Most mergers and acquisitions fail to create value (to read about the 4 reasons that most mergers and acquisitions fail, click here). So how can you tell if a merger has real value potential or is more likely to be a big expensive mistake? Here are the biggest sources of value in mergers and indicators you can use to spot them:

1. Economies of scale (and the challenges of reaping them).

The most oft-cited benefits to mergers are scale effects. Through pooling resources and activities, the partners expect to drive down costs and achieve wider distribution and marketing than either could on its own. These savings are often, however, overestimated. It's not uncommon, for example, for companies to state that they will have significant "back office savings" from functions like legal, accounting, and human resources. However, if both companies are above minimum efficient scale, these functions should all be operating at capacity. There should e few opportunities to achieve economies from consolidating them.

For example, suppose two companies operate customer service call centers. If each center was already optimally utilized, the consolidated call center should require just as many service people, computers, phone lines, and real estate as the two call centers previously required. Furthermore, if the centers were not optimally utilized prior to the merger, it is likely that problem can be solved without the merger, and it is not obvious that a merger will make the solution any easier.

Mergers also don't guarantee that the firm will be able to use greater bargaining power to squeeze suppliers or customers. For increased bargaining power to result in better terms with suppliers or customers, those suppliers or customer must have enough bargaining power to command margins or surplus in the first place. This is not always the case.

Consider, for example, a hypothetical merger between Nike and Adidas. Both shoe giants have their shoes produced by contract manufacturers in developing countries. Manufacturing is routinely relocated to take advantage of lower labor costs in different countries, and competition among suppliers to get a contract from a major athletic shoe brand is high. The suppliers have little bargaining power to begin with; there is not much profit left to squeeze out of them by being an even larger athletic shoe company. There's also not much margin to squeeze out of shoe retailers. Shoe retailers have many substitutes, are exposed to heavy price competition, and clearly do not have the brand loyalty that the shoe makers themselves have. Here too, then, the shoe maker already has the lion's share of the bargaining power and it is not obvious that additional bargaining power will be rewarded by higher prices paid to shoe brands. Will end consumers pay more if a Nike-Adidas conglomerate raised prices? That depends on their price sensitivity and how close they perceive competing products to be. So long as there are other athletic shoes available (and the lack of entry barriers ensures that there will be), Nike and Adidas will have to compete on quality, price, and social responsibility, irrespective of a merger.

For a merger to deliver significant economies of scale benefits, one or both parties should be significantly below minimum efficient scale. What do costs-per-unit look like at different levels of output volume in the industry, and how much could costs realistically be driven down by the merger? How much more is the firm paying for back office activities (customer service costs per customer in a call center, for example) than competitors? Which functions will be consolidated and which assets will be disposed of? Which activities will be moved geographically? How many jobs will be eliminated? If the answer to these questions is trite, it is likely that the savings will be as well.

2. Complementation benefits.

Sometimes two firms merge because they can do something together that they cannot achieve alone - this is what is typically invoked by the notion of "synergies." One firm may have a valuable brand, customer base, or technology that can be profitably utilized by the other, for example. Google's acquisition of ITA software provides an illustrative example. ITA's travel search software enabled Google to develop a state-of-the-art flight search and reservation system that it could serve up to its massive search customer base.

In most cases these benefits could be achieved through arms-length relationships such as supply contracts, licensing agreements, or alliances, making the excess cost and risk of a merger unnecessary. In other cases, to achieve the complementation benefits requires investments or knowledge exchange that would put one or both firms at more risk than they are willing to bear in an arms-length contract.

For example, consider the Google - ITA Software merger mentioned previously.  ITA's flight search, pricing and reservation programs were some of the most advanced in the industry; at the time of Google's acquisition of ITA in 2011, ITA was licensing its software to major travel search companies like Orbitz, Kayak, TripAdvisor, and Bing Travel. Google, on the other hand, had a tremendous advantage in customer reach. Google has the number one search engine in the world, and many people begin their travel planning by searching destinations on Google. This put Google in a prime position to be the first stop for flight search. However, there was asymmetrical risk: ITA's technology could be completely transferred to Google leaving Google with ITAs abilities even if the deal fell apart. Google's advantage in search, however, could not be completely transferred to ITA. The benefits of collaborating were potentially large, but the risk of doing so via an arms-length contract were even larger. ITA thus agreed to be acquired by Google so that their interests would be irrevocably aligned.

It's often easy to identify potential complementation benefits, but how do we know that a merger is necessary to achieve them? First, examine whether sharing the asset requires extensive cooperation and commitment, entails deep knowledge exchange, and/or poses a high risk of expropriation. Will functions, brands, personnel and locations be consolidated? What intellectual property will be at risk? Could licensing agreements or alliances work just as well? If so, keeping the two firms separate could avoid the premiums of an acquisition and the increased coordination costs of managing a larger and more unwieldy firm.

3. Solving ecosystem "hold up" problems.

In many industries multiple players are woven together in a complex ecosystem that collectively delivers value to customers. For example, smartphones are only valuable to consumers when there is both exceptional hardware and a rich library of high quality applications. When there are strong interdependencies between different players in a product ecosystem, there can be a risk of "hold up" if a necessary part of the product bundle is not available at an attractive quality and price level. In this situation, sometimes joint ownership solves otherwise intractable coordination problems.

Consider, for example, the electric vehicle ecosystem. Even though customers may do most of their charging at home or workplace, the availability of public fast charging stations has a large effect on their sense of "range anxiety," and thus the attractiveness of purchasing an electric car. Customers must believe stations are ubiquitous; the fear of being stranded even once is enough to prevent many potential consumers from buying. However, there are three different charging standards for electric vehicles. A charging station that offers CHAdeMO fast charging (for the Nissan Leaf or Kia Soul EV, for example), cannot charge cars that use the SAE combo (e.g., BMW i3, Chevrolet Spark EV, and Volkswagen eGolf), and neither CHAdeMO nor SAE combo charging stations can charge a Tesla vehicle. To make matters worse, it is not obvious that a profitable business model exists in charging. Electricity is cheap, and so long as consumers have the option of charging at home there is a limit to how much stations can mark up the price of providing electricity. As noted previously, much of the value of having a large charging infrastructure is symbolic - it serves to assuage the customer's fear as opposed to being the dominant means by which they charge their vehicle.

How do electric vehicle producers convince firms to provide charging stations if it's not profitable? Managers at Tesla Motors decided to resolve this conundrum by building their own charging stations, in order to ensure that a "hold up" in charging infrastructure would not prevent adoption of Tesla cars.

Overall our default perspective probably ought to be against mergers - we should require abundant and specific evidence of large potential gains to convince us that a particular merger is in the best interest of anyone other than management and the investment bankers constructing the deal. When those gains are large, it will usually not be due to a simple change of ownership boundaries around the firms involved, but rather will typically require significant restructuring of the parties and/or shedding of assets.

Published on: May 1, 2018