Barriers to Exit

What is it?

Barriers to exit are the flip side of barriers to entry. They are those aspects of the industry that make companies reluctant to leave the industry, despite earning below their cost of capital. Barriers to exit could be caused by specific assets, regulations, long term liabilities, or by owners with non-financial objectives. It is a key strategic concept in industries where companies frequently earn under their capital cost (value destruction).

When is it useful?

When considering entry into a new market, ask “What are the barriers to exit” in this market? This will not only help you create your worst-case scenario, it will also be a pointer to overall industry profitability, averaged over the business cycle.

If you are in an industry with high barriers to exit where less efficient competitors depress industry profitability, then ask “How can I lower their barriers to exit”. Airlines can take over planes and staff of failing carriers. Better strategically than having them emerge from Chapter 11 with a new capital and cost structure to depress industry returns for many more years. Chemical companies can buy-up and mothball obsolete capacity.

An Example?

A classic example is the airline industry. Even when carriers go bankrupt, new capital gets injected, the capacity remains in the industry and they re-emerge after bankruptcy proceedings. There are several reasons that barriers to exit are high:

  • Airplanes are very specific assets – you cannot use them for anything else except flying
  • They have little scrap value
  • When not in use they deteriorate. So companies will keep them flying rather than mothball them
  • Politics. Countries are tempted to subsidise rather than let their national carrier exit the business

The net result of these high barriers to exit, to quote Warren Buffet:

“I made the comment that if a capitalist had been present at Kittyhawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money…..I have an 800 number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: “My name is Warren and I’m an aeroholic.” And then they talk me down.