M&A Insights - Value Enhancing Strategies Part 2

According to Columbia University Business School’s Bruce Greenwald, there are four major sources of competitive advantage that, particularly when wielded in combination, offer an unassailable edge: economies of scale, customer captivity, cost and government protection.2

• Scale occurs when a business has high fixed costs as a proportion of its total costs and/or network effects wherein the value of its product or service increases as more customers use it. eBay, PayPal and social networks like Instagram and TikTok are businesses that demonstrate the power and benefits of scale and network effects.
• Customer captivity is earned through customer habit and high switching costs and supports privileged, valuable access to demand. Finance professionals, for example, trained and expertly proficient on platforms intrinsic to their daily workflow like Bloomberg and Capital IQ are loathe to spend time finding and implementing alternatives.
• Structural cost, or supply, advantages arise when proprietary technology or processes (e.g., drug patents), institutionalized learning or experience (e.g., Google’s search data) and/or special access to resources (e.g., Disney’s IP trove) enable a company to deliver products or services more cheaply than competitors.
• Finally, government policy can create competitive moats for certain companies, such as those instances when regulation favors well-heeled incumbents with the resources to manage onerous compliance requirements.

Managing Director

Partner

Jason Birke

David Kaufthal

Value Enhancing Strategies for Professional Services Firm Owners: Competitive Advantages

M&A INSIGHTS

Our prior article on value enhancing strategies touched on how well articulated growth plans, management teams and incentive plans and differentiation tactics help enhance value for Professional Services firms. This installment addresses competitive advantage which, for services firms, can be particularly difficult to obtain. Businesses with sustainable competitive advantage command premium valuations because, to paraphrase one legendary investment guru, such enterprises possess enduring ‘moats’ that protect excellent returns on invested capital.1 Consequentially, one of the first questions we ask when preparing a client for an M&A or capital markets transaction is to describe their company’s competitive advantage. Common responses reference general business characteristics such as “unique culture”, “talented staff” and “brand” that sound compelling, but that do not truly represent distinctive competitive advantages. We believe competitive advantage derives from a beneficial feature unique to a particular company, which enables it to generate results superior to industry competitors and eventually discourage competition. Below, we discuss industrial-strength sources of competitive advantage, attractive business attributes often mistaken for competitive advantage and tactics that support success in sectors like Professional Services where it's secularly challenging to develop competitive advantage.

1. Source: Warren Buffett, 2007 Berkshire Hathaway annual letter to shareholders. 2. Source: Greenwald, Bruce, “All Strategy Is Local”, Harvard Business Review, September 2005;, Greenwald, Knee, et al, Curse of the Media Mogul, Penguin Publishing Group, 2009

M&A INSIGHTS

Companies generating long-term superior returns typically possess a combination of the attributes described above. Many such organizations also possess powerful brands, gifted teams and strong corporate culture, but those assets are products of and serve to reinforce existing competitive advantages and should not be confused for sources of competitive advantage themselves.

• Consider powerful brands. The once-ascendant Blackberry brand, for instance, was only synonymous with mobile communications until the arrival of Apple and Android phones. The ubiquity and strength of the Blackberry brand was not enough to hold off the competition. Brand pales in comparison to true competitive advantages like economies of scale and customer captivity in the streaming wars where the largest entertainment brands – Warner, Disney, Paramount – have, to date, been unsuccessful challenging Netflix’s dominance.
• Team and culture similarly do not hold up as true, sustainable competitive advantages. Employees can always and often do leave. In fact, retaining talent is a constant challenge across even the largest and best operators in the sectors East Wind covers. Superior talent and firm culture are often observable at companies with real competitive advantages. Those enterprises have resources to attract the highest quality talent, pay better salaries and develop rewarding corporate cultures to retain the talent and reinforce their existing competitive advantage.

Competitive advantage is particularly difficult to establish and maintain in sectors, such as Professional Services, where growth is highly dependent upon constantly expanding the talent pool. Relative success is, nevertheless, imminently achievable through - obvious as it may sound - a focus on operational excellence including some of the following tactics: creating and scaling specialized product or service portfolios that leverage an organization’s core capabilities and that are responsive to customers’ needs; exceeding customer expectations; managing costs carefully; implementing culture and compensation programs designed to reward managerial accountability and performance against challenging yet attainable goals; utilizing technology creatively to improve efficiency, reduce cost and free resources to pursue additional revenue generating opportunities; developing referral networks that drive new business; executing targeted marketing programs. Businesses that employ such means can thrive in highly competitive markets and, over time, leverage their success and relative scale, available resources, institutionalized learnings and experience into true, sustainable competitive advantages.

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