Shareholders often have to approve a merger or acquisition before it is consummated. That should be a meaningful check on a company’s management and board, but shareholders frequently rubber-stamp what management decides, failing to question deeply which bid is superior and even whether a merger makes sense at all.
The shareholders of NYSE Euronext had an opportunity this past spring to cross-examine management about the proposed merger of the stock exchange’s parent with Deutsche Boerse. At that time, the Deutsche Boerse proposal valued NYSE Euronext at $10 billion, well under the competing $11.3 billion combined bid from Nasdaq OMX Group and IntercontinentalExchange (ICE). But NYSE Euronext’s management rejected the Nasdaq/ICE bid twice, and, as a result, Nasdaq and ICE tendered their offer to shareholders. In the middle of the back-and-forth, many questions about the deal remained unanswered.
What could shareholders have demanded to know? Below are five basic questions that must be posed for almost any deal. This line of questioning is derived from “The Value of Synergy,” a 2005 paper by Aswath Damodaran, professor of finance at New York University’s Stern School of Business and author of numerous books on corporate finance and valuation.
1. Are there real synergies to be gained?
Management often justifies large transactions by citing operating and financial synergies, but in his paper, Damodaran describes synergies as “often promised and seldom delivered.” To increase value, he says, synergy has to affect the inputs to valuation. So it must produce higher cash flows from existing assets, higher expected growth rates, a longer growth period, or a lower cost of capital.
While the NYSE Euronext deal could lead to economies of scale and increased market power, stakeholders should cast a cold eye on the more dubious synergies. For example, NYSE Euronext and Deutsche Boerse touted the merger as diversifying the revenue stream by bringing the NYSE into the market for high-margin, fast-growing derivatives.
But in and of itself, that diversification will not raise the combined value of those two or any other merging firms. That’s especially true when the companies are publicly traded and have investors that are already diversified and thus don’t need the company to diversify its own revenue streams. (Indeed, in times of relatively normal economic growth, markets are skeptical of the ability of highly diversified companies to deliver robust shareholder returns, and they often apply a “diversification discount.”)
Likewise, some operating synergies, like claims of better growth prospects, are hard to value and envision preacquisition. A combined firm may be able to earn higher returns on its investments, find more investments than the two firms could independently, or maintain high returns for a longer period, but that’s hard to prove prior to the merger.
2. Do the savings add up?
Cost synergies are the easiest to model, says Damodaran. Deutsche Boerse and NYSE Euronext quickly found an extra €100 in projected cost savings when the number put forth by Nasdaq/ICE surpassed theirs. Acquirers also have a better chance of delivering cost cuts because they are concrete and may have “explicit mechanisms for follow-up and monitoring,” says Damodaran.