Managing Director & Senior Partner
In reviewing proposed M&A transactions, buyers’ internal decision makers—including the management team, the board, and the investment committee—should be wary of high synergy estimates and scrutinize them. Moreover, because they are giving more synergy value to targets today, buyers must redouble their efforts to realize synergies and assure the market that the promised value is achievable. (See the related article from the 2018 M&A report, “Lofty Valuations Put a Spotlight on Synergies.”)
Given the importance of synergies in supporting the economics of an acquisition, decision makers must be able to quickly determine whether the proposed estimates are in fact realistic and achievable. At the same time, they must be prepared to communicate the synergies to capital markets effectively, so that investors understand the upside and reward the company for it.
Boards and investment committees bear the ultimate responsibility for assessing the plausibility of the synergy estimates made by their management or M&A teams. Because acquirers often face a competitive auction process, these teams usually lack the opportunity to discuss synergy estimates and the pathway to realizing them with the target’s management. As a result, they typically rely on their own outside-in due diligence analysis.
To test plausibility, the analysis must answer two key questions:
Meeting the transaction hurdle. To ensure that the transaction does not destroy value, the present value of synergies (after one-off costs and taxes) must, at a minimum, be sufficient to justify the acquisition premium paid to the target’s shareholders. If the buyer’s value creation opportunity arising from synergies does not exceed the premium, the synergies fall short of meeting this transaction hurdle. In such cases, investment committees should be wary of arguments that support the acquisition. On the positive side, however, this plausibility test can confirm the existence of synergies that validate a significant acquisition premium.
Alaska Air Group’s 2016 acquisition of its competitor Virgin America illustrates how synergies can justify a high acquisition premium. In announcing the all-cash deal at $57 per share, Alaska Air implicitly offered Virgin America’s shareholders a premium of roughly 50% over the pre-announcement closing price. This premium was economically significant, exceeding the historical average of 33% for all deals in our long-term sample, and translated into approximately $900 million of additional value for Virgin America’s shareholders.
To avoid destroying value for its own shareholders, Alaska Air needed synergies that would increase its annual operating income by $90 million (1.4% of combined sales). This estimate assumes that the company’s weighted average cost of capital is 9% (which translates into a valuation multiple of 11 times operating income) and accounts for the typical one-off integration costs of one full run rate of synergies. Applying a multiple of 10x (the 11x valuation multiple minus 1x for one-off costs), $90 million in synergies would generate the $900 million premium.
In its deal announcement, Alaska Air estimated synergies of $225 million annually (3.1% of combined sales), with one-off integration costs of $300 million to $350 million. The total value of synergies would equal $2.25 billion, applying the multiple of 10x. As a result, the $900 million implicitly transferred to Virgin America’s shareholders through the premium represents 40% of the total value of synergies, and Alaska Air’s shareholders would receive 60% of the value added. The companies would achieve the lion’s share of these synergies through the higher revenues that result from combining their flight networks. Alaska Air’s internal analysis, presented to investors, found that its synergy estimate was in line with synergies announced in recent mergers of US airlines.
Assessing implied future profit expectations. To be valid, a synergy estimate must consider the future operating model of the target company. Inexperienced dealmakers often double count the upside arising from synergies and operational improvements at the standalone target and disregard the interaction between synergies and operational improvements. To verify that double counting has not occurred, the buyer can validate synergy estimates by comparing the target’s expected margins (including the standalone profitability and synergies) or those of the combined company with a benchmark, such as margins of comparable companies. If the synergy estimates lead to margins that far exceed those of the peer group, it is a sign that the estimates might be unrealistic. The deal’s economics may still be rescued if the combined company can pursue a sustainable new business model, but this is rarely possible.
Alaska Air’s acquisition of Virgin America also illustrates this plausibility check. In the year preceding the deal, Virgin America had a 13% margin (pretax profit of $200 million on annual revenues of $1.5 billion). This was substantially below Alaska Air’s margin of 24% (profit of $1.3 billion and revenues of $5.6 billion), which was one of the best margins among North American airlines. The estimated full synergy run rate of $225 million implied that the combined company’s margin would match Alaska Air’s pre-deal profitability of 24%. Despite Virgin America’s lower pre-deal margin, the synergies would ensure that the combined company’s margin stayed at the best-in-class level previously achieved by Alaska Air. Given that Alaska Air would apply its best practices and efficiency measures to Virgin America, the board apparently considered this implicit uplift in the target’s margins to be plausible.
A buyer’s board and management must also ensure that mechanisms are in place to realize the value of synergies. Planning for the achievement of synergies is an essential element of due diligence, so that the buyer’s final bid accurately accounts for the value creation potential and the integration process can start the day after closing.
Two approaches are essential in order to hit the ground running: Establishing a “clean team” enables companies to get a head start on exchanging and analyzing information. And developing a “full potential plan” allows companies to accelerate the postmerger integration.
Clean Teams. Merging companies are generally prohibited from sharing internal information or collaborating before the close. The time period between signing and closing the deal can often be quite long, especially for large transactions or cross-border deals involving companies in the same industry. Regulators and antitrust agencies use this time to complete reviews and investigate the competitive implications of the transaction. For the transactions we studied, the closings occurred, on average, within one year of the deal announcements. However, for approximately 10% of the transactions, the period between announcement and closing exceeded one year. The parties needed the extra time to complete required asset disposals or meet other conditions imposed by regulators.
Although the merging companies’ hands are tied to a great extent while they await the closing, they can create substantial value by setting up a “clean team” composed of third-party personnel. The clean team serves as an intermediary between the merging companies’ integration teams. It reports to a project management team comprising the project leaders from each company and to a steering committee comprising board members and legal teams from each company.
The clean team’s mandate is to accelerate planning and jump-start the integration, including the capture of synergies. To accomplish this, it collects and analyzes sensitive data from both companies and shares sanitized, aggregated interim results with the project management team and the steering committee. Even though clean teams must not share their full analyses with management until the deal closes, these efforts lay the groundwork for an early start on capturing synergies.
Full Potential Plan. After authorities give final approval and the deal closes, the buyer can formally begin the integration. In a previous report, BCG presented a set of essential practices that help achieve the estimated synergies after a transaction closes. (See “Six Essentials for Achieving Postmerger Synergies,” BCG Focus, March 2017.)
To augment these best practices, the savviest corporate acquirers deploy a full potential plan (often referred to as an FPP), an approach also used by many PE firms to maximize the value of their portfolio companies. Leaving no stone unturned, the plan defines and quantifies the operational and top-line improvements required to achieve the expected synergies, as well as the initiatives, costs, and timeline for making it happen.
To develop the plan, a joint task force composed of members of the companies’ management teams and their advisors identifies the full potential improvement for a set of KPIs—including revenues and operating profit, and the implementation costs—over the next three to five years. To lay the groundwork, the task force typically performs an initial assessment, which usually takes three to four months and includes a standardized review of up to 35 specific value levers in three main categories: revenues, costs, and capital management and allocation.
Once the task force completes its assessment of the value potential of the levers, the management team and board of each company jointly decide on the most promising levers and develop the roadmap for achieving the full potential. The roadmap should specify the required resources, set clear responsibilities, and establish an incentive scheme for management that is linked to the plan’s targets.
Merging companies should keep investors informed about their synergy estimates and their efforts to realize the value. On the basis of observations of corporate transactions and a review of case studies, we have identified the following best practices. Two recent mergers illustrate these best practices and how they create value. (See “Synergy Communication in Action.”)
DowDuPont and Alaska Air Group each stand out for applying best practices in communicating synergies.
DowDuPont. Dow Chemical and DuPont provided details about synergies in a press release accompanying their 2015 merger announcement and in a follow-up call with investors. They estimated run-rate synergies of approximately $3 billion for costs and approximately $1 billion for revenues. The realization of the full run rate was expected within 24 months after the closing date.
During the integration process, DowDuPont continued to communicate about synergies, following up through various channels. For example, during investor calls, it confirmed the targets and timing for synergies and gave details on how it expected to realize them. The updates included a breakdown of how expected cost synergies were allocated across the new company’s three divisions. The company also explicitly described several of the initiatives taken to achieve synergies. In addition, it provided examples of the new products that would contribute to reaching the targets for revenue synergies.
The company’s 2017 annual report included information on both the size and the timing of the one-off costs of integration. It also gave examples of what the costs were attributable to, including implementation of restructuring plans, demolition of closed facilities, and employee-related expenses.
Most important, DowDuPont delivered on the promised synergies. In February 2018, the company confirmed that it had achieved its first synergy target. Having already reached annual run-rate savings that exceeded the initial savings estimates for 2017, the company increased its cost synergy target by 10%.
Alaska Air Group. In communicating with investors about the synergies arising from its takeover of Virgin America, Alaska Air provided an overview of its “integration playbook.” This served to reassure investors that the integration process would proceed smoothly and that the synergy estimates were realistic. Public release of the playbook also served to bolster the commitment of the management and integration teams to follow the process and timelines set out in the document.
Additionally, the company released details on the plausibility tests it used to verify the synergy estimates. First, by outlining the implied margin impact of the anticipated synergies, the company showed investors that profitability would not suffer and that the anticipated synergies would not lead to unrealistically high margins. Second, by comparing its synergy estimates with historical transactions in the US airline industry, the company demonstrated that its assessment was in line with industry performance.
Companies’ seemingly insatiable appetite for M&A has driven valuations to record levels and forced buyers to give targets’ shareholders a larger portion of the anticipated synergy value. To succeed in this environment, buyers must redouble their efforts to ensure that the combined companies generate value through synergies and are thus regarded as greater than the sum of their parts. Accurate estimation of synergies, rigorous execution, and copious communication are essential. Dealmakers that can make—and keep—bold but realistic synergy promises will reap the rewards of a value-creating integration.