Looking for a sure thing, forget about synergies

By Pixel Fish

Buyers paying 2.5 times recurring revenue for a client book in 2020 are probably getting a raw deal, unless their EBIT margin is greater than 35%. In part one of a three part series, Paul Barrett cautions buyers to get real about synergies benefits to avoid overpaying.

The crudest way to justify acquiring a business and paying good money for it is to cite synergies.

It’s also misleading.

According to Bain & Company, buyers routinely overvalue the synergies to be had from acquisitions to get a deal over the line, resulting in disappointing outcomes1.

This is due to a number of reasons including lack of experience, lack of information on a target and lack of accountability post-merger.

Enthusiasm also plays a role.

In the current low growth, low interest rate environment, many financial services businesses are keen to do deals to increase their size and scale, and drive efficiencies.

But as my rugby coach used to warn me: “Enthusiasm minus skill equals injury”.

Enthusiasm can make assets appear more attractive than they are and cause buyers to overplay the synergies to be had.

I liken this state to grocery shopping on an empty stomach. It’s a recipe for buying too much and making impulsive decisions.

Achieving synergies in M&A transactions is an important driver of value, however, Bain & Co estimates that mergers result in scale synergies of just 1-2% of combined revenues1.

An analysis of over 800 recent global transactions by Deloitte found synergies ranged between 1-5% of total combined costs2.

That’s a far cry from the large synergy benefits being touted in the investor presentations of some financial services transactions.

The data highlights the mismatch between M&A theory and reality.

Theoretically, the merger of two comparable businesses should deliver scale benefits, operational efficiencies and savings through shared offices, resources and people.

In reality, chasing synergies is as futile as pursuing that elusive pot of gold at the end of the rainbow.

My next column will examine the factors that prevent businesses from achieving synergies including distraction, cultural differences and nasty surprises due to inadequate due diligence.

In short, integration is much harder and more complex than people think. It takes a lot longer and costs more than organisations budget for, resulting in unrealised synergy benefits.

Often the pursuit of synergies through M&A destroys more value than it adds.

Yet almost every M&A business case includes a meaty section on synergy benefits with aggressive targets and forecasts. Strangely, these benefits and targets are rarely analysed and challenged, let alone tracked and measured post-merger.

At AZ NGA, our M&A strategy is based on acquiring capacity and capability, and gaining a competitive advantage.

Our focus is on stretching our capacity for long-term growth by acquiring capability.

That could be specialist advice competencies, a unique technology system or a larger customer base.

We don’t use synergies to pad out a business case. Synergies are desirable but they’re not essential for building a compelling thesis.

That said, unlike the mythical pot of gold, synergies are attainable, although extracting them requires strong fiscal management and complete control over profit margins.

Taking a step back, buyers need to intimately understand the health of their business, especially their real underlying EBIT margins, before trying to understand someone else’s.

This is critical because the EBIT margin of the home-base dictates the EBIT margin of the combined entity, based on an analysis of more than 70 transactions completed by AZ NGA.

As such, we believe that buyers paying 2.5 times recurring revenue for a client book in 2020 are most likely overpaying and will lose out in the long run, unless their EBIT margin is greater than 35%.

The proprietary table below can be used to gain a rough idea of a deal’s merit, prior to conducting thorough due diligence.

This table provides a quick and dirty indication of the minimum home-base EBIT margin required to breakeven in a book buy, based on our insights into the fundamental transference of a home-base’s EBIT margin to the target company.

Recurring revenue multiple Break-even EBIT
1.5-1.7 21-24%
1.8-2.0 26-29%
2.1-2.3 30-33%
2.4-2.6 34-37%
2.7-2.8 39-40%

Ultimately, there is no substitute for effective due diligence. It is key to a successful, fruitful transaction.

Buyers need to intimately know the business they’re acquiring in order to set realistic targets and quantify with a high degree of certainty the impact a transaction will have on the combined entity’s margins and performance.

Post-acquisition, they need to maintain the same level of enthusiasm that catapulted a deal over the line to track, monitor and measure ongoing performance.

The third article in this series will look at things buyers can do to derive real synergy benefits from M&A. It’s not easy but nothing worthwhile ever is.

Read more of Paul Barrett’s articles in Professional Planner.

  1. https://www.bain.com/insights/delivering-ma-benefits-ceo-forum/
  2. https://www2.deloitte.com/content/dam/Deloitte/ch/Documents/mergers-acqisitions/ch-en-fa-st-gallen-mergers-acquisitions-study-v2.pdf
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