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This article is written by Abhishek Nair, pursuing Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from Lawsikho.

Introduction

The idea of synergies in the field of mergers and acquisitions is quite an interesting one and full of complex mathematical predictions. The boiled-down idea behind this concept is that if two companies merge into one single bigger company, there needs to be some value that arises out of it which is larger than the standalone value that they have as separate entities. The question that then arises is why are synergies important in the large scheme of things because it seems like a logical conclusion that if two companies are going to merge and pool their resources then shouldn’t it largely lead to benefit for both the companies. However, this is not factually accurate as it is often noticed that a large number of companies who have merged or been acquired usually fail to live up to their potential as they lacked synergy from the very start and can be squarely blamed on two reasons. Primarily the companies while engaging in resource sharing not only get the benefits but also the negative effects of sharing resources which contaminates the benefits, for example; if the working culture in two companies does not match, there is going to be a frequent clash in the work sphere of the merged company. This is called the contagion effect. Secondly, the M&As are likely to result in extended use of existing resources whose capacities are limited and have not been adjusted for the increased use that comes from the new operations of the merged companies then the companies lose the benefits it seeks to achieve from this merger

The official purpose of the majority of M&A activities is to achieve synergies and to create added value for the new organization. Although the major potential synergies are recognized before the transaction is completed it does not necessarily imply the rest of the softer synergies are going to be achieved. The most successful mergers are usually those in which the companies are in a similar field of business or they at least have something in common. This is why a food giant like PepsiCo targeted and acquired companies like KFC, Pizza Hut, and Taco Bell, forming Tricon Global Restaurants, Inc., the world’s largest restaurant company. Sun Pharmaceuticals went ahead to acquire the global giant of Ranbaxy to create the fifth-largest pharmaceutical company in the world. 

Types of synergy

The next question that then arises is how do you effectively recognize the synergies that exist between two companies? For this purpose, synergies were classified into cost-saving synergies, Revenue and market synergies as well as financial synergies.

Cost-saving synergy

The type of synergy aims at reducing the administrative costs and overhead costs for the combined company than possible for the two separate individual companies. The existing resources of a company that are not being used at full capacity due to the high operational costs can now be better utilized because of the additional cash flows and the ease of doing business that arises out of this merger. To better understand this, take a look at this merger.

The Hindustan Lever Limited(HLL)-Brooke Bond India Ltd.(BBIL) merger is a prime example of a merger based on cost-saving synergy. HLL used to operate in the personal care product market such as soaps and detergents, which meant that the company had very few investment requirements. On the other hand, Brooke Bond Lipton, with its presence in the growing packaged foods market, had a constant need for investment in new products, increasing manufacturing capacities, brand building, and sales exercises which were not feasible at the time when they had a merger profit of 62 crores. The merger led to a 10% reduction in employee costs resulting in an 8% increase in net profit. All in all, this meant the company got cost, financial as well revenue synergy through this merger.

Methods of cost-saving synergy

  • Shared information technology

Mergers and acquisitions generally include selling the proprietary rights to the IP of the company from the seller to buyer, which leads to increased operational efficiency for the new company. For example; in a vertical merger, acquiring patents and trademarks allows them to smoothly integrate the auxiliary process into their main production, negating the usual costs it would have had to undertake.

  • Supply chain efficiencies

Supply chain relationships are one of the most efficient ways to reduce costs as a shared supply chain increases the network for the companies and reduces the cost of distribution. This is especially beneficial in cross-border mergers, where foreign companies merge to share the supply chain since it is difficult to establish a new supply chain in a foreign country. Brands like Zara have effectively utilized the shared supply chain efficiencies by merging their Inditex Ltd brand with Tata’s Trent Ltd which owned multiple retail chains in India and reducing any cost it would have taken for them to set up their distribution channel.

  • Improved sales and marketing

Better distribution sales and marketing channels will increase sales and marketing, in terms of advertisement costs and getting better reach at the grassroots levels. This also leads to revenue synergy in the longer run, but in the short term, cost savings take place because of the pooled resources in the merged firm.

  • Research and development

This works especially well in horizontal mergers where competing firms with similar products can share the research and development that they have developed at the same time allowing for further progress development or room to cut costs in production without sacrificing quality. For example; pharmaceutical companies on mergers usually share the information on the research on any new drug trials that are undertaken and the pooled information leads to better brainstorming as well as increased resources to work on these products.

  • Lower salaries and wages

This is self-explanatory as a merged company would mean an adjustment in the structuring of the company since there is no need for two CEOs, CFOs, etc. This means that the company while growing in size would be adjusting the top-level management structure and reducing the gross total the company spends on salaries.

Revenue and market synergies

Revenue synergy refers to the potential growth in sales in a merged company compared to the two companies individually. This type of synergy is preferred by both buyers and sellers as a higher revenue synergy gives more bargaining power to the seller to increase the premium on the cost of their company which means that horizontal mergers with good synergy it is potentially going to lead to better bargaining power for the seller company as the buyer is willing to pay to acquire his competition. At the same time, buyers are okay with shelling out the big bucks, as the potential profit in increased revenues would mean that there is going to be a substantial positive benefit to the merger in the long term. The idea of market synergies aligns with revenue synergy in the sense that it refers to an increased capability to negotiate with the customers on the goods. This type of synergy has been capped to some extent by the various competition regulatory authorities.

Methods of revenue synergy

  • Patents

This is quite similar to cost-based synergy, however, the goal in acquiring patents is to get proprietary rights to new IP which allows companies to lease their patents and gain revenue in the form of royalty. Access to the IP of competitive companies increases the revenue gained by the creation of a better product which is a by-product of the idea of research and development cost saving.

  • Complementary products

In vertical mergers companies often gain additional revenue by bundling together their products. This leads to companies being able to charge higher prices for the bundle or gain higher revenue by attracting more customers with discounts on the bundle. The cost saving in undertaking auxiliary activities, for example, if an electronics supermarket “A” merges with a company, “B” that is engaged in the servicing and repair of electronic item, it leads to a higher customer base than that “B” could have managed alone because all the customers from the supermarket are going to rely on the servicing aspect but at the same time, the bundle of repair and service while buying the goods increases the customer quality service which in turn just solidifies the customer base. Furthermore, merging two firms with varying geographies and customers will allow the merged firm to gain access to increased demography, producing higher revenue.

  • Increased market share gains

By undergoing a merger, the organization’s market position, as well as customers, can be won from competitors. This leads to companies having a bigger percentage share overall in the market. In addition, an alignment of business units creates increased possibilities to offer the customers a broader product base in the same or similar market, thus contributing to a more complete market offer.

Financial synergies

Financial synergy is indicative of the financial advantage that occurs when two companies merge which otherwise doesn’t exist. Generally, small companies due to their size do not have a vast debt capacity. This leads to them being unable to undertake multiple capital-intensive projects. Merging with bigger companies reduces the cost of capital for these companies and that is an indication of financial synergy.

Methods of financial synergy

  • Tax benefits

Tax benefits can arise from a merger, taking advantage of existing tax laws by merging a high-tax-bracket company with a low-tax-bracket company. If a profitable firm acquires a loss-making company, it can reduce its tax burden by using the net operating losses of the target company to shield itself from tax implications. This is how Murugappa Electronics, which merged with EID Parry, created a company with a near-zero tax burden. Furthermore, financial engineering through mergers can be done by offering equity stakes to owners of the debt-ridden company who will then be willing to sell their shares. 

The firm’s unused debt capacity, unused tax losses, surplus funds, and write-up of depreciable assets also can save on tax costs and increase in value.

  • Increased debt capacity

Banks love a steady and predictable giant of a company because it seems like a good investment. Small companies with an unpredictable financial sheet mean banks are likely to go ahead and reject any attempt for a significant borrowing as there is still some doubt on the ability of the company to repay the bank.  A merged firm can manage to solve this issue by having better borrowing power due to the pre-existing relationship and track record with lending institutions which can help reduce the overall cost of capital. It also reduces the interest rates on loans as banks generally base their interest rates on the liquidity and leverage of a specific company and provide lower interest rates to bigger companies because of their cash flows.

  • Diversification and reduced cost of equity

When large firms acquire smaller ones or when publicly traded firms acquire private firms that are in a different industry it leads to diversification which may reduce the cost of equity for the combined firm. When firms merge, especially in horizontal mergers, when competitive firms merge, they gain a wider customer base, which can result in lower competition. The expanded customer base can also result in increased revenue, market share, and cash flows. Therefore, these competitive advantages can reduce the cost of equity. However, this is highly dependent on the size and industry of the business.

Conclusion

Synergy is the most motivating factor behind mergers, although they are not always achieved and do not always result in higher shareholder returns. Even then, the realization of synergies post-merger is the highest possible way to increase shareholder returns, and the cases where synergies do not result in higher shareholder returns are considered to be fringe factors that do not fit the norm. Therefore, pre-merger financial and legal due diligence assumes greater significance in correctly assessing the synergies or risk losing shareholder benefits. Companies tend to seek out a combination of all the above-mentioned synergies called “combined synergies” as the best synergy as they create a good balance between revenue synergies and cost synergies, contributing with long-lasting values and continuous improvements evolving over time. 

References


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