The developers of Pac-Man built an arcade game so esteemed that it resides in the US Smithsonian Institution and New York’s Museum of Modern Art. Millions of players have moved their rounded Pac-Man figure through a maze – eating small dots and earning points – while trying to avoid getting eaten by the four monsters in hot pursuit. The game is a great analogy for the economy’s industry consolidation since Pac-Man’s debut in the early 1980s.
The legal industry is a recent example of companies “eating” other companies. For years, large law practices have acquired smaller firms to both build broader geographic reach. Now the large law firms are in potential merger talks with each other.
What’s driving these talks? By leveraging overhead costs, mergers enable partners to improve profits and protect their bonuses in the face of falling revenue. The revenue shortfall comes as their clients, who increasingly view law firms as comparable for all but the very complex cases, shift work to mid-size firms that elected to remain independent.
The same pattern emerged in banking. Local banks gobbled up state banks, merged to form national banks, merging again across oceans to form global banks. As revenue shortfalls arose, global banks merged creating behemoths. In pharmaceuticals, publishing, processed food, health insurance, department stores, etc. the pattern repeats itself. Eliminating redundant people pays for acquisition premiums and the C-Suite earns bonuses.
But does this consolidation work? Pac-Man can eat special dots that bring a burst of power, enabling him to momentarily eat his enemies. Similarly, an acquisition or merger does bring a burst of power – creating scale efficiencies and driving up profitability.
But in the videogame, Pac-Man’s surge is temporary and he remains flexible to work his way through the maze and avoid the monsters. In real life, large entities joined together are far more vulnerable. They are harder to manage (witness today’s banking problems) and revenue growth much harder to maintain. Culture differences between the pieces create the equivalent of Pac-Man software bugs. And while executives hope that a consolidated industry will give them more pricing power, it does not necessarily work that way if excess supply remains. It takes only one other qualified competitor for commodity-like competition to emerge. Ask the airlines.
In essence, all these types of acquisitions and mergers do is kick the can called “How do we grow organically?” down the road with worrisome consequences. The challenge of growing earnings from a much larger scale is the reason that banks took on so much risk – starting with their involvement in Enron “loans” and ending with the 2008 financial collapse. In the biotech tools space, Invitrogen grew by acquiring smaller companies, then merged with a larger Applied Biosystems to become Life Technologies. Unable to maintain its growth rate and drive up its stock price, Life is being acquired by a still larger biotech tools company, Thermo Fisher, as it consolidates the industry.
Moreover, efficiency-seeking acquisitions lead to a reduction in employment at a time when there is a shortage of good paying jobs, creating a societal burden that is not incorporated into how the Goldman Sachs of the world calculate return. Another social cost is that the larger firms, unable to grow, turn to crony capitalism to preserve advantage. That, after all, is why the US is the only developed nation whose government does not negotiate drug prices, leading all of us to pay the price.
Therefore, when you see efficiency-seeking acquisitions remember that the Goliaths they create may look unbeatable but are burdened by inherent weaknesses, as was the real Goliath. More nimble niche “David” competitors find ways to beat them, as IBM is discovering when it tries to leverage its software acquisitions, big pharma discovered when scale only slowed down its innovation pipelines, and big banks are discovering as they encounter regional powerhouses like PNC and local business banks.
Admittedly, not all acquisitions are motivated by industry consolidation. The acquisition of a new skill set creates a very different dynamic, one that is far more strategically sound. Consolidation-driven acquisitions, by contrast, could be viewed as a variant of a Ponzi scheme. It works until the music stops which happens if leaders cannot turn larger size into meaningful differentiation and higher customer value.
Consolidation-driven acquisitions are financial plays pure and simple. Unfortunately, our economy and citizens desperately need builders and makers, not financial architects, at our companies’ helms if we are to ever overcome our jobs gap.