Although the Internet has been around for a relatively short time, McKinsey research shows that Internet-related transactions already account for about 20 percent of worldwide M&A activity, both by value and by number of deals (Exhibit 1).

The drive for growth has spurred the deal making—in contrast to M&A in more mature industries, where the driving force is often the desire to reduce excess capacity and achieve economies of scale. When the buyer of an Internet company is another Internet company, it usually acts to build up its core business (for example, an on-line stockbroker acquiring a financial-information company); to extend an existing line (an e-tailer specializing in books and music moving into toys and tools); or to expand geographically (an Internet service provider or portal company buying portals outside the home market). Internet companies that buy "landed" (physical-world) incumbents generally come from the same or a similar sector (Exhibit 2). Incumbents typically make an acquisition to jump-start their own lagging Internet activities. Frequent targets for acquisition are dot-coms involved in business services, such as ISPs, Internet consultants, and business-to-business (B2B) service providers.

We expect growth to continue to be the primary rationale for Internet-related mergers and acquisitions. Like businesses in traditional industries, however, Internet firms operating within the same sector and with complementary strengths will begin to consolidate to achieve economies of scale.

There are several reasons to expect M&A to grow in importance:

• Rapidly closing windows of opportunity. Purely organic development is often too slow to keep pace with rapid change in many parts of the Internet.
• Higher barriers to entry. Attracting customers is becoming prohibitively expensive in some of the more mature business and geographic areas. Thus M&A may be the only way to establish a foothold, even if the price is high.
• More need for control of assets. Fast-moving businesses require simple, straightforward governance models founded on full ownership of assets as opposed to joint ventures or other sharing arrangements.
• More targets available. As the Internet industry develops, some companies with strategic assets (such as privileged technology and networks) have assets tangible enough to be taken over by another company; moreover, these companies and their shareholders are at a crossroads where it may very well make sense to sell out rather than continue to build organically. Lower overall valuations and less attractive prospects for initial public offerings make these targets more affordable as well. In such circumstances, the stock of listed companies with relatively high valuations is a powerful acquisition currency.

This last point is reflected in our analysis. About 90 percent of the acquirers are publicly held—both well-established companies and highly valued Internet players that have just done their IPOs. Some companies have executed a series of acquisitions in a short period. Cisco Systems and Healtheon/WebMD, for example, completed 27 and 9 such transactions, respectively, in the 27 months preceding May 2000. Typically, the targets were less-established, unlisted companies.

But beware. The market’s reaction to announcements of deals has varied according to the type of acquirer. Acquisitions by incumbents were twice as likely to be rewarded as punished, but the market has generally frowned on acquisitions by start-up e-commerce companies. You could speculate that the market regards acquisitions as a smoke screen for their ever-increasing losses (Exhibit 3).

M&A activity has had a mixed impact on share prices. In the period studied (January 1, 1998, to May 22, 2000) the average excess return to acquirers’ shareholders has been 5 percent in the period extending from one week before to one week after the announcement of a deal. But these returns have varied dramatically—all the way from negative 47 percent to positive 260 percent—reflecting the market’s strong views on those deals. As in traditional mergers and acquisitions, the share prices of targets have generally responded in a positive way to announcements of deals, rising by an average of 19 percent during the period studied.

The number of Internet-related deals—transactions involving Internet players on the buying or the selling side—has actually increased by a factor of 11 in this period, surging from about 40 deals in January 1998 to about 450 deals in March 2000. In April and early May 2000, however, the number of deals declined significantly. NASDAQ’s sharp fall, which introduced a high degree of uncertainty about appropriate transaction terms, appears to have temporarily discouraged Internet companies from finalizing planned deals. Once the market stabilizes, it is expected that M&A activity will return to full steam ahead.