Synergy

Benefits achieved by combining companies

Written by Tim Vipond

What is Synergy?

Synergy is the concept that the whole of an entity is worth more than the sum of the parts. This logic is typically a driving force behind mergers and acquisitions (M&A), where investment bankers and corporate executives often use synergy as a rationale for the deal. In other words, by combining two companies in a merger, the new company’s value will be greater than the sum of the values of each of the two companies being merged.

Synergy explained in diagram

What are the different types?

There are generally two types of synergy that can be achieved in an M&A process: (1) cost savings, and (2) revenue enhancements.

Cost saving synergy – usually referred to as operational synergy – can be achieved by eliminating redundant costs, gaining better bargaining power with suppliers and vendors, and improving operational efficiencies. Redundant costs frequently relate to personnel, such as not requiring two CEOs and thus being able to eliminate one from the payroll. Bargaining power with suppliers can be improved because a larger company that places larger orders has more leverage and therefore the ability to negotiate better pricing and better payment terms. Lastly, operational efficiencies may be realized by sharing best practices and streamlining processes across both companies.

Revenue enhancements are derived from the financial synergy that can be achieved by such things as cross-selling complementary products to customers, having more pricing power with consumers, and expanding or being able to enter into new markets and new geographical locations.

Examples of synergy in M&A

A classic example of synergy in M&A is the merger of Kraft and Heinz, announced in 2015.

According to the press release from Heinz:

“The significant synergy potential includes an estimated $1.5 billion in annual cost savings implemented by the end of 2017. Synergies will come from the increased scale of the new organization, the sharing of best practices and cost reductions.”

News articles following the deal commented that the term synergy typically involves closing offices, combining manufacturing facilities, and reducing the number of warehouses, which frequently means a reduction of staff and job losses. For this reason, many employees who worked at Kraft and Heinz were worried about layoffs.

At the time, the combined businesses had approximately $28 billion of revenue, so the total synergies (the $1.5 billion in expected cost savings noted in the Heinz press release) represented approximately 5% of that.

Can synergy be negative?

Synergies can be negative (dis-synergies) if a merger or acquisition is poorly executed. In some cases, forecasted cost savings actually turn into higher costs if the two businesses fail to integrate properly.

According to a study by McKinsey, more than 60% of transactions fall short of the stated synergies they hoped to achieve, and some not only don’t achieve their positive synergy expectations but actually experience dis-synergies.

Part of the reason for over-optimism may be the desire to “sell a deal” to the market or investors and ensure that it looks attractive enough. There are plenty of reasons for managers and executives to want to acquire companies, even if it doesn’t actually create enhanced value. Common reasons include empire building, ego boosting, and providing a justification for larger compensation packages (bigger companies pay higher compensation).

Additional resources

Thank you for reading the CFI guide to M&A transactions. CFI is the official provider of the Financial Modeling & Valuation Analyst certification. To continue advancing your career in the financial industry, these additional CFI resources will be helpful: