Approaching synergies in private companies

The lack of information on privately held companies makes it more difficult to value synergies in a M&A process. We want to give a brief overview of potential sources of synergy, how it is correctly assessed, what approach for the buy-side is recommended in the small and medium-sized enterprise (SME) setting, as well as why Environmental, Social and Corporate Governance (ESG) factors gain importance in the future.

What is synergy?

Synergy is the additional value that is generated by combining two firms, creating opportunities that would not been available to these firms operating independently. It is the most widely used and misused rationale in mergers and acquisitions.

Operating synergies affect the operations of the combined firm and include economies of scale, increasing pricing power and higher growth potential. They generally show up as higher expected cash flows.

Steps in Valuing Operating Synergy

• First, value the firms involved in the merger independently, by discounting expected cash flows to each firm at the weighted average cost of capital for that firm.
• Second, estimate the value of the combined firm, with no synergy, by adding the values obtained for each firm in the first step.
• Third, build in the effects of synergy into expected growth rates and cash flows and revalue the combined firm with synergy. The difference between the value of the combined firm with synergy and the value of the combined firm without synergy provides a value for synergy.

Financial synergies, on the other hand, are more focused and include tax benefits, a higher debt capacity and uses for excess cash. They sometimes show up as higher cash flows and sometimes take the form of lower discount rates.

• Tax Benefits can accrue from takeovers and quirks in the tax law. The value of synergy is the present value of the tax savings that result from the merger. A second potential benefit comes from being able to write up the depreciable assets of a target firm in an acquisition. This will result in higher tax savings from depreciation in future years.
• Debt Capacity Benefits increase as the earnings of the two firms become less correlated. If the cash flows of the acquiring and target firms are less than perfectly correlated, the cash flows of the combined firm will be less variable than the cash flows of the individual firms. This decrease in variability can result in an increase in debt capacity and in the value of the firm. A merger can therefore reduce the overall risk in the combined firm and increase the optimal debt capacity.
• Cash Slack can be a potent rationale for publicly traded firms that have easy access to capital and/or large cash balances and want to acquire small, private firms that have capital constraints. The additional value of combining these two firms is the present value of the projects that would not have been taken if they had stayed apart, but can now be taken because of the availability of cash.

It is important to keep the value of synergy apart from the value of control, which is the other widely cited reason for acquisitions. The value of control is the incremental value that an acquirer believes can be created by running a target firm more efficiently. To value control, just revalue the target firm with a different and presumably better management in place and compare this value to the one obtained with the status quo – existing management in place. If both control and synergy are motives in the same acquisition, it is best to assess their values separately.

An approach for identifying and valuing synergies within a buy-side mandate

Talking about paying for synergy also should highlight the importance of not only valuing control and synergy, but of paying the right price for a target firm. The acquisition price will determine whether an acquisition is value increasing or value destroying to the buy-side. This shows the importance of a strategic approach and dedicated valuation if possible.

Unfortunately, private businesses do not have a market price like publicly traded companies. Because of the lack of information, an aquiring firm can only estimate the value of a target firm as well as possible synergies in first place.

In being able to value synergies for small and mid caps correctly as mentioned before, it is necessary to have independet valuations of the acquiring and target firm available.

• For a professional buy-side mandate access needs to be granted to the non-disclosed financials of the acquiring firm and hereby enabling the engaged M&A advisory to value and understand the client‘s firm without restrictions.
• In-line with the developed acquisition/expansion strategy, the acquiring firm, M&A advisory or both identify potential target firms.
• To keep the acquiring and target firm immune from rumors, an intermediary – such as a M&A advisory – is skilled to protect confidentiality and communicate the benefits of an initial discussion with the management or shareholders of the potential target firm without disclosing too much.
• Subsequent talks and exchange of ideas need to initiate the willingness of a target firm to give access to their related financials.
• A compelling indicative offer or a so-called „Letter of Intent“ provides a trustworthy basis to the target firm’s owner.
• For a best possible understanding of synergies of the combined firm, a thorough due diligence of the target firm in regard to operating and financial synergies is recommended.

The likelihood of being able to perform a thorough due diligence of a target firm in the SME setting is expected to decrease, when both firms compete for business in the same market where they offer the same or substantially similar products or services. Hence, such a situation requires a good understanding of the industry and awareness of conflict issues at each stage of the process.

Professional acquisition bidding can differentiate between control and synergy value. The buy-side may be willing to pay close to 100% of the control value (arguing that the target firm could have made the changes on its own) but only a portion of synergy value (since it could not have been created without the acquiring firm).

ESG and its growing importance for private companies

Environmental, Social and Corporate Governance (ESG) analysis provides companies with an additional way of identifying opportunities and risks related to long-term implications for their supply and value chains. The European Supervisory Authorities published a consultation paper setting out the proposed Regulatory Technical Standards (RTS) on content, methodologies and presentation of disclosures under the Sustainable Finance Disclosure Regulation (SFDR) on April 23rd, 2020. As there is no harmonised standard to identify the relevant metrics to measure each and every ESG factor, this can be seen as a first approach.

The assessment of principal adverse sustainability impacts can be used as a lens to drive up the value of both acquiring and target firm through multiple arbitrage, cheaper acquisition financing and finally a better ESG momentum. We expect to see a number of new and innovative deals with an ESG angle come to market in 2021.

In summary, ESG is becoming an imperative in the M&A due diligence process as companies are increasingly expected to simultaneously perform well financially and make a transparent, positive contribution to society. Forward-looking firms should therefore start to integrate ESG in the overall M&A roadmap to stay ahead of the curve.

Promecon advises clients throughout the entire buy-side or sell-side process. As we have learned from many years of experience in an environment with synergetic potentials for small and mid caps, we know which approaches as well as valuation methods can lead to success. Feel free to contact us if you would like further information about our advisory services.