to 2003 in its pursuit of technological leadership in the network systems industry. Generally, advances in information technology spur changes in the way firms compete.
Innovation in financial markets. Since the early 1970s, capital markets have grown in sophistication and efficiency. The design of new financial instruments has permitted even small and privately held firms to access the capital they need to transform themselves. Jensen and Wasserstein mentioned the rise of the high-yield debt market as an example—this new instrument was highly influential in the rise of leveraged buyouts, and both private equity and debt financing.
Globalization. As product and capital markets become more integrated across borders (thanks in large part to other contributing drivers mentioned here) the competitive arena for any one firm will expand, with new adversaries, suppliers, and customers. Because of this linkage, turbulence abroad can resonate at home.
Organizational invention. Each wave of M&A activity was accompanied by experimentation with a new form of enterprise structure: the horizontal trust, the vertically integrated firm, the conglomerate, the LBO specialist, and the venture capital portfolio.
Changes in consumer demand and supply in product markets. In the past 20 years, industries as varied as toys, media and entertainment, bicycles, and automobiles encountered customers who demanded (and were given) products that were more tailored, more fadlike, more rapidly delivered (i.e., with shorter design and manufacturing cycles), and of higher quality. These requirements imposed on a number of marginal players the choice either to merge or to exit from the industry.
Changes in capital market conditions. The cost of money must remain on any list of drivers of turbulence. Though this would seem to be a macroeconomic driver (and therefore a factor Schumpeter might have warned against) the reality is that capital markets distinguish carefully among industries and firms within industries, as any inter- and intra-industry comparison of valuation multiples will show.
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.
