Where mergers go wrong | 1

Where mergers go wrong

Most companies routinely overestimate the value

of synergies they can capture from acquisitions.
Lessons from the front lines can help.

Scott A.
Christofferson,
Robert S. McNish,
and Diane L. Sias

Its known as the winners curse. In

mergers, it is typically not the buyer but the

seller who captures most of the shareholder
value created. On average, in fact, acquirers
pay sellers all of the value created by the
merger in the form of a premium that
typically ranges from 10 to 35 percent of the
target companys preannouncement market
value. But while the fact is well established,
the reasons for it have been less clear.1
Our exploration of postmerger integrations
points to an explanation: the origins of the
curse2 lie in the average acquirer materially
overestimating the synergies that can be
captured in a merger.3 Even a good faith
acquisition effort can stumble over what
appears to be a remarkably small margin
for error in estimating synergy values.
No question, acquirers face an obvious
challenge in coping with an acute lack of
reliable information. They typically have
little actual data about the target company,
limited access to its managers, suppliers,
channel partners, and customers, and
insufficient experience to guide synergy
estimation and benchmarks. Even highly

experienced acquirers rarely capture their

data systematically enough to improve their
estimates for their next deal. And external
transaction advisersusually investment
banksare seldom involved in the kind of
detailed, bottom-up estimation of synergies
before the deal that are necessary for
developing meaningful benchmarks. Fewer
still get involved in the postmerger work,
when premerger estimates come face to face
with reality.

Lessons learned
To address this challenge, we have begun
developing a detailed database of estimated
and realized merger synergies, grounded in
our experience in postmerger integration
efforts across a range of industries,
geographies, and deal types. We have
accumulated data from 160 mergers so far,
and combining it with industry and
company knowledge we believe that there
are practical steps executives can take to
improve their odds of successfully capturing
acquisition synergies.
For starters, they should probably cast a
gimlet eye on estimates of top-line synergies,
which we found to be rife with inflated
estimates. They ought to also look hard at
raising estimates of one-time costs and
better anticipate common setbacks or dissynergies likely to befall them. They might
also vet pricing and market share
assumptions, make better use of benchmarks
to deliver cost savings, and get a better fix on
how long it will take to capture synergies.
When applied together, especially by savvy
acquisition teams chosen for maximum
expertise and ability to counter gaps in
information, we believe acquirers can do
more than merely avoid falling victim to the
winners cursethey can improve the
quality of most of their deals.

2 | McKinsey on Finance | Winter 2004

E XHIBIT 1

Top-line trouble: 70 percent of mergers failed

to achieve expected revenue synergies
Mergers achieving stated percentage of
expected revenue synergies, percent N 77

23

17
14

13

13
8

30% 30
50%

51
60%

61
70%

71
80%

81 91 100%
90% 100%

Typical sources of estimation error

Ignoring or underestimating customer losses (typically 2% to
5%) that result from the integration
Assuming growth or share targets out of line with overall
market growth and competitive dynamics (no outside view
calibration)
Source: McKinsey (2002) Postmerger Management Practice client
survey; client case studies

Reduce top-line synergy estimates

Wall Street wisdom warns against paying
for revenue synergies and, in this case, the
conventional wisdom is right. The area of
greatest estimation error is on the revenue
sidea particularly unfortunate state of
affairs, since the strategic rationale of
entire classes of deals, such as those
pursued to gain access to the targets
customers, channels, and geographies, is
founded on these very synergies. Nearly
70 percent of the mergers in our database
failed to achieve the revenue synergies
estimated by the acquirers management
(Exhibit 1).

Acknowledge synergy setbacks

Another regularand largecontributor to
revenue estimation error is that few
acquirers explicitly account for the common

revenue dis-synergies that befall merging

companies. Sometimes these stem from
simple disruption of business as usual, but
often they are the direct result of cost
reduction efforts. For example, in retail
banking, one of the most important cost
savings comes from consolidating branches.
Some customers may leave, but the cost
savings are expected to more than make up
for the losses. When one large US bank
acquired a competitor with substantial
geographic overlap, however, it suffered
unusually high losses among the target
companys customers, rendering the deal
unprofitable and making the entire
company vulnerable to takeover. Due
diligence on the targets customer base
would have revealed that they were heavy
branch users and thus especially likely to
defect during an integration that closed
more than 75 percent of the acquired
companys branches. This companys
customer loss experience may be at the
high end, but according to our research,
the average merging company will see 2 to
5 percent of their combined customers
disappear.4
Most acquiring companies can do better,
especially in industries that have undergone
considerable consolidation. Data on the
severity of customer loss experienced by
merging parties in retail banking, for
example, can be gleaned from a variety of
sources: industry associations, regulatory
filings, and press articles. Examples are
numerous enough not only to identify
helpful benchmarks (e.g., 8 percent of
retail deposits at closing branches will be
lost to competitors) but also underlying
drivers of whether a deal will see losses
above or below the benchmark (e.g., the
number of customers who also bank with a
competitor, the distance to the next-

Where mergers go wrong | 3

closest remaining branch, or the presence

of competitors to take over closing
branches). In other industries, a search
may yield only two or three good
precedents and only limited data on those;
even this can greatly improve managements
revenue estimates.

E X H I BI T 2

Cost-synergy estimation is better, but there

are patterns emerging in the errors
Mergers achieving stated percentage of
expected cost savings, percent N 92

36

25

Increase estimates of one-time costs

Many deal teams neglect or underestimate
the impact of one-time costs. For example,
one chemicals manufacturer publicly
committed itself to reducing annual costs
by $210 million at a one-time cost of
$250 million.5 Had it put as much due
diligence into that one-time figure as the
annual synergy target, it would have found
a few relevant precedent transactions
suggesting that it was unlikely to spend less
than $450 million. In trying to fulfill their
original commitment, the company ended
up running over budget, under-delivering
on promised synergies, and falling well
short of revenue growth targets.

12

13

3
1
30% 30
50%

51
60%

61
70%

71
80%

81 91 100%
90% 100%

Typical sources of estimation error

Underestimating one-time costs
Using benchmarks from noncomparable situations
Not sanity-checking management estimates against precedent
transactions
Failing to ground estimates in bottom-up analysis (e.g., locationby-location review of overlaps
Source: McKinsey (2002) Postmerger Management Practice client
survey; client case studies

Compare pro forma projections with

market and competitive realities
Many acquirers rely too heavily on
assumptions about pricing and market share
that are simply not consistent with overall
market growth and competitive reality.
Instead, acquirers must calibrate the
assumptions in their pro-forma analysis
with the realities of the market place. For
example, one global financial concern
estimated that a recent acquisition would
net i1 billion in mostly top-line synergies
within 5 years and 13 percent profit growth
in the first year. With limited overall market
growth, these goals could be achieved only
by using cross-selling to increase market
share without triggering a competitive
response. Actual profit growth was a mere
2 percent.

Apply outside-in benchmarks

to cost synergies
While managers in about 60 percent of
mergers can be commended for delivering
nearly all of their planned cost synergies,
we find that about a quarter overestimate
cost synergies by at least 25 percent
(Exhibit 2). That can easily translate into
a 5 to 10 percent valuation error.6
One route to overestimating cost synergies
starts by failing to use the benchmarks that
are available as outside-in sanity-checks.
One European industrial company, for
example, planned on cost savings of
i110 million from selling, general, and
administrative (SG&A) cost savings, even

4 | McKinsey on Finance | Winter 2004

though precedent transactions suggested

that a range of i25 million to 90 million
was more realistic, and the company
neglected to conduct bottom-up analysis
to justify the higher
Synergies that are not
figure. Worse, this
was an especially
captured within, say, the
risky area in which
to aim high,
first full budget year after
because cutting
consolidation may never be
sales and marketing
expense puts
captured, overtaken as they
revenue growth
are by subsequent events.
at risk, and the
net present value
of pre-synergy revenue growth was
roughly four times more valuable than all
synergies combined.

Temper expectations for synergy

timing and sustainability
Deal teams often make simplistic and
optimistic assumptions about how long it
will take to capture synergies and sustain
them. Important deal metrics such as
near-term earnings and cash flow
accretion can end up looking better than
they deserve as a result, leading to a
substantial overestimates of synergy net
present value.
One company we worked with had
budgeted headcount cost savings (including
severance) as if they were spread out evenly
over each quarter. In practice, however,
managers tended to wait until the last
month of the quarter before making
reductions. As it happens, this example
did not have a material impact on the net
present value of the transaction, but it did
cause the post-merger integration leaders to
miss their projections for first-year
synergies, thereby undermining the
credibility of their process.

Neglecting to phase out certain synergies

can be equally problematic. Companies
often plan to reduce operating costs by
squeezing production capacity and logistics
across the merged organization. But if the
merging companies are growing quickly on
a standalone basis, sloppy incremental
analysis will attribute benefits to the merger
that would have been realized by the
standalone companies. Indeed, one medical
products company, growing at 10 to
15 percent a year, estimated that it would
be using the full capacity of existing plants
within three to four years without a merger.
So many of the savings from closing or
streamlining plants could not rightly be
expected to last long, as the affected
facilities would be quickly reopened. Many
savings, while real, are not perpetual, and
must be phased out. In general, we believe
that it is overly optimistic to include the full
amount of targeted annual synergies in the
continuing value calculation of a net
present value model.
Moreover, the problem isnt just one of
properly translating synergy timing into
present values: bad timing can even affect
whether synergies are captured at all.
Persistent management attention matters in
capturing synergies. We have found some
evidence to suggest that synergies that are
not captured within, say, the first full
budget year after consolidation may never
be captured, overtaken as they are by
subsequent events. We have also observed
that synergies are captured more quickly
and efficiently when the transaction closes
at the start of the two companies annual
operational planning and budgeting process.
One financial institution even learned that
its plans to migrate IT systems had to be
radically altered (i.e., move onto the
acquirers platform rather than the targets)

Where mergers go wrong | 5

to accommodate the relatively narrow

window of opportunity between peaks in
the lending season.

Forming effective deal teams

Estimating synergies is difficult, but the
practice is critical and needs more
investment than it usually receives.
Companies weve studied have used a variety
of ways to improve their synergy estimates.

Involve key line managers

Involving line managers in problem solving
and due diligence not only improves the
quality of estimates but also builds support
for postmerger integration initiatives.
Synergy analysis also illuminates issues
that will shape due diligence, deal structure,
and negotiations.
For example, one client had its head of
operations take the lead in estimating the
savings from rationalizing manufacturing
capacity, distribution networks, and
suppliers. His knowledge of the unusual
manufacturing requirements of a key
product line and looming investment needs
at the acquirers main plant helped improve
the estimates. He also used a due diligence
interview with the targets head of
operations to learn that they had recently
renegotiated their supply contracts and had
not yet implemented an enterprise resource
planning (ERP) system; both of these facts
refined synergy estimates even more. All of
this helped during negotiations and deal
structuring (e.g., knowing that it was all
right to promise that the targets main
European location would be retained, but
to make no promises about their main
US facility). Moreover, his involvement
ensured that he was prepared to act quickly
and decisively to capture savings once the
deal closed.

Another company with substantial acquisition experience left synergy estimation up to

the mergers and acquisitions department,
and paid the price. Based on accurate but
high-level financial analysis (total cost per
customer served), they concluded that there
was no value in integrating customer service
operations. Line managers would probably
have discovered during due diligence that
the targets smaller centers had much lower
labor productivity but compensated for this
with an innovative Web servicing program.
Consolidating operations could have both
improved labor productivity and brought
the Web servicing program to the acquirers
larger service center. But they missed the
unfreezing time immediately following the
merger announcement, and the acquirer lost
the opportunity.

Codify experiences
Internal M&A teams should do more to
codify and improve their synergy estimation
techniques. Every deal represents a valuable
lesson. Some specific actions we have seen
make a difference include: holding a formal
post-integration debrief session with both
the integration and M&A teams (which
ideally should overlap); requiring future
M&A and integration leaders to review
the results of past deals; tracking synergies
relative to plan for two years; and
calculating after the fact what the net
present value of the transaction turned
out to be.
On the other hand, one must not overstate
what can legitimately be learned from
experience, since not all deals are alike.
One bank balanced what it learned from one
acquisition quite skillfully against the
idiosyncrasies of its second major
acquisition. The first had gone badly;
the bank underestimated integration costs

6 | McKinsey on Finance | Winter 2004

by a factor of three. The second went better

because executives leading the deal
understood that they needed to get the cost
(and deposit loss) estimates right. Instead of
simply applying the
One client had its head of
loss data from the
first merger, which
operations take the lead in
did not involve
nearly as much
estimating the savings from
geographic overlap
rationalizing manufacturing
as the second, they
involved a line
capacity, distribution
manager who had
networks, and suppliers.
been part of a
recent branch
closure program. By applying benchmarks
carefully and involving line management, the
bank avoided making the same estimation
error twice.

that a well-designed post-merger integration

effort can sometimes even do better.7

Companies with access to reliable data

can develop sound benchmarks for
estimating realistic synergies. They can
also find insight into the sources and
patterns of error when estimating
them. MoF
Scott Christofferson (Scott_Christofferson
@McKinsey.com) is a consultant and Rob McNish
([email protected]) is a principal in
McKinseys Washington, DC, office. Diane Sias
([email protected]) is a principal in the New
Jersey office. Copyright 2004 McKinsey & Company.
All rights reserved.

Whats next?
Companies with access to reliable data can
develop sound benchmarks for estimating
realizable synergies, insights into the sources
and patterns of error in estimating synergies,
and tools to estimate deal synergies.
Obviously, these efforts can be thorny,
but in our experience they are well worth
the effort.
Once companies have a database in place,
they can explore other strategic issues, such
as whether some synergies are consistently
embedded in the acquisition premium paid
while others are captured by the acquirer,
or whether the stimulating effect of a
transaction is even necessary to improve the
standalone performance of an acquirer.
The former will obviously inform pricesetting and negotiation strategies for
acquiring companies, while the latter will
lead companies to consider tactics other
than an acquisition to accomplish the same
ends. Its important to recognize, however,

See, for example, Hans Bieshaar, Jeremy Knight, and

Alexander van Wassenaer, Deals that create value, The
McKinsey Quarterly, 2001 Number 1, pp. 6473.

Richard H. Thaler, The Winners Curse: Paradoxes and

Anomalies in Economic Life, Princeton, New Jersey:
Princeton University Press, 1992.

Based on our experience assisting in the postmerger

integration of about 160 recent mergers and acquisitions.
These synergies include such elements as economies of
scale and scope; best practice, capability, and opportunity
sharing; and, often, the simple stimulating effect of the
combination on the stand-alone companies.

Based on the 124 mergers for which we have relevant

data, these are the 25th and 75th percentile figures. Not all
merging parties experienced customer loss, but some saw
more than 30 percent.

In this and other examples derived from our client

experience, we have altered the figures (but not the
proportions) as needed to disguise the companys identity.

For example, in the most recent deal one of the authors

was involved in, the net present value (NPV) of the target
(stand-alone value plus base case synergies) would have
been $2.3 billion instead of $2.5 billion if cost synergy
estimates had been off 25 percent.

In our experience, companies are routinely amazed to find

that the unbeatable deal they negotiated with a supplier
is inferior to the deal their merger counterpart has
sometimes with the same supplier!

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