Why synergy benefits are pots of gold at the end of the rainbow

The false promise of synergy benefits is the reason why most M&A transactions result in buyer’s remorse. Before doing a deal, review AZ NGA’s ten-point checklist to determine the probability of success. Paul Barrett explains.

As a kid, I asked my dad to drive my sister and me to the end of a rainbow. “Dad, it’s over there,” I exclaimed. The longer he drove, the further it seemed. Eventually my dad’s narcolepsy got the better of him and he swerved into a roadside ditch; pot of gold nowhere in sight.

Thankfully, my sister directed us back home.

That sad but true story is a metaphor for many M&A transactions.

The journey begins with enthusiasm and excitement. Buyers spend a lot of money and energy pursuing cost savings, efficiencies and scale but ultimately fail to reach their target. Many end up at square one.

In M&A, the main cause of failure is poor integration resulting in unrealised synergy benefits1.

This article – the second in a three part series on understanding and unlocking synergy benefits – examines ten reasons why buyers systematically fail to achieve their stated synergy targets.

Based on an analysis of over 70 transactions completed by AZ NGA in the past five years, the single most critical success factor in M&A is home-base health.

That is because when a business participates in M&A, whether it’s a material acquisition, a tuck-in or a book buy, they are effectively creating a bigger version of the home-base. If they’re not operating efficiently and profitably, they often end up transferring their problems and inefficiencies to the target.

As discussed in my previous article, Don’t overpay for synergies, the earnings before interest and tax (EBIT) margin of the home-base dictates the EBIT margin of the combined entity, therefore, based on our analysis, buyers paying 2.5 times for a client book in the current market are likely overpaying unless their EBIT margin in greater than 35%.

If you’re banking on synergy benefits to make an acquisition business case stack up, use the following list to objectively assess the likelihood of realising synergies.

10 reasons why M&A fails to deliver synergy benefits:-

  1. Distraction: M&A is highly disruptive, especially for the home-base. If home-base is a small business with scarce resources, those resources are typically split between BAU and integration. Performance inevitably takes a hit. In our experience, home-base EBIT margins suffer for a period of time so even if the target has a higher EBIT margin, there is no net improvement to the combined entity’s performance. Buyers need to consider the opportunity cost of M&A because integration can take anywhere from six months to several years to bed down, depending on size and complexity.
  2. Nasty surprises: There is no such thing as a surprise-free Unfortunately, surprises rarely delight on the upside. The most common surprise is client and staff attrition. Due to inadequate due diligence, acquirers anecdotally experience higher attrition than expected. Our analysis shows BEST case client attrition is 9% pa.
  3. Wages: Cost savings through headcount reduction is touted as a key driver of value and synergies. But the promised land of lower staff costs across the broader organisation is a façade because resources are often added (or diverted from the home-base) to assist with integration activity. Post-acquisition, many temporary resources become permanent, resulting in an increase in staff costs.
  4. Acquisition costs: Buyers routinely underestimate the time and cost required to complete a transaction including legal, due diligence and advisory fees. As buyers become more sophisticated and discerning, these costs will only rise. For example, the level and quality of due diligence being conducted buyers today won’t cut it in the future. Investors are increasingly demanding more detailed analysis and insights, which comes at a higher price.
  5. Efficiency code: A buyer’s EBIT margin can be treated as their efficiency code. Therefore, multiplying their efficiency code by a target’s revenue will provide an indication of the combined entity’s maximum pre-tax profit. Basically, the efficiency of the home-base dictates the efficiency of the combined entity, however, mergers often detract from a combined entity’s efficiency code.
  6. Connectivity paradox: The merger of two separate companies involves the melding of different cultures and ways of doing things. As the dominant party, the home-base usually has more influence so if it is not operating efficiently, it will adversely impact the target and the performance of the combined entity.
  7. Misalignment of values and motives: Effective due diligence is not just about confirming the underlying numbers and data, and assessing the probability of achieving those numbers in the foreseeable future. It is also about uncovering non-financial risks such as a misalignment of values and motives between buyers and sellers. Both parties need to agree on what matters most and why in order to effectively engage staff, allocate resources to the right areas and achieve their objectives.
  8. Lack of project management skills: The ability to create an integration plan and apply systems and methods to achieve specific objectives within a finite timespan is a real skill. That skill set and experience does not typically exist inside the average financial advisory SME but it is exactly what’s needed to minimise errors and ensure timeframes and budgets don’t blow out.
  9. Emotion: As explained in my previous column, buyers routinely overvalue the synergies to be had from an acquisition for a myriad of reasons including enthusiasm. Aggressive targets and forecasts may look good in an M&A thesis but they are generally based on hopes and dreams not rigorous analysis.
  10. All care no responsibility: Measuring, tracking and regularly reporting performance is difficult and often confronting, which may explain why businesses don’t do it. However, a strong accountability framework is a key determinant of M&A success. Businesses that keep their focus on synergies by actively managing and tracking their performance are more likely to meet deadlines, hit their targets and grow enterprise value.

Like the mythical pot of gold under the rainbow, synergies continue to evade even the most enthusiastic treasure hunters. That said, unlike chasing leprechauns, the pursuit of synergies is still a worthy cause.

My final column in this series will differentiate between mergers and acquisitions, and question whether integration is necessary at all. Assuming that it is, it will look at winning strategies for extracting synergy benefits. I will share what an ‘ideal’ target looks like.

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