. Accordingly, in addition to proper acquisitions,
an appropriate parenting portfolio may also demand timely divestitures – especially in
cases where there has been a change in strategy.
Despite the limitations of the chosen methodology, this study succeeded in classifying
certain practices as leading valuation practices, and synthesised these into three logical
groupings.
The first grouping is leading practices that form part of the overall M&A process, which
affects synergy valuation. The second grouping is leading practices with universal
application in valuing M&A synergy. Where it was possible to link certain practices
directly to certain origins of synergy, these form part of the third grouping, and are
described separately according to the origin.
The origins of synergy explored in this study included: scale economies; economies of
scope; managerial efficiencies; economies of the capital market; economies in
innovative activity; and for the sake of completeness also other more contentious
origins, including savings in taxation and market power. The dynamic interaction of
efficiencies, where an increase in one type could lead to a decrease in another, is also
highlighted. In addition, certain valuation practices are recommended, where
appropriate. (The findings are summarised in the appendix.)
Ultimately, the search for a synergy effect is not a recent endeavour. Since time
immemorial, humankind has been searching for phenomena with a combined effect
greater than the sum of the parts. But what was true then remains true today: accurately
predicting an effect based on uncertain events is difficult. Given the level of uncertainty
in today’s globalised world, it seems that this may be especially true when valuing
M&A synergies ex ante.
Difficulty and uncertainty should not, however, prevent the search for improvement. In
this case, enhanced accuracy in valuing M&A synergies may lead to improved selection
of worthwhile M&A targets. Better choices in this area may then represent a positive
step towards sustainable business practice.
Here’s to hoping that executives, armed with the necessary tools, manage to realise the
elusive synergy effect.
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178
Merger control considerations in
efficiency rebuttal arguments
• Short-term benefits (normally only
where the market has over-capacity
and products are very similar).
• Long-term benefits (normally only
through coordination of future
capital investments in order to
move production closer to
minimum efficient scale (MES), or
by utilising returns to scale).
Normally considered only where the
efficiency will result in a reduction in
selling prices, and where benefits are
merger-specific. The further requirements
of verifiability and quantifiability are
normally met.
1. Scale economies in production resulting from:
Description of origin
Cost synergy, but only Consider evidence on the MES
• Engineering estimate for the proposed
where the merger will of the industry. Consider the cost
merger.
trigger the benefit, or
of integration. Consider the
• Reasonability test based on
length of time required to move
prompt earlier
information in Exhibit 3.
to MES by combined firm vs.
implementation.
Efficiency does not have the firms unilaterally.
to be merger-specific,
but consider maximum
bid price (Equation [1]).
Type of synergy
Leading practices linked directly to a specific origin of synergy, including efficiencies (if any)
Matters to consider in valuing Leading valuation practice / recommended
M&A synergy ex ante
practice (if available)
(These practices form part of a basic toolkit to be customised and drawn from
for every assignment.)
• Follow an “outside-in approach”, applying the associated four steps, as
described in the text.
• Apply a valuation method based on discounted cash flow.
• In general, an appraiser should apply a conservative outlook, particularly
in valuing revenue synergies.
• Follow an overall process as indicated in Exhibit 2, contingent on the
implementation of an “outside-in approach” and consideration of other
leading practices in assessing specific origins of synergy.
• Perform a Monte Carlo simulation for areas subject to a high level of
uncertainty.
(Implementation of these practices may lead to greater synergy realisation ex post.
An appraiser should therefore consider their implementation in determining the level
of conservatism in valuing M&A synergy ex ante. )
• Consider the number of key M&A processes followed for a merger, with a
focus on early action and other key processes as identified in Exhibit 1.
• Formulate a maximum bid price as described in Equation (1).
• Set corporate culture as a merger screening criteria and focus on ways of
integrating the disparate sales forces (tentative).
Leading practices with universal application
Leading practices linked to the overall approach to M&As
LEADING PRACTICES / RECOMMENDED PRACTICES IN VALUING M&A SYNERGY EX ANTE, SYNTHESISED ACCORDING TO FUNCTION
APPENDIX: SUMMARY OF FINDINGS
SA Journal of Accounting Research Vol. 27 : No. 1 : 2013
A de Graaf & AJ Pienaar
179
Cost synergy. (Pecuniary Consider the implementation None specifically.
Normally only considered where
cost, e.g. in cases of a name
efficiencies will also
substantial. Frequently difficult to
quantify. Savings that represent merely a represent synergy here.) change, the cost of rebranding.
transfer of wealth (pecuniary efficiencies)
are not considered.
Normally considered, unless motivated Cost synergy or, with
mainly by market power or to avoid taxes. increased market power,
Tend to be merger-specific and may lower if allowed by merger
prices to the benefit of consumers in the control, then revenue
short term.
synergy.
Often not, for the argument regularly
Cost or revenue synergy
stands that managerial skill is difficult to (but rare).
measure and is liberally available through
contract.
Only in cases where a merger leads to
access to new, less costly possibilities in
raising capital and the merged entity’s
demand for capital increases. If the
demand does not increase, it represents
merely a pecuniary transfer of wealth
from the creditors to the merged entity.
4. Economies of scope
5. Managerial efficiencies
6. Economies of the capital market
Cost synergy (from
financial synergy).
(Pecuniary efficiencies
will also represent
synergy.)
Financial synergy will have a Incorporate the anticipated effects of the
low total value at best and the merger on the small-stock premium and
bidder should be careful not to credit risk into an updated discount rate.
include too great a proportion in Then incorporate into step 3.2, indicated in
the bid price as they normally Exhibit 2, as part of an overall process. (Pay
contribute most of the benefits cognisance to the provisos for use of this
leading to financial synergy.
overall process, as mentioned in the text).
Compare to industry efficiency None specifically.
benchmarks. Managerial
efficiency is often available to
other potential bidders and thus
often fully paid for. Consider
implementation cost.
Consider the costs of vertical None specifically.
integration, such as greater legal
fees to comply with merger
control regulations.
Consider the cost of integration. Assess redundant areas and apply a
discounted cash flow model. Specifically
supplement with several practices linked to
the overall approach to M&A and practices
with universal application.
3. Scale economies in non-production
areas
Cost synergy.
Normally considered only where it will
result in a reduction in selling prices.
Other requirements are normally met.
Matters to consider in valuing Leading valuation practice / recommended
M&A synergy ex ante
practice (if available)
2. Removal of redundancies
Type of synergy
Merger control considerations in
efficiency rebuttal arguments
Description of origin
180
SA Journal of Accounting Research Vol. 27 : No. 1 : 2013
9. Market power
Never considered as a defence – an
increase in market power is anticompetitive by nature. Even though it
could be privately profitable, it merely
redistributes gains.
Mainly revenue synergy. The legality and ethical facets
of this origin of synergy should
be considered in detail. Further
consider the lowering effect on
other synergies (e.g. from a
decrease in managerial
efficiency and a reduction in
innovative efficiency).
The legality and ethical facets
of this origin of synergy should
be considered in detail.
Never considered as a defence. Even
Cost synergy.
though it could be privately profitable, it
merely redistributes gains.
8. Savings in taxation
• Preferably with the help of a specialist
in competition law, consider if the
merger will be allowed by merger
control.
• If so, consider the effects of market
power (including estimates of market
power and market concentration, and
a calculation of the HerfindahlHirschman Index) on selling prices.
• Incorporate in a discounted cash flow
model.
• Also consider merger control cost and
effect of likely conditions.
• The use of a tax specialist.
• Incorporate into a discounted cash
flow model.
Consider cost of integration. An Where the origin is through gaining access to
appraiser should be particularly external technology (no specific practices
conservative in this area.
identified for other origins):
• Value expanded technology options
using a real-options approach, based
on the Black-Scholes formula.
• Apply a Risk-Weighted Enterprise
Model (tentative), but combine with
other leading practices and Monte
Carlo simulation.
Considered normally in industries with a Yes, revenue and cost
short lifespan, high-technology and a
synergy.
rapid expanding demand. Difficult to
verify; evaluation normally based on an
educated guess.
Matters to consider in valuing Leading valuation practice / recommended
M&A synergy ex ante
practice (if available)
7. Economies in innovative activity
Type of synergy
Merger control considerations in
efficiency rebuttal arguments
Description of origin