What is Synergy?

Mergers and acquisitions are often justified by appeal to something called synergy - the whole being worth more than the sum of the parts. For example, I found one source that divided synergies into operational synergies and financial synergies.

"Operating synergies affect the operations of the combined firm and include economies of scale, increasing pricing power and higher growth potential. They generally show up as higher expected cash flows. Financial synergies, on the other hand, are more focused and include tax benefits, diversification, a higher debt capacity and uses for excess cash. They sometimes show up as higher cash flows and sometimes take the form of lower discount rates."

Aswath Damodaran, The Value of Synergy (pdf)
Stern School of Business October 2005

Some systems thinkers would not regard economies of scale and other cost savings as genuine synergies. They prefer to concentrate on the positive improvements to income and growth, as well as the indirect social benefits. From an accounting perspective, there is no essential difference between higher revenue and lower cost - if the whole costs less than the sum of its parts, for a given quantity of output, then it must be worth more. But a systems perspective may reject this kind of accounting perspective.

From a systems perspective, we are probably also interested in network effects and indirect value. Consider the "benefits" to users if Linked-In merged with Facebook, thus increasing the size of everyone's network. (There are probably better examples than this one.)

What I think is useful is to unpack the basic definition of synergy. Synergy means the whole is worth more than the sum of its parts.

WORTH

• To whom? Shareholders, customers?
• From what perspective? Stock market, competition?
• How measured? Financial value, indirect value?

MORE THAN

• What timescale? Some kinds of synergy may be almost immediate, such as increased bargaining power.

SUM OF PARTS

• How composed, what is the nature of the composition. Among other things, we might consider how composition by merger produces any different kind of synergy than composition by partnership or any other arrangement. 
• Clearly merger is not the only way to achieve operational synergies. One of the challenges for post-merger integration is to make structural and behavioural changes to systems that will release the promised synergies. Some disciplines, such as enterprise architecture (EA), concentrate on the formal structural and behavioural aspects of merging systems, but there are many other issues, including culture, that are not in the standard EA toolbox.

Overall, I think we must recognize that synergy is in the eye of the beholder. Often companies play a game of making the synergies look very high when talking to the stock market, while downplaying the synergies when talking to regulators. They try to persuade the regulators that the merger will create jobs and allow them to offer a better deal to customers, but this is of course totally incompatible with what they've told the City.

A Time To Act 2

Delaying a decision may simply involve holding out for a better offer. For example, when the directors of a company reject a take-over bid, claiming (as they always do) that it significantly undervalues the company.

It would be wrong to take the first offer that is made, if there is a reasonable chance of holding out for more. But on the other hand, if you wait too long for a higher offer, you may lose out.

In a post entitled Logic Need Not Apply, Microsoft employee John Evdemon comments on the refusal of Yahoo directors to accept a take-over bid from Microsoft. Is this simple greed, he asks, or are the Yahoo directors allowing their emotions to rule their heads? In asking this question, John is not just influenced by his current affiliation with Microsoft, but also with a startup company he was involved with previously, whose directors turned down a high offer and were subsequently forced to accept a much lower offer.

According to the New York Post (via Computerworld, Feb 15th 2008), there is a split in the Yahoo board, with some directors advocating acceptance. There is a threat of shareholder lawsuits if the directors could be proved to have acted emotionally, rather than in the best interests of shareholders. But how could this ever be proved?

Company Value

What is a company worth? There are several possible ways of answering this question.

Book Value / Balance Sheet Value	This is the value that is calculated by accountants and verified by auditors, largely based on a historical view of the company's past and present transactions. This value is published periodically (typically 1, 2 or 4 times a year). However, in principle it could be calculated or estimated in near real-time, given sufficient access to company transaction data.
Market Capitalization	This is the value that is derived from the current share price. It is largely based on investor's views of the company's future prospects, as well as general market sentiment.
TakeOver Value	This is the value that someone is prepared to pay to win control/ownership of the company. (There may be different take-over scenarios, with a different valuation attached to each scenario.)
BreakUp Value Sum-of-the-Parts	This is the value that the company would be worth if broken into separate parts. (There may be different ways of breaking up the company, resulting in different valuations.)

We can make a number of observations.

1	In an idealized rational world with perfect information, we might expect all these values to be the same.
2	In the real world with imperfect information, these generally yield different answers. Some people may like to think that one of them reflects the "true" value of the company. But it is generally better to regard them as simply reflecting different kinds of truth about the company, each valid in its own terms.
3	These also vary on a different timescale. The shareprice of a large company (and therefore the market capitalization) may fluctuate many times in an hour, but it is unlikely that the book value changes with this degree of volatility.
4	A company should normally be worth more than the sum-of-the-parts, because there is some synergy between the parts. But this isn't always the case. When the market capitalization is considerably less than a sum-of-the-parts valuation, it is possible to make money by buying the company and immediately breaking it up. One version of this is known as Asset Stripping, where the new owners profit by selling assets that are worth more than the book value.
5	In a takeover situation shareholders usually expect to be offered a premium to the share price, as an incentive to give up their shares. When a takeover is rumoured or announced, the share price usually rises to a value close to the expected takeover price, and so the market capitalization converges with the takeovervalue.
6	After a takeover, some parts of the acquired company may be immediately sold. This may be to recoup or repay the money that was staked on the acquisition, or to satisfy the demands of the regulator. But where these sales are forced or hurried, they may not realize the most favourable sum-of-the-parts valuation.
7	In the long term, these different valuations cannot continue to diverge. The valuations remain coupled, although extremely loosely, and there are various ways in which the valuations may be brought back into alignment. (These are basically feedback loops with very long delays.) Speculators sometimes make large amounts of money by betting on future market adjustments. But the timing of these adjustments cannot be accurately predicted, and speculators sometimes lose large amounts of money by predicting the right adjustment at the wrong time. As Keynes noted, markets can often remain irrational far longer than an individual investor can remain solvent.

One way of experiencing this complexity is by tracking the shareprice and newflow of a large company over a period of some weeks or months. Sometimes shareprice changes can be explained in terms of the newsflow of the company, including takeover rumours; sometimes they can be explained in terms of the economic environment (competitor newsflow, commodity prices); and sometimes they appear to be little more than random fluctuations.

In Spring 2005, we picked four companies quoted on the London Stock Exchange, and asked our students to track one of these companies and interpret the results. This assignment was intended to give students a practical awareness of the extent to which shareprice could be a meaningful indicator of the present value and future viability of a company, as well as practice in interpreting data. By a happy chance, two of the companies were subject to acquisition speculation during the tracking period, which generated some interesting data for the students to work with.

Marks and Spencer

Marks and Spencer is one of the best-known companies in the UK, and combines a strong corporate identity (including management values and style) with serious questions about corporate viability.

The recent take-over approach by retailer Philip Green represents a powerful challenge to the management team and its recent attempts to balance the conflicting demands of identity and viability.

Green's proposition can be distilled down to this message: Allow me to impose my retail and management style, and watch me deliver higher and more sustainable profits.

The directors of Marks and Spencer have rejected this proposition, claiming that they can restore the fortunes of the company without the wholesale destruction of M&S values that Green was feared to be planning. Green has withdrawn, unwilling or unable to fund a higher offer. No doubt the large shareholders and affected banks have had private words with both sides, but the small shareholder has been left (as usual) without a voice.

The stakes are raised. M&S management now has to deliver results for the shareholders that are significantly better than accepting the Green offer, and this means they are going to have to take bold risks. Meanwhile Green's other companies are going to be competing hard. And it's all going to be played out in public, with frequent comments in the business press. Over the next year or so, we have a great opportunity to watch how the identity and viability of a large company develops or unravels.

> more on Marks and Spencer

BTR / Invensys

Brief History

Late 1960s. Owen Green gets the top job in BTR, then a very small company with an indifferent history. Embarks on a series of take-overs.

1980s. BTR regarded as one of the best investments of the decade.

1990-1993. While the rest of the stock market is laid low by recession, BTR shares rise by 60%.

1993. BTR reaches the top of the FTSE 100, with a market capitalization of £14bn.

1993-1998. BTR shares fall by 75%.

1999. BTR merges with Siebe to form Invensys. Invensys shares have fallen a further 90% since the merger.

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Business Drivers

BTR was dominated by the desire to deliver profit, focusing on accounting measures such as costs and return on sales.

BTR generally avoided capital expenditure, and preferred take-over targets with profitable product lines, usually in niche markets. It then increased the prices of these products to the maximum, to generate exceptionally high margins.

BTR’s growth depended on finding a continual stream of take-over targets, and managing them more effectively

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Analysis and Discussion Questions

As BTR grew, it became increasingly difficult to find acquisitions large enough to maintain that level of growth. In the 1980s, someone estimated that if BTR continued to grow at the same rate, it would become larger than the whole UK economy by about 2003. What do you think of a business model that depends on unlimited growth?

"Throughout the 1980s, BTR was held in a position of pre-eminence by investors, other managers, commentators in the press and academia for the effectiveness of its management style." [Alistair Blair] The share price increased dramatically during this period. Can share price and City opinion ever be a good indicator of the true viability of a company?

"Invensys shares … have fallen because the managers and directors … valued profits above products or services that customers would continue to want." [Alistair Blair] In 2003, Lord Marshall, who was chairman of Invensys after the merger of BTR and Siebe, told the Financial Times that managers at Invensys failed to understand the need for investment on new products and capital equipment. Discuss the relationship between short-term viability and long-term viability.

This case was originally written in 2003/2004. Take a look at the more recent history of Invensys. Is there any evidence that it has learned any lessons from the past? Is there any evidence that it has failed to learn?

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Source

Alistair Blair, "Farewell Invensys". Investors Chronicle, 25th April 2003.