Where to Look for Turbulence
The creative destruction view of M&A activity suggests that potential and actual M&A activity will occur in industries and company settings where forces of economic turbulence are particularly active. How one does this is straightforward to describe, and challenging to implement. First, one should listen to both markets and firms. Listening to markets is a “top down” approach of gathering insights. Listening to firms is a “bottom up” approach. The two approaches are complements, and are used by the best analysts in concert.
But where should one begin the listening process? Here, again, are two approaches, which complement each other. On one hand, it is useful to analyze the data that tells the story of the performance results of firms and industries: financial data, market share, cost information, and so on. This first approach could be considered “inside out” because it starts with the details and works toward generalizations. On the other hand, one could build an image of turbulence starting from qualitative information, opinions, and summaries of various sorts, and from these work toward more detailed M&A implications for industries and firms. This second approach would rely on newspaper and magazine articles, securities analyses, CEO speeches, opinion columns, and so on. This second approach might be thought of as “outside in” because it uses aggregative ideas to develop detailed implications.
Combining these two methods with the “what” and “where” approaches yields four styles of monitoring M&A activity and opportunities, as given in Exhibit 4.6. Ideally, no “listening” style should be used in isolation. But as a practical matter, the limitations of time and other resources may force the listener to follow one style. Each style is associated with a successful practitioner; there is no one right approach. The data-intensive “inside out” styles demand strong data-gathering and analytical abilities. Appendixes 4.1 to 4.4 offer some further guidance for ways of implementing an “inside out” approach. The more intuitive “outside in” styles demand an unusual skill in seeing broad patterns and deducing the implications of those patterns.
EXHIBIT 4.6 Styles of Listening for Turbulence, and the Resulting M&A Activity or Opportunities
| Listen to Markets (“Top Down”) | Listen to Firms (“Bottom Up”) | |
|---|---|---|
| Start with Hard Data (“Inside Out”) You can see a pattern of performance results and want to profile the source of turbulence and ultimately the M&A opportunity. | Dig into performance results for industry averages, and for individual players. Then step back and ask, “What turbulence is contributing to this industry’s results?” and “Where is the M&A opportunity in this industry?” Practitioner: J. P. Morgan. | Dig into very detailed performance results for individual firms in the industry. Then step back and ask, “What turbulence is contributing to this firm’s results?” and “Is there an M&A opportunity in this firm?” Practitioners: Carl Icahn; Michael Price; Warren Buffett. |
| Start with Ideas (“Outside In”) You can identify the source of turbulence, and seek to determine its impact and ultimately an M&A opportunity. | Start with the concept of major change events and develop the implications for the aggregate industry and for the rivalry among players in the industry. Ask, “What is the impact of the turbulence on this industry?” and “Where is the M&A opportunity in this industry?” Practitioner: Bruce Wasserstein. | Start with the concept of major change events, and proceed immediately to develop implications for the target firm. Ask, “What is the impact of turbulence on this firm?” and “Is there an M&A opportunity in this firm?” Practitioners: risk arbitrageurs. |
CONCLUSION
M&A activity occurs in waves over time and hits industries differently. Research offers several explanations for this activity: managerial hubris, market mania, market overvaluation, information asymmetry, agency costs, and industry shocks—the thoughtful practitioner will find useful insights from all of these explanations. But underlying these perspectives are differing assumptions about the rationality of managers and markets. The M&A practitioner needs to have a view about this as a foundation to using effectively the tools and concepts in this book.
The notion that industry shocks drive M&A offers some traction for the analyst. The economic turbulence from industry shocks is always present, but it affects various industries, and the firms within them, differently. As a result, the M&A professional needs to develop an ability to tell industry-specific and company-specific stories about the impact of economic turbulence. This is an essential foundation for almost all of the professional skills surveyed in this book: transaction search, forecasting, valuation, due diligence research, negotiation, deal structuring, postmerger integration, and others.
APPENDIX 4.1 How to Listen to Customers of Firms
The most direct way to listen to customers is through the analysis of purchasing patterns and behavior. Four calculations could be done for all comparable products in an industry.
1 Price elasticity of demand, which is simply the percentage change in units sold for every percent change in price. Elasticity gives a measure of the sensitivity of the customer demand to changes in price.
2 Rates of growth on a unit basis, and their sustainability.
3 Sensitivity of demand to pricing and availability of complements and substitutes.
4 Demand segmentation, which focuses on pockets of demand based on geographic area, price, product features, and so on.
Careful demand analysis is challenging for at least two reasons. First, careful analysis requires specialized data that may need to be collected through primary research. Collection of primary data can be arduous and expensive. And second, buying behavior is influenced by numerous factors simultaneously. To isolate the influence of any one factor requires econometric techniques, and a fair amount of clean data. Barabba and Zaltman (1991) give an overview of the organizational and process requirements for successful demand analysis. This is a cautionary foundation for M&A professionals contemplating demand analysis.
APPENDIX 4.2 How to Listen to Macroeconomic and Sector Conditions
Though at first glance the macroeconomic perspective would seem to offer a uselessly high level of abstraction, in fact the themes identified in this chapter influence virtually everything else in an effort to understand M&A activity and conduct an acquisition search. A checklist of measures of the state of the economy would include these 12 measures:
1 Unemployment rate and factory capacity utilization rate. These signal activity levels in the economy, sector, and industry. High capacity utilization can signal increased capital spending. Low unemployment can signal upward pressure on wages.
2 Government fiscal policy: whether stimulative or not. Government spending should be scrutinized carefully for favored sectors and industries, and generally for political goals that would build up some segments of the economy at the expense of others. Sustained deficits over time are associated with increased government borrowing, and the crowding out of corporate investment through higher interest rates.
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