Among stock market investors, there is often no more welcome news than the acquisition or buyout of a company the investor owns. Those buyouts usually come with a hefty premium attached – sometimes as much as 30 percent or more of the pre-acquisition stock price. But why is this the case? Why are acquiring firms wiling to pay substantially more for a stock than investors were just days earlier in most cases?
The answer is often synergy values. Synergies result from additional cost savings and revenue generation that come from combining two firms into one larger firm. For instance, two dollar-store retailers that are combining might be able to share distribution center costs. Certainly only one CEO and corporate HQ will be needed for the combined firm. Beyond cost savings, though, there are often cross-selling opportunities that arise from mergers. For instance, two industrial manufacturing companies that make related products might be able to tap one another’s customer bases after a merger.
The concept of synergies applies to firms of all sizes, from publicly traded goliaths to small, privately owned companies. While there are roughly 5,000 publicly traded firms in the U.S. today, there are hundreds of thousands of small -and medium-sized privately owned firms. These small firms often enter into M&A deals as well, and unlike larger publicly traded firms, small firms often fail to account for synergy values. This is a missed opportunity. Synergy values could add 20 percent or more to many private sale transactions depending on who the buyer is.
While there are small investment banking firms that help middle-market companies with M&A transactions, synergies may or may not be included in any given IB-assisted transaction. Again, that’s a missed opportunity.
Synergy values have to be examined carefully. In many cases, publicly traded synergy values can be overly optimistic. In a few cases though, an acquiring company may have been acting opportunistically, thus shortchanging existing shareholders. To determine which situation is more likely, various forecasting techniques should be used. Probably the most accurate and most defensible such technique is regression forecasting.
Regression analysis is a statistical technique that uses a set of existing data points to assign importance weightings to various facets of a question. For instance, when trying to determine the effect of an increase in interest rates on unemployment, regression analysis would determine the impact that a change in interest rates has, but it might also take into account the effect that consumer confidence, industrial production, and gas prices have on employment. In other words, regression analysis allows one to determine the effect of an interest rate hike on employment after accounting for all other observable factors that would impact employment.
This same concept can be applied to valuation work for firms. Regression forecasting can be used to determine the price that one would expect a company to be acquired for after accounting for characteristics of the target firm such as sales growth, profitability, assets, intangibles, and the industry the target and acquiring company operate in. Synergy values could also be included in this list.
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For attorneys investigating pending mergers for fairness or negotiating on behalf of an acquirer or a target, regression forecasting is a great tool to use. It’s objective, fair, and avoids reliance on the HIPPO (HIghest Paid Person’s Opinion). In legal matters, that objectivity is crucial. Regardless of the method of valuation used, attorneys should be even more careful to ensure that synergy values are considered somewhere in an analysis. Failure to do so risks shortchanging parties in the transaction.
Michael McDonald is an assistant professor of finance at Fairfield University in Connecticut. He holds a PhD in finance. Michael consults extensively with organizations ranging from Fortune 500 companies to start-up businesses on financial matters through Morning Investments Consulting. Michael has served as an expert witness in legal disputes, and is an arbitrator with the Financial Industry National Regulatory Authority (FINRA). Michael can be reached at [email protected].