John Kenneth Galbraith died in 2006 after a very full life that lasted 97 years. But the theories of this brilliant economist are far from going extinct. His vision of the “Modern Firm” and of the so-called “technostructure”, which he described in his book published in 1967 The New Industrial State, has never been more accurate to describe present times. In particular, as we are going to highlight, Merger and Acquisitions (M&As) support very strongly Galbraith’s thesis.
Merger and Acquisitions
M&As are getting bigger and bigger this year. Every sector participates actively to make 2015 the biggest year as far as volume and amount of M&As are concerned. In particular during the latest weeks, the trend was utmost clear: First with the beer sector (SABMiller & AB InBev), but also in the tech sector, as Dell announced the acquisition of EMC less than two week ago, signing the largest deal that the tech sector has ever known with a price tag of approximately $67bn. The trend kept going last Wednesday with Western Digital announcing the acquisition of SanDisk.
Billions of dollars keep flowing, but the underlying reasons for the trend remain relatively unexplained by observers. A lot of talking is about macroeconomics. Today’s conjuncture is indeed very favorable to debt-raising, which an important part of every multi-billion deal. However, the macroeconomic climate and low interest rates do not explain the underlying reasons for M&As. Macroeconomics only explain why so many transactions occur in 2015, not the phenomena itself. We will go further by focusing on one of the most active sector: Tech, IT and communication.
Motivation of the firm
According to John Kenneth Galbraith, the large firms that use complex technologies are organized with what he called “a technostructure”. Meaning that firms have to get the help of committees and groups of specialists, rather than relying on a single man (the entrepreneur). “Modern firms” which are organized like this do not match with the liberal definition of the firm’s goal, which Milton Friedman best summarized in the well-known sentence: “The social responsibility of the firm is to make profit”. The Modern Galbraithian firms do not seek profit. They seek expansion above all. Growth. They want to become more dominant rather than to improve their profitability. Of course, they are very careful to maintain a minimal level of profitability, in order to retain the capital from the shareholders, but do not go further than strictly needed.
Why would they seek expansion and growth rather than profit? One of the main reasons for this is that it is less risky to increase the size than to improve the profitability, and most people are risk-averse (at least in the Western world). It is in fact risky to decrease costs or increase prices, as it leads to unpredictable outcomes. For example, a firm spending more than yours on R&D or on advertisement might beat you because of your attempt to save money. On the other side, growth is a relatively safe bet, whichever form it takes. Internal growth is about expanding a model that proved successful, not about being an adventurous entrepreneur, and is therefore not very risky. External growth diminishes the risk even more: the price of the business the firm acquires is fixed when the deal is made. Thus, there are fewer unknowns, such as the possibility that the development of the business takes more time than expected, or that this new business require new skills and organizational capabilities. The premium that the firm is ready to pay to acquire a business doesn’t only represent a part of the expected “synergies”, but also strongly reflects the risk-aversion of the firm (i.e. its unwillingness to produce internal growth).
Why do firms merge?
We identified two main reasons for companies to merge. The most common is that firms want to benefit from synergies leading to lower costs, and thus higher margins and profits. The second is that it is a way to grow and increase the scale and scope of the company. To test which hypothesis is the most prevalent when a firm does M&A, we went through the press releases announcing M&As for 10 large deals involving 20 different firms:
We counted the number of occurrence of keywords related to each of the two thesis, and also to other themes: Innovation, Growth, Customers, and Profit. Profit includes among other words: “synergies”, “cost”, “savings”, profitability”, “earnings”, “margin”, while Growth is composed by “scale”, “revenue”, “sales”, “growing”, “expand”, and other growth-related words. We present our findings in the following table:
Almost all press releases (90%) bring forward the growth of the company and the increase in scale of the business, but about half of them fail to even mention profits, margins or costs. The proportion of words also goes in the same direction, as we found twice as many growth-related terms than profit-related ones (2.18 times more). Therefore, it seems that firms actually care more about growth than profit, in particular when they merge and acquire other businesses.
It is also interesting to see that “innovation” is often mentioned, which seems standard for the tech sector. It is also to be noticed that customer-related terms, which only consist in “customer” and “customers” in our statistics, are even more present than growth’s keywords. It is also coherent with our thesis: a focus on growth, and thus on higher sales, must also focus on the clients.
This abundance of customer-related keywords, both in numbers and in proportion (all our press releases mentioned it) also reminds us of the “revised sequence” of Galbraith. Indeed, the economist argues that the true economic power doesn’t rely in the hands of the consumers, but in those of the producers. The later actually create products and impose them to the market, creating thus a demand. That is not an original assertion, as it has long been a credo of the liberals. We often speak of the “Say’s Law” (from the French Classical economist J.B. Say – 1803), which states that “Supply creates its own demand”. Our findings seems to corroborate this thesis, as the firms that we mentioned actually seem to put a lot of efforts into creating their “own demand” by focusing on their customers, and on innovation. The “revised sequence” also shows why growth is so important to the firm: a larger firm with a larger distribution network and greater production capabilities, will find it easier to impose its products to the market.
To conclude, a lot of factors come into consideration when a firm wants to merge or acquire another one. Improving the innovation capabilities or increasing the profit are very important factors. However, it is very clear that growth outweighs all other determinants. Growth is the paramount goal of the Modern Firm, and Merger and Acquisitions are a consequence of this quest. Today’s evolution of the IT industry proves Galbraith right.
This article was first posted on The Market Mogul at the following address: http://themarketmogul.com/persistence-galbraith/