Note · Opinion, not rated
A premium is a promise, paid in advance.
An acquisition is the one capital allocation decision where the entire price is handed over on day one and the entire benefit arrives later, in instalments, if it arrives. The announced premium is the most reliable number in the whole transaction. Everything else is a forecast.
Do not ask whether the deal works
The instinct on a deal announcement is to assume a synergy figure and check whether the numbers clear. That question cannot be answered honestly, because the assumed synergy does all the work. Set it generously and every acquisition succeeds. Set it meanly and none does. You end up reading your own prior back out of a spreadsheet.
So reverse it, the way we reverse a valuation. Take the premium as given, because it is announced, unambiguous and paid in cash. Then solve for the savings the acquirer must permanently achieve to have broken even. That number is checkable against what management claims and against the size of the business they just bought.
The arithmetic
Worked example
A target worth $1,000M the day before the bid, with $800M of annual revenue. A 30% premium. Synergies reach full run rate over 3 years, integration costs one year of them up front, 21% tax, 9% cost of capital
- Premium handed over on day one
- $300M
- Annual synergy required, forever
- $42M
- As a share of the target's revenue
- 5.3%
Not once. Not for the three years the integration plan covers. Every year, in perpetuity, just to have broken even on the premium.
Stated that way it becomes a question a reader can actually judge. Is it plausible that combining these two businesses permanently removes 5.3% of the smaller one's revenue in costs, without damaging what was bought? Sometimes yes. Often the honest answer is that nobody knows, and the premium was set by a competing bidder rather than by that analysis.
| Premium | Paid up front | Annual synergy required | As % of target revenue |
|---|---|---|---|
| 10% | $100M | $14M | 1.8% |
| 20% | $200M | $28M | 3.5% |
| 30% | $300M | $42M | 5.3% |
| 40% | $400M | $57M | 7.1% |
| 50% | $500M | $71M | 8.8% |
The relationship is linear and unforgiving. Every ten points of premium adds roughly 1.8% of the target's revenue to the permanent savings requirement. A bidding war that moves a deal from 20% to 40% has not made the acquisition 20% harder. It has doubled the operating improvement required to justify it.
Delay costs more than people model
| Years to full run rate | Annual synergy required | As % of target revenue |
|---|---|---|
| 1 years | $39M | 4.8% |
| 3 years | $42M | 5.3% |
| 5 years | $47M | 5.8% |
| 7 years | $51M | 6.4% |
Integration plans routinely slip. Moving from a three year ramp to seven raises the required permanent saving from $42M to $51M, because the money was paid at the start and the benefit keeps moving right. Time is not neutral when one side of the trade settles immediately.
And a shortfall is not a rounding error
| Share of required synergy delivered | Value destroyed |
|---|---|
| 100% | $0M |
| 75% | $75M |
| 50% | $150M |
| 25% | $225M |
Deliver half of what the premium required and half of the premium is simply gone, permanently, with no accounting entry that says so. The goodwill sits on the balance sheet at cost until somebody impairs it, usually years later, usually under a different management team, and usually described as a non-recurring charge.
Which is where this connects to how the decision got made. An acquisition reliably increases revenue, headcount and the size of the business a chief executive runs. If the pay plan measures any of those, the deal is rational for the person approving it whatever it does to the owners.
What to do with a deal announcement
Find the premium first. Announced price against the undisturbed price, meaning before the leak, not before the confirmation. It is the one number in the release that is not an estimate.
Convert it into a required annual saving using the arithmetic above, and express it as a share of the target's revenue. A demanding number is not disqualifying. An undisclosed one is.
Check what they claim against what they need. Companies announce synergy targets. Compare theirs with the break-even figure. If the claim only just clears the bar, the deal has no margin for the integration going badly, and integrations usually go somewhat badly.
Ask who is paying. Cash from the balance sheet is one thing. Shares issued at a depressed price are a buyback in reverse, and the dilution is permanent.
The premium is the only part of an acquisition that is certain on the day it is announced. Everything offered in exchange for it is a forecast, delivered later, by people who will not be measured on it.