Mergers and acquisitions (M&A) are non-organic growth strategies in which a company takes control of the other, in case of an acquisition; or in which two companies combine their resources and create a new one, in case of a merger. Despite of legal and mercantile differences, in financial terms there is no difference between a merger and an acquisition since in the end, always, one of the companies, understood us the set of shareholders and managers, assume the control of the other firm. Moreover, presumably, the underlying motive to run a merger or an acquisition is always the same: the existence of potential synergies, despite not always being this true, as we will see later.
These yield to the questions of what is a synergy, what is their nature, if the mere existence of synergies is a sufficient condition to run an acquisition, and if it is true that after every M&A operation is there any synergy.
Usually, it is said that there are synergies when 1+1=3, that is, when the whole is worth more than the sum of its parts. Concretely, in the business field, synergies exist when the value of the resulting company from a M&A operation has a larger value than the sum of the values of the involved companies individually. Those synergies are materialized, therefore, in an increase of value, and its origin is founded in the improve of the value drivers of the company. As it is known, the value of a company is given by expected cash flows and the risks associated to them. Thus, we can distinguish synergies that affect i) cash flows: sales increases, operating margins expansion, decreases in CapEx (maintaining constant the growth rate), and tax rate reductions; and ii) the risk of the company: cost of capital reduction, cost of debt reduction or financial structure modification. Moreover, there are authors that states a differentiation between synergies and control change, arguing that synergies occur when it is necessary to involve two or more firms, while change of control doesn’t need the implication of another firm to increase value, just the entry of a new board of directors, with new management ideas. Nevertheless, understanding the essence of synergies in a wide sense, including management changes, is enough to comprehend the underlaying dynamics of these operations.
Despite the existence of synergies, M&A don’t always generate value for the shareholders of the acquirer because the price paid is, sometimes, too high.
Despite the existence of synergies, M&A don’t always generate value for the shareholders of the acquirer because the price paid is, sometimes, too high. When talks between the two board of directors starts, or when rumours about the possible operation are filtered, potential acquired company shareholders demand a control premium, which implies a strong market price rise. Shareholders know that synergies may exist, and that the acquirer would be willing to pay for them. Accordingly, supposing that the market share price reflects the value of the company before the rumours, the increase in the following days or weeks corresponds to the premium required by the acquired firm. If finally the operation succeeds, if the premium paid exceed the value of synergies, the acquiring company would not only have not generated value but would have destroyed it. If the opposite is true, that is, if the premium is lower than the value of synergies, this difference would be the generated value to the acquirer. Therefore, the existence of synergies is a necessary condition (assuming that the acquired company is not undervalued), but not a sufficient one, since the premium paid plays a key role in the value generation process.
Therefore, M&A operations are not the panacea of value creating, and this is showed by evidence since, on average, they do not create value for the shareholders of the acquirer (although value is generated in these operation to the shareholders of the acquired). Jensen & Ruback (1983) show, after analysing some empiric researches, that the acquisitions negotiated by the two board of direction (and afterwards approved in shareholders’ meeting), generate 0 extra profitability. That is, they do not generate nor destroy value (when the operation is run without board of director’s mediating, the extra profitability is around 4%). Yaghoubi et al. (2016) study more than 50 empiric researches, arriving to the conclusion that in the long run, there is no value generated in these operations, but rather a slightly value destruction. Thus, it may be concluded that M&A are not infallible operations, not even mostly profitable, and that the value generation through these operations is the exception instead of the usual.
It may be concluded that M&A are not infallible operations, not even mostly profitable, and that the value generation through these operations is the exception instead of the usual.
Thus, investors not only should put in perspective the value of synergies, comparing it with the premium paid, and considering that is an essential element, but also, they should mind the board of director’s ethics. In this sense, some studies show that managers have different interests from shareholders, and that they undertake M&A operations with the objective of benefiting themselves. Jensen (1986) show that managers do not have incentives to distribute the generated free cash flow as dividends, since this would imply a reduction in the capital of the firm and a reduction in assets under management. So that, with that excess cash, managers run unprofitable M&A operations (i.e. with a higher premium than the value of synergy), making their company larger at their shareholders’ expense.
In conclusion, synergies exist and could be a great source of value creation in the long term, but neither are sufficient condition to create value, nor are the only reason why M&A are undertaken. So that, overconfidence and excess optimism regarding these operations cannot be justified and should always be analysed in detail.
- Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review, 76(2), 323-329.
- Jensen, M. C., & Ruback, R. S. (1983). The market for corporate control. Journal of Financial Economics, 11, 5-50.
- Yaghoubi, R., Yaghoubi, M., Locke, S., & Gibb, J. (2016). Mergers and acquisitions: a review. Part 1. Studies in Economics and Finance, 33(1), 147-188.