The best merger mentality: Conservative and calculating

An agency owner who believes that a merger or acquisition is all about the money may leave a lot more on the table than a premium price. They may be putting the future of their agency in jeopardy.

M&A is actually more about challenges such as integration planning and merging diverse corporate cultures than about purchase price. Many times, failure to look after these essential elements will, in the end, destroy shareholder value rather than increase it.

Too many acquisitions are undertaken because of an overly optimistic expectation of business synergies. That is the path to ruination of a good company. However, a more positive outcome can be expected if the selling agency is realistic about setting an appropriate purchase price and the buyer’s team establishes conservative criteria for its acquisition targets. Then, each side must stick to its convictions.

The primary question that should be asked of an acquisition is “Will it generate long-term value for shareholders?” Although acquisitions can quickly produce revenue, they can also destroy shareholder value just as quickly. This has been well-documented by industry research, such as the recent Boston Consulting Group study that showed that shareholder value was destroyed in 61 percent of all acquisitions between 1995 and 2001. So, whether your agency’s shareholders are three siblings or a passel of portfolio managers, the agency principal must keep their best interests foremost in mind. That is truly job number one.

Insurance distributors have experienced much acquisition activity in recent years, and signs show that it will continue. Why is the industry so hungry for acquisitions? Market conditions are primarily responsible. Rate softening and stabilization have hamstrung organic revenue growth. Plus, increasing competition from other firms who have grown strategically through acquisitions and joint ventures can make the outlook gloomy.

The best decision is to pursue a careful, measured growth plan. But that is easier said than done. Again, the secret lies in the buyer setting strict criteria for acquisition candidates, then sticking to it.

What is the right price?
Arriving at the right price for an agency or brokerage is a bit challenging. In the first place, agency owners often let their emotions get involved when imagining the value of their life’s work. Decoupling emotions from reality is truly a difficult task. Secondly, some people get involved in the art of deal making, and feel they must win at all costs. Again, this is an inappropriate response to arriving at the right price. Finally, the selling agency’s value will be different for each potential buyer, dependent upon the buyer’s needs and potential synergies.

Components of value
Breaking down a potential purchase to its component elements is a good way to understand its value. There is intrinsic value — the net present value of an agency’s cash-flow — and there is synergistic value — the potential value from combining the selling firm with the buying firm. Each must be realistically, even conservatively, calculated.

Intrinsic value is the result of an essentially simple equation. What’s the firm making now? What is it projected to make if no changes are made? What is the appropriate rate at which to discount these values? The result of these questions is commonly stated as a rule of thumb, such as “five times EBITDA (earnings before interest, taxes, depreciation and amortization).” But some people think they’re done with calculating value when they’ve arrived at the result of this equation.

Synergistic value is a bit more challenging. What additional value can be gained from a company that is wisely combined with another company? If calculated well and negotiated properly, the value perceived by the buyer will be greater than what he’s willing to pay to the seller. That’s how he can expect to increase shareholder value by doing the transaction.

How do synergistic values arise, and how are they calculated? You want to find the net present value of cash flow resulting from improving operations at the combined company. Often a CEO will tout synergistic potentials but will have a hard time proving the model. But even if such a calculation will not result in a guaranteed value down to the penny, at least by making a realistic calculation, the risk of a destroying shareholder value through a bad deal can be reduced.

Consider the benefits and pitfalls of three common drivers of value that result from merging companies: reduced expenses, increased revenues, and operational efficiencies.

Reducing expenses
Everyone expects that merged businesses will result in lower expenses to the combined operation, because duplication of some duties and systems can be eliminated. The first questions to come from most merger announcements are how many jobs will be eliminated and how many offices closed. While it’s often true that some personnel savings will be seen, be careful about your expectations. What if a person who’s just been designated “redundant” is actually perceived as quite valuable to the company? That person may just be moved to other duties, so the savings will not materialize.

A similar issue can arise with office consolidation. Is it possible to completely transfer the activities of two similar offices into one combined office? Will inefficiencies arise, or will some of the work out of the eliminated office need to be taken up by another location? If so, the savings from reducing two offices to one may not fully amount to 50 percent.

Even when these actions to reduce personnel and offices can be taken as planned, it’s wise to be realistic about the amount of time necessary to complete the merger of operations. Time, management attention and investment dollars must be calculated to get this operation completed effectively. Often a buyer will initially underestimate the effort necessary to achieve those expense savings.

Increasing revenues
Even if the expenses are hard to wrangle, surely the boost in revenue will spring forth from the combined firm. That’s a bit of a leap, too. Even in a perfect world, where each firm has extraordinary staff and complementary market products, there are variables to be calculated that make sales synergies notoriously hard to accurately estimate.

For instance, distribution channels … you may bulk up your product offerings and the combined entity will then be a player for a broader base of customers, or bigger clients. But the conservative approach would be to estimate cross-selling primarily to each of the firm’s existing customers.

Have you accurately estimated the loyalty of each firm’s clients to stay with the new entity? This is sometimes the biggest hurdle for the sales staff. For instance, customers who may have been comfortable with their existing provider will take the merger as an opportunity to solicit bids. Often, customer loyalty that is historically seen at 95 percent will be closer to 85 percent after a merger.

Operational efficiencies
Many times a buyer will consider a firm that seems to be operating inefficiently and plan to apply “best practices” from its own operation post-merger, expecting efficiency to increase, and thus profit margins to improve. But what may be best for your staff may be resisted or unworkable in another corporate culture, so it’s wise to be wary of yielding great results on this track. Seek to combine the best and the brightest of people and practices from both firms, then chalk up any resulting gains under the heading of good risk management.

Conclusion
If you’re surprised that there are so many elements to a successful M&A transaction, you probably have not completed one recently. The market has become quite challenging, resulting in many potential missteps when seeking growth through acquisitions.

Just consider the atmosphere in which all these calculations must be made. There’s often a short window of negotiations, and confidentiality issues may mean you have less than complete information to work with. Emotions very often will enter into the deal on both sides: by sellers who understandably put a high premium on their life’s work, and by buyers who too often see themselves as able to beat the averages and make a sketchy deal work. Don’t fall into those traps. Be realistic, be conservative, and be profitable. The trick to a successful deal is an open-eyed view of whether the merger’s positive elements result in enough synergistic value to justify the price being sought above the intrinsic value.

In the end, when the right deal arrives and you are reaping the bottom-line results after following through with it, you and your shareholders will be very glad that you stuck to your criteria and let the higher-risk deals pass by.

Steven S. Wevodau, managing principal of WFG Capital Advisors (www.wfgca.com) has extensive experience in mergers & acquisitions and strategic consulting. WFG Capital Advisors provides comprehensive financial solutions to the insurance and financial services industry. Phone: 717-780-7800, E-mail: swevodau@wfgca.com.

Topics Mergers & Acquisitions