Robert F. Bruner - Applied Mergers and Acquisitions

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.

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.

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.

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.

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 yields 18 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.