Is bigger really better?

You would think that the current problems facing mega-financial institutions (with Citigroup being the obvious poster child, but to be fair by no means the only example) that the CEO’s and Boards of large banks would think twice before thinking about pursuing large ‘industry-consolidating’ acquisitions. Don’t get me wrong, I can see how this current downturn could be seen as a seductive opportunity for anyone with a strong(er) balance sheet – not only are targets potentially cheap (at least by historical standards – setting aside concerns about visibility of future earnings) but they are possibly available which isn’t always the case (irrespective of price.) Furthermore, given the current labor market environment, the potential to actually realize efficiencies by consolidating and downsizing must indeed seem tantalizing to experienced industry leaders. And yet…

…and yet, at the risk of oversimplifying, it all just seems to underline a lack of creative strategic thinking at the top. Is the strong buying the weak, the big buying the less big, really the best or the only long term strategic choice faced by global financial services giants? Isn’t there a viable plan B? or C? At times like these, one can be forgiven for asking the question (from Here is the City news):

One upshot of the credit crunch is that some of the smaller or troubled banks look vulnerable to takeover. Only last week Bank of America CEO Ken Lewis said that he thought it will be more difficult for stand alone investment banks (like Goldman, Lehman, Merrill and Morgan Stanley) to survive, and that they may be swallowed up by commercial banking rivals with bigger balance sheets, better capital-structures and deeper pockets. Well, it didn’t take long for the rumour mill to kick into life.

The Daily Telegraph has come out Tuesday and reported that Barclays President Bob Diamond is trying to twist his board’s arm to make a bold bid for an investment bank. And, according to the newspaper, top of his wish-list is Lehman Brothers and under-fire UBS.

As the newspaper points out, Lehman would bolster investment banking arm Barclays Capital‘s presence in the US (something Diamond is keen to do), but there is significant overlaps in terms of jobs in fixed income and huge job losses are likely in the event that a deal is done. Over at UBS, of course, a large proportion of fixed income staff have been (or will be culled), so Diamond and the BarCap team won’t need to do as much axe wielding. And UBS’s equities, wealth management and private banking businesses would make a deal for the Swiss bank highly attractive.

Rumours are also swirling that Ken Lewis himself, despite his much-regretted comments last year about having about as much ‘fun’ as he could stand in investment banking, might be mulling over a run at Merrill Lynch. Although busy putting to bed the Countrywide deal at present, the smart money says that once that is sorted, Lewis might pounce (he is said to have long-coveted Merrill’s brokerage network).

I’m sure there are some good ‘consolidation’ deals out there to be had in the next 12-18 months, but I would further suggest that they will be the exceptions that prove the rule. The biggest risk in my opinion, will be when CEOs and Boards think like traders and not business leaders when considering these deals. In the majority of cases, they would be better off buying out-of-the money calls on firms they think are cheap and (if they are right) reaping the financial rewards of a good trade, rather than buying one firm lock-stock-and-barrel and having to valiantly try to manage through the (probably non-linear) increase in corporate complexity that this would engender.

I’ve been thinking about how to point you in the direction of a fantastic post by Going Private and despairing of just putting up a link saying ‘Read this’, or alternatively lamely regurgitating an executive summary, I am pleased to connect the dots in the context of the question posed above. Going Private blames the strategic ineptness of many businesses on Michael Porter and his Five Circles of Hell:

I blame Michael Eugene Porter. Not that Porter is a dipstick, (well not only that) but because the majority of his modern adherents certainly are.

The eager and almost rabid application of Porter’s “Five Forces” (Supplier Power, Customer Power, Threat of New Entrants, Threat of Substitute Products, Industry Rivalry) to technology products and services has bred an entire generation of MBAs in marketing positions dedicated to developing and maintaining closed systems and closed hardware platforms. This is particularly egregious in the case of business models that are effectively based on distribution channels. In conventional analysis there is nothing wrong with making your living on distribution channels. Remember, that in 1979, when Porter developed the Five Forces framework, distribution channels were highly expensive to create and maintain and, owing to these costs, constructing them effectively presented a significant barrier to entry. Your product didn’t even have to be particularly good, because the threat of substitutes was reduced via the difficulty and expense of the competition actually getting those substitutes (however good they might be) to your customers. Suppliers, if they wanted access to your customer base as a proxy to sell their raw materials, had to go through you. New entrants had to build an entirely new distribution channel. Customers were stuck. You owned the market. But you had to guard this distribution channel carefully. And you had to make sure you hadn’t forgotten something simple and critical. That’s not part of a conventional Porter analysis. But why would it be? Conventional distribution channels are quite physical, antique and boring.

In this post, Going Private makes the point by looking at a variety of businesses such as entertainment (videos, music), telecommunications and consumer electronics: “…particularly egregious in the case of business models that are effectively based on distribution channels.” (emphasis added) Now I would posit that this describes remarkably well much of the business of modern financial services as well. (Indeed some readers may recall my penchant for comparing the business models and the impact of technological changes thereon of the telecommunications industry and financial services…) (Mixing metaphors liberally…) bolting unreconstructed, 20th century, distribution platforms together ad infinitum, might get you a more efficient horse-and-buggy, but I sincerely doubt it will get you a car.

Admittedly this line of thinking is somewhat self-serving given that my business is predicated on helping large financial institutions develop a ‘Plan B’ and to helping them embrace new business ideas and approaches that are adapted to the new techno-economic paradigm. I am sympathetic however (see my previous post) to the institutional reality that it is often easier for a Chief Executive and his team to convince the Board to spend $10 billion on a ‘linear’ acquisition than it is to convince them to spend $10 million on an unproven ‘non-linear’ venture. We think we’ve found a way to help mitigate this behavioral paradox and plan to spend the next few years trying.

If we don’t succeed, I fear the future giants of banking will need a new mascot…

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