scorecardresearchExplainer: Do synergies truly unlock value for businesses?
In economic terms, a merger is the combination of two or more companies in the same market to create a larger and stronger entity.

Explainer: Do synergies truly unlock value for businesses?

Updated: 11 Apr 2022, 08:46 AM IST
TL;DR.
Synergy is the idea that the combined worth and performance of two companies will be greater than the sum of their individual parts.

A business merger or acquisition is an effective strategy for firm growth and additional revenue sources, which can boost bottom-line profitability. Several mergers and acquisitions benefits, ranging from increased market access and reduced market rivalry to improved performance and lower production costs, make consolidation a lucrative and appealing prospect for businesses.

What is a Merger?

Mergers and acquisitions (M&A) is a broad phrase that refers to one or more types of financial transactions that result in the consolidation of firms or assets. A merger, sometimes known as a merger of equals, is a transaction in which two companies of similar size agree to legally unite to form a single, new entity for restructuring, company expansion, product development, or entry into new markets.

Horizontal and vertical integration are the two most common types of merger strategies. A horizontal merger occurs when two companies with comparable product lines unite into a single organisation. A vertical merger occurs when two companies that sell distinct products or services but share the same supply chain join forces. 

Before examining the outcomes of mergers, it is vital to consider the motivations and justifications for the action. The first question is, why do corporations want to merge? Several explanations have been proposed to explain this occurrence. The most widely held belief is that mergers and acquisitions are the quickest way to grow. It is undeniable that growth is essential for a company's survival. According to corporate finance theory, growth and firm value are inextricably linked, and all share valuation models take growth into account. According to conventional economic theory, a firm will increase its output to the optimum size at the lowest point on the average cost curve for a specific product.

What is the role of Synergies in M&A?

The concept of synergy in mergers and acquisitions is highly intriguing and full of sophisticated mathematical predictions.

The basic principle underlying this concept is that if two smaller companies join to form a larger one, there must be some value created that is greater than the value of the two companies as independent entities, implying that one plus one equals three.

The question that then arises is, why are synergies essential in the grand scheme of things, because it seems like a reasonable conclusion that if two companies merge and pool their resources, the combined value would be greater. 

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 the same industry or have something in common.

Objective behind Synergies

The ultimate goal of any transaction, whether it's entering a new market, adding a new product line, or increasing scale through a bolt-on acquisition, is to generate value, and synergies provide chief executives with a quick way to do so.

Synergies not only give that shortcut, but they also provide a great means of communicating the benefits of the merger to shareholders and investors.

Types of Synergies

Synergies are classified into three categories: Revenue synergies, Cost synergies, and Financial synergies. It's worth noting that each transaction can include components of all three in varying degrees.

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 because a higher revenue synergy gives the seller more bargaining power to increase the premium on their company's cost. This means that horizontal mergers with good synergy could lead to better bargaining power for the seller because the buyer is willing to pay more to acquire his competition.

Buyers, on the other hand, are willing to pay top dollar as the potential profit in greater revenues means that the merger will have a significant long-term positive impact.

Market synergies are similar to revenue synergies in that they both refer to an increased power to negotiate with customers on items. The various competition regulatory bodies have capped this form of synergy to some extent.

It should be noted, however, that obtaining revenue synergies takes a few years longer on average than capturing cost synergies, according to the research.

There can be multiple examples of revenue synergies in M&A, but traditionally, revenue synergies result from:

Cross-selling, Reduction of competition, Access to new markets

Revenue Synergy Example

On December 22, 2021, ZEEL announced their merger with and into SPNI (Sony Pictures and Network), Sony will own 50.86% of the merged entity, while Zee's promoters would own 3.99%. The remaining 45.15 percent will be held by Zee's other shareholders.

Experts feel that the Zee-Sony combination will result in an exciting media powerhouse with numerous benefits for both Zee and Sony.

According to experts, both companies own a diverse portfolio of properties that will complement each other instead of competing in the aftermath of the merger.

The combined business is also reported to have roughly a 25% market share in the linear TV arena and potentially generate $2 billion in annual income.

Furthermore, the combined entity will be in a superior position to compete with Disney more effectively both on the distribution and advertising side.

The combination might result in a broadcasting giant with 75 channels covering regional, English, Hindi, kids entertainment, and sports programming.

Cost Synergies

This type of synergy tries to reduce administrative and overhead costs for the combined company more than the two distinct individual enterprises could. Because of the higher cash flows and ease of doing business that result from this merger, a company's existing resources that are not being used to full capacity due to high operating costs can now be effectively utilised.

If revenue synergies can be considered to be value-added at the front end, cost synergies might well be considered value-added in the back office.

Generally, the merger of two companies can create cost savings due to:

Marketing strategies and channels: Costs may be lowered if marketing channels and resources are expanded.

Shared information and resources: Similarly, improving the acquirer's access to fresh research and development might lead to production breakthroughs that result in cost reductions.

Lower salaries: This is self-explanatory, as a merged firm would necessitate a change in the company's structure because there would be no need for two CEOs, CFOs, and so on. This means that when the company grows in size, it will change the top-level management structure and reduce the gross total it pays on compensation.

Streamlined processes: Streamlined processes have the ability to save time and money by making the new company more efficient. Furthermore, supply chains can become more efficient, and the new, larger company is usually able to negotiate better costs from suppliers.

Cost Synergy Example

PVR and Inox, the two major Multiplex players, have announced a merger. The share swap ratio stands at three shares of PVR for 10 shares of Inox.

According to analysts, PVR- INOX, as the new entity will be called, will have a combined box office share of 49%. Existing screens will continue as PVR and INOX respectively, while new screens post-merger will be branded as PVR -INOX. The market share is expected to increase as smaller chains.

The management highlighted key points behind the merger:

The merger will offer compelling revenue and cost synergies as seen from Inox’s lower share of non-ticketing revenue at 42% v/s 48% for PVR. This will allow it to leverage the scale of the merged entity. But given the sizeable scale of Inox in the recent past, we believe it could have bridged this gap even without the merger. PVR too, after multiple rounds of capital raising in the last couple of years, may be able to leverage the balance sheet to drive screen additions.

Historically, the mgmt has been dismissive of the threat posed by OTT platforms. However, for the first time, it acknowledged the threat and the need to create scale to fight the onslaught. The timing of the deal was unclear considering the recovery in the cinema industry and the strong pipeline of movies, including recent feedback on box office revenue.

Analysts expect their proposed merger to offer a competitive advantage over other multiplex operators, and drive bargaining power in terms of newer technologies, rentals and marketing spending. The deal is also expected to boost free cash flow, ensure stranglehold over real estate and bring in cost synergies.

Financial Synergy

Financial synergies are improvements in a company's financial activities and conditions that follow from a transaction. This often involves an improved balance sheet, a cheaper cost of capital, tax benefits, and better access to financing for the combined firm. The last of these, greater access to finance, is typically difficult to quantify, but the logic behind the argument is commonly regarded to be sound.

Financial Synergy Example

The Merger of HDFC into HDFC Bank will create the third-largest entity in India in terms of market capitalisation ( 12.79 lakh crore), after Reliance Industries ( 17.93 lakh crore) and Tata Consultancy Services ( 13.77 lakh crore)

The merger will also create a large balance sheet of 25.61 lakh crore, which is now closer to the country’s largest bank — the State Bank of India with 45.34 lakh crore. The HDFC Bank was already the country’s second-largest bank. ICICI Bank has a balance sheet size of 17.74 lakh crore as of March 31, 2021.

HDFC Bank would also enable seamless distribution of house loans by leveraging its enormous customer base of over 68 million clients, hence improving the rate of credit development in the economy.

Bottom line

The major motivating element behind mergers is synergy, which is not always accomplished and does not necessarily result in improved shareholder returns.

Even yet, realising synergies post-merger is the best approach to boost shareholder returns, and the cases where synergies do not result in better shareholder returns, are seen as outliers that do not fit the trend.

As a result, pre-merger financial and legal due diligence is more important in appropriately calculating synergies.

Companies like to seek "combined synergies," which are a combination of all of the above-mentioned synergies, as the ideal synergy because they provide a good balance between revenue and cost synergies, adding to long-term values and ongoing improvements over time.

Multiplex operating firms PVR and INOX Leisure have announced their merger.
Multiplex operating firms PVR and INOX Leisure have announced their merger.
First Published: 11 Apr 2022, 08:46 AM IST