Académique Documents
Professionnel Documents
Culture Documents
4, 2007
Dodo zu Knyphausen-Aufsess*
Otto-Friedrich University of Bamberg, Feldkirchenstrasse 21,
96045 Bamberg, Germany
E-mail: dodo.knyphausen@uni-bamberg.de
*Corresponding author
Jens Koeppen
AlixPartners GmbH, KoÈnigsallee 53-55, 40212 DuÈsseldorf, Germany
E-mail: jkoeppen@alixpartners.com
Lars Schweizer
Johann-Wolfgang-Goethe-University Frankfurt &
Grenoble Ecole de Management, Mertonstr. 17, D-60325
Frankfurt am Main, Germany
E-mail: l.schweizer@em.uni-frankfurt.de
Abstract: Most merger and acquisition activities destroy value. One reason
for this is that acquisition premiums tend to be too high in relation to the
synergies that motivated the premiums paid. In this paper, we illustrate the
performance implications of overstated synergies and develop a ten-step
reference model for the calculation of synergies in order to avoid
overestimating their potential. After that, we present three case studies in
which we assess how synergies are determined in practice and compare this
to our reference model.
1 Introduction
Mergers and acquisitions (M&A) are a popular strategy for many firms and are
considered to be a key element of economic activity causing industrial change and
rationalisation in the modern industrial era (Jensen, 1993). However, failure rates of
M&A are reported as high as 50±75% (Marks and Mirvis, 1998) and many acquiring
companies paid far more than the market value for their purchases. To justify these
`acquisition premiums', they pointed to potential synergies they said they would reap
as the companies grew together (Brush, 1996; Harrison et al., 1991). However, the
realistic potential for synergies often falls short of these expectations (Chatterjee,
1986, 1992; Lubatkin, 1983; Ravenscraft and Scherer, 1989; Reed and Luffman,
1986; Sirower, 1997). Ex post, it therefore turns out that the purchase prices were too
high. This points to the important role the correct calculation of synergies is
supposed to play as a linking pin (Kode et al., 2003; Sirower and Stark, 2001)
between the M&A strategy (Bower, 2001; Trautwein, 1990), on the one hand, and the
subsequent post-acquisition integration phase (Haspeslagh and Jemison, 1991), on
the other hand.
The synergies calculated as a result of the applied M&A strategy during the
acquisition planning phase determine the necessary amount of synergy realisation,
e.g. either in terms of cost savings or revenue improvements. Thus, they have a
significant influence on the post-acquisition integration phase in which value creation
is supposed to take place (Haspeslagh and Jemison, 1991; Larsson and Finkelstein,
1999; Shrivastava, 1986). Because of that, synergy calculation can be considered as
one very important and indispensable step in the M&A process connecting M&A
strategy and post-acquisition integration.
However, the issue of synergy calculation is still considered to lack sufficient
empirical research. In this context, Javidan et al. (2004, p.254) ask the question `how
do firms define synergy . . . and how do they measure it?' In a similar vein, Sirower
(1997) raises in his `synergy limitation view' two important questions that need to be
analysed in more detail in order to improve our knowledge concerning the
calculation of M&A synergies and, by this, making M&A more successful:
* What can companies do to realistically calculate synergies ahead of a merger or
acquisition?
* What do companies actually do in practice?
The purpose of this paper is to provide an answer to the questions raised by Javidan
et al. (2004) and Sirower (1997) by developing a theoretical-driven reference model
that will be compared with the description of real synergy calculation cases, thus
pursuing an exploratory approach. Firstly, we discuss the impact that overblown
synergy estimates can have on the expected performance of the acquiring company
after the merger, before outlining one possible way of doing so. This procedure serves
346 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer
as the benchmark for three case studies, which we performed to illustrate the `nuts
and bolts' of applying the procedure in corporate practice. Finally, we present some
conclusions.
Figure 1 Relationship between the acquisition premium and the net present value
If the acquisition premium is paid in cash, shareholder value will increase for the
target company in all three scenarios. However, the shareholder value of the bidding
company will increase only if the net present value of the synergies associated with
the acquisition is greater than the premium paid to the shareholders of the target
Identifying synergies ahead of mergers and acquisitions 347
company. If not, shareholder value will be destroyed. If the present value of the
synergies is equal to the acquisition premium, positive synergies will indeed be
realised. However, cash payment of the equivalent premium would transfer all added
value to the shareholders of the acquired company. The acquisition premium is
therefore deemed ex post to have been estimated accurately. It will thus increase the
net present value for the shareholders in the amount of the acquisition premium,
provided that the net present value of future synergies is at least equivalent to the
acquisition premium paid, i.e. if:
Synergies
NPV ÿ Acquisition premium 0
1
X
N
t
1 r
ti
where r is the cost of capital; N is the number of years to be planned; i is the year in
which performance begins to improve; and NPV is the net present value.
Owing to the time value of money, performance improvements that are farther
off in the future have a lower present value than improvements that occur shortly
after an acquisition. Thus, synergies have to be realised quickly. In other words, the
value of the synergies needed increases exponentially with every year by which their
realisation is delayed. Consequently, the necessary synergies can be calculated as
follows:
Acquisition premium
Synergies N :
2
X 1
ti
1 rt
For the sake of simplicity, this equation assumes that potential synergies remain
constant in each planning year. The need to improve the return on capital employed
(ROCE) resulting from payment of the acquisition premium can be expressed as the
ratio of the necessary synergies to the capital employed (P0), i.e. the price that must
be paid to acquire the company.
Acquisition premium
Synergies P0
ROCE N :
3
P0 X 1
ti
1 rt
This dynamic correlation between the acquisition premium, the speed of synergy
realisation and the need to improve performance during the integration phase is
illustrated in Figure 2. The figure assumes a 10-year lifespan for the potential
synergies. In the case of Exxon/Mobil, if the estimated synergy potential can be
realised in the first year after the merger, performance must improve by USD 2.4
billion per annum to break even in respect of the acquisition premium. This is
equivalent to a ROCE of 3.0%. Should the identified synergies only be realised in the
second year, performance must improve by USD 2.8 billion or a ROCE of 3.5%.
However, should the merger only deliver the desired synergies in the sixth year, the
348 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer
The dynamic correlation with the acquisition premium becomes even clearer if one
varies this premium (ceteris paribus). Given an acquisition premium of 26.2% and
assuming that potential synergies are realised within two years, it is necessary to
improve ROCE by 3.5%. By contrast, the need for improvement rises to 6.2% for an
acquisition premium of 56.1%, to 7.8% for a premium of 77.4% and ± in the case of
Mannesmann/Vodafone (104.6%) ± to as much as 8.3%. The lower cost of capital
(6.8%) in the Mannesmann/Vodafone example (relative to a discount factor of 8.3%
for MCI/WorldCom) moderates the requisite improvements in performance and
ROCE. If one observed only the effect of increasing the acquisition premium from
77.4 to 104.3% (ceteris paribus), this would require a greater increase in ROCE.
These scenarios illustrate the difficulty of dynamic performance improvement if an
acquisition premium is paid.
Moreover, it is important to know for how long a company will realistically be
able to tap the synergies. It has a major influence on the present value of potential
synergies and, hence, on the maximum amount that should be paid as an acquisition
premium. The discounted cash flow (DCF) method of corporate valuation assumes
that detailed plans can be drawn up only for a few years. Beyond this planning
horizon, it assumes a constant, sustainable net cash flow (Rappaport, 1986). Based
on these assumptions, the net present value method can be used to calculate a
terminal value.
It is, however, questionable whether similar assumptions can be made in relation
to potential synergies. Along similar lines to company valuation methods, the present
value of synergies would largely derive from their terminal value. The effect of
assumed lifespan on the present value of synergies can be illustrated by computing
alternative scenarios. To do so, let us refer back to the example of the Exxon/Mobil
merger. In Figure 3, the improvements in free cash flow that would be needed to
justify an acquisition premium of USD 16.7 billion (26.2% of the transaction price)
are shown for assumed lifespans of four, seven, ten years and infinity.
Identifying synergies ahead of mergers and acquisitions 349
It is fair to assume that the lifespan of potential synergies depends critically on the
vitality of the industry concerned. If the company operates in a dynamic
environment, the lifecycle theory (Porter, 1980) must be assumed, which states that
customers' needs, technologies, products and markets will continue to change.
Technological changes may lead customers to prefer other combinations of
resources, resulting in a shift in the definition of competitive advantages (Gort,
1969). Synergies associated with products and production processes must be
questioned whenever products and their underlying technologies are replaced by
new products and technologies. Alongside industry cycles, however, the attributes of
the combinations of resources from which potential synergies derive are also very
significant to their projected duration.
When quantifying synergies, it is therefore not realistic to generally assume that
companies will be able to tap the competitive advantages resulting from synergies for
an indefinite period. This is also in line with the argumentation of Shaver (2006) who
demonstrates that an inherent element of M&As is that actions taken to facilitate
synergy realisation might amplify threats and might inhibit the companies' ability to
respond to favourable conditions in the business environment. Moreover, Croson
et al. (2004) show in their experimental study that positive and negative externalities
for a specific industry may arise as a consequence from the M&As.
Shareholders are interested in more than just the net present value of potential
synergies. They also want to understand the process by which this potential has been
calculated. The more information is provided about the methods used to calculate
synergies and the more structured this method is, the less capital market players will
remain uncertain about the possible consequences of a merger.
350 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer
This section aims to develop a method that can facilitate the structured
calculation of the net present value of potential synergies. For instance Gupta and
Gerchak (2002) have developed a mathematical modelling concerning the
quantification of operational synergies in M&As. Our method breaks down into
10 steps (see Figure 4) and it is derived from several years consulting practice of one
of the authors combined with the input taken from academic publications (e.g.
Sirower, 1997). Each step is explained in detail below.
3.2 Step 2 ± identify and calculate cost synergies for the individual years in the
forecast period
The levers of synergies and the action programmes needed to activate these levers in
each business area have to be identified as well. In this step, potential synergies are
Identifying synergies ahead of mergers and acquisitions 351
actually identified with the help of a creative/rational process that draws on annual
financial statements, checklists, interviews and workshops. Once synergy levers and
action programmes have been identified, their in-year and full-year effects must be
calculated. The full-year effect of a potential synergy is the effect that would have
been realised if the corresponding action programme had been applied from the
beginning of the year. This effect is distinct from the in-year effect, which only states
the savings that would be achieved by taking said actions for the remainder of the
current fiscal year.
The calculated in-year and full-year effects are then distributed across the
individual years in the relevant forecast period. One option is to enter the calculated
effect of each lever and for each business area in a separate table. Effects can then be
assigned to the individual expense items in the income statement. This practice
ensures that only those effects are considered that have a quantifiable impact in the
income statement. Any one-off costs incurred in the process of realising potential
synergies should also be stated together with the amount calculated for each synergy.
At the end of the second step, all potential synergies have been identified for each
cost item in the income statement.
3.3 Step 4 ± identify and calculate revenue synergies for the individual years in
the forecast period
The calculation of potential revenue synergies involves identifying the synergy levers
in all business areas, calculating the associated revenue potential and then spreading
this over the individual years in the forecast period. The one-off costs incurred in
generating these extra revenues must then be calculated. Potential revenue gains must
be based on the new cost structure after considering cost synergies. To identify value
added, the costs incurred in generating extra revenues must be deducted from these
revenues.
calculation of the tax rate, one can take the average rate for the two stand-alone
companies. EBIT derived from the income statement should serve as the basis for tax
assessment. This approach assumes that the company will pay the tax bill out of its
own financial resources and ignores that interest on debt capital is tax-deductible.
The cost of capital is therefore applied to correct this simplification.
3.8 Step 8 ± calculate free cash flows for the whole of the forecast period
In a next step, it is necessary to calculate the cash flow that will be generated by
potential synergies and will be available in each year of the forecast period. To this
end, free cash flow generated by the items in the income statement and on the balance
sheet must be determined. The result indicates the free cash flows generated by
synergies for the individual years in the forecast period.
MWA MWB
WACCAB WACCA WACCB :
4
MWAB MWAB
Identifying synergies ahead of mergers and acquisitions 353
The free cash flows (FCFs) calculated for the individual years of the forecast period
(n) are discounted by the calculated cost of capital (1 r). The present value of
potential synergies (C0 ) calculated in this way indicates the maximum acquisition
premium (APmax ) that should be paid if, assuming all identified potential synergies
are realised in full, the shareholders of the acquiring company do not want to see the
value of their company erode. It is then up to the management of the acquiring
company to determine the acquisition premium that must be paid to secure the
merger of the two companies.
Having outlined one theoretical way to identify potential synergies, we now examine
how synergies are actually identified in practice. We use three brief case studies
(Eisenhardt, 1989; Yin, 1984) to answer this question. It is particularly interesting to
note the deviations between the practices applied in the case studies and the method
outlined above. It is likewise important to see what happens to the calculated value of
synergies ± and hence to the maximum acquisition premium ± if individual steps in
the method are omitted. The three case studies we use to examine the practice of
identifying and calculating synergies are the RWE/VEW, Shell/DEA and Austrian
Airlines (AUA)/Lauda Air mergers.
The case studies were chosen because they contain many aspects that are useful
for refining the reference model. These aspects include significant size and market
capitalisation. Moreover, the cases cover different industries. We examined successful
cases (Shell/DEA±Petroleum), moderately successful mergers (REW/VEW±Utilities)
and failures (AUA/Lauda Air±Civil aviation). In 2002, Shell Deutschland GmbH
acquired RWE-DEA AG with expected synergies of EUR 150 million. In 2001,
RWE AG acquired VEW AG and calculated expected synergies of EUR 725 million.
Austrian Airlines AG acquired Lauda Air AG in 2001 and aimed at the realisation of
EUR 73 million in term of synergies.
4.2.1 Step 1
In all three case studies, a baseline was defined to calculate potential synergies.
However, the baselines selected differed considerably. RWE/VEW based their
calculations on actual and forecast figures. Shell/DEA used only actual data,
whereas Austria Airlines/Lauda Air quantified potential synergies on the basis of
budget planning figures. It is only possible to measure and verify real improvements
in performance if actual numbers are used as the basis for calculation.
It is generally impossible to verify potential synergies that are based on forecasts,
because these figures represent moving targets. Having said that, deviations from the
use of actual figures as the baseline (in line with our reference model) only affect
calculated synergies if the actual figures ultimately deviate from the budgeted or
forecast figures used for the calculation. If the forecasts or budgets used are prepared
shortly before the end of a fiscal year, i.e. if it is fair to assume that they will deviate
only marginally from the actual figures, then deviant procedures will probably only
lead to a minimal effect. Moreover, in isolated cases, it is worth investigating whether
the use of forecasts that are inaccurate in places might not deliver better synergy
calculations than the use of actual data that is no longer up to date. This decision
should depend on the extent to which the data material used reflects current business
developments, and on whether operational and/or structural changes in the past
fiscal year preclude the use of actual figures.
Both Shell/DEA and RWE/VEW went to a lot of trouble to adjust their baseline
data. These adjustments were designed to eliminate extraordinary effects, to make
due provision for stand-alone actions that had already been initiated, and to make
the items in the two companies' income statements comparable. AUA/Lauda Air did
not adjust their baseline figures. Furthermore, the use of different terminology by the
two companies meant that key data could not readily be compared.
These cases show that both the calculated value of potential synergies and the
quality of the calculation depend heavily on the quality of the assumed baseline,
which sets the standard against which synergies are quantified.
4.2.2 Step 2
In all three mergers, the companies involved calculated the cost synergies. However,
they considered contrary effects in different ways. In the RWE/VEW case, the
contrary effects were dissynergies arising from one-off effects that had no impact on
recurrent annual cost synergies. Moreover, gross recurrent annual synergies were
equivalent to net recurrent annual synergies. In the Austrian Airlines/Lauda Air case,
not all dissynergies were quantified. Regardless of whether these dissynergies were
one-off effects or recurrent annual effects, neither was deducted from the calculated
cost synergies. The gross synergies stated were therefore too high. By contrast, Shell/
DEA split identified dissynergies into one-off effects and recurrent effects and
deducted recurrent dissynergies from calculated gross synergies.
4.2.3 Step 3
Another step in the reference model is the calculation of cost ratios. Whereas the
Austrian Airlines/Lauda Air and Shell/DEA mergers factored in the new cost ratios,
the RWE/VEW merger assumed a constant ROS of 5%. This pragmatic approach
356 D. zu Knyphausen-Aufsess, J. Koeppen and L. Schweizer
had no significant impact given that, owing to the nature of the two companies'
business, revenue synergies were only of secondary importance. No material
deviation therefore arose from the methodology proposed in our reference model.
4.2.4 Step 4
All three companies calculated revenue synergies as a separate step in a conservative
way. Even so, the figures calculated for revenues synergies varied in each case, as did
revenue synergies as a proportion of total synergies. At RWE/VEW, revenue
synergies were negligible. Moreover, no revenue synergies were assumed to derive
from future business expansion plans. Shell and DEA likewise refrained from
calculating volume-based revenue synergies. Instead, improved margins for new
products were assumed. It was also assumed that dissynergies arising from the early
stages of the merger would offset any performance gains. By contrast, Austrian
Airlines and Lauda Air calculated that performance would improve substantially as
a result of revenue synergies. In all three deals the step of quantifying revenue
synergies took place, although both the amount of these synergies and their
contribution to overall synergies varied considerably.
4.2.5 Step 5
The next step is to make due allowance for taxes. In all three cases potential
synergies before taxes were calculated. Thus, the recurrent annual effect of calculated
synergies on performance had to satisfy not only the demands of shareholders and
creditors but also those of the fiscal authorities. If taxes are omitted from this
calculation, there is the danger that the NPV stated for potential synergies will be too
high.
4.2.6 Step 6
None of the companies involved in our three case studies calculated free cash flow
from the change in working capital and the change in provisions. This is due to the
definitions of synergies that they used. Assumptions were based on recurrent annual
effects on performance, so no provision was made for changes in balance sheet items
that affected cash flows. Whether or not ignoring this step increases or reduces the
calculated synergies can be determined only on a case-by-case basis. Extra cash is
likely to be tied up if substantial revenue synergies are calculated, causing inventories
and receivables to rise to an extent that cannot be offset by an increase in liabilities.
Both RWE/VEW and Shell/DEA calculated only small increases in revenues.
Compared with cost synergies, these were only of minor significance.
The success of M&As has for many years been a focal point for various lines of
business research. Little attention has been paid to how companies go about
quantifying synergies ahead of M&As as an important linking pin between M&A
strategy and post-acquisition integration, the latter being responsible for synergy
realisation. Although previous works have acknowledged the importance of the
acquisition premium to the success of mergers (Javidan et al., 2004; Larsson and
Finkelstein, 1999; Sirower, 1997), there appears to be a lack of understanding of how
the potential synergies that underpin acquisition premiums are quantified in practice.
The reference model for quantifying potential synergies depicted here is not a
universally valid model or approach. It has, however, key elements that practitioners
should use to determine synergies in order to avoid overestimating their potential.
The synergy limitation view (Sirower, 1997) pinpoints the acquisition premium as
one of the most important parameters in management decisions about M&As. This
view therefore rates the acquisition premium as extremely important to the success or
failure of such transactions. Based on the synergy limitation view, this paper develops a
reference model to calculate the NPV of potential synergies as the maximum viable
acquisition premium. The development of this reference model has also drawn on the
insights presented in theoretical works on the preconditions for, causes of, and
classification of synergies. The reference model has been broken down into 10
structured steps. The focus remains on the nature of this model as a process ± a process
that involves clear links to valuation issues. The omission of individual steps in the
process of quantifying synergies influences the calculated value of the synergies.
Case studies were used to compare the reference model-based method of
quantifying synergies with the approaches pursued in business practice. The cases
examined mostly used static models that are unable to identify the economic value
which synergies add for shareholders. Payment of an acquisition premium requires
dynamic performance improvements. However, a static profitability-based approach
to synergy calculation can make no allowance for such dynamic developments. The
use of static models to quantify potential synergies bears the risk that synergies will
be overestimated as the acquiring company seeks to determine a suitable purchase
price.
The differences identified in the way companies approach synergy calculation and
differences in the provision they make for various synergy components cause them to
Identifying synergies ahead of mergers and acquisitions 359
value synergies differently. Logically, this also leads to differences in the extent to
which synergies are then realised in practice. It follows that the success or failure of
mergers is significantly influenced by the method used to quantify synergies.
References