In this episode of the Inside the Strategy Room podcast, senior partner Andy West and partner Jeff Rudnicki, two of McKinsey’s most seasoned M&A experts, discuss what they learned from their recent work with clients of SynergyLab, a new firm initiative aimed at understanding how to most effectively capture synergies in M&A deals. In their conversation with communications director Sean Brown, they share some of their insights, several of which surprised even them. This is an edited transcript. You can listen to the episode on Apple Podcasts, Spotify, or Google Podcasts.
Sean Brown: Today we’re talking to two of our experts about their latest research on deal synergies and how the most successful acquirers have built a winning formula for value creation. Andy West is a senior partner in our Boston office. He co-leads our global M&A practice. Andy has served senior leaders in the healthcare, medical devices, high tech, and industrial sectors on all aspects of dealmaking, divestitures, and integration. Jeff Rudnicki is a partner based in our Boston office who leads our knowledge efforts on capturing value from M&A. His client work focuses on large mergers and acquisitions across a range of industries. Andy, Jeff, welcome.
Andy, let me start with you. What questions were you looking to answer in this latest research on synergies?
Andy West: About ten years ago, we were looking at data showing literally trillions of dollars flowing through M&A in terms of capital allocation and cash put to work, and we wondered: Why are there so few actual insights around value creation? So, we started a piece of work called the Global 1,000, which sought to understand why the world’s largest companies do M&A and what their success rates are. This work debunked myths that, hopefully, most active dealmakers have already dispelled, such as the notion that 70 percent of all deals fail and that M&A offers poor returns relative to strategic acquisitions.
An offshoot of that work was on synergies and ways to think about value creation. We realized there were simply too many assumptions following too much money—that there was just too much leakage between the concept of buying a company, turning that acquisition into expectations, turning those expectations into budgets, and ultimately turning those budgets into cash flows. So, we set up what we call the SynergyLab, which is a group exclusively dedicated to studying and helping clients capture synergies.
Sean Brown: Jeff, what are some of the most common concerns clients have about synergies, especially related to big transactions?
Jeff Rudnicki: You have this big deal that’s going to distract people, take a lot of their bandwidth and maybe cause them to lose their focus on the core business. That’s a very, very common concern. Many executives’ time gets consumed by a large deal, and that is one of the leading reasons why those large deals, on average, underperform.
The other concern is how many people to involve in due diligence and to what degree. The number of deals we see where the head of commercial wants to sit in on the steering committee is unbelievable. And we say, “No, no, you’re the sales leader, keep meeting with customers. We will bring you in and make sure you are consulted on things that affect your business, but we would rather not have you sit on a steering committee for three hours a week.”
Another common question is the transition to integration planning and when you need to involve people. If certain executives aren’t included, they might not believe in the deal and the synergy opportunity, and that may produce a setback in terms of value capture.
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Sean Brown: What does your research suggest are the main issues to consider when assessing synergy potential in deals?
Andy West: Number one is protecting the base business. In considering synergies, it is important to understand that anything you do needs to weigh the investments in management time and attention, and to make sure you do not destroy value in either the asset you are acquiring or your core asset. In fact, when we look at performance on very big mergers and deals that start to approach mergers of equals, this ends up being one of the biggest swing factors in terms of value creation.
Sean Brown: In your work you differentiate between combinational and transformational synergies. How important is this second kind, and does that transformational potential have an impact on deal price?
If you have a one-size-fits-all set of synergy assumptions across three different companies, it’s probably wrong.
Andy West: Combinational synergies are the synergies associated with bringing two organizations together and eliminating redundancy. Transformational opportunities, particularly with larger deals, is absolutely something you should go after, even sometimes at the expense of combinational synergies. We talk about three synergy levers: cost, capital, and revenue. These tend to be very combinational, whether it’s general and administrative (G&A) expenses reduction or, on the revenue side, cross-selling or, on the capital side, capital expenditures and working capital management. Most companies are very familiar with those. As you get into what we call transformational cost, transformational capital, transformational revenue—and frankly, all kinds of revenue synergies—that gets to be a bit more of a gray area. But we think it’s important to think about all of these at various points in the process, not just in the strategy.
Sean Brown: Jeff, anything you would add about the different synergies and how to approach them?
Jeff Rudnicki: I think people don’t pay enough attention on average to capital opportunities. Cost opportunities are a bit easier, but how you think about working capital and capital expenditure efficiency in light of a deal can be a real value driver. Also, companies that are aspirational when they do a deal often put too much into the transformational opportunity bucket. They pick five or six large-scale transformational opportunities to pursue, and that can distract from the base-business combinational opportunities. You should use the transactions as opportunities to transform but, oftentimes, companies overdo it.
I would also add a couple things on revenue synergies. They take longer to realize than, say, a cost synergy, which can be a day one savings. In an acquired investment, sometimes you have to put money into getting salespeople to a new region, and it can be hard to track the revenue synergy dollar versus a normal sales dollar.
Sean Brown: I would assume the synergy potential can be very different in different types of transactions, right?
Andy West: Yeah. It’s important to understand how the different synergy categories apply to the type of deal you are doing. Our clients often fall into a trap where they have been doing one type of deal over and over and the organization gets into a rut about how it thinks about value creation. Then, if you change your play and do a different type of deal, something is lost in translation, because you approach the asset in a way that is consistent with your previous deal archetype, when you should be basing the synergies on the rationale for the current deal.
Sean Brown: How do you segment the different types of deals, and how do these categories affect the approach to synergies?
Andy West: On one side you have relative size, which we think matters in terms of risk and how you view the execution challenges associated with going after synergies (exhibit). For example, if, in a big industry consolidation, two companies that do the same thing and have the same manufacturing footprint buy each other, there are a lot of cost synergies in focusing on the combination and maintaining business momentum.
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That is a very different plane of approach than if you do something like a corporate transformation, which is big but pushes you into an adjacency, a different vertical, or a different part of your value chain. The whole mindset around synergy changes. You migrate away from traditional combinational synergies, the things that are much more tactical to execute, and get into more strategic questions. Are we allocating capital behind the strategy? If you have an IP acquisition or a new business model, very rarely can the deal itself afford all the investment required to build a new business, so you would be asking, are we creating enough synergies? If it is a capability transfer, the question you would ask is, are we finding the extra $100 million or $500 million to properly reinforce those capabilities in our organization to start a transformation? Make sure that, as you think about a specific deal or M&A strategy, you understand how both the mix and the relevance of those different synergy levers might change, so people in the organization are not talking past each other.
Sean Brown: You recently surveyed M&A practitioners on their experiences with synergies, reviewing nearly 400 deals. Can you walk us through some of your main findings?
Jeff Rudnicki: The first one is a little counterintuitive. Only about 20 percent of companies—and this is in large deals—are announcing their synergies publicly, despite evidence that companies that do announce them perform significantly better two years after the deal.
We often hear, “I want to announce, but internally I want to have a buffer.” The fact is, there will be some slippage, and that’s common even in high-performing organizations. We are also often asked what the typical buffer is. We have a bunch of proprietary data where we compare how targets differ from what has been announced publicly, and what we see is a pretty wide delta. On average, the buffer is around 50 percent. So, if it’s $100 million in announced synergies, the internal target will be something like $150 million.
We do see quite a wide variety, though. We have seen companies apply a buffer of several hundred percent. So, you may have a $100 million target, but you use the deal as an occasion to maybe loop in an additional transformational program or a cost program that you were considering anyway.
Sean Brown: Can you offer any guidelines on what synergy levels companies making acquisitions should be aiming for?
There is this big difference between what you pay for and what you go for, and too often, the governance around the deal process keeps those two dialogues from happening.
Jeff Rudnicki: One thing we hear a lot is, “Tell me the benchmark. We are about to do a deal, what’s the benchmark for how much G&A I can take out?” While there are some reasonable rules of thumb, again, when we look at internal data on how companies decide targets, you see a massively wide variety. I think relying on benchmarks really misses the deal’s specific opportunities. Where is the company you are acquiring in terms of its G&A evolution? Where are you? What are your aspirations for this deal, and what is the deal archetype? And by aspirations, I mean, are you going to use this as an opportunity to create a world-class shared services-type facility where you outsource or offshore much of your G&A, or has the company you are acquiring already done that? Because if they have, the deal opportunity will be quite a bit lower. So, I think we are trying to debunk the idea of using a one-size-fits-all outside benchmark.
We looked at deals in the pharmaceutical industry to see what percentage of synergies came out of the target companies’ finance organizations and how that varied among about ten deals. What we found is that, on average, about 50 percent of costs are coming from the finance function. So, if you are acquiring a finance function that has $50 million worth of costs and your company has, presumably, $50 million-plus, because you’re probably bigger, $25 million, on average, is coming up there. But, again, we see a wide variety so, given that, billing that $25 million to your deal model or to your target is missing quite a bit of nuance in both your company and the company you are acquiring. What we saw in the deals we examined is a six-time difference in terms of companies on the low end, which take out only 13 percent of the finance function, and companies on the high end, which are taking out almost all of what they acquire. So, be really thoughtful on the assumptions. If you have a one-size-fits-all set of synergy assumptions across three different companies, it’s probably wrong.
Sean Brown: Is there anything else you would warn companies about—things you see as caveats around synergies?
Jeff Rudnicki: What a company pays for in an asset does not and should not equate to the synergies targeted. Obviously, synergies will be one of the things that inform what a company pays, but there are a bunch of other things. Synergies versus premium or EBITDA multiple actually are not correlated significantly. This will be more relevant in some industries. If you are in one where cost synergies aren’t really a factor in terms of the multiple or the value creation story, then synergies will not be correlated at all with the multiple. In sectors like tech, the competition, the industry dynamics and other things like that will inform the premiums paid, not the synergies.
Sean Brown: Does the speed with which you capture synergies matter?
Jeff Rudnicki: You know, a good rule of thumb is, on most things—in particular on head count—you really want to move fast to avoid business disruption and losing momentum on your base. The companies that do this well, they get past that always-messy integration phase and move to business as usual as fast as possible, so their core operators can pivot back to focusing on the core business.
The rule of thumb is 18 months. You should have the vast majority of synergies captured then. Will there be things that have a long tail, like IT systems, network consolidation, facility footprint consolidation and optimization? Yes. But most head counts can be achieved within a hundred days of close. Most of our clients doing large deals that have a close period of, say, three to six months are aspiring to name three levels down by close or on close.
Andy West: I would add that, just qualitatively, it is surprising how uncorrelated this is with the deal thesis. Organizations can’t afford to be schizophrenic for very long, and what will happen is a dominant culture or business will emerge. You have a limited time to settle into business as usual, so just move quickly—though obviously don’t hurt the asset. If you are ring-fencing it, that’s a completely different conversation.
Sean Brown: What are some of the biggest reasons that synergy estimates end up either unrealistically high or too low? Do you have any specific guidance on the rigor companies need to apply to things like due diligence around estimating synergies?
Andy West: I would say two things. One is, there is this big difference between what you pay for and what you go for, and too often, the governance around the deal process keeps those two dialogues from happening. What I mean by that is, when you don’t own an asset and you have to risk-factor in the unknown. That goes to the board and is a very active decision process, all the executives are typically aligned if it is a big enough deal. Then you own the asset—but operating risk and financial risk are two totally different things. Yet the re-risking of the asset, of saying, “Guys, we were only willing to pay for $100 million of synergies, but there is $500 million, so let’s take some risk. Let’s go for it!”—that conversation never happens. So, issue number one is, there is no re-risking of the asset. You get locked in because management gets locked in on that number and you never go back and re-litigate that, and say, “Guys, as an operator, we are willing to take a lot more risk, and therefore, we are going to up our numbers and our expectations.”
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The other component is, people put hedges on hedges. So, I have a hedge on the diligence number and another guy puts a little hedge on it and then we put a little hedge in the budget. You multiply all those things and you end up with a number that is frankly too low. So, again, it’s about breaking that and saying, I need to know very specifically how much value is being created and get rational numbers—not a number that’s been filtered through eight different channels and had a little bit taken out of it every single time.
Jeff Rudnicki: Sometimes that conservatism will hamstring your organization in making acquisitions. You put a hedge upon a hedge and, all of a sudden, the deal value doesn’t work and another company makes the acquisition. That’s not to say you shouldn’t put bankable, confident numbers into your deal, but if you start hedging upon hedging or relying on a leader who is being very conservative and doesn’t want to over-promise and under-deliver, it can really affect the number of your opportunities.
The second thing is around translating a deal model into an integration target. There really is an art there. It requires change management and real leadership. Let’s say you have a head of IT who is brought in to look at the system footprint and the road map for a company you are acquiring, as well as the synergy opportunity. That person may get comfortable and say, “There is $10 million worth of opportunity.” Once you have made the acquisition, you really want to think bigger. Getting that person to a bolder aspiration, not only on the technology road map but also on synergy capture, really lies in the leadership and change management.
Sean Brown: What about the issue of cultural differences—where does that fit in when assessing different deal archetypes? And does it present a potentially big barrier to realizing synergies?
Andy West: It is absolutely a critical factor, but it’s more important in some types of deals than others. You have to recognize very early in the deal process, is culture going to be a determinant for you going forward? Sometimes, you are buying a new culture, sometimes you are not. Sometimes you are simply absorbing someone. So, first is understanding what you want to get out of the deal. Trying to buy a culture or change your existing culture as a result of a transaction is possible, but it’s very hard. You have to be really honest with yourself what about the culture of the target you need to preserve, and you have to actively manage that. Otherwise it’s an onboarding.
Sometimes the value comes from the onboarding, in which case you need to make sure you have the capacity. Are we the type of company that is going to be easy to work with for a newly onboarded employee? For example, is role clarity high at my company, meaning, are people’s jobs really their jobs? Or, if we acquire somebody, will it be hard for them to figure out how things get done? Do leaders give specific direction at my company or not? I’d say the vast majority of deals are onboarding events, and having an honest dialogue about your own culture will be a determinant in the synergies you get. Are we the kind of company that is good at acquiring because we make new employees successful? That is probably a question you should ask yourself before you go out and spend billions of dollars on acquisitions.
Jeff Rudnicki: I would add that it can really affect synergies if you have a strict target-setting and achievement culture, and the company you are acquiring has less accountability, and the targets are more of a suggestion. That’s where we often see differences manifest in terms of value capture.
The other thing is, companies are often very bad at estimating, outside in, the cultural differences between themselves and the potential target. We’ve heard many times, “These guys are just like us. Several of them used to work for us, so they really understand our culture.” In fact, the reality is that they used to work with you, they hated it, they are now out there to compete with you, so they built a leadership team that is quite different than the one they left. Therefore, get a common understanding of how much culture will matter here. Sometimes it doesn’t. If you are making an IP acquisition, if you are keeping the business separate, having a different culture might be totally fine.
Trying to buy a culture or change
your existing culture as a result of a
transaction is possible, but it’s very hard.
Sean Brown: Let’s dig a little deeper on the point you made earlier about announcing synergies. Why do some companies announce the synergies they expect, and why do you think these companies deliver higher total returns to shareholders?
Jeff Rudnicki: We saw that only 20 percent of companies announce synergies. In three years’ worth of deals we looked at, or almost 2,500 transactions, only about 450 of them announced cost synergies. If you look at the performance end of those 20 percent, you see excess total returns to shareholders [TRS] that beat competitors. An excess TRS as an annual performance is 2 percent above industry peers for those companies that announce and about 4 percent below their peers for companies that did not announce. In the Americas, we see more companies announcing—about twice the number, on average—than the rest of the world.
We ask practitioners all the time, why do they announce or not announce? What people tell us is, we believed in the strategy of the deal and we believed in the value capture, so that’s why we announced. Why did we believe in it? We have experience, we involved our leadership, we did good due diligence. Also, by publicly announcing, we put a bit of an onus on our organization to deliver. In organizations that announce expected synergies, that number hangs out there. Andy and I just talked about how sometimes you need to break that number and aspire for a larger number, but the organization will feel that the announced one is a must-hit number. And if you don’t announce anything, oftentimes there is a lack of information as to what the synergies are and what the aspirations will be. Interestingly, companies announce synergies not because they are paying a lower premium. In fact, they are paying a
higher premium, so that’s not driving these results.
The last thing, which is kind of counterintuitive, is the companies that get a negative market reaction to their deals tend to perform the best. In other words, they announce, and the market hates the deal. On average, these companies had a 10 percent dip in their stock performance, but then they outperformed their industry by 8 percent. So, if you have a bad market reaction the day of announcement, good things are coming, our research shows. And the data is quite positive for companies that re-announce. In other words, they estimated $500 million worth of synergies and six months in, as they open up the aperture, they think it will be $800 million. Those companies perform even better.
Sean Brown: Where is the cause and effect here? Is it that announcing spurs people on to capture the synergies, or is it that only those that are confident they can realize the synergies take the step of announcing their expectations?
Andy West: It’s clearly a correlation, but it’s very hard for us to figure out exact causation. My rule of thumb based on this data, which is frankly shocking—the delta in performance on this excess total return to shareholders is really big—is, why not announce? If there is a good strategic reason, that’s fine. But if you get an insufficient answer, I would pull on that thread, because not announcing will just weaken your integration, it will weaken the deal overall as it comes into the organization. If there is a lack of alignment, a lack of understanding on the value proposition, it is a great excuse to say, “We don’t feel comfortable—why not?” It will lead to a healthier deal, whether you end up announcing synergies or not.
Sean Brown: What kind of one-time integration costs should clients factor into their work to capture synergies from a deal?
Jeff Rudnicki: It’s amazing how many clients ignore this. There are no great rules of thumb, and we see significant variability. Now, these are one-time costs, and they often don’t mean you do or not do the deal. If you have to pay $100 one time to get $100 in recurring synergies, that’s a great investment that you do every time. But this really can have a material impact on cash flow, and your finance function and board will care quite a bit. We have seen quite a number of misses based on faulty assumptions during the deal cycle that came to a head later. What we see on average is that companies are paying 1.1 to 1.2 of integration cost to run rate synergies. What does that mean? If I feel that I will get $100 million in synergies run rate, then on average, my one-time costs are about $120 million.
But the variation is significant. For the 25th percentile across all industries, that number is 0.6, meaning if I have $100 million in synergy, there is $60 million in one-time cost. For the 75th percentile it’s 2.0.
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Andy West: One thing I would add is that the time of this discussion about integration costs happens can be vital. Typically, when you go to management and the management goes to the board to talk about revising one-time costs, you are right in that crucible of setting synergy targets and thinking about how much you will spend on the deal. So, if a little bit before close you come in and say, “Gosh, we underestimated…” Frankly, it’s a lot more complicated then. It puts a lot of scrutiny on the investments you put on the deal or behind the deal, which can then have knock-on effects. So, getting this right up front, when everyone is excited about the deal, is a lot better than coming in with the revision when everyone is worried and thinking about day one.
Sean Brown: Before we wrap up I want to come back to revenue synergies, which you mentioned earlier. Andy, you called them “a gray area” as compared to cost and capital synergies. Can you elaborate?
Andy West: Companies on average don’t feel very comfortable putting a number associated with revenue synergies. Boards will say, “We don’t pay for revenue synergies.” It’s also harder to understand what the value proposition is. When you think about cross-selling, for example, several things have to be true to get that dollar. You have to sell to the same customer; within that customer, it has to be the same buyer. That buyer has to have the same buying process, and your sales rep has to have both capacity and the technical know-how to sell that product effectively. All of those things have to be true to have a solid cross-sell aspiration. When you think about redundant managers in the treasury function, only one thing has to be true: that two people do that job. It does not mean you shouldn’t go after revenue synergies as aggressively, but some things will typically impede your ability realize those synergies.
Jeff Rudnicki: A common understanding of revenue synergies is elusive. We have found hundreds of deals in our database that announce revenue synergies, so we are running some analysis to see how those companies perform. Are they more likely to grow? Are they more likely to outperform their peers? But most companies do not announce revenue synergies. Most, in fact, are not even paying for revenue synergies. I think that can be a mistake. They take longer, they require investment, they are less likely to be realized than cost synergies.
However, they are extremely important. Go back and say, “Could we achieve revenue synergies? Was the deal thesis in fact correct that we had an opportunity to cross-sell and to leverage their great sales force and their capabilities?” Knowing if that happened is a great way to inform future deal flow.
It also tests quantitatively the capability of your organization. The same kind of thing we talked about, where you are citing the top-down guidance, you track performance in a same way you would cost. You understand that revenue synergies will take a little longer and you don’t just roll them into budget and forget whether it’s a revenue synergy or not. You need to understand the sources, and there are three places we can categorize. One is where you sell. That includes new channels, cross-selling to existing customers, geography expansion. Then there is how you sell. This is where the sales force effectiveness or channel coverage matters. Then there is what you sell. Is the deal bringing new products or new bundles to market? Decomposing where your revenue synergy comes from can often be a great way to provide some structure, and it helps you validate which of these you are more likely to achieve.
Sean Brown: Thank you, Andy and Jeff.