Synergy is often used in the physical sciences. If two substances or influences combine to create a much greater impact together. What we refer to as synergy is the reaction to that merger. The effect of the merger must be greater than the sum of both factors or substances operating independently.
In business, synergy is simply the 1 + 1 = 3 effect. It is where the whole is greater than the sum of its part, so when two or more people or organizations combine their efforts.
As a result, firms are able to incur the expenses of the acquisition process. At the same time, the firms will also be able to provide a premium for the target shareholder’s shares.
Operating Synergy
Now let’s dive deeper into what operating synergy means. Think of it this way, there are two firms that are looking to merge together. If both firms are able to achieve greater value and performance while they merge. They also increase their operating income. This also means higher growth for both firms instead of what they achieve when both firms are apart. That is what operating synergy is. This comes from gains that increase revenues or lower costs, although the former is more challenging to attain. However, as it is with most things in life, gains like these are easier in paper than in real life.
Revenue-Enhancing Operating Synergy
As mentioned, this type of synergy can be a lot more challenging to attain. For instance, in one study, McKinsey revealed that approximately seventy percent of mergers fail to reach or attain their goal or expected revenue synergies.
This can come from sources like pricing power, a combination of strengths, and growth from faster-growth markets. When two companies combine, this may result in greater pricing power. Or purchasing power if both are in the same business. Its possibility of being achieved is dependent on the degree of competition in the industry and relevant geographic markets, as well as the size of the merger partners. This may be attained in terms of pricing power if the combination leads to a more oligopolistic market structure.
Oligopoly
What is an oligopoly? It is a state of limited competition. This means that a market may be big or small, but it is only shared by a limited number of producers, suppliers, and sellers.
The combination of functional strengths is another source of revenue enhancement. This can be possible if, for example, one company has strong production abilities while the other has great marketing and distribution. One merger partner could contribute something that the other lacks.
Another potential source of revenue enhancement is higher-growth new markets. In mature markets, corporate growth slowed in Japan and Europes. Large companies needed to invest greater amounts to increase market share or sometimes to merely maintain what they have. But they can also move into rapidly growing markets as a faster way to realize meaningful growth.
Aside from M&A-related increase in revenue being difficult to achieve, M&A-related losses in revenues may also be difficult to avoid. Larger companies are usually avoided by customers of the target. But when the bidder pays a premium for the target, the profitability of its total revenues was likely used to compute the total price. The deal can be a loser if revenues are lost, that’s why an examination of why simplistic projections of deal gains must be carefully done.
Cost-Reducing Operating Synergy
Cost-reducing synergies, according to merger planners, tend to be the main source of operating synergies as revenue enhancement is more difficult to achieve. Economies of scale, or the decreases in per-unit costs, are the cause of cost reductions. When the operation of a certain company or business increases in either size or scale, the result is what we call economies of scale.
Firms that operate at a high per-unit cost for low levels of output are typically manufacturing firms, especially capital-intensive ones. Their fixed costs of running their manufacturing factories are spread out over lower scales of output.
Take note that spreading overhead is the term for when the per-unit costs decline as their output levels rise. An increase in the specialization of labor and management is also another source of these gains, as well as the more efficient use of capital equipment. However, it may not be probable to use capital equipment at such low output levels. As firms experience higher costs and other issues related to the coordination of a large-scale operation, diseconomies of scale may arise. The extent to which these exist is controversial for economists.
For instance, there are those who argue indications of firms that have displayed continued periods of growth while still paying stockholders sufficient return on equity. On the contrary, some economists believe that these companies would be able to give stockholders a greater rate of return if they were smaller, more competent companies.
Mergers & Acquisitions
There are several examples of mergers and acquisitions motivated by the pursuit of scale economies in the cruise industry. One great example of this would be the 1989 acquisition of Sitmar Cruises by Princess Cruises, and the 1994 merger. It is between Radisson Diamond Cruises and Seven Seas Cruises. This acquisition allowed them to offer a wider range for their product line. It allowed them to produce more ships, beds, itineraries while reducing the costs.
There are many pieces of evidence that show the success of M&As in achieving operating economies. In a study done by Lichtenberg and Siegel, they noted the progress in the capability of plants. That had been through adjustment in ownership.
Additionally, they noted that the plants that had the worst performance were the ones most likely to undergo a change in ownership.
Another study by Shahrur analyzed the returns around 563 announced horizontal mergers and tender offers between 1987-1999. He found that there are conclusive combined bidder/target returns. And interpreted that these findings mean that the market saw these deals as to imply that the market saw the deals as better options. Despite these studies, one should not assume that mergers are always the best way to attain such economies.
Economy Scope
Lastly, the economies of scope are the ability of a certain firm to use a set of inputs to provide ample options when it comes to products and services. This concept is closely related to economies of scale. The baking industry is one great example of scope economies. One factor that affected the consolidation within the industry that occurred on the fifth merger wave is the pursuit of these economies.
A meaningful reduction in costs can also be a result of the combination of two companies that yield enhanced purchasing power. One example can be seen in InBev’s acquisition of Anheuser Busch and Mittal’s consolidation of steel producers.
© Image credits to Oleg Magni