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The synergy mirage

Updated Monday 15th December 2008

Dr Brian D Smith looks at how firms build synergy.

It has been hard, in the blizzard of financial crisis news, to see anything positive in the business pages. But beneath the storm of bankruptcies and bank rescues, some companies have been quietly making careful acquisitions. Typically, these haven’t been the “buy a rival” sort of purchases that firms make in order to simply get bigger and realise “economies of scale”. The more recent examples have usually quoted the fashionable term “synergy”. The question is what is synergy and how do firms make it?

Of course the simple definition of synergy is 2+2 =5, so the reason for a merger or acquisition is that the combined firm is more effective than the two separate partners. But synergy is cited as a reason to merge or acquire only slightly more often than “failure to realise synergies” is cited as the reason for a merger failure. It’s important therefore to understand what synergy really is and how, in practice, firms realise it.

A true, realised, synergy means that something must happen in the combined firm that either didn’t happen or happened less well in the two individual firms. In practice, there are two types of synergy a firm can create:

  • Internal synergies: these are created when the combined firm can do something more efficiently internally than could the two separate firms. This might simply be by combining two departments (and cutting costs) or it might by rationalising product, like the car companies do when they share parts for different models.
  • External synergies: these are created when the customers of the two firms somehow interact in a positive way to allow a kind of cross selling. In the past, financial service firms did this, buying mortgage businesses to help sell insurance and other products.

The trick in making synergy happen, therefore, is to know in advance how the mechanism of synergy is suppose to work. Some recent examples make the point.

As I write, the consumer electronics giant Panasonic is considering buying Sanyo. At first sight, this doesn’t make much sense as Sanyo’s business is mostly struggling and Panasonic have lots of other investment opportunities. But look more closely and you will see that Sanyo have some great battery and solar panel technology coming out of their labs. Panasonic reason that those technologies would make lots more money if they were built into to their own green technology strategies, an example of external synergy.

Similar ideas motivated Bank of America when it recently bought Merrill Lynch. The global banking business is complicated and made up of several complementary businesses, like retail banking and investment banking. Banks tend to be more efficient if they have significant presence in more than one area so the combined business of Merrill Lynch/Bank of America is much more effective than the two separate entities. Or at least it will be in time.

A more problematic situation faces Ian Smith, the new boss of Reed Elsevier. One of his major challenges is to repay $2bn dollar that his predecessor borrowed to acquire ChoicePoint. Given the tricky situation facing media markets (Reed Elsevier’s main business), paying back the loan means realising promised internal synergies from the ChoicePoint acquisition. These, it seems, are proving more elusive that was hoped for at the time of the acquisition.

The moral of the story is to not be mislead by the mirage of synergy. Instead, think carefully about what kind of synergy you are trying to realise and how exactly that is going to happen. And that, of course, is exactly what the leaders of these huge firms, and their consultants, are paid for.

 

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