CARNAC, A MAYONNAISE JAR AND SYNERGISTIC VALUE:  The Secret Question:  Did the acquisition maximize shareholder value?

Leader's Edge Magazine - May 2005
Author:  Robert J. Lieblein  

With or without swami magic, you cannot divine the real value of an acquisition from its balance sheet or optimistic predictions of business synergies. Determining if acquiring a broker or agency is the right move depends on whether it will generate long-term value for shareholders.

That is the question business leaders considering an acquisition should have foremost in their minds. While an acquisition is a quick way to increase revenues, it also can be the quickest way to destroy shareholder value. Whether the shareholders consist of you, senior management and Ed McMahon, or whether they are spread from pension fund portfolios to individuals playing the market, your No. 1 job is to continue to increase shareholder value.

Over the last five years, the leading public and private insurance brokers have grown significantly through acquisitions. Last year hit a high-water mark with 224 announced transactions, nearly 25% more than in the previous year.

The trend is expected to continue this year, and we may see an even higher number of acquisitions by both private and public brokers. Market conditions have provided the impetus, as stabilization and softening of rates continue to deal a heavy blow to organic growth. The more erosion in organic growth, the more aggressively brokers pursue acquisitions to boost revenues.

Is aggressive acquisition the best strategy for growth in these conditions? To answer yes, the company must be very disciplined in how it evaluates each deal. The reason is simple—many acquisitions do not produce value for the acquiring company’s shareholders.

This axiom has been constant for many decades, supported by numerous research studies and reports on performance expectations of various acquisitions. A study prepared by the Boston Consulting Group indicated that between 1995 and 2001, 61% of all acquisitions destroyed shareholder value. How could this be the case? Easy. Just blame these factors: overestimating the strategic value of the deal, poor integration, cultural differences and— probably the most common one—paying too much. No matter how hard you try to make the acquisition work, a bad deal will always be a bad deal.

Let’s focus on the most obvious reason for bad deals: overpaying. How can this be avoided? Successful acquirers have a systematic approach to pricing a transaction and do not stray far from it.

Answer: The Right Price

Determining the right purchase price seems like such a simple equation, but there is no one right answer. For any given agency for sale today, the right price will be different for every potential buyer. A common error in pricing is to let your emotions get involved or feeling that you have to win at all costs. When you finalize a deal, the price you paid will reflect the price that the agency was worth to you alone.

The key is knowing that the highest price you are willing to pay will still increase shareholder value—and not paying any more.

Answer: Synergy Is Not Enough

To determine the right purchase price, a buyer needs to understand the different components of value. Those components will vary whether the buyer and seller are privately held or public companies.

All transactions have two value components in common: intrinsic value and synergistic value. Each has to be realistically—even conservatively—assessed for the true value of the acquisition to be clearly understood.

Most people think only intrinsic value—the net present value of the agency’s cash flow as a standalone entity. What is this agency making now, and what is it projected to make without any benefit from new capital or new management? Discount these cash flows at the appropriate rate and you have intrinsic value. When people refer to rules of thumb for estimating value, such as “six times EBITDA (earnings before interest, taxes, depreciation and amortization),” they are talking about intrinsic value. Not too complicated.

Synergistic value is not quite so straightforward. Every CEO will tout the synergy that the two companies will get from the acquisition. Synergistic value is the net present value of the cash flows from improving operations. The resulting entity will be the best thing since hands-free dialing and automatic transmissions. Sure, says the investor. Prove it.

When analyzing the price of a deal, the synergistic value is what results in the premium over the intrinsic value (ignoring the effects of “market value” on public company transactions). In essence, the real trick in determining the right purchase price is to ensure that seller does not receive payment for all of the synergistic value because this is what is left to increase shareholder value to the buyer. 

So, how do you measure synergistic value to make sure you do not overpay? While more of an art than a science, expected synergies can be calculated. If you can’t say with scientific certainty what will result from the acquisition, you can at least reduce the risk to a manageable worry level. After all, isn’t that what you do for your customers every day—manage risk?

There are five business drivers of value from merging two companies: expense savings, increased revenues, operational efficiencies, financial strategies and tax savings. Considering the unique nature of insurance agency and brokerage operations, the first three are primary factors in determining if synergy is possible.

Answer: Expense Savings

Perhaps the greatest potential benefit comes from eliminating duplication in merged businesses. Those news reports announcing acquisitions always get quickly to this point: how many jobs will be eliminated and how much will be saved in expenses? The implication is that mergers end up with many duplicated jobs, and the combined company can make do with one person at each position. That’s often true, but be careful. Will the new company so value the talents of the person who has been made redundant that it cannot bear to part ways with that employee? If so, the costs will not be saved, simply shifted.

Similarly, office operations may be consolidated. If each brokerage has an office in the same city, the ideal situation would be to close one of the redundant facilities. Surely the operations handled by each of those facilities will be duplicated, so slice those in half, too. But again, look at the situation realistically: will the administrative work that’s being axed on paper be completely removed, or does some of that work actually take place somewhere else, perhaps in a location that’s not on the chopping block? You may see less than a clean 50% reduction in costs.

The factor that has the greatest impact on the eventual value of merging operations is the time needed to reach the expected cost reductions. Each of the projected synergies that may occur will eat up time, management attention and investment dollars, and the longer complete integration takes, the lower the return on investment. The biggest risk, therefore, is underestimating the time necessary to reach expected expense savings.

Answer: Increased Revenues

Combining your stellar sales staff and market penetration with complementary products and services of another brokerage is bound to pay dividends, right? If you can offer more products to your customers or draw more customers due to a wider range of products, you may have built a better mousetrap. But Sunny Jim thinking can be a trap of another kind.

You can certainly control what you put out into the marketplace—the products you offer, companies you represent, insurance programs and value-added extras. But there are so many variables beyond your control that veteran dealmakers warn that the potential revenue enhancements from sales synergies are notoriously hard to estimate.

The best synergy might be in your distribution channels, and here is where you can be cautiously optimistic. What products could each company sell to the other company’s customer base? Think conservatively, considering only existing products and assuming only the other company’s existing customer base.

Now let’s face the biggest potential torpedo: you vastly overestimate the loyalty of the customer base upon completion of the merger. Do clients stay with you, or is this a chance to shop around? It has been proven many times over that customer loyalty is greatly overestimated and that a 95% retention rate pre-transaction may be closer to 85% post-transaction. So much for increased revenues through cross-selling. Maybe we should ask banks that have acquired insurance agencies how their cross-selling penetration compared to their expectations!

Answer: Operational Efficiencies

Now we come to the famous “best practices” theory. (If there is one overused term in the insurance industry, it is “best practices.”) In theory, an acquisition that combines the smartest and brightest of both organizations will result in best practices that can yield many operational efficiencies and provide both expense savings and increased revenue.

Does it work? The answer is yes, but it is not nearly as simple or easy to calculate as you might expect. If there is an organization that really implements best practices effectively, it might be Brown & Brown. Just look at the company’s annual margin improvements and increasing stock price, all primarily driven by acquisition, and it’s easy to see how best practices can yield operational efficiencies through acquisitions. However, if you enter operational efficiencies into the value equation for your own acquisition, think conservatively. Identify only those areas that you can easily quantify or in which you have achieved operational efficiencies in the past.

One Golden Rule

While in the midst of a deal, it’s difficult to fully explore the potential synergistic value of combined operations. First, there is the pressure of time, often just a short window of negotiations during which you must be calculating these benefits in the backroom. Due to proprietary information and confidentiality, you will be working with less than a complete set of information. Recognizing that your calculations will ultimately be a forecast, apply the “best-laid-plans” factor and work with a conservative estimate.

Let’s look on the bright side and stop being so darn negative about the prospects. Many deals do work out, right? Well, many deals may have positive elements, but the trick is to understand whether those positives amount to enough synergistic value to justify a price above and beyond intrinsic value.

All of these considerations can be summed up in a piece of advice that’s simple but not necessarily easy: Take a disciplined approach to calculating the deal price. Create a set of criteria that must be met for an acquisition to be worthy of consideration. Make that criteria meet a conservative standard, and don’t let emotions get in the way when evaluating acquisition targets. Then stick scrupulously to your criteria.

Let’s say you decide a target company’s growth rate must be higher than your own. In the course of a year, your staff reviews three deals and each one falls a bit short of this goal. Yet each one offers some lucrative benefit: niche products, market expansion possibilities or duplicative operations that could be merged. At pivotal points when considering each deal, your staff gets excited about the possibilities and urges you to bend the rules. OK, OK, you finally break down and do it.

One month after that decision, a smaller but quite attractive competitor goes on the auction block. It’s a blue-chip operation that easily meets your criteria. Unfortunately, your hands are now full and your bank account empty due to the firm you just acquired. Because you bent your own rules, you have to take a pass on the best opportunity, which then falls into the hands of another competitor. You could have seen that coming even without a swami turban.

Ask yourself the question your investors will surely have on their minds: Did the deal you pulled out of that envelope maximize shareholder value?

Lieblein is a contributing writer and managing principal of WFG Capital Advisors.  rlieblein@wfgca.com