The 2018 M&A Report: Elevating Synergies on the Board Agenda

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.

Do Estimates Pass the Plausibility Test?

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:

• Is the present value of synergies sufficient to justify the acquisition premium?
• Do estimated synergies and the future operating model support profit expectations?

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.

How Can We Achieve the Full Potential?

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.

What Should We Communicate to Investors?

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.”)

• Communicate the estimated synergies in the deal announcement. Discussing synergies in the announcement preserves market value by reducing uncertainty about the transaction. Failure to clarify potential synergies usually hurts the buyer’s share price around the time of the announcement. A negative appraisal of the transaction by investors and equity analysts can only be reversed over time, if the synergies are eventually announced or become apparent.
• Give investors a comprehensive accounting of the synergies. Include a breakdown of the synergies by type, offer examples of each, and specify which business unit, function, or executive is responsible for achieving them. Estimate the integration costs and the timeframe to reach the full run rate. Describe any plausibility checks that have been performed. Simply announcing synergies does not give investors the clarity they seek.
• Use follow-up communications to provide updates. Update investors and equity analysts on the estimated synergy targets, describe the progress toward achieving targets, and showcase the actions taken to foster progress. Investors reward companies that provide follow-up communications with higher returns. (See “The Real Deal on M&A, Synergies, and Value,” BCG article, November 2016.) Communicate the updates through channels that are effective for reaching this audience, such as analyst calls, press releases, and quarterly or annual reports. Additionally, provide employees, customers, and other stakeholders with updates on synergy-related issues that are relevant to them, such as those related to headcount reductions or changes in the product lines.

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.