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.
3 Central bank monetary policy: expansionary or contractionist. The type of policy will influence interest rates, inflation expectations, exchange rates, business investment, and trading volumes in the capital markets.
4 Inflation rate. High rates can destabilize competition and increase uncertainty in business planning.
5 Interest rates, both for the government and corporations. These directly affect valuations of target firms.
6 Exchange rates. Volatility in these can destabilize competition and deeply affect prices and costs.
7 Trade balance. Sustained imbalances can affect the cost of funds, availability of capital, and prices and costs.
8 Consumer optimism. This is strongly correlated with demand for consumer goods and durables and should strongly influence forecast assumptions regarding corporate revenue growth.
9 Gross domestic product, especially its growth rate. The rate of macroeconomic expansion is perhaps the single most influential driver of corporate investment decisions. To the extent possible, one should try to disaggregate growth by sectors and/or industries.
10 Current position in macroeconomic cycle. Publications by the U.S. government afford a variety of indicators for tracking growth of the economy. Similar lists of economic indicators are followed in other countries, and by economic interest groups such as the Organization for Economic Cooperation and Development (OECD). In typical practice, each group of indicators (leading, coincident, and lagging) is combined to form an index of economic performance. Judgments about current and future growth are derived from an assessment of the index trends.
The analyst of macroeconomic themes uses data on these and other measures to identify current and prospective trends that because of their direction and magnitude are particularly relevant for the acquirer’s acquisition strategy. The strategic force of strong consumer demand leads to the theme of increased capital spending. Heavy capital expenditures imply a large financing need. One way to finance capital expansion is by combining cash-rich and cash-poor firms. A second example would be a strengthening currency that triggers increases in imported goods leading to the theme of robust business revenues in shipping and transportation. The possibilities for identifying themes through macroeconomic analysis are numerous.
APPENDIX 4.3 Listening for Turbulence as Communicated through Capital Markets
If markets tell stories about the actual inner condition and prospects of firms, analysts should extend their attention to capital markets. In contrast to product markets, these markets are relatively more transparent about telling us what they see in firms. Moreover, listening to capital markets employs another precept, stay close to investors. By betting their wealth in tough-minded ways each day, investors impound news and expectations about firms into market prices. If, as the bulk of academic research suggests, markets are efficient on average and over time, then one can trust the market to distill what is known about firms and their outlooks into securities prices. Viewed broadly, capital markets offered three arenas from which to derive themes for top-down acquisition tracking: equity markets, debt markets, and the various markets for derivative securities.
DEBT MARKETS
Public and private corporations have trillions of dollars in debt securities outstanding. The prices and trading in these securities yield insights into economic conditions.
Debt yields and their associated risk premiums. Debt yields18 are excellent indicators of risk, and therefore may be useful sources of insights about strategic themes. The more risk one takes, the more one should get paid. This axiom is reflected daily in the pricing of debt securities. The acquisition search analyst should examine both the absolute yields in target businesses, and the risk premium in those yields. This premium is measured as the difference between the yield on a corporate debt instrument, and the yield on a contemporaneous government debt instrument. The premium increases as risk increases. The analyst should review the yields and premiums for candidates cross-sectionally in an industry and scrutinize outliers in risk. Also the analyst should consider trends and changes in risk over time. Divergence in yields among firms in an industry, or material changes in risk premiums are probably evidence of strategic themes.
Credit ratings. Publicly traded debt issues are ordinarily rated for creditworthiness by rating agencies. Here, “creditworthiness” refers explicitly to risk of default in servicing the issue. The analyst should scrutinize the ratings of issuers in the target industry for consistency among the players. Outliers will have an interesting exposure to strategic forces. Also, rating changes are unusual and especially noteworthy—the acquisition analyst will find in these events one or more strategic themes. But it is also important to note that rating changes usually occur well after investors have recognized the need for a change. A better and more timely focus of attention would be the risk premiums for corporate debt over the yield on contemporaneous government debt issues.
Maturity or duration for typical debt issues. The maturity structure of a firm’s liabilities offers clues about the expectations of insiders and creditors about the firm’s future cash flows, and about the nature of the assets standing behind those debts. The acquisition search analyst could compare the maturity structures for firms in a target industry, and check the extent to which those structures have changed over time. The classic advice to corporate borrowers is to set the life of their liabilities equal to the economic life of their assets. To mismatch these two lives is to expose the firm to financial risk.19 While it is notable that most firms ignore this advice, it is a useful starting point for the analyst
