Acquirers often underestimate how long it will take to realize cost savings. Sometimes that happens because the plans specifying how integration will proceed are insufficiently detailed. In other cases, it happens because the people in both companies are resistant to change, and senior managers often delay making tough cost cutting decisions. And, of course, the longer it takes for cost savings to be realized, the less value they create.
REVENUE ENHANCEMENTS
It's sometimes possible for an acquirer and its target to achieve a higher level of sales growth together than either company could on its own. Revenue enhancements are notoriously hard to estimate, however, because they involve external variables beyond management's control. The customer base of the acquired company, for instance, may react negatively to different prices and product features. A combined customer base may balk at making too many purchases from a single supplier. And competitors may lower their prices in response to an acquisition. Revenue enhancements are so difficult to predict, in fact, that some wise companies don't even include them when calculating synergy value. Matthew Slatter, the CEO of Bank of Melbourne, says, 'We model this [revenue enhancements], but never factor it into the price." Similarly, Peter Shaw at ICI considers them "soft synergies" and discounts them heavily in calculations of synergy value.
Despite their dangers, revenue enhancements can create real value. Sometimes the target brings a superior or complementary product to the more extensive distribution channel of the acquirer. That happened when Lloyds TSB acquired the Cheltenham and Gloucester Building
Society (which had a better home-loan product) and Abbey Life (which had insurance products). In both cases, Lloyds TSB was able to sell those products to its dramatically larger retail customer base, thus generating more revenue than the three entities could have done individually. Similarly, having acquired Duracell for a 20% premium, Gillette was confirmed in its expectation that selling Duracell batteries through Gillette's existing channels for personal care products would increase sales, particularly internationally. Gillette sold Duracell products in 25 new markets in the first year after the acquisition and substantially increased sales in established international markets.
In other instances, a target company's distribution channel can be used to escalate the sales of the acquiring company's product. That occurred at Gillette when it acquired Parker Pen. In calculating what it could pay, Gillette estimated that it would be able to get an additional $25 million in sales for its own Waterman pens by taking advantage of Parker's distribution channels.
A final kind of revenue enhancement occurs when the bigger, post-acquisition company gains sufficient critical mass to attract revenue neither company would have been able to realize alone. Consider what happened when ABN and AMRO merged to form ABN AMRO, the large Dutch bank. Afterward, other large banks pulled the new company in on syndicated loans that neither ABN nor AMRO would have been asked to participate in individually.
PROCESS IMPROVEMENTS
Cost savings result from eliminating duplication or from purchasing in volume; revenue enhancements are
generated from combining different strengths from the two organizations. Process improvements, by contrast, occur when managers transfer best practices and core competencies from one company to another. That results in both cost savings and revenue enhancements.
The transfer of best practices can flow in either direction. The acquirer may buy a company because the target is especially good at something. Conversely, the acquirer may see that it can drastically improve the target's performance in a key area because of some competence the acquirer has already mastered.
Take the case of National Australia Bank's purchase of Florida mortgage lender HomeSide. HomeSide has an extremely efficient mortgage-servicing process that NAB plans to transfer to its banking operations in Australia, New Zealand, and. the United Kingdom. The same was true of ABN AMRO when it acquired the U.S. commercial bank Standard & Federal. In that case, process improvements went hand in hand with cost savings: because its mortgage operation was so efficient, S&F eventually took over the combined banks entire mortgage business.
Product development processes can also be improved so that new products can be produced at lower cost and get to market faster. Such was the case when Johnson Controls acquired Prince Corporation, a maker of rear-view mirrors, door panels, visors, and other parts of automobile interiors. Prince was better than Johnson Controls at understanding customers' needs-both existing and anticipated-and consequently it produced higher-margin products. Prince also had an excellent process for ramping up production of new products, which enabled it to move from design to mass production about twice as fast as Johnson Controls could, maintaining higher quality levels while speeding cycle times.
Johnson learned from Prince and was soon able to apply those advantages to its own products.
For an example of the process improvements an acquiring company can bring to the table, take a look at newspaper giant Gannett. Gannett has a database of financial and nonfinancial measures for each of its 85 newspapers; executives use this rich resource to determine best practices, both boosting revenue and lowering costs. Larry Miller, Gannett's CFO, explains, 'We have been able to dramatically improve the papers we've bought. The key for us is knowing in very minute detail how to run a business. This gives us very specific ideas for improvement." Through more efficient production and distribution processes, Gannett has been able to extend its deadlines for news and advertising copy while simultaneously delivering the newspaper more quickly. That helps advertisers and improves Gannett's revenue. Gannett is also able to determine where classified rates are too high, hurting volume, and where they are too low, leaving money on the table. Because it can expect to yield quick, substantial process improvements, Gannett can pay very high premiums for its acquisitions. When you consider that many of the acquisitions are run independently-and so don't offer many consolidation opportunities-the high premiums are quite extraordinary. In fact, Miller has told us, People are often shocked at what we pay." In nearly all cases, though, performance improvements after the fact have justified the high prices.
The synergies of cost savings, revenue enhancements, and process improvements may be easy to understand conceptually, but our research demonstrates how hard they are to forecast accurately. Why? Most calculations of synergy value occur under horrendous conditions: time pressure is intense, information is limited, and
confidentiality must be maintained. Since conditions are so far from ideal, the managers and board members responsible for the final decision should always scrutinize the assumptions underlying the numbers.
FINANCIAL ENGINEERING
Acquirers often think-and hope-that if they borrow cash to finance a transaction, they'll reduce the weighted average cost of capital. That is not a good reason to do a deal. If either the acquirer or the target company could afford to take on more debt; each could have borrowed it on its own.
However, some companies can find genuine synergies
through financial engineering. For example, an acquisition can increase the size of a company to a level where there are clear economic benefits to pooling working-
capital finance requirements and surplus cash, as well as netting currency positions. These benefits can be quite substantial. When the Credit Suisse Group merged with
Winterthur, 10% of the forecasted synergies came from reducing funding costs through optimized capital management.
Here's another genuine financial-engineering synergy: a transaction may allow a company to refinance the target's debt at the acquirer's more favourable borrowing rate without affecting the acquirer's credit rating. That is especially likely to happen in the financial services sector because those companies are big and their risk is diversified.
TAX BENEFITS
Tax considerations are often a barrier that must be overcome to justify a deal, a fact that makes tax-related synergies very difficult to assess. It's useful to distinguish between tax "structuring," which makes the deal possible, and tax "engineering" (also called tax planning), which ensures that the overall tax rate of the combined company is equal to or lower than the blended tax rates of the two companies before the deal. Regulators often believe that companies using perfectly legitimate structuring and engineering techniques to avoid incurring additional costs are simply taking advantage of loopholes. Thus companies are not anxious to disclose any clever techniques they may have used.
The goal of tax structuring is to avoid as many onetime tax costs as possible. Those costs may include capital and transfer duties, as well as change-of-ownership provisions that can trigger capital gains or prevent tax losses from being carried forward.
