frenzy. Buyers’ shareholders approve acquisitions consistent with the prevailing mania, even though the deals may destroy value.
Where in this space would you position your view? It helps to reflect deliberately on this question because how you approach the tools and concepts in the rest of this book will be colored by your fundamental assumptions about what drives M&A.
My own view is that, on average and over time, markets and managers are rational (the operative phrase here is on average and over time). In the main, this encourages the use of tools and concepts founded on assumptions of rationality—these tools give a special benchmark for assessing deals as if markets and managers were rational. Periodically, markets and managers can lose their moorings. When they do, my practice is to cling to a value-style focus on intrinsic values and make decisions accordingly. This follows the philosophy that one must retain one’s fundamental discipline regardless of market conditions (for more on this, see Chapter 9).
“CREATIVE DESTRUCTION” AS THE DRIVER OF M&A ACTIVITY
Rationality does not necessarily dictate stability of industrial markets. The catalog of industry shocks is long. But why is it rational for them to occur? The economist Joseph Schumpeter articulated some answers with his writing on the destructive quality of business cycles. Since waves of M&A activity are roughly associated with the ebb and flow of the economic cycle, Schumpeter’s work has direct relevance to M&A activity. It is the fate of most economists to be remembered more for their path of reasoning than for their conclusions.9 Schumpeter’s important contribution to economics was to focus attention on the key figure in economic growth: the entrepreneur. All the important economic theorists who preceded Schumpeter either ignored (e.g., Adam Smith) or scorned (e.g., Karl Marx) what the entrepreneur actually does. Schumpeter argued that the entrepreneur seeks to create turmoil, and to profit from it. This bumptious actor10 realizes that in any stable economic setting, profits will flow to established firms doing business in established ways. He wrote:
The function of entrepreneurs is to reform or revolutionize the pattern of production by exploiting an invention or, more generally, an untried technological possibility for producing a new commodity or producing an old or in a new way, by opening up a new source of supply of materials or a new outlet for products, by reorganizing an industry and so on…. This kind of activity is primarily responsible for the recurrent “prosperities” that are due to the disequilibrating impact of the new products or methods. To undertake such new things is difficult and constitutes a distinct economic function, first, because they lie outside of the routine tasks which everybody understands and, secondly, because the environment resists in many ways that vary, according to social conditions, from simple refusal either to finance or to buy a new thing, to physical attack on the man who tries to produce it. To act with confidence beyond the range of familiar beacons and to overcome that resistance requires aptitudes that are present in only a small fraction of the population and that define the entrepreneurial type as well as the entrepreneurial function. This function does not essentially consist in either inventing anything or otherwise creating the conditions that the enterprise exploits. It consists in getting things done.11
Only by entering the competitive field with some new process or product can the entrepreneur hope to claim a cut of the profits of the industry. This describes an economy of ceaseless and self-generated change. Business cycles arise because entrepreneurs swarm or cluster around opportunities. Schumpeter wrote:
Why do entrepreneurs appear, not continuously, that is, singly in every appropriately chosen interval, but in clusters? Exclusively because the appearance of one or a few entrepreneurs facilitates the appearance of others, and those the appearance of more in ever-increasing numbers…. Hence the first leaders are effective beyond their immediate sphere of action and so the group of entrepreneurs increases still further and the economic system is drawn more rapidly and more completely than would otherwise be the case into the process of technological and commercial reorganization which constitutes the meaning of periods of boom.12 (Schumpeter’s emphasis)
The swarming suggested by Schumpeter describes well the geographic attraction of technology entrepreneurs to places like Silicon Valley, northern Virginia, and the Boston beltway. But it also has relevance for observed clustering of M&A activity by industries. Like iron filings to a magnet, opportunity draws the M&A entrepreneur.
Why is it, then, that investment opportunities and M&A deals tend to cluster by industry? Schumpeter lays the foundation for answering this crucial question.
The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process…. The fundamental impulse that sets and keeps the capitalist engine in motion comes from the new consumers’ goods, the new methods of production or transportation, the new markets, the new forms of industrial organization, that capitalist enterprise creates…. The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation—if I may use that biological term—that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism…. Every piece of business strategy acquires its true significance only against the background of that process and within the situation created by it. It must be seen in its role in the perennial gale of creative destruction.13
Schumpeter’s foundation for our understanding of M&A activity might be distilled into the following points:
Entrepreneurs who seek to create something new and profit by it drive waves of activity. If this is relevant to M&A, then we should observe at the center of individual transactions leaders who, as Schumpeter says, “get things done” against various forms of resistance in the environment. Schumpeter tells us that to understand waves of M&A activity, we should find the leader/entrepreneurs at the center of this activity.
Profit-creating opportunities arise from new products and processes, new logistics, new markets (domestic and foreign), new forms of organization, and so on. If this is relevant to M&A, then we should observe at the center of individual transactions, and clusters of transactions within an industry, some kind of economic turbulence. Schumpeter implies that in order to understand waves of M&A activity, we should listen for the turbulence at the level of firms and markets, not at the level of the economy. The turbulence that is relevant is almost always industry-specific. This explains why deals cluster within industries, and why the attempt to explain M&A waves in the aggregate is fruitless: Each industry or market has its own rich story.
M&A is a process of creative destruction. The destructive aspects of M&A are well documented in the press: plant closings, uprooting of managers and their families, layoffs, transaction-related lawsuits, and so on. Schumpeter hastens to remind us that it is through these processes that the economy renews itself and makes itself more agile and resilient to macroeconomic shocks. To prevent the destruction is to prevent the renewal.
A case in point is presented in Naomi Lamoreaux’ study of the M&A wave of 1894–1904. During that period, more than 1,800 firms disappeared into the formation of 93 consolidated firms with an important, if not dominant, share of market in their respective industries. Though most of these new firms quickly lost their
