When people think or say the term ”synergy”, it is often associated with the physical sciences. Not a lot of people would think about what the term synergy means in the world of economics and finance.
The term itself plays a huge role in the financing and economics world. It means that the profitability of a corporate combination as opposed to the individual parts of the firms that were combined.
Think of it this way, if there is a synergy in both corporations, the anticipated existence of the synergistic benefits will allow both firms to incur the expenses of the acquisition process. In addition to that, both will still be able to afford to give their target shareholders a premium for their shares.
Synergy
Here’s an equation for you: Synergy may allow the combined firm to appear to have a
positive net acquisition value (NAV).
NAV = VAB − [VA + VB] − P − E
where:
VAB = the combined value of the two firms,
VA = the value of A,
VB = the value of B,
P = the premium paid for B, and
E = the expenses of the acquisition process.
If we reorganize the equation above, we get:
NAV = [VAB − (VA + VB)] − (P + E)
Looking closely at the equation above, you will notice that the term in the brackets is the synergistic effect. The effect must always be greater than the sum of the P+E in able to justify going forward with the merger.
However, in any case, that the bracketed term is not greater than the sum of the P + E, the bidding firm will have overpaid for the target. So, what does it really take to be considered synergistic effects?
Well, there are some researchers who view synergy broadly. These researchers include the elimination of inefficient management by installing the more capable management of the acquiring firm.
The Revenue-Enhancing Operating Synergy
Now that we have established what the term synergy means in the financing and economics world, we will discuss the first main type of synergy: the revenue-enhancing operating synergy.
Before we dive in deeper, it is important to know that there are two main types of synergy that are both operating synergy forms. There are revenue enhancements and cost reductions synergy. As stated above, today’s discussion is all about the former. What is revenue enhancing operating synergy?
Revenue enhancements and efficiency gains or operating economies may be derived in horizontal or vertical mergers. These revenue-enhancing operating synergies are not too easy to achieve.
In fact, there was a survey once by McKinsey in which they concluded that 70% of mergers have failed to achieve their expected revenue synergies. So, how do corporations go about this? Well, first, let us establish that these revenue-enhancing synergies can come from different sources which are listed below:
- The pricing power or purchasing power.
- The combination of functional strengths
- The growth from faster-growth markets or new markets
Now, how will two companies merge create synergy? The combination of two companies may lead to greater pricing power or purchasing power. Greater pricing or purchasing power can be achieved only if the two companies are in the same business.
However, it’s success ability will also depend on the degree of competition in the industry both companies are in. It will also depend on the relevant geographic markets as well as the size of the merger partners. With respect to the pricing power, if the combination leads to a more oligopolistic market structure, this can be highly possible.
Increased Concentration
On the other hand, if there are large pricing gains to be achieved through the increased concentration, then the deal may not get regulatory approval. There is research on the source of gains from horizontal mergers that concluded that the gains associated with such deals can be attributed to efficiency improvements and not attributed to the increased market power.
The studies mentioned above have examined the stock market response reactions – or sometimes the lack of a response by every competitor, customer, and suppliers. Additionally, there is another potential source of merger revenue enhancement. This can be the combination of functional strengths.
A great example of this would be if one company has a strong R&D or production abilities while the other company is great at doing marketing and distribution. In every deal, there is a high possibility that each merger partner could be bringing important capabilities that the other company lacks on the table.
There are plenty of great examples of this that have happened in the pharmaceutical industry through the mergers between drug companies with good R&D and large pharmaceutical companies with great manufacturing capacity and quality control as well as global marketing and distribution capabilities.
The pharmaceutical industry has been struggling to improve in R&D areas and quality control. A merger between two companies who have at least one of these capabilities is a surefire revenue-enhancing operating synergy.
Slow Growth
In mature markets like Japan and Europe, corporate growth has slowed for a significant number of years. The slowed growth in these markets has made it harder and harder for different companies (small and large) to achieve meaningful growth.
In cases like this, it sometimes means that large companies have to invest greater amounts to increase market share. There are also cases when large companies invest greater amounts only to maintain what they already have.
However, companies like these may be able to achieve a significant increase in growth by moving into a more rapidly growing market such as those in the emerging world. But what do companies do when they struggle to expand their mature markets?
There are plenty of companies who are struggling to expand and reach their rapidly diminishing returns who enter a higher-growth new market. This is one of the fastest ways to realize meaningful growth for a large company.
There you have it for the discussion of revenue-enhancing operating synergy. We hope this article has helped you gain new information on how to improve your company’s growth and do better in your market or industry. Read also: Acquisition: Achieving Growth in a Slow-Growth Industry