This article originally appeared on the Boston Consulting Group website by Jens Kengelbach, Georg Keienburg, Timo Schmid, Dominik Degen, and Sönke Sievers
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.