Any seasoned business owner knows that developing and executing strategy is a critical aspect of driving corporate value. Here we take a look at the benefits of a mergers and acquisitions strategy.

Being part of a business without strategy is like being in a ship without a sail – the business may stay afloat but there is no impetus driving the operation to a desired destination. This will lead to stagnation, and incremental value creation is rare when this is the case. Fortunately, there are many different types of strategy that can be implemented in a business, from marketing to development to operations to financial. All of these are generally adopted with the same objective in mind – to enhance value for stakeholders.

The Mergers and Acquisitions (M&A) strategy

One type of strategy that can generate significant value if successfully executed is M&A. This is a strategy that sophisticated investors have implemented for years, but is still often overlooked by many corporates. M&A can broadly be defined as the process of merging with or, more commonly, acquiring another company. This can lead to immediate growth, diversification, and certainty, all of which can drive value. While the reward for this type of strategy can be significant, it is also relatively risky in nature and can be constrained by access to capital.

The M&A value proposition

So why can a M&A strategy be so effective? There are two main reasons: multiple arbitrage and synergies. Synergies are the more boisterous elder sibling that attract most of the attention, while multiple arbitrage lurks in the shadows, often underestimated or misunderstood by business owners. While purchasers commonly acquire businesses for the more obvious synergy benefits, it is important to understand that both concepts can have a significant effect on value.

Multiple arbitrage – corporate valuation is commonly based on a multiple of earnings. Generally speaking, the less risk a company poses to an investor, the higher the multiple applied. Naturally, a larger business is less risky in that it is less likely to fail and should exhibit a lower degree of volatility due to general diversification. This will lead to higher valuation multiples. When a business acquires or merges with another business, the combined entity is immediately larger and less risky than the companies separately. The incremental value realised by an acquirer should therefore be based on a higher multiple than that which was paid. This will lead to an immediate uplift in value for the stakeholders of the purchaser without having to make any operational improvements. This concept is known as multiple arbitrage.

Synergies occur when two entities are able to produce combined earnings that are greater than their sum separately. This can either be due to cost savings that become available, or due to an uplift in revenue that would have otherwise not been achievable. Cost savings are often realised through the elimination of the overlap of roles and functions within the combined business, while sales synergies can take a bit more time and investment in relationships to realise. Synergistic increments in revenue can be derived through opportunities such as the ability to cross-sell into a different customer base, the addition of a competency/revenue offering that did not exist for one of the businesses prior to acquisition, enhancing the process or product offered, etc. Unlike multiple arbitrage, the synergy value proposition is not immediate and can require an investment in operational integration and relationships before being realised. The value here again comes down to the fact that many businesses tend to be valued based on a multiple of earnings. Synergies increase the earnings aspect of this concept.

An illustrative example

Often, the best way to illustrate the value of a M&A strategy is through a hypothetical example. Imagine that two similar companies exist:

• Company A – deriving EBITDA of £5 million annually
• Company B – also deriving EBITDA of £5 million annually

Both businesses have a valuation multiple of 8x, meaning that the value of each separately is £40 million. Now imagine that the following happens:

1. Company A acquires Company B for £40 million, and they have combined earnings of £10 million
2. The valuation multiple for the combined operation is now 10x EBITDA
3. Company A spends the next year integrating Company B into their operating model. As a result, synergies of £2 million are generated, meaning that EBITDA of the combined operation is now £12m

As soon at Company B is acquired, the combined operation is in theory worth £100 million (£10m x 10) i.e. £40 million has been paid and £60 million of value has been received. £20 million has been generated through multiple arbitrage. One year post-acquisition, the operation is now worth £120 million (£12m x 10). This single acquisition has now created £40 million of incremental value for the shareholders of Company A in one year, a return of 100%. Now imagine that this process is executed a number of times, and you should begin to understand the significant value that is possible through a M&A strategy.

Final Words

Here at Gerald Edelman, we are very excited by the prospect of businesses implementing M&A strategies. Each M&A process is exciting, risky, intense, and often unpredictable. Our Deal Advisory team has strong experience in navigating through such processes, and would be more than happy to discuss strategy, whether involving M&A or not, with you or any business stakeholders that you think could benefit from a no-obligation discussion. If you are thinking of selling your business in the coming years, we’d also be delighted to discuss what this might look like and how buyers would benefit from acquiring you!