How capital markets have changed competitive strategies?
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3 July 17th, 2012
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How capital markets have changed competitive strategies? How capital markets have changed competitive strategies? The problem Harvard’s Michael Porter competitive strategy model, the five forces, has been with us for years. It gained recognition and became an industry standard. The logical framework, with suppliers and buyers as well as entrants and substitutes constituting a multiple of competitive forces, scored points. Yet the model was introduced in the mid eighties, a near three decades ago at a point of time when Reagan’s capital market deregulation was gathering steam. Structured finance, shadow investment banking and generous leverage ensued. They changed the nature of competition and with that the relevance and applicability of Porter’s intellectual product. This will be the focus of this article. The article starts with a review of the five force model. The framework and the underlying assumptions are examined. Derived patterns of strategic behavior are also explored. This is followed by an analysis of the cause of loss of relevance today and the role of the capital market in that. Impact of strong capital market forces on the strategic behavior of corporations is analyzed and derived novel competitive strategies are introduced. The article is based on contemporary work on capital market dynamics and innovations. Porter’s early work is, it goes without saying, provides the framework. Porter’s five forces The essence of Porters concept is that there are five forces that determine the competitive intensity and attractiveness of an industry. Attractiveness in this context refers to overall industry profitability. An “unattractive” industry is one in which the combination of these five forces acts to drive down overall profitability. An attractive industry is one where the forces enhance industry profitability. Three of Porter’s five forces refer to competition from external sources. The remainder is internal threats. Each of those five forces rest on a set of premises. Threat of entrants. The premise here is that profitable markets attract entrants and that it is in the interest of the incumbents to limit this entry. Entry barriers are, in this case, the answer. Those could include product differentiation, branding, high switching costs, strong capital requirements, denial of access to the supply chain, strong customer loyalty , and absolute cost advantage. Threat of substitute products or services. Functional substitutes within common product boundaries could create a propensity to substitute to the detriment of the existing businesses. Key variables here include the relative price performance of substitute, size of buyer switching costs, perceived level of product differentiation, number of substitute products available in the market, ease of substitution and the availability of sub-standard constituting a quality substitute . Bargaining power of buyers. The bargaining power of buyers rests on the premise that buyers are able to put the firm under pressure through firm substitution Buyers are able to do that if they are highly concentrated , if there is a high degree of dependency upon existing channels of distribution, if buyer switching costs relative to firm switching costs are high, if buyer information is available , if there are ready substitutes and if buyer price sensitivity is high. Bargaining power of suppliers. Again the premise here is the ability to exercise pressure on the firm. This could have roots in supplier switching costs relative to firm switching costs, , degree of differentiation of inputs , impact of inputs on cost or differentiation, presence of substitute inputs, strength of distribution channel, supplier concentration to firm concentration ratio, employee solidarity (e.g. labor unions) and supplier competition. Intensity of competitive rivalry. This could be the prime competitive force. The roots again lie in sustainable competitive advantage through innovation and powerful competitive strategy E-Mail:
Taken together the five forces determine the competitive strategic behavior of the firm, according to Porter. Four concepts of corporate strategy are cited: portfolio management, restructuring, transferring skills and sharing activities. Portfolio strategy, perhaps the most significant of all four, implies the use of corporate expertise and analytical resources to spot attractive acquisitions provide capital, supply managerial competency and exercise control.
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What went wrong? One of the most serious flaws in Porter s analysis, in the authors view, is the marginal attention paid to capital markets and the profound impact those would have on the scope, reach and impact of the five forces. Capital markets have undergone radical change (Farrell et al, 2008) since Porter’s early writing and there was, it goes without saying, no way for him to anticipate that. Let us recall, however, that Porter’s work and publication of Competitive Advantage (Porter, 1985) ran parallel to key economic events as Reagan’s economic policy initiatives including deregulation (Boskin, 1987) and the process of financial product, process and institution innovation that ensued. A shadow investment industry emerged with powerful structured finance instruments and equally powerful investment institutions to match (El Namaki, 2010). Monetary policies stimulated leveraged acquisition. Emboldened investment institutions as private equity and sovereign wealth funds enhanced merger and acquisition. The result of all of that were a new genre of strategies and a different pattern of strategic behavior. A behavior that embodies, among other things, capital markets as the underlying trigger of strategic moves (private equity industry), ruthless restructuring as the road to survival (General Motors) , concentration as the medium to strategic competitive advantage (Gillette) and predictable exit (Kodak). This has altered the very premises of the five forces.
The five forces are undermined, today, by capital market influence. Let us explore each. Capital market impact Entry
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How capital markets have changed competitive strategies?
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Entry decisions into an industry are driven, according to Porter, by attractive returns. One may add, also, capital access. This access has assumed great significance since the credit crisis events of 2007 and beyond and the far reaching restructuring of the American, and European, investment banking industries that ensued. Investment banking Institutions have restructured and, at times, ceased to exist. Global capital supply conditions changed too with wealth and financial assets cumulating in emerging market economies and aging population, alternative investments, and attempts at financial regulation changing capital supply conditions in developed economies an equity gap is evolving with equity input falling short of corporate investment needs. (McKinsey Global Institute, 2011) Substitution Substitution is a function of several variables one of which is the size and scope of the R and D function. There is empirical evidence supporting the notion that financial or more accurately capital supply constraints could undermine R and D and with that product and service substitution. Research done on the determinants of R&D investment and the role of financial constraints in their performance concluded that a strong relationship does exist between financial constraints and R and D. The research actually concludes that firms financially constrained, but not otherwise constrained, are adversely affected in their pursuit of R&D activity (Amaresh K et al, 2007). Buyers, Suppliers and rivals. The structure and the relationship between buyers, suppliers and rivals have undergone considerable change since the days Porter declared his premise. Capital markets have had, ever since, a profound impact on the composition of the players, their attributes and their core competencies. This was largely the result of waves of mergers and acquisitions consummated, primarily, by the private equity industry. Companies were acquired because of their patents, licenses; market share, supply chain, human resources, management or even culture .The period between 2003 and 2009 witnessed the latest of these waves (Kummer and Steger, 2008) whose thrust was dampened by the events of the financial crisis. Private equity merger and acquisition volume reached, worldwide, $ 182 billion in 2010 a full 55% below 2007 record. Yet global exit activities grew to a three year high of $232bn in the same year, despite an overwhelming hostile economic environment (Private Equity, 2011). What if capital markets are allowed into the model? Analysis done so far supports the proposal that capital markets are pivotal to competitive behavior. The introduction of forces of the capital market in Porter’s model would actually lead to the emergence of what we may term capital market driven competitive behavior. This is a behavior where capital market institutions and instruments provide the driving force. The competitive behavior could take several forms including the following: Seeking concentration. This is a behavior distinguished by a merger and acquisition effort aiming at reducing the number of competitors within an industry and increasing the concentration level within that industry. Examples are abundant in industries as varied as breakfast cereals and computing equipment in the United States. Four firms dominate those industries and have a combined market share in excess of 50%. Those levels of concentration could act as entry barriers limiting the probability of new entrants. Dynamic portfolio configuration. This strategic behavior connotes a desire to constitute a dynamic business portfolio guided by capital investment goals. This is a dynamic portfolio that might mean rapid acquisition and divestment of strategic business unit in search of strategic competitive advantage and returns. Examples are again abundant. General Electric attempts at divesting the appliance division and entry into other alternative energy industries is a typical example. Premeditated exit. This is a strategy that implies a cessation of business based on a full knowledge of the reasons for termination and even a possible enhancement of the triggers. Examples could include General Motors and Kodak. Both were quite aware of factors undermining their performance and the prospective perils. It took a President of the United States to prod the first into action and a market force to drive the second down the cliff. The difference of Porters analysis cannot be more striking. Our analysis starts with the capital market and ends with corporate strategic behavior. Porter starts with the corporation and ends with corporate driven strategic behavior. Summary and conclusions Harvard’s Michael Porter competitive strategy model, the five forces, has been with us for years. It gained recognition and became an industry standard. The logical framework, with suppliers and buyers as well as entrants and substitutes constituting a multiple of competitive forces, scored points. Yet the model was introduced in the mid eighties, a near three decades ago at a point of time when Reagan’s capital market deregulation was gathering steam. Structured finance, shadow investment banking and generous leverage ensued. They changed the nature of competition and with that the relevance and applicability of Porter’s intellectual product. The article reviews the five force model and analyses of the cause of loss of relevance today. The outcome is an adjusted five force model that takes into account the impact of capital market “innovations” and dynamics on competitive behavior. Investment capital market conditions impacts upon entry. R and D outlays are dependent on fund availability on the one hand and expected capital returns on the other. Merger and acquisition waves have increased concentration and with it a critical change in the relationship between suppliers, buyers and rivals. Three patterns of strategic behavior emerge as a result: seeking concentration, dynamic portfolio configuration and premeditated exit Capital market forces have rendered the five force model grossly inadequate. About Author Prof Dr m s s el namaki, is Dean, Victoria University, School of Management, Switzerland Retired Dean, Maastricht School of Management, MSM, the Netherlands.
[email protected], Box 122097, Dubai, UAE, Tel. +971505087490
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