Tech M&A expert warns CIOs: Be careful what you ask for

M&A industry veteran Paul Deninger, a vice chairman at Jefferies & Co., has made a living advising companies on mergers, acquisitions, IPOs and the like. But even he acknowledges that too much industry consolidation isn't a good thing for technology innovation. I spoke with Deninger this week about the state of the M&A market and what’s likely ahead.

How would you characterize this year's network industry M&A activity?

The market in technology in 2008 has been OK, not great. The volume of transactions feels like it's been off by about a third and value has come down as well, so maybe in aggregate it's been a little under half of what it was in '07. But unlike the debt and equity markets where virtually nothing is happening, there is M&A activity going on, even in the fourth quarter.

So what of the deals that did take place, like those involving big carriers such as AT&T and Verizon Wireless?

In a tough market environment the character of the M&A transactions that will take place shifts from companies looking for growth to more consolidation. That's because your own business is not growing as fast as you would hope, so the only way to grow earnings is to cut costs and the easiest way to do that is in the context of a consolidation. We saw a lot of consolidation M&A in 2008 and I think you're going to see more of it in 2009. You could even argue that the HP-EDS transaction is a consolidation even though it greatly expanded HP's reach in services and made them even bigger than IBM in that market.

One of the things that has happened in this decade is a dramatic reduction in the number of IPOs per year. Such that we are in the eighth straight year of a decline in the number of public technology companies. You would have to go back to 1988-1989 to find a period where you had a decline in the number of public technology companies for two straight years. That's not quite a generation, but it's pretty damn close. What does that mean? The effect is that the number of buyers is shrinking and consolidation among those buyers means that those that are buying are bigger. There's been a hollowing out of the middle market and by that I mean companies with $2 billion-$10 billion in market cap. If you go back in time you would have been able to name dozens of companies that had $1.5-$2.5 billion of market cap and were aspiring to be the next Cisco or SAP or Oracle. That is very rare and almost no longer the case today because of the paucity of IPOs and the consolidation of the market.

What does the nature of this M&A activity mean to CIOs and other high-level network executives?

What I would say to CIOs is: Be careful what you ask for, you might get it. I believe that your readers and the companies they serve have benefited dramatically from the innovation cycle that we have come through. It has been driven by young entrepreneurial companies. I remember the early 1980s when IBM's innovation was dead. IBM had so much account control that they could basically say yeah, we don't need to bring this innovation to market, sort of like the automakers. Customers will buy what we tell them to buy. But technology innovation shook that status quo and it was good because enormous productivity came out of it. Massively changed business processes and improved global competitiveness came out of it. Incredible ways to access new customers in new ways to drive revenue came out of it. CIOs are more aggressively now than ever saying we don't want to buy from small companies, we want to buy from large companies, so find yourself a partner. And I just would throw a little caution to say in an environment like we're going into where the natural economic activity is going to be to drive consolidation be careful what you ask for, you might get it. If it becomes increasingly hard to sell to the customer base, if it becomes increasingly hard to get the revenue traction to go public, then the innovation engine on which you rely will die. And how far away from Cisco is IBM in 1984? The challenge and question I would put in front of your readers is that.