Why is synergy so difficult in mergers of
related businesses?
Sayan Chatterjee
Sayan Chatterjee is
Professor of Policy at the
Weatherhead School of
Management, Western
Reserve University and a
Batten Fellow of the Darden
School, University of
Virginia, USA
This article considers why mergers and acquisitions between companies that are considered to be in
similar but different businesses are often surprisingly problematic. Typically the justification for such
mergers or acquisitions is that, because the businesses are complementary, their union can lead to
an increase in revenue (revenue synergy), efficiency (cost synergy) or both. In academic research
these types of unions are known as ‘‘related’’ mergers. For this article, the author interviewed the
CEOs of many successful acquiring firms and studied numerous case accounts of unsuccessful
mergers. He also looked at academic research on related mergers dating back to the early 1980s,
some of which had raised caution signals that have been largely ignored.
he belief in potential synergy by merger adherents has not diminished very much
over the last twenty years despite a record of extravagant promises, mixed
successes and many outright disasters. Often the proponents of new mergers justify
them by describing how the value chains of the merging firms ’’fit’’ together and how there is
potential for rapid growth via cross-selling. As a famous example, in the early 1980s United
Airlines acquired Hertz car rental, Westin Hotels and a few other service businesses with the
idea that they could cross-sell travel customers. These mergers were considered ’’related’’
because these firms shared some customers. But growth and profits from the expected
cross-selling never materialized and eventually the acquired companies were spun out. In a
more recent example, AOL and Time Warner merged to benefit from cross-selling synergies
created by combining complementary functions. After the merger, AOL’s subscribers were
bombarded with pitches for Time Warner products, such as broadband access and music
by Time artist Brandy, which did not have the expected success. So instead of creating
valuable synergy, the merger led to the loss of enormous shareholder value for Time Warner.
T
Even with such striking failures in the news, until relatively recently not many managers
questioned the likelihood of merger synergy between related companies[1]. Likewise there
exists voluminous but inconclusive academic research that seeks to justify synergy as a
valid reason for undertaking mergers. However, one of the earliest empirical studies of this
genre questioned the validity of synergy in related mergers[2] (as contrasted with
horizontal-business or same-business mergers). So how do the drivers of merger success –
from due diligence, to valuation, to integration – promote synergy between related
business? And what evidence is there that supports or contradicts what the adherents of
synergy believe? And what types of related mergers are more likely to fail?
Synergy, the golden prize of related mergers, flourishes when the combination of disparate
parts within the new organization can lead to more revenues, more efficiency, or more of both
than what the individual parts could muster as stand alone units. Such synergy is difficult to
achieve merely by adding new technology or talented employees, especially when the
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VOL. 35 NO. 2 2007, pp. 46-52, Q Emerald Group Publishing Limited, ISSN 1087-8572
DOI 10.1108/10878570710734534
‘‘ Until relatively recently not many managers questioned the
likelihood of merger synergy between related companies. ’’
process by which the interconnected activities increase efficiency, or value to customers, is
complex – such as the supply chains of Dell or Wal-Mart[3]. In almost all cases, such
complex business operations were developed internally and often over a long period of time.
There have been many mergers, such as AOL/Time-Warner that have tried to create these
complex interactions following the merger. Among these, the ones that get the most attention
are synergistic mergers of equals. Another reason such unions grab headlines is because
these are often a bet-the-company gamble. In contrast, the acquisition of a small company is
unlikely to change the business model of the acquiring firm significantly and so is less
newsworthy[4]. While mergers of equals can sometimes lead to spectacular successes,
such as Kraft-General Foods and Novartis, we argue the odds are heavily stacked against
them. Perhaps the most significant obstacle to a merger of equals, or large complex mergers
in general, is that these are difficult to integrate[5].
Synergy and integration
Synergistic mergers may, at least in theory, create competitive advantage when their
complexity makes imitation difficult by would-be competitor. But this same complexity can
also lead to integration problems. The acquiring firm in a synergistic merger is typically
looking at an idiosyncratic situation and, therefore, its inability to draw upon previous
experience often leads to an underestimation of the integration issues and difficulties.
Consider a synergistic merger that is studied as a classic of this genre: AOL/Time Warner.
This deal was sold to the shareholders on a promise of cross-selling and other synergies. If
AOL had thoroughly explored the organizational constraints and cultural differences during
due diligence then they would have been a little less optimistic about achieving some of the
synergies. Consider these events:
On Valentine’s Day (2001), AOL Time Warner Inc.’s America Online service hosted an online chat
with movie star Keanu Reeves . . . As part of the chat, AOL set up links to other online sources on
Mr Reeves, including an article created by People.com, the online version of People magazine,
which is published by the company’s Time Inc. unit. According to people familiar with the details,
AOL asked People.com to edit out the phrase, ‘‘He may not be Oscar material (so far, at least),’’
because it wasn’t Keanu friendly. People.com editors refused, and AOL didn’t link to the story
during the chat[6].
Soon after this, much to the reluctance of AOL management, they were forced to add
‘‘editorial independence’’ as prominently in their list of company values as ‘‘teamwork’’ – a
prerequisite for synergy[7].
There are numerous other such instances of planned synergy that failed to materialize.
Consider the cross-promotion that was supposed to bring in more revenues. One market
that Time had targeted was the internet radio stations accessible to AOL subscribers. The
basic idea was to increase the royalties for Time Warner’s recording artists played over the
internet radio stations. Time expected these radio stations to go along with the royalty
increase because of AOL’s subscriber base. Instead the internet radio stations severed their
links with AOL. AOL’s subscribers ended up with only AOL radio stations. It seems, the issue
of royalty conflicts were not carefully reviewed during the negotiation stage before this
source of revenue was booked as synergy. The clearest admission that the merger synergy
was abandoned came from the 2002 directive by the new CEO Richard Parsons: each
individual unit would focus on what they are good at individually. Over emphasizing the
potential for collective good is a common mistake in synergistic mergers and AOL is not
alone in misjudging the opportunities.
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Synergistic mergers and valuations
There is research evidence that the premiums paid in mergers perceived to be synergistic
by managers (termed ‘‘related mergers’’ in the strategy literature) are higher[8] than purely
financial (unrelated) mergers as well as horizontal (same industry) mergers. However, there
is also evidence the acquiring firms in ‘‘related’’ mergers do not benefit or are actually worse
off compared to unrelated as well as horizontal mergers[9]. Our interviews with practicing
managers confirm this research evidence. In a related merger, the seller knows much more
of the true value than the buyer, even though the buyer may think that it knows what it is
buying.
Consider the case of Kellogg’s acquisition of Lender’s Bagels. In late 1990s, Kellogg bought
Lender’s Bagels (a maker of frozen bagels) from Kraft in a desperate effort to get into a high
growth market – bagels. However, the true growth market was in fresh bagels and not the
frozen bagels that Lender’s sold. To compound this mistake, Kellogg saw Lender’s as a
related business because Kellogg was selling Eggo waffles in the grocery freezer. In sum,
Kellogg did not know the entire bagel business. To paraphrase a former Kellogg executive:
‘‘Kraft got a good deal out of the sale.’’
It should be common sense that mergers that are dependent on coordination of partially
familiar activities (complex or otherwise) by two former independent entities will be more
difficult to value. Our advice to managers who are contemplating so-called related mergers:
it is absolutely imperative to have much more clarity with these mergers than you think you
have. The fact that parts of the acquired business are related to yours can lull you into
complacency, which can be disastrous. On top of that, if the co-ordination of the integration
is complex, this unwarranted confidence increases the risk even more. In three well
documented mergers – AT&T/NCR, Quaker Oats/Snapple and AOL/Time Warner – the
acquirers all assumed that they could precisely predict the revenue increases that would
only arise from such complex coordination of activities of the merging firms. Moreover, they
thought that they could achieve these increases very quickly. It turns out they were very
wrong.
How to reduce the valuation risks of a synergistic merger
Managers should expect synergistic mergers to be difficult and success elusive. For one
reason, they tend to be one-off initiatives, and thus unique. Because of this, it is very difficult
to develop a repeatable acquisition process. Thus, synergistic mergers or acquisitions are
likely to be excessively costly and to experience integration problems.
The following checklist – based on our assessment of problematic mergers and on
conversations with successful acquirers – may enable potential purchasers to avoid some
of the major pitfalls:
B
Avoid high-pressure deals. If the combination is truly unique, then it avoids a major pitfall
for all acquisitions – a high-pressure competitive bidding process. Further, negotiations
of such deals are more likely to be friendly and transparent. Leadership’s goal should be
to manage one-off synergistic mergers much the same way that serial acquirers such as
Danaher or RPM do deals. These firms often pursue a target for years and even decades.
Not only does their long-term perspective give these acquirers much better insight into
what they are buying, but they often receive favorable treatment from the seller because
of the long-standing relationship.
‘‘ Managers should be extremely circumspect when
contemplating one-off mergers or acquisitions. ’’
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B
Same industry mergers are less risky. Travelers/Citicorp and Hewlett-Packard/Compaq
mergers were secretly negotiated over a long period of time, which allowed all the
participants to develop realistic expectations. In both cases, all the parties were in the
same industry, so everyone understood the business and the industry dynamics.
Surprisingly, both mergers exceeded their basic goals.
B
Synergies in cost reductions are easier than revenue increase. Based on a survey of
academic research, interviews and anecdotal evidence, it is my conclusion that it is much
easier to achieve success when the stated goal of a merger is its potential for cost
reduction rather than its potential to increase revenue. For example, following its
disastrous acquisition of Lender’s, Kellogg’s next purchase was the frozen vegetarian
burgers unit of Worthington Foods. However, with this acquisition Kellogg fared much
better because they focused on the cost side of the synergy and did not assume that the
market would grow by itself[10]. Likewise, the Hewlett-Packard/Compaq merger was
largely predicated on a consolidation of capacity that could be accurately measured.
Despite Carly Fiorina’s sudden departure before integration was complete, all the cost
targets of the merger were met earlier than predicted. HP had established an objective of
achieving $1.3 billion in cost savings by November 2003. Yet within a year, according to
Forrester Research, HP had posted savings of $3.7 billion, and acquired new strength in
servers and IT services[11].
The previous observation also solidifies our belief about mergers in the same industry
faring better than related mergers. In a merger or acquisition driven solely by
consolidation of capacity in a market or industry, the revenue increase would come from
simple supply-demand dynamics that are much easier to understand. In contrast, the
typical related merger expects revenue increases from complicated cross-selling and
other inter-functional coordination. In general, there is strong and uniform academic
evidence that horizontal industry consolidations, motivated by capacity reduction, are
one of the few merger categories that seem to succeed[12].
B
Clarify the source of revenue increase. On the other hand, the evidence regarding related
(as opposed to horizontal) mergers that can lead to new revenue opportunities is
extremely mixed. Consider, for example, ATT’s effort to develop a broadband strategy by
acquiring the leading cable companies TCI and MediaOne in the early 1990s. This was an
entry strategy that required paying an excessive premium to overcome the entry barriers.
As time has shown, ATT’s rival, Comcast, became the beneficiary when this strategy failed
and it acquired all of AT&T’s cable assets at fire-sale prices.
In sum, it is very difficult to come to a definitive conclusion in advance about the potential
for revenue increase, especially for related (as opposed to financial or unrelated)
mergers. This makes it highly risky to establish revenue increase as the primary
justification for such mergers. As one former Kellogg executive commented on the failed
Lender’s Bagel merger, ‘‘very often you do not know what you do not know.’’
So how can managers mitigate this risk? An alternative approach is to seek a merger as a
last resort and instead try to determine if the synergies can be obtained through
contractual mechanisms. For example, in the case of United’s merger with Hertz car
rentals and the Westin hotel chains, United could have reaped the significant benefits of
cross-selling between its car-rental and hotel partners by simply referring customers to
each other without getting into a merger[13] – as most airlines do at present.
B
Do not make a bad situation worse. In 1999, Prudential acquired the boutique Silicon
Valley investment bank Volpe Brown Whelan in order to get into the booming Internet
firm’s underwriting business. This is a classic ‘fit’ driven merger where the acquiring firm
buys a complementary resource. During its negotiations with Volpe, Prudential’s
dealmakers drew up a list of 12 bankers and analysts considered critical to the firm’s
value. Yet many of these vital personnel left when Prudential closed Volpe’s trading desk
and integrated the trading operations with Prudential’s own. Prudential was trying to
extract cost synergy. Yes, Prudential paid a premium to buy the underwriting business.
However, trying to recover the premium by consolidating the trading desk was the wrong
integration priority. Instead, Prudential may have been able to generate the cost savings it
sought through the merger by integrating the trading desk, if they did not hurry the
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‘‘ The fact that parts of the acquired business are related to
yours can lull you into complacency, which can be
disastrous. ’’
process and antagonize the key traders. These traders were the first line of contact with
the customers. The cost reduction was not worth losing these key personnel.
The case of the Volpe acquisition by Prudential illustrates an important lesson. Let’s suppose
that your firm has acquired a profitable business. You have paid a premium for it. Now you
realize that it is difficult to achieve the synergy and you probably will not recover the
premium. Our advice is not to try to squeeze the acquisition to produce a quick profit. Trying
to force the issue may well lead to the target firm losing ground to its competitors. This is
exactly what happened when Rubbermaid acquired Little Tikes in 1984 and wanted to
integrate it with its other product lines. The end result was that the founder of Little Tikes quit
Rubbermaid, and started step 2, a company that effectively competed with Little Tikes. As a
result, the Little Tikes division suffered a string of annual losses and was divested in
November 2006. As these cases show, in certain situations the mishandled acquisition of a
relatively small target can lead to painful consequences for the acquiring firm.
Two types of special cases
Opportunistic acquisitions
The problem with opportunistic acquisitions, whether they are synergistic or not, is that they
are likely to be ad hoc ventures that cannot draw upon previous experience. Research
suggests that, as a defense, decision makers must try to develop an in-depth understanding
of the acquisition’s market. A case in point, in 1993 Merck wanted to use the disease
management database of the leading pharmaceutical benefit management company,
Medco, to get into the formularies of the managed care companies. Merck’s investment paid
off in the 1990s mainly because Merck had invested in in-house disease management
programs before making the $6 billion hostile bid for Medco. Thus, it had a slight
information/knowledge advantage over pharmaceutical companies that acquired
pharmaceutical benefit management companies in the wake of Merck/Medco –
acquisition. Any kind of information advantage will be a buffer against paying too much.
As another method of defense against overpaying, Cisco routinely tries to develop products
in-house first before making an acquisition.
Hostile bids
What about hostile bids? The Medco acquisition ultimately ended up as a friendly merger,
but there are acquisitions that remain hostile to the end. Many hostile bids are not built
around synergy but rather a short-term opportunity to create value by restructuring or
breaking up the acquired company, a common ploy in the 1980s. These acquirers motivated
by restructuring did not really suffer from an information disadvantage because they could
not care less about the internal goings-on of the acquired company. They simply applied
their skill at restructuring and breaking up companies over and over again – so in some
sense they benefited from repetition. For this reason, restructuring acquisitions also have a
good track record[14].
A hostile bid can also be justifiable if the value proposition and the value extraction
processes are understood by the purchaser. Consider Oracle’s hostile bid to acquire
PeopleSoft. Oracle was willing to pay $6 billion (an initial offer that was subsequently raised)
simply to buy PeopleSoft’s 3,000 customers. There was no information disadvantage
because Oracle made the calculation that the market power that it would generate by
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removing PeopleSoft as a competitor (or of avoiding the formation of a stronger competitor
through the merger of PeopleSoft and J.D. Edwards) was worth $6 billion[15]. Note that,
there was no complicated plan to integrate PeopleSoft with Oracle. In sum, hostile bids that
have a purely financial goal are likely to work, provided the acquiring firm has done its
homework and has complete clarity about the viability of the value proposition.
However, hostile bids that expect to create value by a complex melding of the acquiring and
acquired firm are much less likely to succeed. Commenting on AT&T’s hostile bid for NCR in
1990, NCR Chairman Chuck Exley said that AT&T was ‘‘like an electricity company that wants
to get into the Mixmaster business!’’[16]. In fact, the NCR acquisition was an unmitigated
disaster. Our advice: never attempt a synergistic hostile takeover.
Some final advice to leaders
Research shows that acquiring firms that rely on a repeatable acquisition process have the
highest probability of success. The reverse is also true: occasional acquirers that seek
synergy or a unique opportunity have to contend with all the impediments to acquisition
success and are less likely to succeed. Even experienced acquirers should approach
synergistic mergers with great care and not put too much faith in their prior success record.
Phillip Morris found out that its success with the Miller acquisition did not help it when it
undertook the ad hoc acquisition of 7-Up. Similarly, Quaker Oats’ experience acquiring
Gatorade did not ensure success when it attempted the opportunistic acquirement of
Snapple. Our conclusion: managers should be extremely circumspect when contemplating
one-off mergers or acquisitions.
Notes
1. Mark L. Sirower (1997), The Synergy Trap: How Companies Lose the Acquisition Game, The Free
Press, New York, NY. This book summarizes a stream of research starting with Sayan Chatterjee’s
article ‘‘Types of synergy and economic value: the impact of acquisitions on merging and rival
firms,’’ Strategic Management Journal, Vol. 7, pp. 119-139 (1986).
2. Chatterjee (1986) op. cit.
3. This is in effect a ‘‘merger’’ of the procurement activity of Dell/Wal-Mart with the manufacturing
activity of their vendors. The reason that competitors have not been able to imitate these supply
chains is because of their complexity.
4. This complexity can be a problem even for smaller acquisitions – the types that we have previously
argued are more likely to pay off. However, the previous sections deal with an increase in the
productivity of the small target’s assets and not synergy from a comprehensive combination of the
acquirer and acquired companies’ activities. In fact, sometimes these smaller firms targeted as
synergistic acquisitions can become a money pit if the acquired firm is not careful (Joseph L. Bower
‘‘Not all M&As are alike – and that matters’’, Harvard Business Review, March 2001, Vol. 79 No. 3,
pp. 92-101). Recall AT&T’s acquisition of NCR and Quaker Oats’ acquisition of Snapple.
5. Chatterjee (1986) op. cit. hinted at this possibility but did not provide any evidence.
6. Julia Angwin and Matthew Rose, ‘‘Creating a ‘new media’ concept, Wall Street Journal, Eastern
Edition, 03/09/2001, Vol. 237 No. 48, p. B1, p. 1
7. Julia Angwin and Matthew Rose op. cit
8. Singh, H. and Montgomery, C. (1987), ‘‘Corporate acquisition strategies and economic
performance,’’ Strategic Management Journal.
9. Anand and Singh. 1997 op. cit. Lubatkin (1987), ‘‘Merger strategies and stockholder value,’’
Strategic Management Journal, pp. 25-37. D.J. Flanagan (1996), ‘‘Announcements of purely related
and purely unrelated mergers and shareholder returns: Reconciling the relatedness paradox,’’
Journal of Management, pp. 823-835. Chatterjee (1986), op. cit., E.B. Eckbo (1983), ‘‘Horizontal
mergers, collusion, and stockholder wealth’’, Journal of Financial Economics, pp. 241-273.
10. According to the Kellogg executive who integrated the Worthington merger, the revenue estimates
were not borne out.
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11. Charles Rutstein, with Galen Schreck (2003), ‘‘A year later: HP can claim integration success’’,
Forrester Research, May 9.
12. Chatterjee (1986); Anand and Singh (1997) op. cit.
13. The principles for deciding between a contractual arrangement versus and organizational
arrangement were well developed in the mid-1960s by Oliver Williamson.
14. Michael E. Porter (1987), From competitive advantage to corporate strategy, Harvard Business
Review, May/Jun, Vol. 65 No. 3, pp. 43-59.
15. Porter (1987), op. cit. calls it the better-off-test.
16. Paul Carroll, ‘‘Is it synergy or just sin?’’ Context, Winter 2002/2003
About the author
Sayan Chatterjee is a Professor of Policy at the Weatherhead School of Management, Case
Western Reserve University and a Batten Fellow of the Darden School, University of Virginia.
He is currently studying innovation, competitive strategies and M&A with a focus on merger
integration. Sayan Chatterjee can be contacted at: sxc14@po.cwru.edu
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