The impact of economic, industry and product cycles on M&A
In a recent M&A study by Deloitte, about 60% of executives interviewed cited “Overstated Revenue Forecast” as the greatest concern in valuing a target. The study goes on to say that “In general, buyers and target companies can be expected to differ in predictable ways when it comes to valuation. But these natural tendencies are being exacerbated by prevailing business and economic uncertainties.”
Most of these executives have recently been bitten by acquisitions made ahead of a slowing economy that did not pan out as expected. In some cases the acquisitions were made after the recession, but the expectation of strong recovery after the recession did not materialize. Economic cycle is an example of a fundamental factor that should be taken in to considerations by any company looking into an M&A transaction.
When initiating an M&A transaction, I believe that there are three different types of cycles that need to be taken into account. These cycles help to determine the future revenue streams of a company and its economic value.
It is no secret that the economy goes in cycles. An economic cycle consists of growth phase, peak, recession, and trough, followed by a repetition of the same elements. Economic cycles in the recent past have tended to go in roughly 10 year bursts. In an average cycle, the growth phase typically lasts for 6 of the 10 years. The early part of this growth cycle is usually characterized by low interest rates, residual gloom and doom, and general lack of liquidity as the market digests the realities of the preceding trough. As the growth cycle continues, the market sentiment becomes predominantly bullish, interest rates will likely go higher, and the financial market develops a considerable amount of liquidity as investors chase growth opportunities.
From a buyer’s perspective, acquiring a company in early growth would yield the best results. However, from a seller’s perspective, selling the business in the later parts of the growth phase is likely to give the results.
Unrelated to economic cycles, industries go through their own phases. A typical industry cycle consists of early adopter phase, growth, maturity, followed by decline. The early adopter phase is typically characterized by low industry revenues, where a few innovative companies make high margin products that take the lion’s share of the industry profits. The growth phase is marked by widespread customer adoption, increasing industry volume, and new competition. This typically is the most rewarding stage for investments – this is where companies in the industry move from microcap and midcap to become large caps. During the maturity stage, industry growth subsides, margins contract, and consolidation takes hold. From an acquirer’s point of view, an entry in the growth stage is likely to be most rewarding. Alternately, from a seller’s perspective, a sale in the late growth stage is likely to be the most rewarding.
Within each phase of an industry cycle, several products have they own cycles. Typical product life cycle phases include development, introduction, growth, maturity, and decline. From an M&A standpoint, acquiring a company in the development stage presents the highest risk but also potentially a very high reward. Most M&A activity, however, is centered on the growth phase of a product lifecycle. Here again an acquisition made during the early part of a product lifecycle is likely to be advantageous to buyers, whereas a sale made during the later growth stages helps the seller capture most of the value from the product lifecycle.
Hits & misses
A savvy seller or acquirer needs to be aware of these cycles to maximize the return on M&A activity. A transaction that hits the upswing of all these cycles is likely to do extremely well and a transaction that hits the downswing of these cycles is likely to do extremely poorly. A successful example when all cycles are aligned is Google’s purchase of Android in 2005. The mobile phone industry was just about to take off and Android was a development stage buy. When Android-based products started becoming available, the world economies were just starting to come out of a major recession.
On the other end of the spectrum, Eddie Lampert’s acquisition of Sears & Kmart in 2005 was a disaster. Both companies were in a declining retail sector with poor product offerings, and the timing of the deals, going into one of the biggest recessions of the modern times, did not help.
Timing is the key
Conducting a transaction that benefits from the alignment of these three cycles may be appealing, but in practice it is very difficult thing to do. Understanding the nature of economic cycles is a fairly simple task, but timing the exact beginning and end of each of the cycle is nearly impossible. And, even if one can time the cycles accurately, it may not be feasible to get a deal done at the most optimal time. For example, the seller may not be able to take advantage of it due to personal, liquidity, or other issues. Similarly, an acquirer’s capital may be tied up, or there may not be access to capital at favorable terms.
However, for a deal to be successful, not all the cycles need to align. Instead of trying to time these cycles to perfection, sellers and buyers are far better off understanding the nature of the cycles and making transactions at the best possible juxtaposition of all these three cycles. For an advantageous transaction, it is imperative that the parties develop deal terms that reflect the risks of the life cycle stages.