Overestimation of Synergies
Synergy is a peculiar word—depending on the context it either stands for the pipe dreams of management or a hard-nosed rationale for a deal. Often it is a little of both. Consider the following example: A large health services company paid several billion dollars for a more profitable company in a related industry segment. Given its stepped-up investment base, the target’s post acquisition after-tax earnings would have had to be about $500 million for the acquirer’s return on its investment to approach its cost of capital. The year before the transaction was consummated, the target’s earnings were about $225 million. Therefore, it needed to close an earnings gap of more than $275 million through “operating synergies.” That meant more than doubling the earnings base. The acquirer’s inability to make improvements of this magnitude resulted in destruction of significant shareholder value. In the ensuing three years, market indices rose while the acquirer’s returns to its shareholders were actually negative. Clearly in the foregoing case, the estimation of deal benefits became disconnected from reality somewhere along the way. ”The Vision Thing” often underlies such situations, where a visionary CEO’s idea of an industry-transforming deal runs straight into the reality of day-to-day business.