High barriers…to understanding

201304_stone_wall_horizonIn what has to be the second most often used throw-away line behind “[insert name] is a leading [insert industry sector] company“, is the too-frequent, inadequately supported, drive-by industry analysis summed up by “high barriers to entry.” This becomes a nails-on-chalkboard experience when so often misused by non- or under-initiated underwriters, lenders, and pundits.

Let’s take a step back to understand why entry barriers are important anyway?

Many people associate barriers to entry with the competitive analysis model outlined by Michael Porter’s “Five Forces” in his seminal work [1] published in 1980. As most will recall, the Forces are: industry competitors, buyers, suppliers, substitutes, and potential entrants. There is much to be said about raising the bar regarding analysis of competitors, suppliers, and buyers – and certainly much more to be done on elucidation of product/service substitutes. But as the focus of this post suggests, I share the view that barriers to entry are as important as the earlier mentioned Forces in determining the long-term attractiveness of a given industry. Tragically too often glossed over by analysts, lenders, and credit committees, the relative viability of barriers to entry impacts both the probability of threats from potential entrants and it influences the legacy competitors’ behavior within the industry. And entrants often make a big difference in a leveraged lending investments with longer hold horizons:

Incumbent firms – firms that are already operating – should take entry into account when making their strategic decisions. Entrants – firms that are new to a market – threaten incumbents in two ways. First, they take market share away from incumbent firms, in effect reducing an incumbent’s share of the ‘profit pie.’ Second, entry often intensifies competition. [2]

To be effective, barriers would allow incumbent firms to make a positive economic profit themselves – but make it (at least appear) unprofitable for potential entry by new firms. Besanko, et al. posit that “barriers to entry may be structural or strategic. Structural entry barriers exist when the incumbent has natural cost or marketing advantages or when the incumbent benefits from favorable regulations. Strategic entry barriers result when the incumbent aggressively deters entry. Entry deterring strategies may include limit pricing, predatory pricing, and capacity expansion…”

Here’s the rub: we find that many writers and users of financial analyses invest too little effort, rigor, and working knowledge in supporting, much less proving, their assertions of “high barriers to entry.” They should be – it is not a flip marketing term. There are typically material impacts on the attractiveness and true risk profile of investments if this assessment of the competitive landscape is inaccurate. I have seen deals go from funding to liquidation in less that 14 months where the barriers to entry where ephemeral and the customer switching costs woefully over-estimated. In one instance, a service level disruption snow-balled into a catastrophe for the portfolio company. I don’t think, to this day that the bank or lenders understood what allowed the competitive dynamics of the sector to change so radically, so quickly (an attractive niche that was, in truth, almost completely indefensible which found competitors and entrants move with a vengeance when they sensed blood in the water). Bottom line: real, sustainable barriers matter – illusory barriers do not.

Too recently, I had the painful experience of listening to an commercial banker assert in committee and in a single sentence that: “the industry is highly fragmented with thousands of mom-and-pop companies and high barriers to entry.”  This may not make you cringe now (though I did – especially when the committee raised no objection to this notion) but over future posts I will expand on the barriers to entry concept. My hope is that you’ll re-evaluate this banker’s statement and question whether he had a real grasp of the potential risks at hand (or the credit, overall, actually).

As we coach our clients involved in underwriting and debt/equity investing, we firmly believe that a thorough industry analysis and a painfully honest assessment of the target company’s real competitive position therein is a key element of any serious underwriting – and not to be left to a cut ‘n paste exercise from an stock analyst report or Confidential Information Memorandum. An credit that fits in a box, but that has not been effectively underwritten is really just a credit-time-bomb in a box – and it will impact probability of default and loss given default.

(post originally published in 2012, updated 2013)

[1] Porter, M.E. Competitive Strategy: Techniques for Analyzing Industries and Competitors. New York: The Free Press
[2] Besanko, D., Dranove, D., Shanley, M., Schaefer. Economics of Strategy. 5e. New Jersey: John Wiley & Sons, Inc.
[3] Ibid

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