How to Win in the Midst of an Industry Consolidation

Big Fish Little Fish

Industry consolidation is the process when a few companies start buying up other companies in the same industry and the number of competitors in an industry shrink dramatically. The main goal for the consolidators is to grab market share, cut costs, boost productivity, and improve investment returns through scale economies.

I’ve studied industry consolidation in business school, participated in a few industry consolidations as a consultant, and I founded a company in my current portfolio to take a lead role in consolidating its target industry.

Industry consolidation is almost inevitable: over time, most industries will consolidate to where the largest three to five companies will dominate an industry and the rest of the smaller players are rendered almost irrelevant as they retreat to specialty niches. Think homebuilders, airlines, autos, enterprise resource planning (ERP) software, or virtually any mature industry. They are all industries that started out with thousands of players, but as the industries grew up, they consolidated into larger and larger companies. This process may take less than decade or it may take several decades, but it almost always happens in a predictable pattern.

The winners in the first phase of building any industry are usually experts that developed broad knowledge about the industry and customer requirements and as pioneers build the industry from the ground up. As an industry grows and attracts more attention, there are leaders that emerge to take the industry to a new level of performance in phase two as the industry transforms from an owner/operator industry to a more mature and more consolidated industry.

The winners in this second phase are usually larger-scale consolidators with sufficient capital and leadership to invest heavily in best practices business processes and technology to provide higher service levels, better information, and more consistent results to the customers they serve. This heavy investment enables these companies to dramatically lower their operating cost and achieve higher rates of growth. However, most nascent industries shifting from phase one to phase two are a collection of equity-starved small companies that do not have ready access to venture capital or private equity and have little ability to react competitively to a well-financed threat. Therefore the winners in phase two are usually well capitalized companies that are poised to take advantage of the market consolidation opportunities.

The pattern of any industry consolidation, therefore, usually looks something like this:

1. First wave of consolidation:

  • Mistakes are often made
  • Business models are not yet perfected
  • Initial market resistance to consolidation

2. Second wave of consolidation:

  • Learn from mistakes of first wave
  • More thoughtful business models
  • Acquisition activity accelerates with educated market more ready, willing, and able to sell their business and join the consolidation effort

3. Industry goes through complete transformation:

  • Changes in capitalization
    • Capital continues to flow to the leaders to finance further growth
    • Industry leaders capital strength and scale gives them bigger budgets for R&D, sales and marketing, and infrastructure investment
  • Changes in competitive dynamics
    • Service quality rises dramatically
    • Value proposition differentiation becomes more pronounced
    • Prices decline
    • Costs are dramatically reduced
  • Changes in market share mix
    • Big customer relationships are locked up
    • Small companies feel growth and margin squeeze
    • Many small companies fail
    • Three to five industry leaders emerge and end up with the majority market share

If you choose to be a consolidator, prepare to raise a lot of capital and hire a stellar “deal team” to help you execute all of the acquisitions you will need to do in order to build a meaningful company quickly enough to become one of the final companies standing. There are several trends and/or threats which create a well-timed opportunity for industry consolidators that can attract the capital and management expertise:

  • The creation of world-class technology platforms can dramatically reduce the cost of operations and more than double earnings, but carries a price tag of millions of dollars. Such an investment is far beyond the reach of nearly every existing company in young industries. Small independent companies will typically under invest in technology and as they lose market share to larger market leaders, they will likely experience even more depressed margins as the performance gap widens between the market leaders and the average industry participants.
  • If there is a large number of small company owner/operators that decide to exit a market in the face of consolidation pressures, there can be the likelihood of a glut of sellers all trying to exit which result in a buyer’s market and lower purchase price multiples for the sellers
  • If the customer industry has already consolidated to a great extent, then this type of consolidation usually presages service provider consolidation to meet the more stringent demands of higher and higher levels of service and quality from their providers and to rebalance the power of the two negotiating parties. The ability of the smaller owner/operator companies to deliver such service levels and to achieve such negotiating power will fall short. Consolidators will usually experience market share growth at the expense of smaller competitors and leave fewer customer opportunities for those smaller firms, reducing their ability to grow their revenues and earnings.

This industry consolidation poses both threats and opportunities for the smaller industry participants. The threats are ominous for small owner/operators that try to compete without carving out a distinctive value proposition for a specific niche in the industry. When the travel agency industry consolidated, for example, nearly 75% of the small owner/operator travel agencies closed their doors. Those were the companies that held out and didn’t sell to a consolidator, were too small to be acquired, or did not recognize the need to modify their market and business model to stay relevant.

The opportunities for small company owners include building a company specifically to be acquired by a large consolidator. If you choose to “build to suit” for a consolidator, study the industry and the consolidator well and then build a company that is ideally positioned strategically and geographically for them to purchase. But do your homework. Meet with them ahead of time to ascertain their typical acquisition process, the size of companies they like to acquire, the capabilities they look for, and the purchase multiples they typically pay. That way your chances of being an attractive acquisition candidate will multiply.

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About Wade Myers

Wade has founded or co-founded, invested in, and been a director of over 25 companies and has completed 55 financing and M&A transactions. His previous work experience includes the Boston Consulting Group and Mobil Corporation. Wade also served as an Airborne Ranger in the US Army where he was a decorated veteran of the Gulf War. He is a Baker Scholar graduate of Harvard’s MBA program and is married with five children.

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