Advances in Mergers and Acquisitions [1 ed.] 9780857244666, 9780857244659

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ADVANCES IN MERGERS AND ACQUISITIONS

ADVANCES IN MERGERS AND ACQUISITIONS Series Editors: Sydney Finkelstein and Cary L. Cooper Recent Volumes: Volumes 1–2:

Edited by Cary L. Cooper and Alan Gregory

Volumes 3–8:

Edited by Cary L. Cooper and Sydney Finkelstein

ADVANCES IN MERGERS AND ACQUISITIONS VOLUME 9

ADVANCES IN MERGERS AND ACQUISITIONS EDITED BY

SYDNEY FINKELSTEIN Tuck School of Business, Dartmouth College, USA

CARY L. COOPER Lancaster University, UK

United Kingdom – North America – Japan India – Malaysia – China

Emerald Group Publishing Limited Howard House, Wagon Lane, Bingley BD16 1WA, UK First edition 2010 Copyright r 2010 Emerald Group Publishing Limited Reprints and permission service Contact: [email protected] No part of this book may be reproduced, stored in a retrieval system, transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without either the prior written permission of the publisher or a licence permitting restricted copying issued in the UK by The Copyright Licensing Agency and in the USA by The Copyright Clearance Center. No responsibility is accepted for the accuracy of information contained in the text, illustrations or advertisements. The opinions expressed in these chapters are not necessarily those of the Editor or the publisher. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN: 978-0-85724-465-9 ISSN: 1479-361X (Series)

Emerald Group Publishing Limited, Howard House, Environmental Management System has been certified by ISOQAR to ISO 14001:2004 standards Awarded in recognition of Emerald’s production department’s adherence to quality systems and processes when preparing scholarly journals for print

CONTENTS LIST OF CONTRIBUTORS

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INTRODUCTION

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MERGERS AND ACQUISITIONS: A REVIEW OF PHASES, MOTIVES, AND SUCCESS FACTORS Rachel Calipha, Shlomo Tarba and David Brock

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CHINA’S OUTWARD MERGERS AND ACQUISITIONS IN THE 21ST CENTURY: MOTIVATIONS, PROGRESS AND THE ROLE OF THE CHINESE GOVERNMENT Hui Tan and Qi Ai

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TRUST DYNAMICS IN ACQUISITIONS: THE ROLE OF RELATIONSHIP HISTORY, INTERFIRM DISTANCE, AND ACQUIRER’S INTEGRATION APPROACH Gu¨nter K. Stahl and Sim B. Sitkin

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OVERCOMING BIASES IN M&A: A PROCESS PERSPECTIVE Massimo Garbuio, Dan Lovallo and John Horn

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MERGERS AND ACQUISITIONS AS A RESPONSE TO INTRA-INDUSTRY DEPENDENCE Henri A. Schildt, Tomi Laamanen and Thomas Keil

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POLITICAL CONNECTIONS AND FAMILY BUSINESS DIVERSIFICATION Hsi-Mei Chung and Hung-Bin Ding

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VALUE CREATION IN CORPORATE ACQUISITIONS: LINKING VALUE CREATION LOGIC, ORGANISATIONAL CAPABILITIES AND IMPLEMENTATION PROCESSES Richard Schoenberg and Cliff Bowman

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BEYOND KNOWLEDGE BASES: TOWARDS A BETTER UNDERSTANDING OF THE EFFECTS OF M&A ON TECHNOLOGICAL PERFORMANCE Giovanni Valentini and Alexandra Dawson

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ALLURE AND DANGER OF THE BOUTIQUES: THE INFLUENCE OF THE SPECIALIZATION OF INVESTMENT BANK ON THE ACQUIRER’S PERFORMANCE Alexander Sleptsov

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LIST OF CONTRIBUTORS Qi Ai

School of Management, Royal Holloway, University of London, Egham, Surrey, UK

Cliff Bowman

Cranfield School of Management, Cranfield University, Cranfield, Bedford, Bedfordshire, UK

David Brock

School of Management, Ben-Gurion University, Beer-Sheva, Israel

Rachel Calipha

School of Management, Ben-Gurion University, Beer-Sheva, Israel

Hsi-Mei Chung

Department of Business Administration, I-Shou University, Kaohsiung, Taiwan

Cary Cooper

Lancaster University, Lancaster, UK

Alexandra Dawson

John Molson School of Business, Concordia University, Quebec, PQ, Canada

Hung-Bin Ding

Department of Management and International Business, Sellinger School of Business and Management, Loyola University Maryland, Baltimore, MD, USA

Sydney Finkelstein

Tuck School of Business, Dartmouth College, Hanover, NH, USA

Massimo Garbuio

The University of Sydney, Sydney, Australia

John Horn

McKinsey & Company, Washington, DC, USA

Thomas Keil

Institute of Strategy, Aalto University, Espoo, Finland vii

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LIST OF CONTRIBUTORS

Tomi Laamanen

Institute of Strategy, Aalto University, Espoo, Finland

Dan Lovallo

The University of Sydney, Sydney, Australia

Henri A. Schildt

Hanken School of Economics, Helsinki, Finland

Richard Schoenberg

Cranfield School of Management, Cranfield University, Cranfield, Bedford, Bedfordshire, UK

Sim B. Sitkin

Fuqua School of Business, Duke University, Durham, NC, USA

Alexander Sleptsov

College of Business, University of Illinois at Urbana-Champaign, Illinois, IL, USA

Gu¨nter K. Stahl

WU Vienna, Austria and INSEAD, France and Singapore

Hui Tan

School of Management, Royal Holloway, University of London, Egham, Surrey, UK

Shlomo Tarba

Open University of Israel, Kfar Saba, Israel

Giovanni Valentini

Bocconi University, Milan, Italy

INTRODUCTION Calipha, Tarba, and Brock start the volume off with a reminder of the fragility of mergers and acquisitions (M&As). The track record is not good, and there are many reasons for this. In truth, each of the chapters in this book takes on the challenge of understanding why the success rate of M&As is as poor as it is, on a global basis. This despite the extraordinary levels of M&A activity seen before the financial crash in 2008, and the many signs that global companies are about to embark on another wave of deal making. Nonetheless, Calipha, Tarba, and Brock have a good place to start because of their broad review of the M&A literature. These authors focus on three primary, and central, aspects of mergers and acquisitions. What do we know about M&A processes, such as due diligence and integration? Why do companies engage in mergers and acquisitions? Here Calipha and Tarba explore such motives as new market entry, acquisition of scarce resources, and synergy realization, among others. Their inquiry leads them to focus on the key managerial and organizational factors that are generally associated with M&A success, such as the relative size of M&A partners, managerial involvement, culture, and organizational structural issues. With this extensive review as a backdrop, the next three chapters in this volume focus specifically on process issues, but in quite different ways. In the first of this set, Tan and Ai examine the process Chinese companies go through in making acquisitions. They look at both state-owned enterprises and non-state-owned companies making deals to grow in other countries and regions of the world. Perhaps unsurprisingly, these authors highlight the key role the Chinese government plays in M&A. In so doing, however, this chapter not only provides new insights, but also suggests all sorts of interesting follow-up research questions. Given the role of China in the global economy, research studies like this one are critical. The second chapter on process, by Stahl and Sitkin, draws on the trust literature and research on sociocultural integration in mergers and acquisitions to develop a model of the antecedents and consequences of trust dynamics in acquisitions. The model proposes that target firm members’ perceptions of the acquiring firm management’s trustworthiness are affected by the relationship history of the firms, the interfirm distance, ix

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and the integration approach taken by the acquirer. The model explains the mechanisms by which trust and ambivalence may affect a variety of attitudinal and behavioral outcomes, and offers a number of testable propositions that are derived from this model. Process is looked at in a different way in the chapter by Garbuio, Lovallo, and Horn. Here, process is all about decision making. These authors apply a terrific methodology to four critical decisions during the M&A process – the decision to pursue an acquisition, preliminary due diligence, the bidding phase, and final due diligence – to help identify, and address, inherent biases in how managers are going about these challenges. Garbuio et al. draw on psychology to better understand how decision makers go wrong, but importantly, present some corrective strategies that can help executives overcome the biases that affect each phase in the decision-making process. Finally, these authors discuss two biases, loss aversion and comparative ignorance, that motivate decision makers to actually forego acquisitions that could provide their firms with profitable growth opportunities. This chapter is a great example of how lessons from different disciplines can add value to our understanding of M&A success and failure, and provides a deep dive into one of the reasons Calipha, Tarba, and Brock identify for why deals go wrong. One of the most well-known theories of acquisition is resource dependence theory. Actually, the theory is considerably broader than M&A, but as it turns out this theory has been particularly good at predicting whether or not acquisitions are undertaken by firms. The idea is that companies that are dependent on others will seek to reduce their dependence by buying their way out of it. So a firm that depends on a supplier or buyer in the supply chain is more likely to buy a firm like that to reduce their dependence. Jeff Pfeffer published one of the first empirical articles with this logic in 1972, but with only an occasional follow-up (Finkelstein, 1997), further exploration of resource dependence in the context of M&A seems overdue. We have two such chapters. In the first, Schildt, Laamanen, and Keil test the resource dependence hypothesis in an intraindustry context, as opposed to the interindustry setting typically modeled. They find that mergers and acquisitions among pharmaceutical firms tend to take place among firms with technological and competitive interdependencies, an important result in this stream of work. This is a careful study that also rules out alternative explanations, and will be seen as an important new insight in the literature. The second chapter in this volume that takes up resource dependence does so in a different way. Chung and Ding examine the impact of formal and informal political connections on the scope of family business diversification

Introduction

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in 35 Taiwan-based family business groups. They report that the informal political connections possessed by the parent generation owners of family business groups are better predictors of family business diversification than the informal political connections established by the children generation owners. This result complements the resource dependence theory by suggesting that durable and nontransferable political connections possessed by family leaders have a unique effect in the corporate decision to diversify. An interesting finding, and a chapter like Tan and Ai that studies a population long overdue for more investigation. The next two chapters take up a more traditional strategic management perspective on mergers and acquisitions. Schoenberg and Bowman develop a typology of acquisition value creation logics derived from the dynamic capability literature and explore the organizational capabilities and implementation processes required for the effective delivery of three value creation logics: governance-based, cost-based, and knowledge-based. These authors further develop a contingency model whereby effective corporate acquirers make a conscious choice as to their predominant value creation logic based on a consideration of their organizational capabilities, which in turn defines the characteristics of appropriate target companies and the necessary implementation actions required to realize value postacquisition. This typology has the potential to lead to considerable follow-on work, which is very encouraging and exciting. Relatedly, Valentini and Dawson look at the impact of M&As on technological performance. They argue that, when it provides additional technological resources, M&As promote the creation of more value in the innovation process. On the other hand, when it allows the redeployment of complementary assets, M&As enable more value to be captured from the innovations, and hence foster firms’ incentives in the innovation process. This chapter is on the money for what we need to understand better in the world of M&As, and is also in line with burgeoning work on the resourcebased view of the firm. The final chapter in the volume takes a fresh look at the role of acquisition advisors, and empirically examines whether acquirers are better off with boutique or bulge-bracket advisors. The key factor in this decision appears to be acquirer experience. Sleptsov finds that less experienced acquirers can benefit more from selecting a boutique advisor, perhaps because, as he argues, its deeper involvement in the decision-making process during the development of the acquisition proposal and more focused and selective information gathering can help minimize the negative consequences of the cognitive overload that the inexperienced acquiring managers might

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otherwise experience. At the same time, more experienced acquirers with presumably better developed acquisition decision-making routines should be better off selecting a bulge-bracket bank as their advisor – in order to enhance its ability to collect all pertinent information related to the planned acquisition. In all, the nine chapters in Volume 9 of Advances in Mergers and Acquisitions continue to follow the hallmark of the series – innovative work by scholars around the world on fundamental questions concerning mergers and acquisitions. We anticipate these chapters will be very well received by the research community, and generate in turn further work on this essential topic.

REFERENCES Finkelstein, S. (1997). Inter-industry merger patterns and resource dependence: A replication and extension of Pfeffer (1972). Strategic Management Journal, 18, 787–810. Pfeffer, J. (1972). Merger as a response to organizational interdependence. Administrative Science Quarterly, 17(3), 382–394.

Sydney Finkelstein Cary L. Cooper Editors

MERGERS AND ACQUISITIONS: A REVIEW OF PHASES, MOTIVES, AND SUCCESS FACTORS Rachel Calipha, Shlomo Tarba and David Brock ABSTRACT Mergers and acquisitions (M&As) have become an increasingly broadbased phenomenon, and their numbers are growing dramatically in the United States, Europe, and elsewhere throughout the globe. Still, research shows us that less than 50% of M&As succeed. At the same time scholarly research on M&As abounds, presenting the opportunity to step back and review what we have learned and what we still do not know. Although the field of M&A research is far too broad and complex to be covered in one review essay, we attempt to begin at the beginning, covering some historical and background issues before surveying three topics fundamental to successful M&As. First, in order to lay the foundations for better understanding of M&A processes in general, we overview various approaches from those that include just two phases – premerger and postmerger – to those with seven phases – including aspects of due diligence and integration phases. The second topic refers to M&A motives such as entering a new market, gaining new scarce resources, achieving synergies, and so forth. The third issue is M&A success factors. Here we synthesize a large body of research that has pointed to many different managerial and organizational factors that are generally associated with M&A success, for example, relative size of M&A partners, managerial Advances in Mergers and Acquisitions, Volume 9, 1–24 Copyright r 2010 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1108/S1479-361X(2010)0000009004

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involvement, culture, and organizational structural issues. While no review of these topics can claim to be comprehensive, we do attempt to present a good variety of literature approaches representing not only elite scholarly journals but also some important practitioner-oriented books and articles.

INTRODUCTION Numerous empirical researches attempted to identify external variables (related to the field and the environment) and internal variables (related to the companies involved in the process) that will help predict the success of the mergers and acquisitions (M&As), both domestic and international. However, we know very little, and there is a large gap between the dominance and number of the M&As in the world and the outcomes of academic research in this field (Shimizu, Hitt, Vaidyanath, & Pisano, 2004). King, Dalton, Daily, and Covin (2004) on their part maintained that even with the impact of variables such as previous experience in acquisition, mode of payment for the acquisition, level of relatedness between the companies and the type of acquired company, variables that seem to greatly influence the acquisition success, a significant correlation has not been identified between them and the M&A success. These findings pose a great and complex challenge to the researchers in the field of M&As and indicate the need to continue to research in depth and in breadth the parameters that influence the overall M&A deal success. The growth in M&A activity, the volume of capital involved, and the pervasiveness of M&A stand in sharp contrast to their high rate of failure. Marks and Mirvis (2001) noted that at best one-quarter of M&As achieve their financial objectives. According to the Accenture and the Economist Intelligence Unit global M&A survey of 2006, present-day corporate strategy is focused firmly on M&As as a tool for promoting future growth and creating sustainable value. As a result, companies are aggressively seeking and buying compatible and synergistic businesses to bolster core strengths, and shedding noncore operations. Many companies, however, still fail to capture the much anticipated added value from M&A deals. When asked to draw on their recent experience to pinpoint the critical elements of a successful crossborder M&A transaction, respondents most often cited ‘‘orchestrating and executing the integration process’’ (47% of respondents), conducting due

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diligence (43%), and energizing the organization and understanding cultural issues (40%). The same factors were generally regarded as key to successful domestic transactions as well, although in cross-border deals the emphasis on cultural differences and various postacquisition integration approaches is naturally greater (Accenture & Economist Intelligence Unit, 2006). Another report on M&As produced by the Boston Consulting Group (2007) shows that the popular assumptions underpinning current thinking on M&A are based not merely on averages but also on unrepresentative averages derived invariably from small case studies originating from particular industries and relatively narrow time frames. This approach has fueled a dangerous one-size-fits-all approach to M&As, contributing to their persistently high failure rate. At times the need to move rapidly is indeed essential throughout the consummation of the M&A deal, but speed must be balanced against other considerations. On some issues it is advisable to move deliberately; on others, more trenchant action may be necessary, depending on a variety of factors such as strategic fit, synergy potential, and cultural differences between amalgamating entities (Deloitte Report on M&A, 2007). M&As are a common managerial strategy, whether used by firms to enter new markets, subdue a rival, or acquire valued resources such as technology, locations, or people. Scholarly research on M&A abounds, not only from within the strategic management area – which tends to justify M&A in terms of synergies and competitive advantage – but also from the financial management area – which has an interest in risk-reducing portfolio effects. While on the one hand M&A continue to be a popular corporate strategy (Gopinath, 2003), on the other hand there is unrelenting evidence that M&A failure rates are high (Kitching, 1967; Brockhaus, 1975; Lubatkin & Lane, 1996; Cartwright & Schoenberg, 2006). For example, M&A activity involving Israeli companies that were either acquired or merged totaled $3.2 billion in 2007 in 75 deals – the second highest number of M&A deals in any one year to date. M&As of VC-backed Israeli companies in 2007 totaled $1.9 billion and consisted of 32 deals. According to Israeli Venture Capital Association General Manager Guy Holtzman, ‘‘In times of uncertainty in capital markets, exits generally take place through M&A transactions rather than IPOs. Global technology firms with operations in Israel may well take advantage of the current economic situation and expand their local activities through acquisitions.’’ Israeli companies were also on the acquiring side in some 60 deals in 2007, including about 20 where one Israeli company acquired another Israeli company, and nearly 40 acquisitions of foreign companies. Israeli

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companies spent $2.15 billion on M&As in 2007, of which $1.96 billion was for acquisitions of foreign companies. In this chapter we begin by acknowledging the dismal track record of M&A strategy in general, and proceed to review the literature on the topic with the objective of improving and integrating understanding of M&A. Specifically our chapter concentrates on three fundamental topics, namely M&A phases, motives, and success factors.

M&A SWINGS AND ROUNDABOUTS? Business M&As do seem to come in waves, perhaps fashions. ‘‘Like the mini-skirt, discotheques, and anti-war demonstrations, business mergers and acquisitions were a fashion of the 1960s’’ (Brockhaus, 1975, p. 40). Lubatkin and Lane (1996) similarly talk about a ‘‘wave’’ of mergers in the 1990s. However, Brockhaus (1975, p. 40) continues to explain that, unlike other fashions, ‘‘this one had dire consequences for many of its most enthusiastic fans. One-third of all corporate mergers and acquisitions since World War II have failed and dissolved, while more than one-half have merely endured with mediocre results.’’ While acknowledging the chronic M&A track record in his classic paper, ‘‘Why do Mergers Miscarry,’’ Kitching (1967) also suggests that there are important lessons to be learned by studying M&A processes. Until now there does not seem to be a concerted effort to consolidate M&A knowledge and thus to provide the basis for the learning advocated by Kitching et al. Lubatkin and Lane (1996) found that the mergers of 1990s were not different from mergers during the 1980s and 1960s. According to them, the myths that drove the 1960s continued to influence mergers in the 1990s. These myths include blind faith in portfolio models, risk reduction via unrelated diversification, and obtaining synergies via related M&As. A common theme in explaining merger failure is overattention to financial factors at the expense of the human and organizational elements. According to Boland (1970), personnel factors, particularly top management talent and the depth of management talent, need more consideration at the premerger stage. Levinson (1970) attributes M&A failures to be psychological considerations not being given as much attention as financial issues. Mirvis and Marks (1992) concur, asserting that management usually pays great attention to the M&A’s financial issues and not enough to organizational fit, cultural issues, and psychological factors. A similar viewpoint comes from Appelbaum, Gandell, Yortis, Proper, and Jobin (2000b) who conclude that

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in order for an M&A to give the company a long-range competitive advantage, more attention needs to be paid to behavioral, as well as the financial and the legal, approaches. In order to lay the foundations for better understanding of M&A in general, we first consider the topic of M&A phases. Perhaps analogous to medical students initially studying anatomy before dealing with the health of their patients, we would like to know more about the relevant components of the M&A process in order to clarify terminology and process. The second topic to be reviewed is that of M&A motives. As noted earlier, there is a wide variety of reasons a firm may want to acquire another, and successful management approaches are surely contingent on these motives. Again, from a fundamental perspective, we would like to understand the breadth and variety of motives firms may have for seeking M&As. The third and final issue is M&A success factors. Here we survey and synthesize a large body of research that has pointed to many different managerial and organizational factors that are generally associated with M&A success.

MERGER AND ACQUISITION PHASES To understand better what the various component parts, phases, or stages of M&A might be, we reviewed prior research in the area and found various approaches from two to seven phases. For example, Boland (1970) divided the M&A process into two phases: premerger and postmerger. Schweiger and Weber (1989) divided the process into premerger and implementation. Salus (1989) divided the process into three phases: premerger, merger, and postmerger. Appelbaum et al. (2000b) and Appelbaum, Gandell, Shapiro, Belisle, and Hoveven (2000a) also structured the process into three phases: premerger, during, and postmerger. Yet according to Carpenter and Sanders (2007), there are four phases to a merger: idea, justification (including due diligence and negotiation), acquisition integration, and results appraisal, whereas Vance, Fery, Odell, Marks, and Loomba (1969) agree on that there are four phases, contributing the following colorful names and definitions: The courtship: This phase is the time – when possible – to familiarize the management of the acquired company with the advantages to both companies of the proposed marriage and how you envision these advantages to be brought about. Management philosophies, company policies, objectives, and strategies of both companies should be discussed (p. 156).

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The marriage ceremony: This second phase of the merger is primarily a legal step. All of the key management are brought together, so the top officer of the acquired company can announce the marriage and the reasons for it. An announcement directed to the employees of both companies is made at the same time as the public release of information (p. 156). The honeymoon: ‘‘The deal is made and the ‘real’ management and personnel integration begins. Two-way communication is the major objective during the honeymoon period’’ (p. 156). After the honeymoon: ‘‘This is the ‘adjustment’ phase – the ribbon has been tied around the two companies, the philosophical infusion has started to take effect’’ (p. 159). According to Farley and Schwallie (1982), the process has six phases: integration with the strategic plan, intelligent screening, evaluation of targets through creativity and analysis, understanding value and price, anticipating the postacquisition phase, and efficient implementation. According to Kazemek and Grauman (1989), the process has seven phases: assessment, joint planning, issues analysis, structure selection, securing approvals, final planning, and implementation. Finally, Parenteau and Weston (2003) maintain that the M&A process has four typical phases – strategy planning, candidate screening, due diligence and deal execution, and the ultimate integration phase. Interestingly, while researchers and practitioners point out that effort toward integration during the postmerger integration period is critical to performance (Schoenberg, 2000; Schweiger & Goulet, 2000), the interrelationships between synergy potential exploitation between amalgamating firms, integration approaches, corporate and national culture, and eventually their influence on the success of international mergers are not clear (Weber, Reichel, & Tarba, 2006). Moreover, rather strikingly the results of empirical studies are inconsistent and even contradictory (Shimizu et al., 2004). A summary of the M&A phases in the literature is presented in Table 1. The above brief selection of M&A phases clearly shows our field’s ability to be ‘‘splitters’’ – that is, to analyze a phenomenon into component parts. As the scholarly field of strategy research reaches maturity, we are clearly witnessing a tendency of scholars to look at parts rather the whole. Moreover, in their recent British Journal of Management overview article, Cartwright and Schoenberg (2006) reflect on the growing interest in

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Table 1.

M&A Phases and Corresponding References.

The M&A Phases Premerger and postmerger Premerger and implementation Premerger, merger, postmerger Premerger, during, and postmerger Idea, justification (including due diligence and negotiation), acquisition integration, and results The courtship phase, the marriage ceremony, the honeymoon, and after the honeymoon Integration with the strategic plan, intelligent screening, evaluation of targets through creativity and analysis, understanding value and price, anticipating the postacquisition phase, and efficient implementation Assessment, joint planning, issue analysis, structure selection, securing approvals, final planning, and implantation Strategy planning, candidate screening, due diligence and deal execution, and the ultimate integration phase

References Boland (1970) Schweiger and Weber (1989) Salus (1989) Appelbaum et al. (2000a, 200b) Carpenter and Sanders (2007) Vance et al. (1969) Farley and Schwallie (1982)

Kazemek and Grauman (1989)

Parenteau and Weston (2003)

postmerger integration among contemporary researchers. Similarly, topics such as postacquisition resource transfer (Capron & Pistre, 2002; Ranft, 2006), postacquisition performance (King et al., 2004), speed of integration (Angwin, 2004; Homburg & Bucerius, 2006), and postacquisition integration strategies (Puranam, Singh, & Zollo, 2003, 2006; Puranam & Srikanth, 2007; Zollo & Singh, 2004) have been common in recent issues of the Strategic Management Journal. While it is beyond the scope of this review chapter to question why scholars generally tend to focus on certain subareas over time, and specifically why the postmerger phase seems to be gaining in popularity, this review should at least serve as a reminder that M&A research potentially covers a broad range of topics reflecting a variety of functional bases. Corporations may assign different teams of specialists – experts in negotiations, valuation, human resource management, technology, and law – to deal with specific phases. Researchers may focus their papers on narrow topic. However, it behooves us all also to see the big picture – be it comprised of two, three, four, or more parts – so as not to stray from the overall strategic mission of our work. In the following section we continue with the concept of strategy to ask and answer questions about why firms embark on acquisitions in the first place.

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MERGER AND ACQUISITION MOTIVES There are several explanations for why M&As occur, and Seth, Song, and Pettit (2002) argue that understanding these motives is key for understanding M&A success or failure. The primary reason for an M&A is to achieve synergy by integrating two or more business units in a combination with an increased competitive advantage (Porter, 1985). The other two M&A motives, according to Carpenter and Sanders (2007) and Seth, Song, and Pettit (2000), are managerial self-interest (or materialism) and hubris, neither of which we will dwell on in this review. What is synergy? According to Campbell and Goold (1998, p. 139), ‘‘The word synergy is derived from the Greek word synergos, which means ‘working together.’ ’’ In business usage, synergy refers to the ability of two or more units or companies to generate greater value working together than they could working apart. Carpenter and Sanders (2007) mention five sources of synergy, namely reducing threats, increased market power, cost savings, increased financial strength, and leveraging capabilities. Along very similar lines, Campbell and Goold (1998) continue to identify six forms of synergy: 1. Shared know-how – units/companies often benefit from sharing knowledge or skills. 2. Shared tangible resources – units/companies can save a lot of money by sharing physical assets or resources. 3. Pooled negotiating power – by combing their purchases, different units/ companies can gain greater leverage over suppliers, reducing the cost or even improving the quality of the goods they buy. 4. Coordinated strategies – it sometimes works to a company’s advantage to align the strategies of two or more of its businesses. Coordinating responses to shared competitors may be a powerful and effective way to counter competitive threats. 5. Vertical integration – coordinating the flow of products or services from one unit/company to another can reduce inventory cost, speed product development, increase capacity utilization, and improve market access. 6. Combined business creation – the creation of new businesses can be facilitated by combining know-how from different units, extracting discrete activities from various units and combining them in a new unit, or establishing internal joint ventures or alliances. Contemporary M&As are commonly justified as intending to provide cost savings. This is often in concert with the above-mentioned vertical integration synergy, indicated by Townsend (1968) as using a common

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manufacturing facility or research laboratory, for example, companies may gain economies of scale and avoid duplicated efforts. M&A is often linked to a business or competitive strategy such as entering a new product/market segment or changing the basis of competition. These M&A motives include:  to develop a new niche, enlarge the product line, or complement the products or service of the acquiring company (Levinson, 1970);  to increase market power (Pennings, Barkema, & Doma, 1994; Trautwein, 1990);  increasing market share (Gopinath, 2003). M&A is at least often couched in corporate strategic terms – that is, part of an intended pattern of relationships between business units within a larger family of businesses. In these cases the strategy could be one of relative concentration (remaining within the same or related industries) or diversification (branching into other industries). Wheelen and Hunger (2001) expand these two categories as follows: (a) Two kinds of concentration strategies:  Vertical growth – the firm grows vertically in the value chain from extracting raw materials to manufacturing to retailing.  Horizontal growth – the firm expands horizontally, around the same location in the value chain. The firm can accomplish this by expanding their products into other geographic locations and/or by increasing the range of products and services offered to current markets. (b) Two kinds of diversification strategies:  Concentric diversification – the company grows into a related industry with the goal of synergy.  Conglomerate diversification – the company grows into an unrelated industry; here, the primary concern is financial. A summary of all the motives and corresponding references is given in Table 2. Our review of M&A motives has reminded us of the importance of the ‘‘diversification’’ concept in this regard. However, research on diversification (e.g., Graham, Lemmon, & Wolf, 2002; Campa & Kedia, 2002; Palich, Cardinal, & Miller, 2000) has consistently questioned the efficacies of these strategies. Simply, diversifying firms move from a business/product/market domain in which they are relatively well established with critical resources (such as experience, supply chain partners, and reputation) to a domain in which they are likely to have less of those resources (Hitt, Bierman,

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Table 2.

M&A Motives and Corresponding References.

The Motive

References

Enlarge the product line or complement the products or services Growth in market power Increase market share Spread the risk by investing Synergy

Levinson (1970)

Pennings et al. (1994), Trautwein (1990) Gopinath (2003) Pennings et al. (1994), Trautwein (1990) Campbell and Goold (1998), Carpenter and Sanders (2007), Porter (1985), Seth et al. (2000, 2002), Townsend (1968)

Uhlenbruck, & Shimizu, 2006a). The potential problems are compounded in the contemporary global environment in which cross-border M&As are more and more common. As such, the diversifying firm must constantly cope with the inefficiencies involved with entering remote markets, unfamiliar legal systems, and foreign cultures (Brock, Yaffe, & Dembovsky, 2006). While some firms may experience positive learning effects as they expand, our survey of research on firm diversification has thus far not found these benefits to be consistently significant (e.g., Palich et al., 2000; Hitt, Tihanyi, Miller, & Connelly, 2006b). And while techniques such as foreign assignments and unified corporate language are proposed to overcome cultural barriers, they can also meet with opposition (Dvorak & Abboud, 2007). The international arena certainly presents the corporation with intriguing opportunities – for example, to organize overseas acquisitions into centers of excellence (Frost, Birkinshaw, & Ensign, 2002) or as alternatives to greenfield investments (Harzing, 2002). However, managers, researchers, and investors alike should still be alarmed at M&A failure rates (Cartwright & Schoenberg, 2006) and should be mindful of the need for M&A motive to be clearly in the valuecreating ‘‘synergy’’ category rather than the other two (self-interest and hubris) mentioned by Carpenter and Sanders (2007). This cautionary sentiment leads us naturally on to the next section of this chapter.

M&A SUCCESS FACTORS The next part of our journey to better appreciate M&A effectiveness is to survey the literature to see what others had written about indicators of M&A success. Here we found a wide range of issues that have been found

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to influence M&A success. We arrange our findings into the following 12 categories and further subcategories of M&A success factors. Strategic Motive Linking back to the prior section of this chapter, it is important that an M&A’s motive is strategic, failing which the acquisition will likely not be compatible with the corporate capabilities and goals. When considering its objectives, a company needs to take into account its own competitive status, strengths, and weaknesses, and top management’s aspirations and competencies (Mirvis & Marks, 1992). Kitching (1967) wrote that managers have two different approaches to an M&A decision: ‘‘golf course’’ implies that the management jumps at an opportunity that may arise serendipitously and ‘‘crystal ball’’ implies that the management thinks strategically and the decision is a part of an overall corporate strategy of the company. Based on 22 executive interviews, Kitching concluded that companies which use the ‘‘golf course’’ approach failed and companies which use the ‘‘crystal ball’’ approach succeeded. A few years later, Levinson (1970) added that there can also be two psychological reasons for M&A: ‘‘fear’’ implies that merger derives from the feeling that unless the company grows, larger companies will destroy it and ‘‘obsolescence’’ implies that merger is an attempt to refresh – because organizations, like aging people, become more stereotyped in their ways, less adaptable to changing condition, and less flexible in their efforts to cope with their environments. The psychological terminology aside, these are both examples of strategic motives. Like the ‘‘synergy’’ concept discussed above, and unlike the materialism and hubris motives mentioned by Seth et al. (2000), it is important that the M&A begin with some value-creating logic that is consistent with the corporate strategy. A firm that plans an M&A needs to identify and evaluate its objectives as early a possible (Brockhaus, 1975), or face the likelihood of inconsistent intentions and results. Type and/or Degree of Diversification Still in the strategic domain, the type of the diversification that the acquisition intends to achieve – be it horizontal, vertical, concentric, or conglomerate – influences the match and relationship between the acquiring and acquired company. This match may well influence the performance. Research findings suggest that most firms generally prefer related to unrelated acquisitions

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(Hayward, 2002; Palich et al., 2000), and that related diversification is more profitable (Park, 2003). Kitching (1967) interviewed executives from 22 companies who were involved in 69 acquisitions. He measured success by the financial results, comparing forecasts to the results two to seven years after the M&A. The results were: conglomerate (45% of the total) accounted for 42% of all failures, concentric marketing (13% of the total) 26% of all failures, concentric technology (14% of the total) 21% of all failures, horizontal (25% of the total) 11% of all failures, and vertical integration (3% of the total) 0% failures. These results imply that horizontal mergers are relatively successful, while concentric marketing and technology acquisitions together have the greatest failure rates. Porter (1985) shows that horizontal and concentric mergers are more closely associated with higher synergy than conglomerate and vertical mergers and, therefore, have the potential to outperform the latter. The explanation for the different results in the aforementioned Kitching study, according to Weber, Shenkar, and Raveh (1996), can be that some horizontal mergers have more problems than conglomerates when there are different cultures; when the cultures are similar, the companies will have synergy and the process will succeed. Bruton, Oviatt, and White (1994) found, in their study, strong support for the theory that related acquisitions of distressed firms (companies which need to sell all of their assets) perform better than unrelated acquisitions of distressed firms. Lubatkin and Lane (1996) conclude that ‘‘When a corporation puts its eggs in different baskets by diversifying into unrelated and marginally related businesses, it actually decreases its ability to protect each of them – too many businesses to run and too few commonalities among them.’’ This statement states what has become a common assumption in the 40 years since the Kitching (1967) study, namely that related acquisition involves less risk compared with acquisition of unrelated firms and is thus more likely to succeed.

Selection Criteria Selection criteria are the criteria determined by the acquiring company’s search team for selecting potential merger partners. The decision about the criteria is critical since it helps the company to be consistent and not be influenced by emotions or react impulsively (Kitching, 1967). Successful corporate leaders select strategic criteria by consensus to aid the search team in choosing suitable candidates (Mirvis & Marks, 1992). The following two sections discuss the two most common and important criteria used, price and strategic fit.

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Price The price paid for the acquired firm is generally considered to be a key success criterion (Kitching, 1967). According to Severson (1989), before the company decides to acquire, it needs to thoroughly analyze the acquired company’s assets in order to verify their market value. The company needs to check if there are any loans or documentation problems. This careful assessment will let the acquirer offer a fair purchase price and maximize the benefits of the deal. Rappaport (1979) and Terry (1982) emphasize the importance of valuation and pricing of acquisition, and it stands to reason that the acquirer’s financial performance will suffer in the long run if the price paid for an acquisition is more than it is worth, even allowing for any synergetic benefits. In contrast, Smith (1997) found that there is little correlation between price premiums and whether the deal creates value. Similarly Kusewitt (1985) did not find any relation between the price paid and the performance. There are expensive deals that create value and bargains that lose money. The explanation can be that most important is not only how much you pay but also what you can do with the acquired company in order to turn it to a good transaction. Strategic Fit The other important selection criterion is strategic fit, which is defined as ‘‘the degree to which the target firm augments or complements the parent’s strategy and thus makes identifiable contributions to the financial and nonfinancial goals of the parent’’ (Jemison & Sitkin, 1986, p. 146). Schweiger, Weber, and Power (1989) define strategic fit as ‘‘synergies that create competitive advantage.’’ Both of them mentioned that strategic fit could influence on the success of the acquiring companies. According to the literature review by Lubatkin (1983), the company’s gains or losses from a merger are dependent on the strategic fit between the competitive strengths and market growth rates of the acquiring and acquired companies. The more they fit, the more gain is possible. This point links back to the strategic issue of ‘‘diversification’’ discussed above.

Management Involved in the Process Boland (1970) mailed questionnaires to a random sample of companies involved in the 2,815 mergers announced during the first half of 1969. The first question asked of the chief executives concerned the consideration they gave to 26 marketing, manufacturing, financial, and personnel aspects

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during a premerger evaluation of the acquired company. He found that strong consideration by top executives was given to top management talent (76%) and depth of management talent (62%). These managers need to be specialists in different areas and, in spite of the differences, they need to work cooperatively to solve any conflicts (Mirvis & Marks, 1992). The following two categories thus relate. Human Resource Management Building on the above logic, it is essential to involve the HR executives as early in the M&A process as possible (Mirvis & Marks, 1992). HR knowledge about the human side of the employees, for example, motivation, can be essential to managing the postmerger integration. Also, differences between the acquiring and acquired company in job grading, training, performance appraisal, career development, salaries, and other aspects of HR management need to be given attention (Mirvis & Marks, 1992). Schweiger et al. (1989) examined the human resource factor, asking executives from 80 companies to evaluate 15 human resource criteria and whether they were considered in the M&A decision – for example, executive compensation plans and employment agreements. They found that these criteria did not get a lot of attention, although they are very important to the success of the company. According to the study by HR consulting firm Towers Perrin in 2000, only 39% of HR people were involved in due diligence; by 2005 the number had grown to 62% (Brown, 2005). Operating Managers and Key Staff People Further, when considering inclusion of managers in the M&A process, it is important to remember that operating managers and key staff have the dayto-day knowledge the firm needs to operate. They are the people who implement the acquisition decision. Their involvement in the prestage can have a huge contribution, not only to the nuts and bolts of the implementation but also to their general commitment to the future merged organization (Drucker, 1981; Searby, 1969).

Culture Most management researchers and practitioners point out that cultural differences and integration efforts during the postmerger integration period are critical to performance (e.g., Stahl, Mendenhall, & Weber, 2005; Shimizu et al., 2004). However, the interrelationships among corporate

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culture, national culture, and integration approaches, as well as their influence on the success of international mergers, are not clear (Stahl & Voight, 2008). Moreover, the results of empirical studies are often contradictory (Schoenberg, 2006; Teerikangas & Very, 2006). Cultural differences create organizational challenges that impede integration and increase acquisition costs (Brock, 2005; Cartwright & Price, 2003). National cultural differences are often cited as complicating business transactions in general (Hofstede, 1980) and are associated with M&A failure (Li & Guisinger, 1991). Mayrhofer (2004) shows how national culture influences antecedent choices to M&A. Brock, Barry, and Thomas (2000) show how cultural differences have more powerful effects from the headquarter to subsidiary direction than vice versa, and illustrate how language differences impede interunit understanding. Corporate culture is defined by Schein (1985) as ‘‘the beliefs and values shared by senior managers regarding appropriate business practices.’’ Weber and Schweiger (1992) recommend that management should pay as much attention to cultural fit (corporate and national) during the premerger search process as it does to financial and strategic factors. According to Appelbaum et al. (2000b), the decision of which model of organizational culture will be used needs to be determined in the prestage. The different models to be considered are:  using one or the other culture;  creating a culture that incorporates the strongest aspects of either culture;  creating a completely new culture that does not use either as its base.

Difference in Size Difference in size between acquiring and acquired company can reflect lack of empathy and misunderstandings between organizations of hugely disparate proportions. Common results are lack of knowledge of the (large) acquiring company about the competencies needed for managing a small company, and vice versa. There are a number of ways to measure difference in size, for example, the difference between the numbers of employees of the acquiring and the acquired company or the difference between the sales or the assets. Brockhaus (1975, p. 44) defines size mismatch as, ‘‘a situation in which the sales of one firm are less than two percent of the sales of the other’’ and asserts that 84% of the mergers deemed failures since World War II were size mismatches by this definition.

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Bruton et al. (1994) hypothesized that the ratio of acquired firm to acquiring firm size has an association with performance of acquired distressed firms, but the hypothesis was not supported. The distressed firms were firms in which all the assets were sold to another firm. The study concerned 817 firms that had been acquired between 1979 and 1987 (32 acquisitions were eliminated later because of a number of problems). Relative size was measured as the ratio of the acquired firm’s revenue to that of the acquiring. The performance was measured by subjective measure using a panel of academic evaluators composed of three faculty members from universities. They evaluated the success on a scale of 1 (very unsuccessful) to 7 (very successful). Bruton et al.’s (1994) conclusion was, ‘‘Perhaps relative size had no effect on acquisition performance because its effect was too weak.’’ The lack of effect may also be attributed to good management, as implied by Kitching (1967, p. 92): ‘‘Size mismatch can be overcome with the use of the right organizational structure and reporting relationship.’’

Organizational Structure Organizational structure should be examined at the early merger phases since it is an integral part of management and corporate policies (Brockhaus, 1975). The acquiring company has several decisions to make, including how to structure the resulting firm postmerger. Level of decentralization, for example, is a critical issue. In addition to creating resistance and resentment where autonomy is removed, predominantly centralized decision making has the potential to isolate top management from the rest of the organization (Young & Tavares, 2004). According to Brockhaus, in decentralization, the acquired company can continue with their values and the employees can continue to work within their established operating patterns. This avoids confusion and the acquired company works independently and separately, but is still under supervision by the parent company. Boland (1970) found that 42% of the executives gave consideration to the compatibility of the organization structure.

Control System An issue related to structure is control. Differences in control systems can lead to defective reporting relationship between the acquiring and acquired

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company; thus, they should be negotiated as soon as possible in the M&A process to avoid future misunderstandings. Mirvis and Marks (1992, p. 72) give an example of this difference, describing the ultimate situation whereby ‘‘Bureaucracy at one [side] and ‘adhocracy’ at the other can cause a problem.’’ For example, at the time that HP acquired Apollo, HP controlled its divisions formally while Apollo functioned more like a closely knit team. That difference caused integration problems for the merger.

Comprehensive Examination of All Stakeholders Even though there may be many complex stakeholder groups – such as customers, suppliers, employees, unions, local communities, and stockholders – it is very important to take them all into account, anticipate any resistance, and clearly identify potential threats and opportunities (Mirvis & Marks, 1992). This examination avoids future resistance and possible confrontations with key stakeholder, which can result in lost revenues and other negative outcomes.

Analysis of Future Capital Need A critical mistake is underestimating the future investment and other capital needs at the acquired company before signing on the deal (Kitching, 1967). Missing something at this level can cause major financial difficulties later on.

Ambiguity While there usually is substantial ambiguity during the prestage, by the end of the due diligence process the managers of successful M&As aim to resolve any outstanding details, obtain answers to questions, and generally avoid any misunderstanding (Jemison & Sitkin, 1986). Continuity of the ambiguity to the integration stage can lead to severe misunderstandings. A summary of all success factors is presented in Table 3. The contemporary emphasis on theory development in top quality scholarly journals has led to less emphasis on basic main effects – such as key success factor’s influence on performance – than was the case three to four decades ago when the strategy research field was in its infancy. Our review thus still relies heavily on older research in which basic M&A

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Table 3. Factors Influencing the Success/Failure of M&A. M&A Success/Failure Factors

References

Strategic motives: strategy or passion The type and/or degree of diversification

Brockhaus (1975), Kitching (1967), Levinson (1970), Mirvis and Marks (1992), Seth et al. (2000) Bruton et al. (1994), Kitching (1967), Lubatkin and Lane (1996), Porter (1985)

Selection criteria

Brockhaus (1975), Kitching (1967), Mirvis and Marks (1992) Kusewitt (1985), Rappaport (1979), Severson (1989), Smith (1997) Terry (1982), Jemison and Sitkin (1986), Lubatkin (1983), Schweiger and Weber (1989)

Price Strategic fit

Management involved in the process Specialists Boland (1970), Mirvis and Marks (1992), Schweiger and Weber (1989) Human resources Brown (2005), Mirvis and Marks (1992) Operating managers and key Jemison and Sitkin (1986) staff Culture

Difference in size Organizational structure System of control Examination of all shareholders Analysis of future need Ambiguity

Appelbaum et al. (2000b), Brichacek (2001), Brock (2005), Brock et al. (2000), Gopinath (2003), Hofstede (1980), Li and Guisinger (1991), Mayrhofer (2004), Schein (1985), Weber and Schweiger (1992), Weber et al. (1996) Brockhaus (1975), Bruton et al. (1994), Kitching (1967), Kusewitt (1985), Mirvis and Marks (1992) Boland (1970), Brockhaus (1975) Kitching (1967), Mirvis and Marks (1992) Mirvis and Marks (1992) Kitching (1967) Jemison and Sitkin (1986)

correlates such as size and price were more likely to be explored. Still, more recent work is refining our understanding of more complex constructs – such as Gautam and Katila’s (2001) work on size of knowledge base and the Kavangh and Ashkanasy (2006) study on the impact of leadership. More recent research has also added several critical dimensions. For example, simple conceptualizations of national culture are increasingly questioned (Baskerville, 2003; Kirkman, Lowe, & Gibson, 2006; Sivakumar & Nakata, 2001) and researchers are investing more in developing more robust culture measures (House, Hanges, Javidan, Dorfman, & Gupta,

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2004). We thus anticipate further advances in understanding cultural factors in M&A in the near future.

DISCUSSION As stated in the section ‘‘Introduction,’’ we have begun a process of reviewing the M&A literature with a view to understanding the relevant processes and synthesizing the research results for the benefit of managers and future researchers. The scope of the chapter thus was restricted to M&A phases, motives, and success factors. Each section of the chapter suggests – either implicitly or explicitly – topics for future research. Thus, our discussion of various M&A phases – such as Parenteau and Weston’s (2003) strategy planning, candidate screening, due diligence and deal execution, and the ultimate integration phases – begs further work in analyzing each of these phases and linking it to various performance outcomes. Our second topic, namely M&A motives, reflects external motives (such as growth or globalization) as well as more internal orientations (such as changing business models or achieving synergies). While old and new research in these areas abounds, more detailed work is needed in order to integrate findings and relate them to internal and external business contingencies. The ‘‘M&A Success Factors’’ topic clearly covers a lot of ground, several books having already been written for most of the factors discussed. Nevertheless, one still can see the need for further work especially in the strategic areas such as objectives, selection criteria, managerial involvement, and structure/control. Clearly M&A research has come a long way in the four decades since the emergence of the scholarly field of strategy research. As the field reaches maturity, we should see convergence of more and more strategic issues with the M&A filed. This trend is already building. For example, Carow, Heron, and Saxton (2004) study the effect of early mover advantage in acquisitions and Homburg and Bucerius (2006) study the effects of integration speed. Several issues from the international business field such as entry mode (Brouthers, 2002) and expatriate assignments (Belderbos & Heijltjes, 2005) are already addressing research questions central to the M&A domain. Once research has been consolidated on the early and central M&A phases, the crucial issues of postmerger integration and longer term managerial incentive systems should be addressed. These aspects are important, as was reflected in the extant ambiguous findings of the effect of acquisitions experience. It is clearly desirable for a firm to gain competencies in aspects of M&A along with M&A experience. As suggested

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by Pennings et al. (1994), the key is to build the learning processes into organizational knowledge management systems and managerial training systems, and then reward managers who stay and continue to be part of successful M&As.

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Puranam, P., Singh, H., & Zollo, M. (2003). A bird in the hand or two in the bush? Integration trade – offs in technology – grafting acquisitions. European Management Journal, 21(2), 179–184. Puranam, P., Singh, H., & Zollo, M. (2006). Organizing for innovation: Managing the coordination–autonomy dilemma in technology acquisitions. Academy of Management Journal, 49(2), 263–280. Puranam, P., & Srikanth, K. (2007). What they know vs. what they do: How acquirers leverage technology acquisitions. Strategic Management Journal, 28, 805–825. Ranft, A. (2006). Knowledge preservation and transfer during post-acquisition integration. In: C. Cooper & S. Finkelstein (Eds), Advances in mergers and acquisitions (Vol. 5). New York: JAI. Rappaport, A. (1979). Strategic analysis for more profitable acquisitions. Harvard Business Review, 57, 99–110. Salus, N. P. (1989). Public relations before and after the merger. Bottomline, 6, 47–49. Schein, E. H. (1985). Organizational culture and leadership: A dynamic view. San Francisco: Jossey-Bass. Schoenberg, R. (2000). The influence of cultural compatibility within cross-border acquisitions: A review. In: C. Cooper & A. Gregory (Eds), Advances in mergers and acquisitions (Vol. I, pp. 43–59). New York: JAI. Schoenberg, R. (2006). Measuring the performance of corporate acquisitions: An empirical comparison of alternative metrics. British Journal of Management, 17, 361–370. Schweiger, D. M., & Weber, Y. (1989). Strategies for managing human resources during mergers and acquisitions: An empirical investigation. Human Resource Planning, 12(2), 69–87. Schweiger, D. M., Weber, Y., & Power, F. (1989). Strategies for managing human resources during mergers and acquisitions: An empirical investigation. Human Resource Planning, 12(2), 69–87. Schweiger, M. D., & Goulet, P. K. (2000). Integrating mergers and acquisitions: An international research review. In: C. Cooper & A. Gregory (Eds), Advances in mergers and acquisitions (Vol. I, pp. 61–91). New York: JAI. Searby, F. W. (1969). Control postmerger change. Harvard Business Review, 47(4), 4–12. Seth, A., Song, K., & Pettit, R. (2000). Synergy, materialism or hubris? An empirical examination of motives for foreign acquisitions of US firms. Journal of International Business Studies, 31, 387–405. Seth, A., Song, K. P., & Pettit, R. R. (2002). Value creation and destruction in cross-border acquisitions: An empirical analysis of foreign acquisitions of U.S. firms. Strategic Management Journal, 23, 921–940. Severson, M. A. (1989). The merger and acquisition game into the 1990s. Financial Managers Statement, 11(5), 6–10. Shimizu, K., Hitt, M. A., Vaidyanath, D., & Pisano, V. (2004). Theoretical foundations of cross-border mergers and acquisitions: A review of current research and recommendations for future. Journal of International Management, 10, 307–353. Sivakumar, K., & Nakata, C. (2001). The stampede toward Hofstede’s framework: Avoiding the sample design pit in cross-cultural research. Journal of International Business Studies, 32(3), 555–574. Smith, W. K. (1997). Mercer on management: Post-deal management is vital to M&A success. Management Review, 86, S4.

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Stahl, K. G., Mendenhall, M. E., & Weber, Y. (2005). Research on sociocultural integration in mergers and acquisitions: Points of agreement, paradoxes, and avenues for future research. In: G. K. Stahl & M. E. Mendenhall (Eds), Mergers and acquisitions: Managing culture and human resources. Stanford, CA: Stanford Business Books. Stahl, K. G., & Voight, A. (2008). Do cultural differences matter in mergers and acquisitions? A tentative model for examination. Organization Science, 19(1), 160–176. Teerikangas, S., & Very, P. (2006). The culture–performance relationship in M&A: From yes/ no to how. British Journal of Management, 17, 31–48. Terry, R. (1982). Ten suggestions for acquisitions success. Managerial Planning, 31, 13–16. Townsend, H. (1968). Scale innovation, merger and monopoly. Oxford: Pergamon Press Ltd. Trautwein, F. (1990). Merger motives and merger prescriptions. Strategic Management Journal, 11, 283–295. Vance, S., Fery, J. B., Odell, I. G., Marks, L., & Loomba, N. P. (1969). The impact of mergers on management theory. Academy of Management Journal, 12, 153–167. Weber, Y., Reichel, A., & Tarba, S. Y. (2006). International mergers and acquisitions performance: Acquirer nationality and integration approaches. The annual meeting of Academy of Management best paper proceedings, Atlanta, GA. Weber, Y., & Schweiger, D. (1992). Top management culture conflict in mergers and acquisitions: A lesson from anthropology. International Journal of Conflict Management, 3(4), 285–302. Weber, Y., Shenkar, O., & Raveh, A. (1996). National and cooperate cultural fit in mergers/ acquisitions: An exploratory study. Management Science, 42, 1215–1227. Wheelen, T. J., & Hunger, J. D. (2001). Strategic management and business policy (8th ed.). Upper Saddle River, NJ: Prentice Hall. Young, S., & Tavares, A. (2004). Centralization and autonomy: Back to the future. International Business Review, 13(2), 215–237. Zollo, M., & Singh, H. (2004). Deliberate learning in corporate acquisition: Post-acquisition strategies and integration capability in U.S. bank merger. Strategic Management Journal, 25, 1233–1256.

CHINA’S OUTWARD MERGERS AND ACQUISITIONS IN THE 21ST CENTURY: MOTIVATIONS, PROGRESS AND THE ROLE OF THE CHINESE GOVERNMENT Hui Tan and Qi Ai ABSTRACT The increasing number of cases of developing country multinational enterprises (MNEs) buying assets from developed countries through merger and acquisition (M&A) calls for more systematic evidences on this area. As a typical and representative developing country, China has already drawn the world’s attention with several high-profile cross-border M&As in recent years. By examining the recent evidences of Chinese outward M&A, this chapter reviews the main motivations of outward M&A among state-owned enterprises (SOEs) and non-SOEs, and presents an overall picture of China’s outward M&A in the last decade. In doing so, this chapter intends to explore the crucial role played by the Chinese government in orchestrating its internationalization activities and the long-term implications on the competitiveness of Chinese firms in the global marketplace.

Advances in Mergers and Acquisitions, Volume 9, 25–50 Copyright r 2010 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1108/S1479-361X(2010)0000009005

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INTRODUCTION With the rise of China’s economy over the last three decades, its outward foreign direct investment (OFDI) also flourished. China’s total accumulated OFDI has reached US$229.6 billion, placing it 15th in the world (UNCTAD, 2010). In the year 2009 when global recession negatively impacted on world economy and reduced overall OFDI, China made a total of US$48 billion, becoming the sixth largest OFDI source country worldwide (UNCTAD, 2010). In the first seven months of 2010, China’s OFDI climbed to US$26.75 billion, which is scattered in 113 countries and areas, and engaged with 2,034 enterprises overseas (MOFCOM, 2010a, 2010b). Of all accumulated Chinese OFDI, an increasing amount belongs to outward merger and acquisition (M&A), totalling US$42.6 billion at the end of 2009 (Thomson Reuters, 2010). Among its OFDI in the first seven months of 2010, outward M&A stands at US$6.1 billion (MOFCOM, 2010a, 2010b). Based on the figures of the last couple of years, China can claim to be the third largest source country in the global outward M&A league table (Thomson Reuters, 2010) (Fig. 1). There are increasing academic interests in China’s OFDI in recent years (Alon & McIntyre, 2008; Buckley, Cross, Tan, Liu, & Voss, 2008; Deng, 2004, 2007; Morck, Yeung, & Zhao, 2008; Voss, Buckley, & Cross, 2008), including its outward M&A (Chen & Young, 2009; Deng, 2009, 2010; Hirt & Orr, 2006; Luedi, 2008; Schu¨ller & Turner, 2007; Woodard & Wang, 2004). Existing research on China’s outward M&A has centred on its strategic motivations (Child & Rodrigues, 2005; Deng, 2009; Hemerling, Michael, & Michaelis, 2006; Rui & Yip, 2008; Wang & Boateng, 2007). What is lacking or absent from the above research is an examination of the other issues with respect to China’s outward M&A, such as valuation, postM&A integration, knowledge transfer and organizational learning after the taking place of M&A, and performance appraisal (Birkinshaw, Bresman, & Nobel, 2010). Given that China has been characterized as a market system with socialist characteristics, it is an obvious gap with respect to how the Chinese government (central and local governments) impacts on China’s outward M&A. From an institutional perspective, this chapter intends to look in details of the way the Chinese government regulate the outward M&A activities conducted by the Chinese firms and to establish the longterm impact this may have on a firm’s competitiveness. The contribution of this chapter lies in its focus on the unique institutional context of China’s outward M&A, in particular the role of the Chinese government. Taking an institutional perspective, this chapter

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Fig. 1. China’s Outward M&A and OFDI Total Annual Value (in Million US$). Source: UNCTAD (2008) and Statistical Bulletin of China’s Outward Foreign Direct Investment (2007, 2008).

argues that informal institutions and rules contributed to the fast expansion of current M&A by China. However, this could have a detrimental effect to the long-term competitiveness of China as a nation and Chinese firms as sustainable competitors. The structure of this chapter is as follows: after an examination of the current literature on the rationale behind Chinese firms’ M&A, we then describe the M&A activities conducted in the last 10 years and analyse the administrative process of managing outward M&A in China, hence highlighting the crucial role played by the Chinese government. Finally, we identify the key issues arising from China’s M&A activities and make recommendations for future research.

LITERATURE REVIEW ON CHINA’S OUTWARD M&A Existing research on M&A is predominantly concerned with M&A motives, including economies of scale and scope, synergistic effects, access to strategic assets, non-profit-maximizing behaviour, knowledge acquisition,

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extension of market reach, improvement of industry position, consolidation of industry and personal motives such as empire building, etc. (Buckley & Ghauri, 2002; Hopkins, 1999). Other key issues with respect to M&A cover the management of M&A (such as valuation problems, product/market/ technology match, impact of national culture on integration process, organizational fit, post-M&A learning), post-M&A performance and the international regulation of M&A (Bresman, Birkinshaw, & Nobel, 1999; Pautler, 2003; Quah &Young, 2005; Thomson & McNamara, 2001). Dunning (1977, 2006) puts forward two main drivers for companies involved in outward M&A as asset augmentation and asset exploitation. Extensive literatures argue that several issues motivate multinational enterprises (MNEs) to invest abroad through various entry modes including: natural resources seeking, market seeking, strategic assets seeking, technology seeking, diversification, efficiency theory and so on (Dunning, 1993; Luedi, 2008; Wang & Boateng, 2007; Deng, 2004). Whatever a firm was driven by initially, its ultimate aim is enhancing its competitive advantages (Chen & Young, 2009). Chinese acquirers’ motivations are proved to be generally similar, yet have several distinctive features1 (Table 1) (Deng, 2004; Buckley et al., 2008). First, natural resource seeking is the primary motivation among many China’s outward M&As. Although China is well known as a large country with abundant natural resources, it still needs to explore energy and resources from other countries due to its enormous consumption and high growth rate. Therefore, it has long been a vital plan for Chinese government to seek a stable supply of natural resources through outward M&A activities, notably undertaken by state-owned enterprises (SOEs) (Taylor, 2002). More recently, the rapidly growing GDP and its staggering foreign exchange reserve have helped Chinese firms to invest in natural resources

Table 1.

Differences in the Main Motivations of Outward M&A by Chinese SOEs and Non-SOEs.

SOEs Natural resource seeking Increasing international competitiveness Maintaining domestic leading position

Source: Deng (2004) and Schu¨ller and Turner (2007).

Non-SOEs Strategic asset seeking Access to new markets Seeking technologies Diversification Seeking efficiency

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overseas. Luedi (2008) assesses China’s outward M&A from 1995 to 2007 and finds that the natural resources–seeking M&As take the largest proportion in both the number of deals and the total deal value. Deng (2007) also argues that the reason why Chinese MNEs have acquired foreign assets through outward M&A lies in its need for strategic resources. There are eight deals in the category of natural resources seeking among the 10 largest Chinese outward M&As in recent years, including the largest case so far: CHINALCO’s acquisition of part of Rio Tinto Plc with a total value of US$14.5 billion. Second, strategic asset seeking is becoming ever more important. Strategic assets are identified as such resources and capabilities which are unique and valuable for a company, and are able to contribute to the company’s competitive advantage and superior performance (Amit & Schoemaker, 1993).2 Those specialized resources and capabilities are hard to create and imitate. Strategic asset–seeking FDI is growing rapidly over the last three decades (Dunning, 1998), and M&As are considered as the most effective way to gain fast access to strategic assets (Homburg & Bucerius, 2005; Wesson, 2004). This is particularly true for Chinese MNEs, which are newcomers in international market and control very limited strategic assets. They have to seek superior resources and capabilities overseas, mostly from developed countries, due to the backwardness of indigenous companies (Nolan, 2001). In order to enhance their competitive advantage at both home and abroad, Chinese firms need to engage in strategic asset–seeking FDI by way of M&A (Deng, 2007). Some research categorizes this type of motivations as a strategic intent perspective to interpret the rationale behind the motivation of Chinese MNEs (Rui & Yip, 2008). Chinese government has been particularly keen to improve the international competitiveness of SOEs and turn them into global players (Schu¨ller & Turner, 2007). For example, Shanghai Automotive Industrial Corporation (SAIC) acquired Ssangyong Motors in July 2004 in a deal roughly worth US$500 million. This is the first overseas M&A by a Chinese automotive manufacturer, which provided a good learning base for Chinese indigenous firms to acquire manufacturing skills, in-house design capability as well as an international brand. Shortly after, Nanjing Automotive’s3 acquisition of the British firm Rover was regarded to have further strengthened Chinese automotive industry’s competitiveness in car manufacturing. Third, diversification plays a key role in the drive of outward M&A. Mainstream financial theory believes that non-systematic risk can be eliminated by diversification (Treynor, 1961; Sharpe, 1964). Outward M&A is an effective way to reduce financial and operational risks based on

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geographical diversification (Seth, 1990). This is because outward M&As can diversify their non-systematic risk by arbitrage on different exchange rates, tax regimes, etc. On this front, some Chinese banks and insurance companies, such as China Investment Corporation (CIC) and China International Capital Corporation (CICC), have already invested in overseas financial institutions and markets to diversify their product portfolios and contain risk (Luedi, 2008). There are other motivations said to be behind the outward M&A activities by Chinese MNEs, such as seeking market expansion, access to Western brands or a result of globalization (Martin, Swaminathan, & Mitchell, 1998; UNCTAD, 2000). For example, companies such as ZTE, Huawei and Haier invested overseas through M&A to gain access to new international markets. Similarly, TCL’s purchase of Schneider Electronics also aimed at penetrating the European market and avoiding possible charge of dumping (Buckley et al., 2008). Another good example is Lenovo’s acquisition of IBM’s PC Division, which extended Lenovo’s brand awareness worldwide. However, when examining any case, the distinction between the above motivations is not always clear-cut (Deng, 2004), or put another way, the motivations behind any individual M&A decision can be multiple. Given that the majority of China’s outward M&As are conducted by Chinese SOEs, which are incentivized and managed differently from typical firms in a market economy (Child, 1994), it is doubtful whether mainstream theories and empirical findings from Western countries are also applicable in the case of Chinese firms. It is clear that the current state of research on the outward M&A activities of Chinese firms is primarily focused on its motivations. There is a lack of work on the other aspects of issues relating to M&A, such as the management of M&A process, post-M&A integration and learning, and performance and regulation of M&A by national government (Buckley & Ghauri, 2002). These are the gaps calling for more research to be conducted to increase our understanding and knowledge on these issues. This chapter intends to shed light on some of them. The last point regarding the role of government is especially pertinent as Chinese government has always maintained its central role in regulating economic activities directly (Schu¨ller & Turner, 2007; Voss et al., 2008; Gu & Reed, 2010). This leads to the key question of how firm strategy and management behaviour is influenced by its institutional context. Oliver (1997) argues that the resources and firms are embedded in a certain social context, which could not be neglected. He divides the institutional context of a firm into

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three dimensions, which are internal culture, inter-firm relations and influences from the government and society. China has its own economic and political system which is different from the West. SOEs can receive special loans from state-owned non-commercial banks, for example, the Export–Import Bank of China, to help them accomplish the outward M&A in line with national or governmental priorities. This is the biggest advantage for Chinese SOEs to beat their Western competitor (Schu¨ller & Turner, 2007). Following on this lead, this chapter intends to establish how the Chinese government regulates and facilitates Chinese firms in their outward M&A activities, hence filling a big gap in existing literatures.

CHINA’S OUTWARD M&A IN THE 21ST CENTURY China’s outward M&A has experienced a dramatic change over the past 10 years. We can divide this into two periods as given in the next two subsections. 1999–2004: Initial Development as a Result of China’s ‘Zou Chu Qu’ (Go Global) Policy China’s ‘Zou Chu Qu’ (go global) policy was first declared in 1999 and then formalized in the 10th Five-Year Plan in 2001 as an official endorsement of active OFDI and outbound M&A (Voss et al., 2008). 2001 was also the year when China joined the World Trade Organization (WTO), which offered China the chance of closer integration with the global economy. At this stage, the amount of M&A transactions was initially rather low, indicating that Chinese firms did not go all out to engage outward M&A. Instead, they started to consider the global market as part of their business marketplace following the policy direction of the Chinese government. The China Merger and Acquisitions Yearbook (2003) referred 2002 as the ‘Yuan Nian’ (the first year of an era) of China’s M&A. As a result of the ‘Zou Chu Qu’ (go global) policy and China’s accession to the WTO, significant changes took place in both domestic and overseas markets. Several liberalization steps were taken by the Chinese government to help companies invest abroad, such as removing repatriation requirement for the overseas profits made by Chinese acquirers and simplifying the approval process of outward M&A (see Appendix B for details). Against this background, the total annual value of outward M&A increased from less than US$500 million annually in 2000 and 2001 to more than US$1,000 million in the next three years (see Table 2).

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Table 2. China’s Outward M&A in Annual Value and Number of Deals. Years

Annual Value in Million US$

Number of Deals

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

0 16.5 202.1 60.3 3.2 572.7 484.7 307 249.1 451.4 798.8 1,276.2 101 470 452.435 1,046.51511 1,646.524 1,125.11 5,278.97 14,904.291

1 4 6 3 2 12 28 19 13 17 30 23 13 35 22 35 73 59 58 61

Source: UNCTAD (2008).

Among the cases of China’s outward M&A during this period, TCL’s acquisition of Thomson’s Television Division and SAIC’s acquisition of Ssangyong, both taking place in 2004, gained wide attention. In the TCL– Thomson case, it was initially considered as a market-seeking and technology-seeking M&A. However, it turned out that TCL did not obtain Thomson’s market channels in Europe and North America as planned, and that the acquired old-generation technology was not deemed to be valuable any more due to the technological upgrading in the traditional TV sector, that is, the replacement of the CRT TV by new-generation flat screen TV (Deng, 2010). In the SAIC–Ssangyong Motor’s case (worth US$500 million), the Chinese acquirer overestimated the brand value of the target and wrongly predicted the direction of the global automotive market. The large air displacement SUV, which was the pillar product of Ssangyong, was not well received by the market in an increasingly energy-saving conscious era. On top of it, SAIC was not well prepared to deal with the South Korean trade union. It had to withdraw from Ssangyong in 2009 after suffering

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a huge loss over the years. Therefore, the year of 2004 was nicknamed the year of ‘Da Yue Jin’ (giant leap) of Chinese overseas M&A (Zheng, 2009).

2005 to Present: The Blossoming of China’s Outward M&A Lenovo’s acquisition of IBM’s PC division ushered in a breathtaking period of China’s outward M&A with global implications. Administratively, the examination and approval procedures of outward M&A activities were further simplified4 and more supporting policies were developed,5 with some powers transferred to provincial authorities. The total annual value of outward M&A jumped to US$5 billion in 2005 and never dropped below this threshold thereafter. Despite the challenging economic environment as a result of global recession, Chinese acquirers still accomplished 298 cases of overseas M&A in 2009, which is the highest number by far (Thomson Reuters, 2010). That year ended with the largest M&A by a Chinese automotive manufacturer: Geely’s acquisition of Volvo from Ford totalling US$1.8 billion. There are two reasons behind the fast expansion of China’s outward M&A since 2005. First is the ‘visible hand’ of the government. In addition to direct financial support from the government, further easing of administrative control over the process of outward M&A plays a significant role. For example, in the first half of 2009, two regulations were published to further simplify the approval process of overseas M&A.6 Second reason is the pressure to go international as a consequence of China’s opening of domestic market. Removing entry barriers to foreign investors in accordance with WTO rules means more fierce competition for Chinese indigenous firms. Chinese enterprises, especially non-state-owned enterprises (non-SOEs) which ‘lack domestic political protection’ (Voss et al., 2008, p. 16), speeded up their outward M&A to improve their competitive advantage at both home and abroad. Limited liability companies contributed 32% of outward M&A amount in 2005, and the percentage of SOEs dropped (Investment in China, 2007). This picture was turned upside down a couple of years later due to the effect of the global financial crisis in 2008. Non-SOEs were strongly influenced by the financial tsunami while SOEs stayed firm based on the support of the state. The Statistical Bulletin of China’s Outward Foreign Direct Investment (MOFCOM, 2009) showed that SOEs accounted for 69.6% of the Chinese OFDI stock at the end of 2008 (see Fig. 2) and 9 out of the 10 acquirers in the influential outward M&A by Chinese enterprises are SOEs (see Table 3).

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Fig. 2. Chinese OFDI Stock Distribution at the End of 2008. Source: 2008 Statistical Bulletin of China’s Outward Foreign Direct Investment (by MOFCOM).

Table 3.

Ten Largest Outward M&As by Chinese Companies Since the Recent Global Financial Crisis.

Date

Bid Value in US$100 Million

12 December 2007

39.5

1 February 2008

145

21 August 2008

20

7 July 2008 26 September 2008 11 June 2009

25 20 13.86

22 24 25 19

10.2 66 72.4 13

June June June June

2009 2009 2009 2009

Chinese Bidder

National Grid CHINALCO Sinopec and PetroChina CNOOC Sinopec China Minmetals Corporation PetroChina SUNING Sinopec CNOOC & Sinopec

Target Name

National Transmission Corp. Rio Tinto Plc Petro-Tech Peruana

Target Nation Philippines United Kingdom United States

Awilco Offshore ASA Norway Tanganyika Oil Canada OZ Minerals Australia SPC LAOX Addax Angola Oil

Source: China Mergers and Acquisitions Yearbook (2008–2010).

Singapore Japan Switzerland United States

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THE ROLE OF THE GOVERNMENT IN CHINA’S OUTWARD M&A The Chinese government manages China’s outward M&A through varying policies and approval procedures to different types of enterprises. In this chapter, we divided the Chinese companies into following categories in light of ownership and administration authority: SOEs and non-SOEs, comprising share-issuing public companies and private companies. SOEs include central enterprises (owned directly by the central government) and local enterprises (owned by provincial and metropolitan governments) (see Fig. 3).

Approval Procedures and Supporting Policies In a typical outward M&A case, Chinese investors should register with and get approval from three governmental authorities: the National Development and Reform Commission (NDRC), which is in charge of the planning, supervision and harmonization of China’s economy; the MOFCOM, which examines the merit of the proposed M&A; and the SAFE, which is responsible for the examination of the sources and remittance of foreign exchange involved. Chinese acquirers should first register and get the approval from SAFE, then apply for the ratification from corresponding NDRC (at national or provincial level), and finally apply to MOFCOM

Chinese Acquirers

SOES

Central Enterprises

Fig. 3.

Non-SOEs

Local Enterprises

Public Companies

Private Companies

Categories of Chinese Companies Based on Ownership and Level of Administration Authority.

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(national or provincial level) for certifications before they are allowed to remit overseas. Investors should also obtain the ratification from StateOwned Assets Supervision and Administration Commission (SASAC) if the proposed acquisition involved state-owned properties (including SOEs and those non-SOEs where government holds certain percentage of shares). The detailed approval procedures are stated in Appendix A. The role of Chinese government in outward M&A is based on the socialistic ideology that the state should macro-control the economy and grasp the lifeline of each industry by controlling over large SOEs (Fischer, 2002; Schu¨ller & Turner, 2007). Thus, the government established a series of bureaucratic hurdles in the last century. Although those regulation barriers were gradually removed following the ‘Zou Chu Qu’ (go global) policy and China’s accession to the WTO, the approval procedures are still complex and unclear to many. The interventionist policy also has its merit, though. Since every overseas acquisition should be recorded by NDRC, and individual enterprises are not allowed to sign any documents with legal validity before the approval of NDRC, Chinese government can supervise these proposed M&A cases in light of some ‘hidden rules’ which might be beneficial to investors. For example, competition among Chinese acquirers is not encouraged and the situation that two Chinese enterprises bidding up to acquire one target never happened (People’s Daily, 2010). This kind of protectionism lessened competition between Chinese firms. Having said that, discrimination does exist between SOEs and non-SOEs in the form of ‘hidden rules’. As stated above, Chinese investors should get approval from SAFE, NDRC and MOFCOM before they are allowed to remit funds overseas. There are indeed written regulations and policies on these examinations, but the factors for examination are not clear to all. Whether an overseas M&A project can be approved or not depends on subjective judgement of corresponding government officers to a certain extent. Moreover, the set of approval procedures is time-consuming. Several months will be a very ideal result for private enterprises that have no strong governmental relationships (i.e. ‘Guanxi’ in Chinese). Acquirers in other countries might have accomplished the acquisition before Chinese enterprises qualified to dispatch funds abroad. Facing such disadvantages due to administrative burden, some enterprises choose to keep their foreign exchange overseas and in turn use them in outward M&A. This kind of ‘illegal’ operation may lead to penalty from governmental authorities, but investors would rather accept this penalty sometimes as it is often much less costly than that arising from the complex approval and administrative procedures (China Economic Weekly, 2007).

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Things become much easier for large SOEs. They usually can not only pass the examination quickly and smoothly, but also benefit from certain designated policies. For example, according to one government policy,7 most SOEs can receive special loans from the state-owned non-commercial banks, such as the Export–Import Bank of China, to help them accomplish the outbound M&A in line with state need. Another example is the risk management and investment consultancy that CECIC provided to key overseas projects encouraged by the state.8 In contrast, non-SOEs were not the subject of this kind of preferential policies. The influence of Chinese government on outward M&A can also be reflected in the issue of corporate governance and the outcome of outward M&A. Since the state is the largest shareholder of the publicly listed shareissuing enterprises, it is possible that these SOEs can conduct outward M&A in accordance with the state need and infringe against the interests of the minority shareholders, which gives rise to a principal–principal conflict (Su, Xu, & Phan, 2008). Chen and Young (2009) confirm the existence of principal–principal conflicts in the Chinese SOEs based on an empirical study using event study methodology. They find that the outcomes of crossborder M&A are negatively related to the government ownership. Su et al. (2008) also suggest that the increase of government ownership positively relates to the ineffectiveness of acquirers’ corporate governance.

DISCUSSION AND CONCLUSIONS The phenomenal rise of China’s outward M&A in the 21st century is a fascinating story for a developing country with per capital GDP less than onetenth of the industrialized counterparts. While China is currently at a stage of fast industrialization with huge demand for capital injection and still a large recipient of inward FDI, the speeding up of its outward M&A over the recent years has been intriguing. There are many different views on China’s massive outward M&A (e.g. Chen & Young, 2009; Hirt & Orr, 2006; Wang & Boateng, 2007). Based on the above description of the government’s key role in orchestrating China’s outward M&A activities, we argue that the reason for China to fast forward and become a significant capital source country (while other emerging economies such as the other BRICs are not in a comparable stage) lies in China’s unique institutional context. The discriminatory policy adopted by the Chinese government to support SOEs in pursuit of key M&A targets overseas indicates the inseparable relationship between government and SOEs in this country. It highlights the important role

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played by informal rules (such as those ‘hidden rules’ mentioned earlier) and informal institutions in a society where formal rules and formal institutions are experiencing modernization and internationalization as part of China’s integration into the global market. While formal rules and formal institutions are supposed to be inherently better than informal ones (North, 1990), what happened in China raises serious issues of increased transaction cost for business and its negative implication to the sustainable competitiveness of Chinese SOEs in the global market in the long term. More efficient business organizations such as non-SOEs could also suffer due to the fact that there is no level playing field created along China’s increasing internationalization. Put simply, China’s long-term national competitiveness could be in jeopardy should such discriminatory policies and informal institutions continue to function at the expense of formal ones. While principle–principle conflict has been identified as an issue for Chinese acquirers (Su et al., 2008), there is a lack of recognition of the principle–agent conflict, given the close relationship between the state and SOEs. Managers as agents of state assets can be replaced or transferred by government bureaucrats as they see fit. Thus, managers could pursue shortterm result at the expense of firm’s long-term interest to keep their jobs and seek promotion. This short-termism vs. long-termism can contribute to failures of China’s outward M&A activities. Lastly, the absence of expertise in cross-cultural management is a big barrier to China’s success in the global M&A market. There are many issues causing breakdown in post-M&A integration. As indicated by the case of SAIC’s acquisition of Ssangyong, Chinese managers are not well prepared to deal with cross-cultural management. Chinese organizations, including SOEs as well as non-SOEs, have not taken this dimension seriously; thus, they are not in a position to control the process of post-M&A integration as expected. Whether Geely’s acquisition of Volvo will eventually be successful also, to a large extent, pins its hope on effective cross-cultural management. To conclude, the increasing number of cases of developing country MNEs buying assets from developed countries through M&A calls for more systematic evidences on this area. As a typical and representative developing country, China has already drawn the world’s attention with several highprofile cross-border M&As in recent years. Supported by the largest foreign exchange reserve of the world, Chinese state-controlled companies are well positioned to buy up ailing Western companies or strategic assets in resource-rich countries as part of China’s drive to expand OFDI. By examining the recent evidences of Chinese outward M&A, this chapter argues that the crucial role played by the Chinese government is behind the

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39

extraordinary expansion of China’s outward M&A activities over the recent years. However, China’s long-term competitiveness is at stake if the informal rules and institutions continue to overshadow the proper working of the formal institutions. Future research, preferably based on empirical studies, should look at the issues arising from the management of M&A process, such as principal–agent conflict and post-M&A integration, which are still under little consideration.

NOTES 1. Fischer (2002) suggests that motivations of overseas investments by SOEs and non-SOEs are not the same, that is, those of SOEs are more in line with the ambition of the Chinese government while those of non-SOEs are more in tune with typical Western companies. 2. Some literatures distinguish technology seeking from strategic asset seeking (Deng, 2004). In this chapter, we consider all intangible assets such as patents, technical know-how, etc., as part of strategic assets. 3. Nanjing Automotive is now part of SAIC as a result of domestic M&A. 4. This is contained in ‘The interim administrative measures of examination and approval of overseas investment projects’, which was promulgated in October 2004 and still valid up to this day. 5. Such as ‘Circular concerning relevant issues of establishing the risk guarantee mechanism of key overseas investment projects’ and ‘Circular concerning policy of granting credit aid to key overseas investment projects encouraged by the state’. Further details are listed in Appendix A. 6. ‘Regulations on overseas investment administration’ by the Ministry of Commerce (MOFCOM) and ‘Circular on regulations of foreign exchange in the overseas direct investment by domestic institutions’ from the State Administration of Foreign Exchange (SAFE). 7. See ‘Circular concerning policy of granting credit aid to key overseas investment projects encouraged by the state’. 8. See ‘Circular concerning related issues of establishing the risk guarantee mechanism of key overseas investment projects’.

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Hopkins, H. D. (1999). Cross-border mergers and acquisitions: Global and regional perspectives. Journal of International Management, 5, 207–239. Investment in China. (2007). Available at http://www.fdi.gov.cn/pub/FDI/wzyj/ztyj/wzhb/ t20070829_82410.htm. Accessed on 15 August 2010. Luedi, T. (2008). China’s track record in M&A. The McKinsey Quarterly, 3, 75–81. Availabe at http://www.ieco.clarin.com/2008/06/17/chtr08.pdf Martin, X., Swaminathan, A., & Mitchell, W. (1998). Organizational evolution in the interorganizational environment: Incentives and constraints on international expansion strategy. Administrative Science Quarterly, 43, 566–601. MOFCOM. (2009). 2008 statistical bulletin of China’s outward direct investment. Available at http://hzs.mofcom.gov.cn/accessory/200909/1253868856016.pdf. Accessed on 5 June 2010. MOFCOM. (2010a). Available at http://wms.mofcom.gov.cn/. Accessed on 5 June 2010. MOFCOM. (2010b). China’s outward foreign direct investment achieved US$26.75 bn in the first seven months. People’s Daily, August 18, p. 1. Morck, R., Yeung, B., & Zhao, M. (2008). Perspectives on China’s outward foreign direct investment. Journal of International Business Studies, 39(3), 337–350. NDRC. (2010). Available at http://www.sdpc.gov.cn/. Accessed on 5 June 2010. Nolan, P. (2001). China and the global economy. London: Palgrave Macmillan. North, D. (1990). Institutions, institutional change, and economic performance. New York: Norton. Oliver, C. (1997). Sustainable competitive advantage: Combining institutional and resourcebased views. Strategic Management Journal, 18(9), 697–713. Pautler, P. A. (2003). The effects of mergers and post-merger integration: A review of business consulting literature. Working Paper. Bureau of Economics, Federal Trade Commission. People’s Daily. (2010). An interview of Li Shufu, CEO of Geely. People’s Daily, August 7, p. 2. Quah, P., & Young, S. (2005). Post-acquisition management: A phases approach for crossborder M&A. European Management Journal, 23(1), 65–75. Rui, H. C., & Yip, G. S. (2008). Foreign acquisitions by Chinese firms: A strategic intent perspective. Journal of World Business, 43(2), 213–226. SAFE. (2010). Available at http://www.safe.gov.cn/model_safe/index.html. Accessed on 5 June 2010. Schu¨ller, M., & Turner, A. (2007). Global ambitions: Chinese companies spread their wings. Journal of Current Chinese Affairs – China Aktuell, 34(4), 3–14. Seth, A. (1990). Value creation in acquisition: A re-examination of performance issues. Strategic Management Journal, 11, 99–111. Sharpe, W. F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of Finance, 19, 425–442. Su, Y., Xu, D., & Phan, P. H. (2008). Principal–principal conflicts in the governance of the Chinese public corporation. Management and Organization Review, 4(1), 17–38. Taylor, R. (2002). Globalization strategies of Chinese companies: Current developments and future prospects. Asian Business and Management, 1(2), 209–225. Thomson, N., & McNamara, P. (2001). Achieving post-acquisition success: The role of corporate entrepreneurship. Long Range Planning, 34(6), 669. Thomson Reuters. (2010). FACTBOX – China’s outbound M&A in 2009 and the past decade. January 19. Treynor, J. L. (1961). Toward a theory of market value of risky assets. Unpublished manuscript.

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UNCTAD. (2000). Cross-border mergers and acquisitions and development. World Investment Report 2000. United Nations, New York and Geneva. UNCTAD. (2008). Available at http://stats.unctad.org/fdi. Accessed on 27 July 2010. UNCTAD. (2010). Investing in low-carbon economy. World Investment Report 2010. United Nations, New York and Geneva. Voss, H., Buckley, P. J., & Cross, A. R. (2008). Thirty years of Chinese outward foreign direct investment. Paper presented at 19th CEA UK conference – China’s three decades of economic reform (1978–2008), April 1–2, University of Cambridge, UK. Wang, Q., & Boateng, A. (2007). Cross-border M&As by Chinese firms: An analysis of strategic motivation and performance. International Management Review, 3(4), 19–29. Wesson, T. J. (2004). Foreign direct investment and competitive advantage. Cheltenham: Edward Elgar Publishing. Woodard, K., & Wang, A. Q. (2004). Acquisitions in China: A view of the field. China Business Review, November–December, 34–38. Zheng, L. (2009). Bloody battle overseas. Nan Jing: Nanjing University Press.

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APPENDIX A. THE APPROVAL PROCEDURE OF CHINA’S OUTWARD M&A Step One: Foreign Exchange Registration with SAFE Based on ‘Regulations for foreign exchange administration of domestic institutions overseas direct investments’ 1. Chinese investors should explain the source of funds to local Administration of Foreign Exchange when registering. 2. After examining the application documents submitted by investors, local Administration of Foreign Exchange will issue ODI registration IC card (started from January 2009). Step Two: Obtaining Approval from NDRC (Including Provincial DRC) Based on ‘The interim administrative measures of examination and approval of overseas investment projects’ 1. Investors should report to corresponding Development and Reform Commission (state or provincial level) and receive the confirmation letter before applying for approval of DRCs. 2. Different kinds of projects should be examined by different governmental authorities. All projects in Taiwan and countries which have no diplomatic relations with China should be approved by NDRC.

Natural resource exploitation projects

Non-resource exploitation projects

oUS$30 million

WUS$30 million to o200 million

WUS$200 million

Local DRCs

NDRC

State Council

oUS$10 million

WUS$10 million to o50 million

WUS$50 million

Local DRCs

NDRC

State Council

3. Investors are not allowed to sign any documents with legal validity before the approval of NDRC.

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Step Three: To be Authorized by MOFCOM Based on ‘Regulations on overseas investment administration’ 1. Once decided to conduct outward M&A, investors should report to MOFCOM and SAFE (state or provincial) and submit the form entitled ‘Report Prior to Enterprises’ Overseas M&A’. 2. After the approval of NDRC, investors should apply to the MOFCOM (state or provincial) for ‘Enterprises’ Overseas Investment Certificate’ under the following conditions: Projects that Should be Authorized by MOFCOM

Projects that Should be Authorized by Provincial Commerce Authorities

Projects in countries which have no Projects between US$10 million diplomatic relations with China and 100 million Projects in specific countries which Natural resource exploitation are identified by MOFCOM projects Projects over US$100 million Projects that need to attract investment at home Projects involving multi-countries Projects with special aim Projects invested by central enterprises Other Steps of Government Administrative Control 1. The approval of fund to conduct feasibility study (by SAFE) After submitting application of the overseas investment project, investors can apply to the local Administration of Foreign Exchange for fund to cover the cost of conducting feasibility study. 2. The Foreign Exchange Registration Certificate (by SAFE) After the approval of NDRC and MOFCOM, investors should obtain Foreign Exchange Registration Certificate from SAFE before exchanging the fund in RMB Yuan into foreign currency. 3. Obligation of being supervised and reporting (by MOFCOM and SAFE) Investors should cooperate with the joint annual inspection of overseas investment by MOFCOM and SAFE and submit quarterly

China’s Outward Mergers and Acquisitions in the 21st Century

ODI statistics report to help MOFCOM build a national statistics system of overseas investment. Special Steps for SOEs Central SOEs and local SOEs should report to corresponding SASAC of the State Council before applying to other governmental authorities. Source: MOFCOM (2010a, 2010b), NDRC (2010) and SAFE (2010).

45

September 1999

September 1995

September 1993

August 1991

March 1991

June 1990

March 1989

July 1988

Issuing Date

Supplementary circular to measures for governing the foreign exchange of overseas investment Circular concerning certain projects being exempted from paying deposits for overseas profits

Detailed rules for implementation of measures for governing the foreign exchange of overseas investment Opinions of State Planning Commission (previous name for current NDRC) on enhancing the administration of overseas projects Provisions on establishment and approval of overseas investment project proposal and feasibility study report The standards of examining and approving the source of foreign exchange for overseas investment

Regulations governing the approval of setting up trade-related enterprises overseas Measures for governing the foreign exchange of overseas investment

Notification and Regulations

The first document that formulated the approval procedures by NDRC

NDRC

SAFE

SAFE

SAFE

The requirement for security deposit charge of certain projects is loosened

Source of fund for overseas projects should be examined and approved before making applications to other governmental authorities Investors are allowed to purchase foreign exchange

The first regulation about overseas investment by NDRC

NDRC

SAFE

The first regulation on governing the foreign exchange for overseas investment Detailed rules for applying foreign exchange for overseas investment

Overseas profits should be remitted to China

Description

SAFE

MOFCOM

Enunciator

APPENDIX B. OFFICIAL REGULATIONS ON CHINESE OUTWARD M&A

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Circular concerning relevant issues on removing repatriation requirement for the overseas profits made by Chinese acquirers Circular concerning printing and distributing the statistic template for overseas investment Circular concerning relevant issues of simplifying the examination of the source of foreign exchange for overseas investment

Circular concerning relevant issues of returning the deposit of overseas investment profit Circular concerning relevant issues of further deepening the reform of foreign exchange administration for overseas investment Circular on establishing information database for potential firms of making overseas investment

November 2002

July 2003

November 2003

October 2003

March 2003

December 2002

October 2002

Circular concerning applying the comprehensive performance appraisal system for overseas investment Tentative measures for the joint annual inspection of overseas investment

October 2002

MOFCOM

SAFE

SAFE

SAFE

MOFCOM

MOFTEC (predecessor of MOFCOM) SAFE SAFE

MOFTEC (predecessor of MOFCOM)

To detect the willingness of potential investors into overseas market

Relevant approval process simplified

Preparing for publishing the Statistical Bulletin of China’s Outward Foreign Direct Investment Industrial investment projects, foreign aid projects and strategic investment projects authorized by the State Council no longer to be examined. Foreign exchange obtained abroad will not be examined any more Overseas profit deposit not required anymore

Removal of the need to repatriate overseas profit in the future

The first regulation on post-investment inspection

Performance appraisal system of overseas investment established

China’s Outward Mergers and Acquisitions in the 21st Century 47

Interim administrative measures of the examination and approval of overseas investment projects Decision on the examination and approval of established overseas investing enterprises Circular on reporting before making overseas M&A

Circular concerning relevant issues of expanding the trial regions of foreign exchange administration for overseas investment

October 2004

May 2005

March 2005

October 2004

Circular concerning policy of granting credit aid to key overseas investment projects encouraged by the state

The tentative administrative rules of approving overseas investment projects The guidance catalogue of countries and industries for overseas investments (1–3)

Notification and Regulations

October 2004

July 2004, October 2005, January 2007

April 2004

Issuing Date

SAFE

MOFCOM SAFE

MOFCOM

NDRC

MOFCOM Ministry of Foreign Affairs (MFA) SAFE NDRC China EXIM Bank

NDRC

Enunciator

APPENDIX B. (Continued )

Once decided to carry out overseas M&A, investors should report to corresponding MOFCOM and SAFE and submit ‘The reporting table before overseas M&A’ The scope of the trial regions is expanded to the whole country; available foreign exchange is increased for investors; the approval authority of local SAFEs is expanded

Providing financial support to key M&A projects that can strengthen international competitiveness and market development Investment projects should be approved by NDRC or provincial DRC according to the category and bid value Feasibility study report is not required anymore

Outward M&A investors are not allowed to sign any documents with legal validity before the approval of NDRC Investment into listed countries and industries is encouraged and incentivized

Description

48 HUI TAN AND QI AI

May 2009

December 2008

January 2008

November 2006

June 2006

June 2006

October 2005

September 2005

July 2005

Circular concerning relevant issues of establishing a risk guarantee mechanism for key overseas investment projects Circular on adjusting the administration of overseas financial guarantee provided by domestic bank Detailed regulations on the examination and approval of established overseas investing enterprises Circular on adjusting certain foreign administrative polices concerning overseas investment Circular on establishing the statistic examination system of overseas investment by destination Urgent circular on enhancing the statistic system of outward foreign direct investment Circular concerning relevant issues of adjusting the examination and approval of overseas investment Circular concerning relevant issues of implementing the overseas investment module of information system on foreign direct investment Regulations on overseas investment administration MOFCOM

SAFE

MOFCOM

MOFCOM

MOFCOM

Simplified the approval procedures of overseas investments and expanded the authority of provincial Commerce Bureau

Use IC card to manage foreign exchange of overseas investments

Expanded the authority of provincial Commerce Bureau

To put emphasis on building a sound statistic system for overseas investment

Specific regulations based on ‘Decision on the examination and approval of established overseas investing enterprises’ Investors can purchase foreign exchange with CNY for overseas investment without upper limit To ensure the accuracy and completeness of the statistic data of China’s OFDI

MOFCOM

SAFE

Applying balance administration instead of examining each transaction

Providing risk management and investment consulting to key projects encouraged by the state

SAFE

NDRC CECIC

China’s Outward Mergers and Acquisitions in the 21st Century 49

Circular concerning relevant administrative issues of the overseas loan by domestic enterprises Circular concerning relevant issues of strengthening the administration of overseas investment projects Circular on regulations of foreign exchange administration of domestic institutions in their overseas direct investment Circular concerning relevant issues on joint annual inspection of overseas investment Circular concerning relevant issues on tax credit of offshore income

Notification and Regulations

Ministry of Finance (MOF) State Administration of Taxation (SAT)

MOFCOM SAFE

SAFE

NDRC

SAFE

Enunciator

Source: MOFCOM (2010a, 2010b), NDRC (2010), SAFE (2010) and Voss et al. (2008).

December 2009

December 2009

August 2009

June 2009

June 2009

Issuing Date

APPENDIX B. (Continued )

Comprehensive performance appraisal will no longer be taken as part of annual inspection Regulation on tax credit of offshore income

Enlarged funding source of overseas loans. Simplified the examination and approval of overseas loans Investors should report to NDRC before starting substantive work in outward M&A projects Changed the examination and approval of overseas investment funding source

Description

50 HUI TAN AND QI AI

TRUST DYNAMICS IN ACQUISITIONS: THE ROLE OF RELATIONSHIP HISTORY, INTERFIRM DISTANCE, AND ACQUIRER’S INTEGRATION APPROACH Gu¨nter K. Stahl and Sim B. Sitkin ABSTRACT Drawing on the trust literature and research on sociocultural integration in mergers and acquisitions (M&As), we develop a model of the antecedents and consequences of trust dynamics in acquisitions. The model proposes that target firm members’ perceptions of the acquiring firm management’s trustworthiness are affected by the relationship history of the firms, the interfirm distance, and the integration approach taken by the acquirer. Ability, benevolence, integrity, and value congruence perceptions are proposed to converge into a generalized trust judgment or result in a state of ambivalence, depending on whether the trustworthiness attributions are consistent or conflicting. The model explains the mechanisms by which trust and ambivalence may affect a variety of attitudinal and behavioral outcomes. A number of testable

Advances in Mergers and Acquisitions, Volume 9, 51–82 Copyright r 2010 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1108/S1479-361X(2010)0000009006

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propositions are derived from this model, and the implications for M&A research and practice are discussed.

For the past three decades, there has been a growing body of research on the variables that affect the success of mergers and acquisitions (M&As). Despite this large body of research, both the key factors for M&A success and the reasons why so many M&As fail remain poorly understood. A meta-analysis of 93 empirical studies conducted by King, Dalton, Daily, and Covin (2004) revealed that the postacquisition performance of acquiring firms fails to surpass that of nonacquiring firms, which suggests that anticipated synergies are often not realized. Of most interest for this chapter’s central focus, this meta-analysis showed that none of the most commonly researched antecedent variables (degree of diversification, degree of relatedness, method of payment, prior acquisition experience) were significant in explaining variance in postacquisition performance. King et al. (2004) conclude that ‘‘despite decades of research, what impacts the performance of firms engaging in M&A activity remains largely unexplained’’ (p. 198). While attempts to explain M&A success and failure have traditionally focused on strategic and financial factors, an emergent and growing field of inquiry has been directed at the sociocultural and human resources issues involved in the integration of acquired or merging firms. Variables such as cultural fit (Morosini, Shane, & Singh, 1998; Weber, Shenkar, & Raveh, 1996), management style similarity (Datta & Grant, 1990; Larsson & Finkelstein, 1999), the pattern of dominance between merging firms (Cartwright & Cooper, 1996; Hitt, Harrison, & Duane Ireland, 2001; Jemison & Sitkin, 1986), the acquirer’s degree of cultural tolerance (Chatterjee, Lubatkin, Schweiger, & Weber, 1992; Pablo, 1994), leadership philosophy and style (Kavanagh & Ashkanasy, 2006; Sitkin & Pablo, 2005), and the social climate surrounding a takeover (Birkinshaw, Bresman, & Hakanson, 2000; Hambrick & Cannella, 1993; Schweiger, 2002) have increasingly been recognized to be critical to the success of M&As. A potentially important, but underexplored, variable in the integration process is trust. Indirect evidence for the critical role of trust in M&A can be drawn from research that suggests that the development of trust is critical to the successful formation and implementation of cooperative alliances between firms, such as joint ventures, R&D collaborations, and marketing partnerships (Child, 2001; Inkpen & Currall, 2004; Gulati, 1995; Zaheer,

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53

McEvily, & Perrone, 1998). For example, trust built as firms engage in repeated alliances reduces the likelihood of opportunism and other transaction costs (Gulati, 1995). In the context of M&A, there is a large body of anecdotal evidence in the form of case studies (e.g., Chua, Stahl, & Engeli, 2005; Olie, 1994) and interviews with acquired managers and employees (e.g., Krug & Nigh, 2001; Schweiger, Ivancevich, & Power, 1987) that suggest that trust is critical in the post-merger integration process. The following quote from Daniel Vasella, CEO of Novartis, concerning the merger that created the Swiss pharmaceutical giant highlights both the importance and fragility of trust in M&As: Only in a climate of trust are people willing to strive for the slightly impossible, to make decisions on their own, to take initiative, to feel accountable; trust is a prerequisite for working together effectivelyy.Among all the corporate values, trust was the one that suffered most from the merger. (Chua et al., 2005, pp. 391–392)

Despite the large body of anecdotal evidence supporting the critical role of trust in M&As, little is known about the factors that facilitate or hinder the development of trust in acquired organizations. The benefits of trust and the damage incurred by trust violations make it essential to understand the conditions under which trust can develop after a takeover. In the following sections, we develop a model that synthesizes our current understanding of the antecedents and consequences of trust in acquisitions, with target firm members’ trustworthiness perceptions as a key mediating process. This chapter is not intended as a critique of models that posit strategic and economic drivers of M&A activity and success; instead, it is intended to offer an important supplement to that research by organizing the robust literature on the psychological and sociocultural factors that promote successful postacquisition integration, with a particular focus on trust.

DYNAMICS OF TRUST IN ACQUISITIONS Processes related to the development of trust appear to be most important in related acquisitions that require substantial interdependence between the combining firms. Acquisitions can be part of a strategy of related diversification in which the acquired business is expected to provide new resources, product lines, and managerial expertise or foster growth through unrelated diversification with no intention of achieving synergies a (Haspeslagh & Jemison, 1991; Pablo, 1994; Schweiger, 2002). While there are a few cases when an acquired firm is either entirely absorbed or left completely autonomous,

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M&A researchers seem to agree that related acquisitions require higher levels of operational integration and lead to greater organizational changes in the target firm – and thus increase the potential for conflict (Buono & Bowditch, 1989; Datta, 1991; Larsson & Finkelstein, 1999). Trust does not appear as critical an issue in acquisitions that require lower levels of integration, because acquired units are usually granted a considerable degree of autonomy and there is less extensive interaction among the employees of the two firms (David & Singh, 1994; Slangen, 2006). Fig. 1 presents the theoretical model developed in the following discussion. It focuses on trust relations between the two main parties involved in an acquisition: the top management of the acquiring firm or, in the case of a merger, the dominant partner (henceforth, acquiring firm management); and the employees of the acquired firm or, in the case of a merger, the subordinate partner (henceforth, target firm members). The model proposes that target firm members’ perceptions of the acquiring firm management’s trustworthiness are affected by a set of factors related to the firms’ relationship history, interfirm distance, and integration approach. Although trust is composed of distinct elements or dimensions that can vary independently, it is proposed that the different dimensions of perceived trustworthiness form an overall trust impression that can lead the trustor (i.e., the target firm members) to assess in general how much the trustee (i.e., the acquiring firm management) can be trusted (Mayer, Davis, & Schoorman, 1995). More specifically, the model suggests that target firm members’ perceptions of acquiring firm managers’ trustworthiness in terms of their ability, benevolence, integrity, and value congruence converge into a generalized trust judgment or result in a state of ambivalence, depending on whether the trustworthiness attributions are consistent or conflicting. These trust dynamics are posited to affect various attitudinal and behavioral outcomes. Next, we define the central construct in our study, trust; describe the dimensions of perceived trustworthiness of the acquirer; and explain how factors related to the firms’ relationship history, interfirm distance, and integration approach affect target firm members’ perceptions of the acquiring firm management’s trustworthiness.

Defining Trust in Acquisitions Research on trust within and between organizations has shown that trust exists at different levels. While most research on interorganizational trust

• • • •

Autonomy preservation Multiculturalism Expected benefits Communication quality

Integration Approach

Process Variables

• Cultural distance • Power asymmetry • Relative performance

Interfirm Distance

• Collaboration history • Reputation • Mode of takeover

Relationship History

Status Variables

Fig. 1.

Ability Integrity Benevolence Value Congruence Trust or Ambivalence

Model of Trust Dynamics in Acquisitions.

• • • •

Perceived Trustworthiness of Acquiring Firm Management

• Organizational commitment • Citizenship behavior • Information sharing • Willingness to collaborate • Intent to stay

Target Firm Employees’ Attitudes and Behaviors

Trust Dynamics in Acquisitions 55

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has been carried out at the firm level of analysis (Arin˜o, de la Torre, & Ring, 2001; Das & Teng, 1998; Ring & Van de Ven, 1992; Vlaar, Van den Bosch, & Volberda, 2007), trust has also been conceptualized at the individual, dyadic, or group level or as a multilevel phenomenon (e.g., Currall & Inkpen, 2002; Zaheer et al., 1998). In this chapter, the level of analysis chosen for the trustor is the individual or, on an aggregated level, the group (i.e., the members of the target firm). This conceptualization of trust is consistent with Zaheer et al.’s (1998) definition of interorganizational trust as ‘‘the extent of trust placed in the partner organization by the members of a focal organization’’ (p. 142). Central to most definitions of trust are the notions of risk and vulnerability. In the absence of risk, trust is irrelevant because there is no vulnerability (Lewicki & Bunker, 1996; Mayer et al., 1995; Rousseau, Sitkin, Burt, & Camerer, 1998). In this study, we refer to trust as ‘‘a psychological state comprising the intention to accept vulnerability based upon positive expectations of the intentions or behavior of another’’ (Rousseau et al., 1998, p. 395). Conversely, distrust can be defined as negative expectations of another’s intentions or behavior (Sitkin & Roth, 1993; Lewicki, McAllister, & Bies, 1998). This conceptualization of trust has also been applied to interorganizational relationships. For instance, in joint ventures, factors such as open communication and information exchange, task coordination, informal agreements, and levels of surveillance are all manifestations of trust based on a willingness to rely on, or be vulnerable to, another party under a condition of risk (Currall & Inkpen, 2002; Inkpen & Currall, 1997). It has been observed that the turbulence following the announcement of a merger or an acquisition creates a breeding ground for distrust because the situation is unpredictable, easy to misinterpret, and people feel vulnerable (Hurley, 2006; Jemison & Sitkin, 1986; Schweiger & Walsh, 1990). Social networks and mutual understanding established through years of working together are sometimes destroyed in an instant. With a new organization, a new top management team, and a new superior, there is little trust initially, and employees are left wondering what the next wave of changes will bring and whether they will be negatively affected (Datta & Grant, 1990; Hambrick & Cannella, 1993; Lubatkin, Schweiger, & Weber, 1999). The period following the announcement of a takeover is thus one of intense risk assessment in which target firm employees have to judge whether the acquiring firm’s management can be trusted. Theoretical work on trust has suggested that trust can take various forms, ranging from cognitive-based (or ‘‘calculative’’) trust, which is based on the predictability, dependability, and consistency of another party’s behavior, to

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affect-based (or ‘‘identification-based’’) trust, which is rooted in emotional attachment and concern for the other party’s welfare (Lewicki & Bunker, 1996; Rousseau et al., 1998). These bases of trust represent stages that are hierarchical and sequential, such that as relationships develop and the parties form emotional bonds, more complex levels of trust are attained (Lewicki, Tomlinson, & Gillespie, 2006; Mayer et al., 1995). Consistent with prior research on interorganizational trust, we focus mainly on calculus-based trust, which involves a predominantly cognitive assessment of others’ trustworthiness. However, this conceptualization of trust does not mean to imply that individuals affected by a takeover act as rational decision-makers. Research suggests that following the announcement of a takeover, employees tend to place disproportionate weight on rumors and other unreliable information sources while selectively searching for, discounting, or reinterpreting important information (Jemison & Sitkin, 1986; Schweiger & Walsh, 1990). Given the limited amount of validated information that is available about the acquirer’s plans, motives, and intentions, the effects of such perceptual and attributional biases on employees’ trust judgments may be profound. Also, it should be noted that although our analysis focuses mainly on the cognitive aspects of trust dynamics in acquisitions, corporate takeovers involve a number of identity issues that have strong affective components. Dimensions of Perceived Trustworthiness One approach to understand why a given party will have a greater or lesser amount of trust for another party is to consider attributes of the trustee (Gabarro, 1978; Hurley, 2006; Mayer et al., 1995; Whitener, Brodt, Korsgaard, & Werner, 1998). Mayer et al. (1995) proposed that individuals’ trust in others is based on their propensity to trust and their perceptions of others’ trustworthiness, rooted in their interpretation of the attributes and behavior of others. Their model of organizational trust suggests that three characteristics of a trustee are particularly critical for the development of trust: ability, integrity, and benevolence. In addition, trust research has shown that value congruence is another important element of trust (Gabarro, 1978; Sitkin & Roth, 1993). These characteristics are important if researchers are to understand the factors that influence the development of trust in the aftermath of a takeover. Ability The perceived ability or competence of a party is an essential element of attributions about that party’s trustworthiness (Butler, 1991; Mayer et al.,

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1995; Sitkin & Roth, 1993). Gabarro (1978), from interviewing executives, identified nine bases of trust, of which four – functional competence, interpersonal competence, business sense, and judgment – are related to the ability dimension. Competence perceptions also play an important role in interorganizational relationships. For example, Mishra (1996) observed that to the extent that a supplier’s products meet a buyer’s quality standards, the buyer will no longer inspect those products before accepting delivery, evidencing greater trust in the supplier’s competence. Benevolence Trust in another party in terms of benevolence, goodwill, or concern does not mean that the other party lacks any self-interest; rather, ‘‘trust in terms of concern means that such self-interest is balanced by interest in the welfare of others’’ (Mishra, 1996, p. 267). For instance, in manager–subordinate relationships, acting in a way that protects employees’ interests, being sensitive to employees’ needs, and refraining from exploiting employees for the benefit of one’s own interests all affect the degree to which managers are judged to have benevolence (Whitener et al., 1998). In interorganizational relationships, a party can logically expect another party to act benevolently if both parties share the same goals and interests. Research on cooperative alliances between firms has shown that goal congruence and the perceived benefits derived from an alliance have a positive impact on the mutual trust and commitment of the parties involved (Ring & Van de Ven, 1992; Sarkar, Cavusgil, & Evirgen, 1997). Integrity Integrity perceptions can be explained in terms of expectations about the reliability, dependability, or consistency of a person’s behavior (Butler, 1991; Hurley, 2006; Mayer et al., 1995). For example, in manager– subordinate relationships, if managers behave consistently over time and across situations, employees can better predict manager’s future behavior and become willing to take risks in their relationship with their supervisor (Whitener et al., 1998). If, in contrast, employees notice a discrepancy between what managers preach and what they practice, perceptions of managers’ trustworthiness will deteriorate. The consistency of a party’s past actions, credible communications about the trustee from other parties, and the extent that the party’s actions are congruent with his or her words all affect the degree to which that party is judged to have integrity (Mayer et al., 1995).

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Value Congruence In addition to the ability, integrity, and benevolence perceptions, research indicates that perceived value congruence helps to establish trust between individuals, groups, and organizations (Gabarro, 1978; Sitkin & Stickel, 1996; Young-Ybarra & Wiersema, 1999). Trustworthiness attributions often involve the perception that the trustee adheres to a set of principles that the trustor finds acceptable. Such perceptions are facilitated by value congruence between the parties involved in a relationship. In contrast, distrust may be engendered when an individual is perceived as not sharing key values, because ‘‘[w]hen a person challenges an organization’s fundamental values, that person may be perceived as operating under values so different from the group’s that the violator’s underlying world view becomes suspect’’ (Sitkin & Roth, 1993, p. 371). In interorganizational relationships, it has been shown that shared norms and values facilitate the creation and maintenance of trust between firms (e.g., Gulati, 1995; Sarkar et al., 1997). Next, we explore how, in the context of acquisitions, factors related to the relationship history, interfirm distance, and integration approach may influence target firm members’ perceptions of the acquiring managers’ trustworthiness along these four dimensions.

Antecedents of Target Firm Member’s Trust in the Acquiring Firm’s Management Fig. 1 suggests that target firm members’ trustworthiness perceptions are affected by a set of status variables, which comprise aspects of the acquirer– target relationship, as well as process variables related to the acquirer’s integration approach. The distinction between status variables and process variables is consistent with current theory on M&A integration. ‘‘The process perspective’’ (Birkinshaw et al., 2000; Haspeslagh & Jemison, 1991; Jemison & Sitkin, 1986) on M&A suggests that while factors such as strategic, organizational, and cultural fit determine the potential for synergies, the extent to which that potential is realized depends on the ability of the acquirer to manage the integration process in an effective manner. It should be noted that the status variables and process variables proposed to affect trust are likely not independent of each other. For instance, factors such as collaboration history, cultural distance or mode of takeover will likely affect the degree of control imposed on the target, i.e., whether the acquirer will adopt a more ‘‘hands-on’’ or ‘‘hand-off’’

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integration strategy (Haspeslagh & Jemison, 1991; Hunt, 1990; Pablo, 1994). Also, variables within each of the two sets of antecedents (status and process) cannot be assumed to be completely independent of each other. For example, the degree to which the acquirer removes autonomy from the target firm is likely to affect the quality of communication between the two firms (Jemison & Sitkin, 1986). Next, we discuss each of the variables and their proposed relationships. Relationship History Relationship history is composed of the target firm’s preexisting relationship with the acquiring firm, the acquiring firm’s reputation, and the mode of takeover. We propose that the extent to which the members of a target firm perceive the acquiring firm’s management to be trustworthy is a function of prior interfirm contact or, in the absence of a history of collaboration, the reputation of the acquirer. Reputation represents a cumulative record of past behaviors, serving as a reliable signal of the ability, dependability, benevolence, and value congruence of a counterpart. The behavior of firms in relationships with other partners allows potential partners to infer their future behavior and may thus facilitate or hinder the emergence of trust (Johnson, Cullen, Sakano, & Takenouchi, 1997; Parkhe, 1993). Even more powerful than reputation is direct experience, or a history of collaboration. A large body of research on the role of trust in work groups, strategic alliances, and socially embedded partnerships suggests that trust evolves over time through repeated interactions between partners (Gulati, 1995; Ring & Van de Ven, 1992; Zaheer et al., 1998). Like romantic relationships, interfirm relationships mature with interaction frequency, duration, and the diversity of challenges that partners encounter and face together (Lewicki et al., 1998). As Rousseau et al. (1998, p. 399) have noted, ‘‘[r]epeated cycles of exchange, risk taking, and successful fulfillment of expectations strengthen the willingness of trusting parties to rely upon each other and expand the resources brought into the exchange.’’ Furthermore, partners come to learn each other’s idiosyncrasies and develop deeper mutual understanding over time, which improves the affective quality of the relationship (Inkpen & Currall, 2004; Parkhe, 1993). This indirect evidence from the alliance literature suggests that in acquisitions, familiarity through prior contact may facilitate the emergence of a shared identity and trust. However, Ring and Van de Ven (1992) have argued that trust can be expected to emerge between organizations only when they have successfully completed transactions in the past and they perceive one another as complying with norms of equity. If members of the target firm and the

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acquiring firm had a conflict-rich or inequitable exchange prior to the acquisition, this is likely to limit the potential for trust to emerge. Thus, both the length and the quality of the prior relationship with the acquiring firm will be critical in influencing target firm members’ trust. Finally, we propose that the mode of takeover or tone of the negotiations – whether it is friendly or hostile – is an important factor in determining target firm members’ trust. It has been argued that hostile takeover tactics can result in sharp interorganizational conflict and difficulties integrating acquired firms (Buono & Bowditch, 1989; Hambrick & Cannella, 1993; Hitt et al., 2001). Hambrick and Cannella (1993) have observed that the atmosphere surrounding a hostile takeover is often characterized by bitterness and acrimony, making smooth social integration after the deal less likely and that trust can erode quickly when executives from a hostile takeover target and those of the acquiring firm battle each other in a public forum, each being suspicious of the other’s intentions and claiming the other party’s lack of integrity. Social Identity Theory (Tajfel, 1982; Turner, 1982) suggests that under conditions of external threat, such as in a hostile takeover attempt, ‘‘us-versus-them’’ thinking is likely to set in, with individuals striving to maintain their positive social identity by idealizing their own group and denigrating the other. Support for this proposition can be found in research findings that show that hostile takeover attempts lead to resistance and increased cohesiveness among the target firm members (Elsass & Veiga, 1994; Krug & Nigh, 2001). Collectively, these arguments suggest that the relationship history, which is made up of the direct experiences that the members of the target firm had with the acquiring firm in the past, as well as the reputation that the acquirer brings to the relationship, will be critical in influencing trust. If the acquirer’s executives have repeatedly demonstrated their ability, integrity, benevolence and value congruence over an extended period of time, they are more likely to be perceived as trustworthy. The foregoing discussion suggests that collaboration history and reputation may influence trustworthiness perceptions along all four dimensions, whereas mode of takeover will affect trust mainly through perceptions of the acquiring firm managers’ integrity and benevolence. Thus, we advance the following propositions: Proposition 1. Target firm members’ perceptions of the acquiring firm managers’ trustworthiness are influenced by the firms’ relationship history. Specifically, Proposition 1a. The longer and more positive the collaboration history, the greater the likelihood that target firm members will perceive the

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acquiring managers to have ability, integrity, benevolence, and congruent values. Proposition 1b. The better the acquirer’s reputation, the greater the likelihood that target firm members will perceive the acquiring managers to have ability, integrity, benevolence, and congruent values. Proposition 1c. The friendlier the mode of takeover, the greater the likelihood that target firm members will perceive the acquiring managers to have integrity and benevolence. Interfirm Distance The second set of trust antecedents proposed in this chapter affect trustworthiness attributions through perceptions of interfirm distance. These variables include cultural distance, power asymmetry, and relative performance. The cultural distance hypothesis (Hofstede, 1980) suggests that the difficulties, costs, and risks associated with cross-cultural contact increase with growing cultural divergence between two individuals, groups, or organizations. Although studies that tested the cultural distance hypothesis in the context of M&A have yielded inconclusive results (see Cartwright & Schoenberg, 2006; Schweiger & Goulet, 2000, for reviews), research on trust indicates that shared norms and values facilitate the development of trust and the emergence of a shared identity (Lewicki et al., 1998; Sarkar et al., 1997). Conversely, trust can erode and the potential for conflict increase when a person or group is perceived as not sharing key values (Sitkin & Roth, 1993). Social Identity Theory suggests that in a merger situation, the mere existence of two different cultures is enough to lead to in-group outgroup bias and conflict: Organizational members, while emphasizing their own positive distinctiveness, tend to exaggerate the differences between their own and the partner’s culture (e.g., Hogg & Terry, 2000; Kleppestø, 2005; Vaara, 2003). In-group bias and out-group derogation are likely to be greatest when the out-group is perceived to be very different from the ingroup, such as in cross-border acquisitions (Elsass & Veiga, 1994). As a result of social categorization processes, out-group members may be perceived ‘‘as uniformly unethical or malevolent, incompetent, and illinformed – and the in-group is viewed in the opposite terms’’ (Sitkin & Stickel, 1996, p. 212). In cross-border acquisitions, feelings of resentment, hostility, and mistrust may be further fueled by cultural stereotypes, prejudices and xenophobia (Teerikangas & Very, 2006; Vaara, 2003).

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Cultural distance is thus likely to affect trust not only through perceptions of value congruence but also because it increases the likelihood that the other party is ascribed various negative attributes, such as incompetence, malevolence, or lack of integrity. Power asymmetry refers to the extent to which there can be a unidirectionality of influence from acquirer to target. The capability and tendency of the acquiring firm for exercising power to enforce its preferences upon the target is particularly strong when the acquirer is significantly larger than the target firm. In such cases, target firm members’ needs tend to get overlooked or trivialized by the acquirer (Datta & Grant, 1990; Hambrick & Cannella, 1993; Jemison & Sitkin, 1986). As Pablo (1994) has noted, the effect of power differences ‘‘is not simply the overwhelming and domination of the smaller entity through sheer magnitude, but also the intensification of beliefs about superiority and inferiority’’ (p. 810). Acquiring executives tend to adopt an attitude of superiority and treat the members of the target firm as inferior, thus leading to status degradation and the voluntary departure of key employees (Hambrick & Cannella, 1993; Lubatkin et al., 1999). Research suggests that the mere existence of power asymmetries may generate suspicion and mistrust through anticipation of dominance by the acquiring executives. For instance, it has been observed that target firm members altered their behavior in response to the threat of a powerful buyer even prior to being acquired, for example, by seeking employment elsewhere (Hambrick & Cannella, 1993; Krug & Nigh, 2001). Also, research on alliances suggests that as power asymmetry increases, the weaker party tends to become distrustful because the more powerful party has no need to be trusting and can use its relative power to obtain cooperation (Das & Teng, 1998; Kumar, 1996). Underperformance of the target relative to the acquirer may have a similar effect on trust. Poor target firm performance in the past is likely to increase an acquirer’s tendencies toward arrogance and domination (Datta & Grant, 1990; Jemison & Sitkin, 1986). Hambrick and Cannella (1993) have observed that even if executives of a poorly performing firm are not fired outright after their acquisition, they may feel inferior or depart voluntarily because they are anticipating the dominating behaviors of their ‘‘conquerors.’’ Lower-level employees are likely to experience anxiety from fears they might lose their jobs or be unable to meet the acquirer’s exacting performance standards. Paradoxically, though, it has been observed that when a smaller or underperforming firm is acquired by a significantly larger or financially healthy buyer, target firm members often welcome the takeover and are energized to become part of something larger or more

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successful than themselves (e.g., Chaudhuri, 2005; Evans, Pucik, & Barsoux, 2002). This is especially true when they see the acquiring company as being a savior or having a more enlightened culture, or when they see other positive outcomes in being associated with the acquirer (better pay, more prestige, etc.). For example, Bastien (1987) observed that the overall mood of target employees was celebratory and optimistic after a ‘‘white knight’’ acquisition by a healthy buyer. Being liberated from weak and ineffective management may enhance target firm employees’ trust, because they perceive the acquirer’s executives as more effective and competent than their own. Thus, we propose that there is not a general effect of power asymmetry and relative performance on target firm members’ trust. Rather, these attributes are likely to lead to conflicting trustworthiness perceptions: while being acquired by a significantly larger, more powerful, and more successful company may be a frightening prospect to the members of a target firm, the greater power and superior performance of the acquirer relative to the target may at the same time elicit perceptions of managerial competence. Taken together, these arguments support the following propositions: Proposition 2. Target firm members’ perceptions of the acquiring firm managers’ trustworthiness are influenced by the interfirm distance. Specifically, Proposition 2a. The greater the cultural distance, the greater the likelihood that target firm members will perceive the acquiring managers to be lacking ability, integrity, benevolence, and congruent values. Proposition 2b. The more powerful the acquirer relative to the target, the greater the likelihood that target firm members will perceive the acquiring managers to have ability, and the lesser the likelihood that they will perceive them to have benevolence. Proposition 2c. The better the performance of the acquirer relative to the target, the greater the likelihood that target firm members will perceive the acquiring managers to have ability, and the lesser the likelihood that they will perceive them to have benevolence. Integration Approach In addition to the status variables discussed earlier, our analysis suggests that trust is influenced by a set of process variables relating to how the acquirer approaches the postacquisition integration. Although, theoretically,

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integration can result in a balanced merging of two organizations, cultures and workforces, this balance rarely occurs in practice. Instead, the acquirer or dominant partner typically removes autonomy from the target firm and imposes a rigorous set of rules, systems, and performance expectations upon it to gain quick control (Datta & Grant, 1990; Hambrick & Cannella, 1993; Jemison & Sitkin, 1986; Pablo, 1994). Because tight controls tend to signal the absence of trust, their use typically hampers its emergence, often resulting in a cycle of escalating distrust (Inkpen & Currall, 2004; Jemison & Sitkin, 1986). Autonomy removal can be devastating from the perspective of the members of the target firm and lead to feelings of helplessness and open hostility, as managers and employees vigorously defend their autonomy – a situation that Datta and Grant (1990) have termed the ‘‘conquering army syndrome.’’ In such a situation, it seems likely that the acquirer’s executives are perceived as uniformly malevolent and not to be trusted. They may also be seen as lacking integrity, especially if target firm members perceive a gap between the acquirer’s stated goals and intentions, and the actual integration approach taken, as in the case of the DaimlerChrysler ‘‘merger’’ (Epstein, 2004; Vlasic & Stertz, 2000). The degree to which an acquiring firm tends to impose its policies, norms, and expectations on the target firm depends on the acquirer’s multiculturalism (Chatterjee, et al., 1992; Nahavandi & Malekzadeh, 1988; Pablo, 1994). The term multiculturalism refers to the degree to which an organization values cultural diversity and is willing to tolerate and encourage it (Nahavandi & Malekzadeh, 1988). A multicultural acquirer considers diversity an asset and is therefore likely to allow an acquired firm to retain its own values and modus operandi. In contrast, a unicultural acquirer emphasizes conformity and adherence to a unique organizational ideology and is therefore more likely to impose its culture on the target firm. Jemison and Sitkin (1986) have observed that cultural arrogance and insensitivity can trigger feelings of resentment, anger, and hostility on the part of the target firm members. Cultural intolerance is also likely to increase the tendency to overemphasize cultural differences, thereby resulting in perceived value incongruence and an attitude polarization toward distrust (Sitkin & Roth, 1993). There is evidence that the expected benefits of the organizational changes that result from the takeover, particularly the quality of the post-acquisition reward and job security changes, is a critical factor in determining employees’ reactions to an acquisition (Hunt, 1990; Schweiger & Walsh, 1990; Van Dick, Ullrich, & Tissington, 2006). For instance, Graves (1981), in a case study of an acquisition of a firm of brokers in the reinsurance

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industry found that the employee reactions depended to a large extent on the personal benefits and losses attributed to the takeover. If the members of a target firm see the takeover as a chance for more job security and increased prospects for compensation and promotion, this is likely to affect their attitudes toward the acquirer in a positive way and reduce the potential for conflict (Cartwright & Cooper, 1996; Schweiger, 2002). As an illustration, Bartels, Douwes, De Jong, and Pruyn (2006) revealed that the expected utility of the merger (anticipated benefits such as salary increases or more job security) was the strongest predictor of employees’ identification with the postmerger organization. Finally, we propose that the quality of communication is a key factor in determining the level of trust that target firm members have in the acquirer’s management. M&As are associated with high degrees of stress and uncertainty for the individuals affected by them, especially those of the target firm. Providing acquired employees with credible and relevant information has been shown to reduce the uncertainty associated with a takeover and to mitigate the negative effects on perceptions of managers’ trustworthiness (Bastien, 1987; Schweiger & DeNisi, 1991). The quality of communication has also been shown to increase employees’ identification with the postmerger organization (Bartels et al., 2006). A lack of credible and open communication, on the contrary, has been found to result in intense rumor activity, anxiety over job security, and feelings of suspicion and mistrust (Buono & Bowditch, 1989; Marks & Mirvis, 1998). While the credibility of the information provided by the acquirer can be considered a sine qua non for trust to emerge, Hogan and Overmyer-Day (1994) found that too much information disseminated to employees in acquisitions characterized by high levels of integration exacerbated undesirable attitudes and behaviors, because it increased anxiety in a situation where employees already felt uncertain about their jobs. Thus, the quality and timing of communication may be more important in affecting trust than the amount of information provided by the acquirer. For example, failure to share relevant information in a timely manner may be judged to be typical of the acquiring executives’ incompetence; ambiguous, contradictory, or incorrect information disseminated by the acquirer may be perceived as a sign of managers’ duplicity or dishonesty; the use of detached language devoid of emotion when informing employees about necessary layoffs may convey the impression that managers lack compassion and care; and differences in communication style may be seen as an indicator of fundamental value incongruence. Because ineffective communication can promote a distorted picture of the acquiring executives’ motives, intentions and actions,

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we propose that communication quality will affect trustworthiness perceptions along all four dimensions. The foregoing discussion suggests the following propositions: Proposition 3. Target firm members’ perceptions of the acquiring firm managers’ trustworthiness are influenced by the integration approach. Specifically, Proposition 3a. The greater the degree of autonomy preservation, the greater the likelihood that target firm members will perceive the acquiring managers to have integrity and benevolence. Proposition 3b. The greater the degree of multiculturalism, the greater the likelihood that target firm members will perceive the acquiring managers to have congruent values. Proposition 3c. The greater the expected benefits from the organizational changes resulting from the takeover, the greater the likelihood that target firm members will perceive the acquiring managers to have ability and benevolence. Proposition 3d. The more timely, credible and useful the information provided by the acquirer, the greater the likelihood that target firm members will perceive the acquiring managers to have ability, integrity, benevolence, and congruent values. Table 1 provides a summary of the propositions. Collectively, the evidence suggests that the firms’ relationship history, interfirm distance, and the acquirer’s integration approach affect target firm members’ trust through perceptions of the acquiring managers’ ability, integrity, benevolence, and value congruence. With this foundation, we attempt to specify the mechanisms by which the four bases of trust might combine in determining overall trust in acquisitions.

How the Dimensions of Perceived Trustworthiness Combine in Acquisitions The model presented in this chapter rests on the idea that the four dimensions of perceived trustworthiness vary largely independently of one another and represent different components of an overall trust construct. However, from the trust literature, it is not clear how the various bases of

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Table 1.

Proposed Effects on Trustworthiness Perceptions.

Status and Process Variables

Relationship history Collaboration history Reputation Mode of takeover Interfirm distance Cultural distance Power asymmetry Relative performance Integration approach Autonomy preservation Multiculturalism Expected benefits Communication quality

Perceptions of Acquiring Managers’ Trustworthiness Ability

Integrity

Benevolence

Value congruence

þ þ

þ þ þ

þ þ þ

þ þ

 þ þ



  



þ

þ

þ

þ þ

þ þ þ

þ

Note: þ / indicates positive/negative relationship.

trust combine in influencing overall trust. While some scholars (e.g., Mishra, 1996) have suggested that they combine multiplicatively in determining overall trust, others (e.g., Mayer et al., 1995) have argued that there may be situations in which a meaningful amount of trust can develop with lesser degrees of one or more of the factors, thus suggesting an additive effect on overall trust. Yet others have proposed that the bases of trust identified in the literature do not combine, but, rather, that individuals tend to ‘‘partition’’ their trust and work with interaction partners around specific and compartmentalized interdependencies (Lewicki et al., 1998). Sitkin et al. (Sitkin & Roth, 1993; Sitkin & George, 2005) and Lewicki et al. (Lewicki et al., 1998, 2006; Lewicki & Wiethoff, 2000) have argued that trust and distrust are not opposite ends of a single continuum and that it is possible for parties to hold simultaneously different, and sometimes inconsistent, views of each other. They argue that the motives of relationship partners are usually only partially convergent and partially divergent and that relationships are often multifaceted and compartmentalized, yielding the possibility that relationship partners may trust each other in certain respects and not trust each other in other respects. As Lewicki et al. (1998) have pointed out, the coexistence of trust and distrust is common in multiplex working relationships such as in teams, partnerships, and alliances.

69

Trust Dynamics in Acquisitions [W]e need to y see [relationships] as complex, multidimensional constructs. The building blocks of these relationships are facet elements in which we encounter the other within a given context, at a given point in time, and around a given interdependency. Within each facet element, trust or distrust can developy. [It] is possible (and likely) that as facets aggregate, they are not necessarily consistent with each other, and individuals can accommodate facets and hold views of the other that do not need to achieve this consistency. (Lewicki et al., 1998, p. 444)

Our model of trust dynamics in acquisitions builds on these ideas and extends them. We propose that the ability, integrity, benevolence, and value congruence dimensions of trust vary largely independently of one another and that each dimension represents a unique perspective from which target firm members assess the acquiring managers’ trustworthiness. Fig. 2 illustrates how each of the four dimensions varies along a continuum. The simplest cases of generalized trust or generalized distrust assume high or low levels of all four factors. In these cases, perceptions of the acquiring firm management’s ability, benevolence, integrity, and value congruence will converge into one overall trust judgment. However, our previous analysis suggests that in the aftermath of a takeover, the more common state is not one of consistency but, rather, of imbalance and conflict. There are several reasons why ambivalence or ‘‘complex trust’’ – that is, some combined level of trust and distrust (Lewicki et al., 2006; Example of generalized distrust

Example of Example of complex trust generalized (ambivalence) trust

Ability

low

high

Integrity

low

high

Benevolence

low

high

Value Congruence

low

high

Fig. 2.

Generalized and Ambivalent Trust Conditions in Corporate Acquisitions.

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Sitkin & Roth, 1993) – is the rule, rather than the exception in acquisitions. First, our analysis suggests that some antecedent variables lead to conflicting trustworthiness perceptions. For example, high performance of the acquirer relative to the target may elicit perceptions of managerial competence, but at the same time raise concerns about the acquiring executives’ benevolence. In other words, target firm employees may trust the acquiring managers to make competent decisions, but not necessarily trust them to act in accordance with their needs and interests. Such conflicting trustworthiness perceptions are likely to undermine the development of a singular overall trust expectation (Lewicki & Wiethoff, 2000). Another reason why trust and distrust are likely to coexist in the aftermath of a takeover is that the specific configuration of antecedent variables may facilitate the development of trust in terms of some dimensions but hamper the emergence of trust on others. For example, a powerful acquirer may be inclined to remove autonomy from the target firm and impose its culture, systems, and performance expectations upon it in order to gain quick control, yet at the same time provide strong incentives for the target firm members to conform (e.g., Chaudhuri, 2005). In such a situation, target firm members have reason to trust the acquirer in some respects, but have reason to be wary and suspicious in other respects. Collectively, these arguments suggest the following propositions: Proposition 4. The more consistent target firm members’ perceptions of the acquiring managers’ trustworthiness in terms of their ability, integrity, benevolence and value congruence, the greater the likelihood that a generalized trust expectation will develop. Proposition 5. In acquisitions, the existence of conditions that elicit conflicting trustworthiness perceptions means that the ability, integrity, benevolence, and value congruence dimensions of trust will generally diverge, resulting in varying degrees of ambivalence. The multifaceted and inherently ambivalent nature of trust relations in acquisitions has far-reaching implications for the process of sociocultural integration, as discussed below. The Consequences of Generalized and Ambivalent Trust Conditions in Acquisitions While it is theoretically possible that target firm members’ trustworthiness perceptions converge into a generalized expectation that the acquirer can be

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trusted (or is to be distrusted), the foregoing discussion suggests that the relationship is more likely to be characterized by ambivalence – the coexistence of trust and distrust. In this section, we discuss how target firm members may resolve the resulting tensions and what the implications are for the process of sociocultural integration. Generalized Trust and Generalized Distrust In cases where trustworthiness perceptions along the four dimensions converge, this generalized expectation that the acquiring firm’s management can be trusted is likely to affect target firm members’ attitudes and behaviors in a positive way. If target firm members have confident positive expectations (i.e., trust) about the acquiring firm managers’ ability, integrity, benevolence and value congruence, they will be more willing to be vulnerable and engage in behaviors that put them at risk (Lewicki et al., 2006; Mayer et al., 1995). In the aftermath of a takeover, the willingness to be vulnerable may be manifested in target firm employees who engage in open and candid communication with managers of the acquiring firm, are willing to subjugate their personal goals for the goals of the new organization, and remain with the organization even though they could get attractive jobs elsewhere. This is consistent with two meta-analyses of research on the role of trust in organizational settings (Dirks & Ferrin, 2001, 2002), which suggest that trust affects a variety of attitudinal and behavioral outcomes, including communication and information sharing, organizational commitment and citizenship behavior, and intent to stay in the organization. Likewise, the negative employee reactions and integration outcomes often observed in M&A, such as employee resistance, a focus on personal security rather than organizational goals, lack of commitment to the new organization, a tendency to not pass information up or down, and high rates of turnover (e.g., Buono & Bowditch, 1989; Hambrick & Cannella, 1993; Marks & Mirvis, 1998; Schweiger, 2002; Vaara, 2003) can partly be explained in terms of trust (or a lack thereof), in that these attitudes and behaviors reflect an unwillingness to be vulnerable on the part of the target firm members and to engage in behaviors that put them at risk. When taken together, these two streams of research on organizational trust and on sociocultural integration in M&A suggest the following proposition: Proposition 6. A generalized expectation that the acquiring firm management can be trusted (is to be distrusted) will be positively (negatively) associated with attitudinal and behavioral outcomes, such as target firm

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member commitment, willingness to cooperate, information sharing, citizenship behavior, and intent to stay. Next, we discuss the consequences of conflicting trustworthiness perceptions, which result in varying degrees of ambivalence. Ambivalence According to Lewicki and Wiethoff (2000), the internal conflict created by states of ambivalence that are characterized by elements of both trust and distrust ‘‘serves to undermine clear expectations of the other party’s behavior and force the actor to scrutinize every action by the other to determine whether it should be counted in the trust or the distrust column’’ (p. 102). We propose that in the aftermath of a corporate takeover, this state of ‘‘adaptive vigilance’’ (Kramer, 1994), coupled with perceptual biases and sense-making tactics typically employed by individuals under conditions of uncertainty and stress, is likely to lead the members of the target firm to selectively search for, discount, or reinterpret important information in a way that may result in a drift toward distrust. Such tendencies are well documented in the M&A literature. For example, Marks and Mirvis (1998) have observed that as a result of the uncertainty following the announcement of an M&A, employees tend to scrutinize every action by the management to determine what will happen to them and whether management can be trusted. Employees become preoccupied with what the merger means for themselves and tend to focus on the losses and ignore the gains. Rumor-mongering produces worst-case-scenarios and ‘‘us-versus-them’’ thinking, resulting in an exaggerated view of differences and a lack of attention to similarities. Jemison and Sitkin (1986) have shown how under conditions of uncertainty and stress following an acquisition, the members of both companies become hypervigilant, overly suspicious of the other’s motives and intentions, and prone to overreact. The resulting cycle of escalating conflict may lead to further distrust and polarization of preconceived attitudes about the other party. If unaddressed, the mutually reinforcing distrust can grow in intensity until relationships are irreparably damaged and integration fails. This is consistent with psychological research (e.g., Brewer, 1981; Kramer, Brewer, & Hanna, 1996) that suggests that basic cognitive processes, such as social categorization, may heighten distrust and suspicion between individuals from different groups in a way such that ‘‘presumptive distrust tends to become perpetual distrust’’ (Kramer, 1999, p. 594). Suspicion is likely to be triggered by situations where one’s experiences with another

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party are inconsistent and the relationship is multifaceted and inherently ambivalent (Lewicki et al., 1998). Violated trust expectations can give rise to paranoid cognitions and to the reinterpretation of evidence of actual trustworthiness (Bies & Tripp, 1996; Sitkin & Roth, 1993). As a result, benevolent conduct by the acquiring firm’s executives may be seen as further evidence of their duplicity or malevolence, while evidence of their trustworthiness is summarily dismissed. The resulting cycle of distrust may be further reinforced by perceptual and attributional processes that contribute to asymmetries in the trust-building versus trust-destroying process. For instance, Kramer (1999) cites evidence to suggest that negative, trust-destroying events are generally more visible than positive, trustbuilding events; that trust-destroying events carry more weight in judgment than trust-building events of comparable magnitude; and that sources of bad, trust-destroying news tend to be perceived as more credible than sources of good news. Collectively, these findings suggest that in the aftermath of a corporate takeover, once the seeds of distrust are sown, they may be self-generating (Kramer, 1999; Sitkin & Roth, 1993). This leads to our final proposition: Proposition 7. The greater the degree of ambivalence that results from conflicting trustworthiness perceptions, the greater the likelihood of a drift toward distrust, as target firm members selectively search for, discount, or reinterpret important information about the acquiring firm’s management.

CONTRIBUTIONS AND IMPLICATIONS Scholars have long criticized the lack of theory development and the fragmented nature of research in the area of M&A integration, arguing that M&A are multifaceted phenomena that require a unified research approach that integrates concepts and ideas from various disciplines (Larsson & Finkelstein, 1999; Schweiger & Goulet, 2000; Shimizu, Hitt, Vaidyanath, & Pisano, 2004). For instance, Schweiger and Goulet (2000, p. 87), in a review of the literature on M&A integration, have noted that ‘‘[a]lthough many aspects of integration have been addressed by research, there exists a need to consolidate the findings of these studies in an effort to significantly advance M&A theory.y Antecedents of, and the context surrounding, M&As need to be simultaneously and parsimoniously linked to integration processes.’’ In an initial effort toward a more theoretically grounded understanding

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of the process of sociocultural integration (Birkinshaw et al., 2000; Shrivastava, 1986), we applied trust theory to the domain of corporate acquisitions. By linking organizational, cultural, and human resource perspectives on M&A to notions drawn from the trust literature, we hope to gain a better understanding of the mechanisms by which aspects of the acquirer-target relationship, as well as process variables related to the acquirer’s integration approach affect target firm members’ reactions to a takeover. Despite a large body of anecdotal evidence that supports the critical role that trust plays in M&As, surprisingly little is known about the factors that facilitate or hinder the development of trust in acquired organizations. The model developed in this chapter proposes that target firm members’ perceptions of the acquiring firm managers’ trustworthiness converge into a generalized trust judgment or result in a state of ambivalence, depending on whether the trustworthiness attributions are consistent or conflicting, thus yielding the possibility that target firm members might trust the acquirer’s executives in certain respects and not trust them in others. Our approach draws upon existing research on trust in that we view trust relationships as inherently multifaceted and complex (Lewicki et al., 1998; Mayer et al., 1995). However, our analysis of trust dynamics in acquisitions extends the literature on organizational trust in several important ways. This chapter represents one of few attempts to specify the mechanisms by which the various bases of trust (e.g., Hurley, 2006; Mayer et al., 1995; Whitener et al., 1998) combine in determining overall trust. Importantly, the model developed in this chapter explains how a range of specific tactics typically employed in the aftermath of a takeover may motivate target firm members to selectively search for, discount, or reinterpret important information about the acquirer in a way that results in a drift toward distrust, with potentially negative implications for the sociocultural integration process. Our analysis of the role that states of ambivalence, characterized by elements of both trust and distrust, play in the postacquisition integration process is very much in line with recent research into the sociocultural and human resources implications of M&As (e.g., Birkinshaw et al., 2000; Goulet & Schweiger, 2006; Krug & Nigh, 2001; Marks & Mirvis, 1998). This research has shown that, in the aftermath of corporate takeovers, trust is fragile – it is easily broken and hard to repair. For instance, M&A case studies (Chua et al., 2005; Olie, 1994; Sales & Mirvis, 1984) suggest that the uncertainty associated with M&A, impending layoffs, and the disruption of social networks create a breeding ground for distrust. In such situations, relatively minor trust violations may be sufficient to ‘‘tip the scales’’

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(Dirks & Ferrin, 2001, p. 461) and result in a drift toward distrust, because individuals will tend to perceive the violation in ways consistent with their already low levels of trust – as yet another sign of the acquiring managers’ incompetence, duplicity, or malevolence. The tendency to interpret trust violations in ways consistent with initial trust levels is particularly strong in situations characterized by some degree of ambiguity. In these cases, trust (or distrust) provides a perceptual ‘‘lens’’ that affects the interpretation of another’s past actions, the conclusions one draws about the factors motivating the other’s action, one’s psychological and behavioral responses to the action, and predictions of the other’s future behavior (Dirks & Ferrin, 2001; Kramer, 1999; Sitkin & Roth, 1993). These cognitive processes and perceptual biases can go a long way toward explaining the negative and self-reinforcing trust cycles often observed in M&As (e.g., Jemison & Sitkin, 1986). They also explain why it may take a long time to build trust after a merger or takeover, but only an instant to destroy it. Our analysis suggests that in acquisitions, ambivalence or ‘‘complex trust’’ – i.e., the coexistence of trust and distrust – is more common than ‘‘pure’’ trust or distrust. This may not be such a bad thing after all, from the perspective of the members of the target firm. While most of the literature on organizational trust assumes that trust is inherently good and distrust is inherently bad, Lewicki et al. (2006) argue that some distrust can be functional and even healthy in certain circumstances, particularly when there are reasons to suspect that another party is not trustworthy. In the context of acquisitions, too much trust can be damaging because it allows the target firm employees to be exploited and taken advantage of by the acquirer. For instance, acquired employees may be enticed to stay with promises of salary increases or promotions that never materialize. Under this perspective, ‘‘benign and unconditional trust appears to be an extremely dangerous strategy’’ (Lewicki et al., 1998, p. 451), and a certain amount of ‘‘prudent paranoia’’ (Kramer, 1996) seems appropriate. Further research in this area is needed to determine which facets of trust matter most for acquired employees and to identify the contexts in which high trust levels produce dysfunctional consequences and distrust or ambivalence can produce beneficial outcomes. This chapter provided some new insights into the trust dynamics in acquisitions. However, there are several possible limitations that need to be discussed. First, the proposed model of the role of trustworthiness perceptions in acquisitions requires further conceptual refinement. The model rests on the idea that ability, integrity, benevolence and value congruence are important bases of trust and that each dimension represents

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a unique perspective from which the target firm members assess the acquiring firm management’s trustworthiness. While the importance of these four factors is well established in the trust literature (e.g., Gabarro, 1978; Mayer et al., 1995; Sitkin & Roth, 1993), the question of how they exactly combine in determining overall trust levels in different organizational contexts deserves further investigation. In the context of acquisitions, future research may well reveal that the four bases of trust discussed in this chapter have distinct antecedents, different attitudinal and behavioral correlates, and different implications for the post-acquisition integration process. The model presented in this chapter treats the main party affected by an acquisition – the members of the target firm – as a single, homogeneous entity. It thus implicitly assumes that different groups within the target firm will respond the same to an acquisition. However, individuals may vary in their responses to a takeover, depending on their personalities, experiences, and roles in the organization (e.g., Buono & Bowditch, 1989; Hambrick & Cannella, 1993; Schweiger & Walsh, 1990). For example, some of the proposed relationships may depend on the hierarchical level in the organization, that is, whether senior executives, middle managers, or rank-and-file employees are affected. Hostile takeover tactics and autonomy removal, for instance, are likely to affect acquired top managers more strongly than lower-level employees. While the potential moderating effects of individual difference variables are beyond the scope of this chapter, we believe that the role of individual-level moderators is critical to more fully understanding the trust dynamics in acquisitions. The main focus of this chapter was on the motivational and behavioral reactions of acquired personnel. This bias toward the target firm’s perspective notwithstanding, the proposed model points to the important role of the acquiring managers in building and restoring trust in acquisitions. One fruitful avenue for future research is to consider the role of trust repair strategies in restoring damaged relationships after M&As. Recent research on trust repair (e.g., Bottom, Gibson, Daniels, & Murnighan, 2002; Kim, Dirks, Cooper, & Ferrin, 2006; Tomlinson, Dineen, & Lewicki, 2004) points to the potentially critical role of reconciliation tactics and conflict management strategies such as apology, repentance or reticence in interrupting, and possibly reversing, negative trust spirals. Finally, the temporal dimension of trust in acquisitions warrants more attention. Prior research on organizational trust suggests that trust changes over time, developing, deteriorating, and sometimes resurfacing in longstanding relationships (Das & Teng, 1998; Lewicki et al., 2006; Rousseau et al., 1998). The quality of trust may change over the course of a relationship,

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from calculus- or deterrence-based trust to a more relational-based trust, as the parties gradually expand the resources brought into the exchange, form emotional bonds, and identify with each other’s goals (Lewicki & Bunker, 1996; Tomlinson et al., 2004). Although this chapter does not explicitly address how trust is incrementally built and sustained over time, our emphasis on integration process variables implies that trust is a dynamic phenomenon. Because of the inherent dynamics of the integration process, trust relations in acquisitions may be more accurately depicted as ‘‘singleframe snapshots of a dynamic time-series process’’ (Lewicki et al., 1998, p. 444). A more complete understanding of trust in acquisitions would come from consideration of its evolution over time, beginning at the time of the announcement of an acquisition and ending when the acquired firm is either successfully integrated or integration has failed.

CONCLUSION The evidence presented in this chapter suggests that trust plays a key role in the integration process. Consistent with a ‘‘process perspective’’ on acquisitions (Haspeslagh & Jemison, 1991; Jemison & Sitkin, 1986), our analysis points to the important role of the acquiring firm’s executives in building trust and contributing to the success of an acquisition. While even minor trust violations can result in a drift toward distrust, with potentially negative consequences for the integration process, building and restoring trust requires the consistent and long-term display of managerial trustworthy behavior.

ACKNOWLEDGMENTS The authors thank Andrew Carton, Mathew Hayward, Harry Lane, Rikard Larsson, Allan Lind, and Amy Pablo for their helpful comments on earlier drafts of this chapter.

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OVERCOMING BIASES IN M&A: A PROCESS PERSPECTIVE$ Massimo Garbuio, Dan Lovallo and John Horn ABSTRACT Mergers & acquisitions (M&A) are an important element of any company’s growth plan. However, the actual performance of most M&A activity fails to live up to the expectations of the acquirers. The psychological biases that affect decision-making have been posited as a source of this disappointing performance. The broad strokes in which these biases have been offered up as explanation for M&A failure don’t offer much insight into the specific causes, and therefore the actions business leaders can take to mitigate their impact. We review a 4-step M&A process, identify the different biases that affect the different stages, and then offer practical debiasing techniques targeted at that particular stage of the decision-making process. This targeted debiasing can help business leaders find practical solutions to this vexing problem. Finally, we review two biases that motivate decision makers to avoid pursuing M&A deals at all – to the detriment of achieving their growth targets.

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This chapter is a derivative work from a previously published paper in the Harvard Business Review, December 2007.

Advances in Mergers and Acquisitions, Volume 9, 83–104 Copyright r McKinsey and Company 2010 All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1108/S1479-361X(2010)0000009007

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INTRODUCTION Mergers and acquisitions (M&As) are important vehicles for strategic growth (Lubatkin, 1987). However, they have been found to have a negative effect on the shareholder wealth of acquiring firms (Bradley, Desai, & Kim, 1988; Jarrell, Brickley, & Netter, 1988; Agrawal, Jaffe, & Mandelker, 1992; Berkovitch & Narayanan, 1993) and their long-term profitability (Fowler & Schmidt, 1988; Herman & Lowenstein, 1988; Ravenscraft & Scherer, 1987). When financial failure is measured as the ability to outperform the stock market or increase profits, failure rates between 60% and 80% are not uncommon (Jensen & Ruback, 1983; Marks & Mirvis, 2001; Tetenbaum, 1999; Andrade, Mitchell, & Stafford, 2001). In addition, executives of acquiring firms report that only 56% of their acquisitions can be considered successful as measured by the original objectives set for them (Schoenberg, 2006). Overall, empirical evidence concludes that, on average, acquisitions do not create value for the shareholders of acquiring firms (Andrade et al., 2001), and acquisition premiums paid inversely affect acquirers’ shareholder returns for up to four years following the acquisition date (Sirower, 1997). In his seminal work on the psychological underpinning of M&A failures, Roll (1986) proposes the ‘‘hubris hypothesis’’ to explain why acquirers tend to overpay for their targets. Hayward and Hambrick (1997) found several indicators that associate CEO hubris with acquisition premiums. However, the hubris hypothesis alone does not give a comprehensive picture of why M&As often fail. Through a more fine-grained analysis, we can examine a richer set of psychological biases – systematic errors in processing information and making choices – that can enter the M&A decision-making process and help to explain what can go wrong at each step. Given that M&A decision making entails a process, we propose that executives can use a targeted debiasing approach to improve their decisions in this context. The approach requires executives to first identify the cognitive mechanisms at play during various decision-making steps and then use a set of techniques to reduce bias at specific decision points, thereby leading to sounder judgments. This approach has successfully been applied to other executive decisions, such as market entry (Horn, Lovallo, & Viguerie, 2005) and exit (Horn, Lovallo, & Viguerie, 2006). The chapter proceeds as follows. In the next section, the core of our work, we draw on existing literature to break down the M&A decision-making process into four major phases: the decision of whether to pursue an acquisition, preliminary due diligence, the bidding phase, and final due diligence. Then, for each phase, we first consider its key elements (e.g., the kind of information

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considered by executives), discuss the empirical evidence from psychology that is relevant to the processing of these elements, and expand on how psychology explains the empirical evidence. Next, we present some corrective strategies that can help executives overcome the biases that affect each phase in the decision-making process. We then discuss two biases, loss aversion and comparative ignorance, that motivate decision makers to forego acquisitions that could provide their firms with profitable growth opportunities. We conclude with a discussion of the approach presented in this chapter.

BIASES IN M&A DECISION MAKING Three main motives have been proposed to explain M&A activity (Hayward & Hambrick, 1997; Walsh & Seward, 1990; Berkovitch & Narayanan, 1993). First, firms damaged by poor management are acquired by better-managed firms to eliminate inefficiencies and increase shareholder value (e.g., Fama, 1980). Second, M&As are performed to exploit synergies between the acquirer and the target firm such that the value of the new entity should exceed the value of the two independent entities (Rumelt, 1974; Barney, 1988; Prahalad & Hamel, 1990). In both cases, acquisition premiums, defined as the ratio of the ultimate price paid per target share divided by the price before news of the takeover, generally have been considered to reflect acquiring executives’ perceptions of how much additional value they can extract from the target firm, either by eliminating the target firm’s inefficiencies (Fama, 1980) or by exploiting synergies. Third, a line of literature argues that takeovers arise from individual, group, and social factors rather than strategic considerations (Roll, 1986; Hayward & Hambrick, 1997; Haspeslagh & Jemison, 1991), which is where a process perspective can make a contribution. Our discussion of biases in M&A decision making is built on the key steps that characterize the decision-making process, as in Lovallo, Viguerie, Uhlaner, and Horn (2007). Previously, several studies established a link between strategic decisionmaking processes, a firm’s choices, and its performance (Dean & Sharfman, 1996; Papadakis, Lioukas, & Chambers, 1998; Elbanna & Child, 2007). Recently, disentangling the role of analysis and process in strategic decisions, Garbuio and Lovallo (2010) found that, although both analysis and process matter, process has a much greater impact on the success of a strategic decision. In the M&A context, Jemison and Sitkin (1986)

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Table 1. Process Step

The M&A Decision-Making Process, Biases, and Corrective Procedures. Bias(es)

Debiasing Prescription(s)

Pursuing a target

Empire building Lemming effect

1. Good governance in assessing merger drivers 2. Incentives for organic and inorganic growth should be comparable

Preliminary due diligence

Confirmation bias

Actively seek disconfirming evidence

Role-conferred bias of external advisors

1. Consider hiring trusted advisers who are interested in the long term 2. Have two advisers argue against each other 3. Minimize the role of investment bankers

Overconfidence Planning fallacy

Use reference-class forecasting 1. Use reference-class forecasting 2. Consider implementation issues upfront

Availability heuristic Explicitly perform cultural due diligence The bidding phase

Winner’s curse

1. Tie the compensation of the person responsible for the deal’s price to the success of the deal 2. Have a dedicated M&A function that actively generates alternatives to the deal under consideration and sets a limit price for each deal

Final due diligence

Anchoring and adjustment

1. Entertain multiple M&A possibilities as part of a broader backup plan 2. Hire fresh, dispassionate experts to examine the relevant aspects of the deal without divulging the initial estimate

Sunk-cost fallacy

Assess upfront when to stop bargaining and walk away

developed a set of propositions that argue for the importance of process and highlight several types of impediments affecting acquisition outcomes. While each deal has unique characteristics, in this chapter we consider the four main phases common to all M&A decisions: the decision to pursue a target (‘‘Do I want to grow through M&As?’’), preliminary due diligence (‘‘Do I want to buy this company and what is it worth?’’), bidding (‘‘How much do I have to pay for it?’’), and a final phase of due diligence and deal closure (‘‘What do the company’s books suggest I should actually pay?’’). At each step of the process, psychological biases affect the soundness of the decision making. Table 1 summarizes the biases and debiasing steps.

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Pursuing a Target: Empire Building and the Lemming Effect Noneconomic justifications for embracing an acquisition path include executives’ personal preferences for doing a deal and their desire not to be left out of a merger wave, biases that we, respectively, call ‘‘empire building’’ and the ‘‘lemming effect.’’ Prescriptive advice for both biases is discussed at the end of the section. Empire Building Before a target is even identified, empire building springs from a CEO’s desire to increase his span of control, sometimes regardless of his firm’s profitability. One firm that explicitly tried to build an empire was WorldCom. WorldCom not only aspired to be the first global long-distance telecommunications firm but also the ‘‘king’’ of the Internet as well. This type of overweening ambition can lead to broken promises and, eventually, malfeasance and bankruptcy. Several studies suggest that a CEO’s desire to increase his span of control is a sound hypothesis of acquisition motives, grounded in CEO personality as well as compensation. Executives are thought to derive individual benefits from managing increasingly larger firms, which provide more pay, power, and prestige (Shleifer & Vishny, 2003; Bliss & Rosen, 2001; Barro & Barro, 1990; Jensen & Murphy, 1990; Kostiuk, 1990; Winn & Shoenhair, 1988; Murphy, 1985; Agarwal, 1981; Ciscel & Carroll, 1980). CEOs tend to negotiate in their own interests during M&A negotiations (Hartzell, Ofek, & Yermack, 2004). Grinstein and Hribar (2003) find that powerful CEOs receive significantly larger bonuses and tend to engage in larger acquisitions relative to the size of their firms with respect to less powerful CEOs. The Lemming Effect The ‘‘lemming effect’’ refers to a situation in which a CEO blindly follows an industry-wide trend toward acquisitions due to a desire not to be left behind in a consolidating industry. Aggregate merger activity has been characterized by ‘‘large bursts of activity separated by lengthy intervals of very low activity’’ (Nelson, 1959, p. 126). This was exemplified in 1999 by the repeal of the Glass–Steagall Act, which had prohibited any single institution from acting as any combination of an investment bank, a commercial bank, and an insurance company. As a result of the repeal,

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several mergers occurred. The first merger was the one between Citicorp (a commercial holding company) and Travelers Group (an insurance company), forming the conglomerate Citigroup. Goel and Thakor (2009) suggest individual M&A activities explain wave behavior, where periods of intense merger activity are followed by periods of fewer mergers. Namely, they argue that wave behavior can be attributed to CEOs’ envy of one another’s compensation, which tends to increase with firm market value and size. In a sample of M&As announced between 1979 and 2006, Goel and Thakor found that earlier acquisitions in a merger wave display higher synergies and returns than later acquisitions. In addition, the compensation gains of acquiring firms’ top management teams are higher for earlier acquisitions than for later acquisitions. Countering empire building and the lemming effect depends on good governance and incentives. In terms of governance, boards of directors are responsible for questioning the motives of CEOs’ proposed acquisitions. They should hold management accountable by insisting on clear value drivers to support a transaction. The devil’s advocate literature sheds light on how such conversations should unfold (Schweiger & Finger, 1984; Schweiger, Sandberg, & Rechner, 1989). Namely, a member of the decision-making group is charged with questioning the assumptions and approaches of the rest of the group through critical evaluation. As this role is formalized, the devil’s advocate is free to explore issues and request clarifications without feeling inhibited about questioning or disagreeing with the opinions of other group members, especially those in more senior positions (Feldman, 1984; Murnighan & Conlon, 1991). In terms of incentives, executive compensation is often linked to firm size, providing a motive for M&A deals that are unjustified by economic benefits to the acquirer. Evidence suggests that boards of directors treat internal investments and acquisitions differently and that the incentives for undertaking each differ as well. In fact, Harford and Li (2007) found that CEO compensation changes surrounding major capital expenditures are much smaller and more sensitive to performance than those following acquisitions. To correct for this tendency, incentives for undertaking major capital expenditures and acquisitions should be made comparable. Finally, if an industry is experiencing a merger wave, and a firm is not among the first or second acquirer, this should suggest that the motives for the proposed merger are more likely noneconomic. Therefore, the acquiring firm’s board should carefully scrutinize the potential deal.

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Preliminary Due Diligence: Five Traps The preliminary due diligence stage of the M&A process is characterized by five cognitive biases: the confirmation bias, the role-conferred bias of external advisors, overconfidence, the planning fallacy, and underestimation of cultural differences due to availability heuristics. We offer strategies for overcoming each bias and their potentially costly consequences.

Confirmation Bias People have a strong tendency to seek information that they consider supportive of favored hypotheses or existing beliefs and to interpret the information in ways partial to those hypotheses or beliefs. Similarly, we tend to avoid and discount information that would disconfirm our beliefs and support alternative possibilities (Koriat, Lichtenstein, & Fischhoff, 1980), even if compelling evidence exists that our initial beliefs are wrong (e.g., Henrion & Fischhoff, 1986; Ross & Anderson, 1982). In M&As, for example, initial beliefs about price and synergies tend to bias the subsequent analysis. Watson (1960) used a basic experiment to demonstrate the confirmation bias. In this experiment, participants were presented with a triplet of numbers, such as 2-4-6, and asked to suggest the rule used to generate that triplet, for example, successive even numbers. Next, participants were asked to suggest additional triplets and were told whether each was consistent with the rule to be discovered. People typically tested hypothesized rules by producing only triplets that were consistent with the proposed rule, such as 8-10-12 or 16-18-20. Participants precluded themselves from discovering the correct rule – for example, any three numbers increasing by 2 – by not proposing triplets that were inconsistent with the hypothesized rule, such as 1-2-3. The strategy of proposing confirming evidence rather than disconfirming evidence would obscure the fact that the hypothesis was incorrect. Nickerson (1998) summarizes several other experiments demonstrating the confirmation bias. The confirmation bias is particularly pernicious during M&A preliminary due diligence, for which the key outcome is a letter of intent (LOI) from the acquirer with a price range that is enticing enough to move the deal forward. The need to provide an acceptable initial bid often biases all acquirer’s analyses upward. Instead of having synergy estimates guide the price, as would be appropriate, the LOI often guides the synergy estimates. As such, the entire due diligence process is seeded with a biased estimate even before much factual information has been exchanged.

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The best way to counteract confirmation bias is to actively seek disconfirming evidence. Of course, most companies examine potential pitfalls at some point during the M&A process, but often not with the same degree of insight and strategic rigor that they build into their initial case for a deal. Role-Conferred Bias of External Advisers As a result of the confirmation bias, people tend to evaluate evidence in a selective fashion, focusing on evidence that supports the conclusion they would like to reach and evaluate that evidence in an uncritical fashion (Holyoak & Simon, 1999; Koehler, 1991; Lord, Ross, & Lepper, 1979; Russo, Medvec, & Meloy, 1996; Russo, Meloy, & Medvec, 1998). In addition, when people know they are accountable for their decisions and when they know the preferences of their audience, accountability does not necessarily lead to more thoughtful processing, but can instead increase the likelihood that the decision-maker’s judgments will be consistent with the audience’s known preferences (Tetlock, 1983). Experimental and field research documents the detrimental effects that the role-conferred bias of external advisers can have in the M&A process. In one experiment, Moore, Tanlu, and Bazerman (2010) find evidence that professional auditors’ judgment is biased in favor of the firm that hired them. Participants were told that they had been hired by a target firm as its external auditor or by a potential outside investor. Next, some were asked to make an accounting valuation of the target and then to assess others’ accounting valuations; other participants were asked to assess others’ valuations before making their own valuations. Naturally, the target firm in question would have preferred a more favorable evaluation, whereas the investor would have preferred to know the true value of the firm before deciding to invest funds in it. Participants who were told they worked as the target’s external auditor were more likely to approve the firm’s accounting than were those who represented outside investors. Consistent with accountability research (Tetlock, 1983), an auditor who feels accountable to a client is more likely to issue a favorable audit report than one who feels accountable to a party within his or her own firm (Buchman, Tetlock, & Reed, 1996). In the M&A context, it is unlikely that potential acquirers’ advisers begin their work with the hope of learning that a target firm is unworthy of acquisition by their clients. Rather, they start with the desire to reach a positive conclusion about the worthiness of a target to the acquirer and issue an ‘‘unbiased’’ evaluation of the ideal price. They also have desire to be involved in later stages of the deal and to be rehired by the client. Thus, advisers face a conflict of interest: only through unbiased judgments can

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they build a strong, long-term reputation for impartiality, yet they have financial incentives to advise clients to acquire. Given that judgments compatible with clients’ wishes are most accessible in memory, advisers use them to anchor and influence successive valuations. Implicitly aware of this role-conferred bias of external advisers, Warren Buffett cautioned potential acquirers in his 2009 letter to the shareholders of Berkshire Hathaway, ‘‘Don’t ask the barber whether you need a haircut.’’ To counter this bias, executives from acquiring firms, especially those who do deals infrequently, should attempt to steer clear of advisers driven by one-shot profit motives and to hire advisers who are interested in building a reputation by providing objective recommendations that stand the test of time. Hiring two sets of advisers to debate different opinions could be beneficial. In addition, there is evidence that investment bankers are not essential, and possibly damaging, to acquisitions. Porrini (2006) found that the presence of acquirers’ bankers correlates positively with acquisition premiums, even when controlling for the presence of targets’ bankers. Similarly, Kesner, Shapiro, and Sharma (1994) found that premiums correlate positively with bankers’ fees for both targets and acquirers, suggesting that a misalignment exists between acquirers’ bankers’ interests and acquirers’ interests, such that acquirers’ bankers are not minimizing the premiums their clients pay. Studies have also found that, controlling for expertise, cumulative abnormal returns to acquirers that hire bankers are lower than those to acquirers that use in-house acquisition teams (Servaes & Zenner, 1996). Taken together, these findings suggest that acquiring firms should carry out the investment banking function in-house. Overconfidence Overwhelming evidence exists that people are overconfident in at least two ways (see Moore & Healy, 2008). First, we tend to overestimate our abilities, performance, level of control, and odds of success in various situations. Students overestimate their performance on exams (Clayson, 2005), and other groups overestimate the speed at which they can complete work (Buehler, Griffin, & Ross, 1994) and the degree of control they have over a given task (Presson & Benassi, 1996). Second, overconfidence can manifest itself as excessive precision in one’s beliefs. In studies that ask for numerical answers (e.g., the length of the Nile River) and then for estimates of confidence intervals surrounding these answers, people show overconfidence about the precision of their own answers (e.g., Soll & Klayman, 2004). The overconfidence bias may be especially insidious when it comes to identifying revenue and cost synergies in potential M&As. Since revenue

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synergies are less likely to be realized than cost synergies (Sirower, 1997), heavy reliance on the former may signal a problem. One way to avoid overconfident synergy estimates is to use reference-class forecasting (Kahneman & Tversky, 1979; Kahneman & Lovallo, 1993). This technique requires the decision maker to obtain a reference class of past, comparable cases when making predictions about the costs and benefits of a new project. By introducing information about successful as well as unsuccessful past projects, the decision maker is forced to consider the entire distribution of possible outcomes. Also, it is not necessary to try to calculate the exact value of the synergies in comparable deals; grouping them into a few performance categories – good, bad, or disastrous, for example – often suffices. Doing so prevents the decision maker from focusing on similar, easily recalled acquisitions, which typically have proven successful and are close in time and space to the decision at hand. By using realized outcomes of past acquisitions rather than manipulated estimates of the current potential acquisition, reference-class forecasting provides more reliable, top-down estimates of the true costs and benefits of an acquisition.

Planning Fallacy When forecasting the outcomes of risky projects, executives often fall victim to the planning fallacy. Psychologists have defined the planning fallacy as the tendency to underestimate task-completion times and costs, even when one knows that the vast majority of similar tasks have run late or gone over budget (Buehler et al., 1994; Kahneman & Tversky, 1979). The planning fallacy is a well-established bias in the experimental literature. In one set of experiments, Buehler et al. (1994) assessed the accuracy of psychology students’ estimates of completion times for their yearlong honors thesis projects. In the experiments, the students’ ‘‘realistic’’ predictions were overly optimistic: 70% took longer than the predicted time, even though the question was asked near the end of the school year. On average, students took 55 days to complete their theses, or 22 days longer than they predicted. Similar results have been found for a wide variety of tasks, such as holiday shopping, filing taxes, and other routine chores (Buehler et al., 1994; Buehler, Griffin, & MacDonald, 1997). These findings are not limited to the laboratory. Cost and time overruns in large infrastructure projects have been studied by considering numerous contractual arrangements (Flyvbjerg, Holm, & Buhl, 2002; Mott MacDonald, 2002). Entrepreneurs seem to be highly susceptible to this bias. An analysis of start-up ventures in a wide range of industries found that

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more than 80% failed to achieve their market-share targets (Dunne, Roberts, & Samuelson, 1988). We suggest two possible and complementary ways to mitigate the planning fallacy. First, to reduce the tendency to produce optimistic estimates of completion times, reference-class forecasting of revenues and costs, as described above, holds great promise. Second, acquirers should consider upfront integration issues. Firms that are successful at integration can formally identify best practices and use them to improve future integration efforts. This is true for M&A deals that are part of well-defined acquisition programs, where acquisitions are seen as a means to an end and where superior deal identification, structuring, and integration practices have been developed over time (Chatterjee, 2009). Also, serial acquirers such as Cisco, CEMEX, and GE discovered that mergers run more smoothly if integration begins early in the dealmaking process and if detailed written plans include clear objectives to be met immediately after the deal closes (see Chatterjee, 2009, for Cisco; Ghemawat and Matthews, 2000, for CEMEX; Ashkenas, Demonaco, & Francis, 1998, for GE). This commitment to learning, codification, and continuous improvement has helped make these firms world-class integrators across the globe. Availability Heuristic in the Evaluation of Cultural Fit A special case of the planning fallacy is the difficulty people often have integrating two different cultures. Poor culture fit and lack of compatible culture have been much-cited yet persistently overlooked aspects of M&A failure. Haspeslagh and Jemison (1991) as well as Jemison and Sitkin (1986) point out that investment bankers tend to focus their analysis of M&A deals on issues related to strategic fit, which can be analyzed with standardized frameworks using readily available data, while neglecting issues related to organizational fit (e.g., Newbould, 1970; Firth, 1980; Weber, 1996), which requires much less readily available information. This suggests that executives fall victim to the availability heuristic (Tversky & Kahneman, 1973) when collecting and evaluating information. That is, they may excessively focus on financial issues rather than cultural fit issues because the former are more readily available than the latter. In a simulation experiment, Weber and Camerer (2003) showed how conflict between merging firms’ cultural conventions can substantially diminish performance. Participants were assigned to either an acquiring or an acquired firm and given time to develop, within each group, a common language for describing generic photos of offices. When the firms were

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‘‘merged,’’ participants who role-played as managers of the acquiring company communicated much more effectively with subordinate participants from their own firm than with those from the other firm; in fact, they sometimes grew impatient with subordinates from the acquired company. The researchers concluded that the more deeply ingrained firm-specific language is and the more efficient the firm is, the more difficult integration is to achieve. They also noted that employees of both firms tended to overestimate the performance of the combined firm and to attribute any diminished collective performance to the other firm. Field studies have shown that executives’ tendency to underestimate cultural fit challenges between merging entities leads to reduced profitability and a shortened life span for merged companies (Newbould, 1970; Firth, 1980; Weber, 1996; Datta, 1991; Chatterjee, Lubatkin, Schweiger, & Weber, 1992). Other studies point out that highly similar organizational cultures, combined with differences in market positioning and target markets, benefit integration speed (Homburg & Bucerius, 2006). In a recent study using 32 interviews, Lodorfos and Boateng (2006) examined 16 M&As that occurred from 1999 to 2004 in the chemical industry in Europe among firms such as Novartis, Aventis, GlaxoSmithKline, and Monsanto. The authors concluded that over 90% of respondents were (ex post) well aware that cultural differences are a major impediment to the success of M&As in meeting the organizations’ and investors’ expectations, and that cultural differences lead to misunderstandings, conflicts, and clashes. One way executives can prevent the underestimation of cultural conflicts is to explicitly perform cultural due diligence (Harding & Rouse, 2007). A useful tool is network analysis maps, which describe the connections among people in an organization, thereby providing insights about cultural similarities, employee retention, and network integration. Although a target’s web of internal contacts typically can be examined only after an acquirer gains comprehensive access to the firm’s books, there are situations in which network analysis can be performed before an offer is made. For example, by examining the citations of journal articles of consulting and research centers, it is sometimes possible to infer the types of connections and skills present in the firm.

The Bidding Phase: The Winner’s Curse Once a firm identifies a target, executives initiate negotiation with the target by proposing a purchase price. If there are multiple bidders for a target, the

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winner’s curse can come into play (Thaler, 1980), such that one party bids above the target’s true value and thus is ‘‘cursed’’ by acquiring it. Bidding wars often lead to above-value offers. The winner’s curse concept, first discussed by Capen, Clapp, and Campbell (1971) and demonstrated in the experiments of Bazerman and Samuelson (1983), is based on the notion that pressure to win a bid may boost bid offers, such that the winner sacrifices profits or perhaps even suffers a loss. For example, oil companies bidding for drilling rights to a parcel of land would turn to experts for valuations. While the valuations can be difficult to approximate, even if companies bid substantially less than the estimates provided, the circumstances are likely to foster a general trend of high estimates leading to higher bids and low estimates leading to lower bids. As such, the winning bidder is likely to have reached the highest approximation of the land’s value and quite possibly an overvalued bid, causing him or her to be ‘‘cursed’’ to experience disappointment. To counteract the winner’s curse, we propose two techniques. The first requires tying the compensation of the executives responsible for the deal’s price to the success of the deal – for example, to the percentage of estimated synergies realized. Another strategy is to have a dedicated M&A function that actively generates alternatives to the deal under consideration and sets a limit price for each deal. Firms that do not proactively maintain a deal pipeline often find themselves overpaying for what seems to be their only alternative. This method does not offer a guarantee against the winner’s curse since the bidder’s maximum price still might be greater than the target’s true value, but it can prevent the bidder from increasing the bid above the level initially deemed prudent. Finally, if the acquiring firm’s limit price changes during the bidding or if negotiations start without a limit, someone in the firm should draw the bidding team’s attention to these shortcomings.

Final Due Diligence: Anchoring and Adjustment and Sunk Costs Once an initial bid is accepted, the acquirer receives much greater access to the target’s books and has the opportunity to perform additional due diligence. In this final phase, the acquirer’s goal is to thoroughly evaluate the investment in light of the more detailed information now available from the target. At this stage, two biases can come into play: anchoring and adjustment and the sunk cost fallacy. We discuss them in turn and conclude with potential debiasing techniques.

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Anchoring and Adjustment Anchoring on a set number has been documented as one of the most robust judgment biases (Tversky & Kahneman, 1974). Specifically, the first number considered as a possible answer to a question serves as an ‘‘anchor.’’ Even when people know the anchor was randomly generated, as in the spin of a wheel of fortune (Tversky & Kahneman, 1974), their adjustments away from it are almost always insufficient. In M&A settings, the initial value assessment of the deal is very likely to serve as an anchor. In one study, experienced real-estate agents were asked to assess a property’s value (Diekmann, Tenbrunsel, Shah, Schroth, & Bazerman, 1996). Each agent was given a booklet about the house being sold, which included specific information about the house as well as the prices and characteristics of other homes in the area that had recently been sold. The only difference in the information the various brokers received was the listing price of the house, which was randomly manipulated within a range of plus or minus 11% of the actual listing price. The agents then visited the house that was being sold as well as several other houses in the neighborhood. The agents unanimously agreed that they did not factor the house’s listing price into their evaluation of its ‘‘true’’ value. Nonetheless, the listing price significantly affected their valuations. Furthermore, after a second valuation and when told about the results, the agents continued to maintain that the listing price anchor had no effect on their prices. In the M&A context, initial valuations, such as the price range in the LOI, can also serve as anchors during the due diligence phase. Many acquirers fail to adjust sufficiently from an initial price, even in the face of surprising or unfavorable new evidence about the target. Because bargaining down the LOI price is difficult and rare, walking away from the deal tends to be the only way to avoid overpaying. Sunk Cost Fallacy After the initial bidding stage is over, the acquirer typically includes the costs of preparing initial estimates in all the future due diligence steps. That is, while economic theory prescribes that only prospective costs should be relevant in investment decisions, there is strong evidence that people consider sunk costs that have already been incurred when making such decisions. This results in misallocation of resources and, in the M&A context, pursuit of acquisitions that are likely to be unprofitable. Arkes and Blumer (1985) offer evidence of the persistence of sunk costs in an experiment in which people who were ready to buy season tickets to see a campus theater group were randomly divided into three groups. The first

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group included individuals who were required to pay the full price. A second group received a 13% discount, and the last group received a 47% discount. The researchers then monitored attendance at the plays during the season. In the first half of the season, people who paid the full price attended significantly more plays than did those who received discounts. (The effect disappeared in the second half of the season.) Other evidence of sunk costs is found in Arkes and Hutzel (2000), Staw and Fox (1977), and Whyte (1986). In the M&A context, when executives feel they have sunk a great deal of time, money, effort, and reputational capital into making a deal happen, they are often unwilling to surrender, even if the costs are unrecoverable. This is likely to be a bigger problem for CEOs who have never completed such a deal before as they face added pressure to succeed, lest they appear to be novices in the acquisition space by walking away. We propose two ways to counteract anchoring and adjustment and the sunk cost fallacy in the final phase of negotiation. First, and most promisingly, firms can entertain multiple M&A options as part of a broader backup plan and assess upfront when to walk away from a given deal. When multiple offers are in play, people are less likely to become emotionally attached to a single deal. As bargaining continues, having a few options on the table also allows executives to shift their attention to another deal with a better price–value ratio. Of course, the ability to juggle several options at once requires a disciplined, ongoing M&A process and the attention of a larger M&A team. Second, and equally as important, a firm should hire fresh, dispassionate experts (controlling for external advisor bias) who are in the dark about the initial estimate to examine the relevant aspects of the deal, a technique used by some private equity firms. The independent team should evaluate the new information uncovered during detailed due diligence – data unavailable before the initial bid was accepted.

AVERSION TO M&A DEALS: LOSS AVERSION AND COMPARATIVE IGNORANCE Our discussion so far has focused on the psychological mechanisms that affect executives as they are pursuing an acquisition target. But executives who deliberately avoid acquisition targets, even when inorganic strategies could improve their growth potential, are also affected by certain other biases. Executives may be reluctant to pursue M&A deals because they incorrectly believe doing so is riskier than pursuing organic growth, even

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though the probability that internal ventures will succeed is not necessarily greater than the odds that external ones will. Following Lovallo et al. (2007), we propose that aversion to M&A deals springs from two key biases: ‘‘loss aversion’’ and ‘‘comparative ignorance.’’ Loss Aversion Loss aversion refers to the common tendency for the fear of losses to overshadow the desire for gains of an equivalent amount. In many experiments, the psychological impact of a loss has tended to be about 2–2.5 times greater than that of a gain (for a review, see Kahneman, Knetsch, & Thaler, 1991; Tversky & Kahneman, 1991). This means that to accept an even chance of losing $10, most people require an upside of $20–$25. Loss aversion often motivates individuals to choose inaction over action. To avoid loss aversion, the acquirer should aggregate a particular M&A decision within its larger portfolio of strategic choices and thereby mitigate the loss associated with a single poor outcome. To understand the power of aggregation, consider the following experiment (similar to those reported in Kahneman & Lovallo, 1993). Imagine that you are about to flip a coin. If it lands tails up, you will lose $10,000. What is the lowest amount you would have to receive if the coin lands heads up to accept the gamble? Now imagine you can make 20 of these gambles. What is the lowest amount you would have to receive for each heads up to accept the bet? Did the value of this amount drop? Clearly, as the number of gambles rises, the chance of overall loss becomes vanishingly small. Similarly, over a significant time horizon, firms can undertake numerous investments. As long as acquisition investments do not threaten the firm’s viability, they should be considered a small part of a continuing gamble. Unfortunately, M&A aversion can be part of a firm culture’s, such that executives face the threat of dismissal for even one relatively small deal that does not pan out. Comparative Ignorance Aversion to M&A deals also can be explained by comparative ignorance, or the fact that individuals prefer to bet on what they know rather than on what they do not know. Fox and Tversky (1995) demonstrated comparative ignorance by showing that, given a pair of betting options, people prefer the gamble that is comparatively less uncertain given their knowledge. In their experiment, participants were asked to price bets based on whether the temperature at a given time in San Francisco (a familiar city) or Istanbul (an

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unfamiliar one) was greater or less than 601F. Some participants priced bets on only one city; others priced bets on both. When they were able to compare the two bets, participants were willing to pay over 50% more for the San Francisco gamble than for the Istanbul gamble. But when different groups were asked to price bets on only one city, they priced the gambles equally. Comparative ignorance led the former group to value the familiarcity gamble more highly, even though it had an identical risk profile. Executives can overcome comparative ignorance by comparing the actual returns their firm has achieved on internal projects to the returns their firm and others have achieved in M&A deals. Such baseline, objective measures of the two types of returns can be formulated using a reference class of similar deals (Kahneman & Tversky, 1979; Lovallo et al., 2007) conducted by the focal firm and others. This type of reference-class forecasting reduces the uncertainty surrounding an acquisition’s potential range of outcomes and the ambiguity inherent in an unfamiliar gamble.

CONCLUSION Mergers and acquisitions are a vital component of most companies’ growth options. For M&A deals to achieve long-term success, acquirers must identify the potential impediments that affect the process and address them one by one. This chapter identified the key phases in the M&A decisionmaking process, the psychological biases that affect each phase, and a targeted debiasing approach of corrective procedures for each phase. We conclude with a caveat. It has been argued that the acquisition experience itself may help to mitigate biases in the future (Bruton, Oviatt, & White, 1994), especially among similar acquisitions (Hayward, 2002; Haleblian & Finkelstein, 1999). Yet the actual performance of many serial acquirers reveals scant evidence of learning-by-experience. Three conditions might enable acquisition experience to improve M&A performance. First, executives tend to make generalization errors that diminish M&A performance until they have acquired a sufficient amount of experience. Haleblian and Finkelstein (1999) find an overall U-shaped relationship between an organization’s acquisition experience and its acquisition performance, as measured by return on assets. Second, successful serial acquirers seem to have a clearly defined acquisition program driven by a core business logic and significant interdependencies (Chatterjee, 2009). Finally, for experience to have a positive impact on performance, knowledge

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acquired from past acquisitions must be systematically articulated and codified (Zollo & Singh, 2004; Zollo, 2009). In conclusion, we have illustrated how a targeted debiasing approach can help old and new acquiring teams make more accurate value estimates and mitigate the influence of cognitive biases. By improving the decision-making process in this manner, firms improve the chances that their acquisitions will lead to success rather than the all-too-common post-merger disappointment.

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MERGERS AND ACQUISITIONS AS A RESPONSE TO INTRA-INDUSTRY DEPENDENCE Henri A. Schildt, Tomi Laamanen and Thomas Keil ABSTRACT A firm’s behavior is constrained by its access to resources owned or controlled by different constituencies in its environment. Mergers and acquisitions are one way to proactively manage these resource dependencies. Research on resource dependence reducing merger and acquisition patterns provides an important cornerstone of resource dependency theory and a basis of our present knowledge of the aggregate industrylevel merger and acquisition patterns. However, due to the predominant focus on inter-industry merger and acquisition patterns in earlier research, much less is known as to whether the same logic could also be applied to explain intra-industry merger and acquisition patterns. In this chapter, we extend the resource dependence results to an intra-industry context. In particular, we show that mergers and acquisitions among pharmaceutical firms tend to take place among firms with technological and competitive interdependencies. To distinguish our finding from the competing resource scale and scope explanations, we show that the likelihood of a resource dependence reducing acquisition is moderated by the crowding of firms’ technological positions and prior alliance ties. Consistent with the resource dependence explanation, both weaken the

Advances in Mergers and Acquisitions, Volume 9, 105–133 Copyright r 2010 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1108/S1479-361X(2010)0000009008

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effect of overlapping technological positions even though both alliance ties and crowding otherwise are positively related to merger and acquisition patterns in line with the social structural explanations.

A firm’s behavior is constrained in several ways by its limited access to resources owned or controlled by different constituencies in the environment (Lawrence & Lorsch, 1967; Pfeffer & Salancik, 1978). When faced with its critical resource dependencies (Castrogiovanni, 1991; Pfeffer & Salancik, 1978), a firm can choose to either adapt to its environmental constraints or try to proactively shape them (Child, 1972; Daft & Weick, 1984) by engaging in cooperative or acquisitive strategies (Hennart, Kim, & Zeng, 1998; Vanhaverbeke, Duysters, & Noorderhaven, 2002). Mergers and acquisitions are one way for firms to proactively manage their resource dependencies. Acquiring a firm that controls or competes for specific resources may help alleviate a critical interdependence. In a seminal study of 854 large US mergers, Pfeffer (1972) found that the volume of economic transactions across any two industries was positively related to the proportion of acquisitions across the same industries. Subsequent work has replicated and extended these results. Pfeffer and Salancik (1978, p. 121) showed that industry concentration affected the propensity to acquire customers and suppliers. Burt (1980) examined an industry’s structural autonomy in a network of economic transactions across industries, and found that mergers and acquisitions appear to occur due to the need to manage interorganizational constraints arising from inter-industry transaction patterns. Similarly, Galbraith and Stiles (1984) and Palmer, Zhou, Barber, and Soysal (1995) found that an industry sector’s power in relation to other industry sectors relates to firms’ merger and acquisition patterns. Finkelstein (1997) confirmed that Pfeffer’s original findings hold even though their explanatory power somewhat diminishes when applying more refined analytical methods. Casciaro and Piskorski (2005) recently revisited the resource dependence research emphasizing the importance of differentiating between mutual dependence and power imbalance. Finally Xia (2010), recently confirmed resource dependence arguments as an explanation of cross-border acquisitions. Research on resource dependence reducing merger and acquisition patterns provides an important cornerstone of resource dependency theory and a basis of our present knowledge of the aggregate industry-level merger and acquisition patterns. However, given the use of inter-industry transactions as a measure of resource dependence, previous research has been

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mostly limited to explaining vertical acquisitions across industries. This is a significant limitation since, as already Pfeffer (1972) noted, inter-industry mergers and acquisitions represent a relatively small proportion of all merger and acquisition transactions. One could in principle expect the same basic principles to apply also to intra-industry acquisitions, but there is so far no empirical evidence that would confirm this assumption. A second limitation of the studies that apply the resource dependence perspective to explain merger and acquisition patterns is the predominant focus on industry level explanations. For example, Pfeffer (1972) finds that the level of industry consolidation has an inverted U-shaped relationship with acquisition likelihood, reflecting the expected benefits from consolidation. The industry-level research setting does not, however, allow for an analysis of any company-specific differences due to, for example, different industry and resource positions. This shortcoming would seem rather problematic since research on the resource-based view has evidenced that firm-level heterogeneity may in fact play a central role in a firm’s strategic behavior (e.g., Rumelt, 1991). Given these limitations, alternative explanations, such as resource scale and scope explanations and theories of economic efficiency, have dominated the studies on intra-industry mergers and acquisition patterns. The question remains, however, whether resource dependence arguments play any role in explaining intra-industry merger and acquisition patterns. In this chapter, we address some of the limitations of earlier research on intra-industry merger and acquisition patterns and thereby re-introduce resource dependence explanations into the context of intra-industry acquisitions. Building on social structural explanations of technological change (Podolny & Stuart, 1995; Podolny, Stuart, & Hannan, 1996), we apply the concepts of technological position, technological niche crowding, and organizational niche crowding in the context of resource dependence research to help determine important intra-industry resource dependencies of a firm. We examine the antecedents to merger and acquisition patterns and industry evolution through an analysis of technological interdependencies and merger and acquisition patters among the US pharmaceutical firms. During the past 15 years, the emergence of biotechnology, the race for major drug discoveries, and the dramatic merger and acquisition activity have radically changed the US pharmaceutical industry structure (e.g., Barr, 1998). Extending the recent work by Vanhaverbeke et al. (2002) on network ties and acquisition patterns, we find that the merger and acquisition likelihood is higher among firms whose technological network positions

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overlap. Consistent with resource dependence theory, we find that the crowding of the shared technological domains moderates this relationship. The greater the presence of other actors in the shared technological positions, the less frequent are acquisitions due to the smaller expected dependency reduction benefits. We also find that the existence of prior mutual alliance ties reduces the positive effect of overlapping technological positions on acquisition likelihood, even though alliance ties otherwise increase the merger and acquisition likelihood. In line with Vanhaverbeke et al.’s (2002) findings, mutual alliance ties would seem to act as substitutes for mergers and acquisitions in crowded, emerging technology areas.

THEORY AND HYPOTHESIS Economic Rationales for Intra-Industry Mergers and Acquisitions Prior literature has identified three broad groups of economic rationales for mergers and acquisitions within an industry: economic efficiency, resource acquisition and redeployment, and market power explanations. Economic efficiency explanations of mergers and acquisitions focus on the potential to improve the cost base of the firm through scale or scope advantages. Prior research has suggested that acquisitions might help create financial, operational, or managerial synergy benefits (Chatterjee, 1986; Trautwein, 1990). However, empirical results have often been mixed (e.g., Chatterjee, 1986; Fowler & Schmidt, 1988; Slusky & Caves, 1991). Resource-based explanations suggest that acquisitions and alliances allow for access to and reconfiguration of unique resources. Acquiring resources such as technology or specialized knowledge is frequently mentioned as an acquisition motive (e.g., Ahuja & Katila, 2001; Anand & Delios, 2002; Blonigen & Taylor, 2000). Acquisitions have commonly also been found to lead to resource redeployment both within the acquiring and acquired firm (Capron, Dussauge, & Mitchell, 1998; Capron, Mitchell, & Swaminathan, 2001). Finally, market power–based explanations suggest that mergers and acquisitions can improve a firm’s market position vis-a`-vis competitors. Acquisitions within an industry can reduce competition in an industry or deter the entry of new players (Trautwein, 1990). Market power–based explanations are similar in nature than the explanations that are driven by competitive resource dependency. The finer-grained difference between these two competition-oriented explanations is that market power explanations are

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geared to reducing competition, in general, while competitive resource interdependence is caused by competition for a specific resource.

Mergers and Acquisitions as a Response to Resource Dependence According to resource dependence theory, firms engage in acquisitions to manage their critical resource dependencies. In the resource dependence theory, there are two main types of interdependencies that a firm needs to manage: symbiotic and competitive interdependence (Pfeffer, 1972; Pfeffer & Salancik, 1978). Symbiotic interdependence results from vertical relationships in which organizations exchange resources. Such relationships could, for example, be supply relationships or cooperative R&D where one firm supplies its results to the other. Competitive interdependence, in contrast, results from two organizations competing for the same resource(s). Under competitive interdependence, the future actions of competitor A are a source of uncertainty for competitor B and vice versa. When both firms are dependent on the same resource(s), their paths are intertwined, and they may face difficulties in prospering without managing the interdependency. According to resource dependence theory, firms try to actively manage and reduce their dependence on their most critical resources. In practice, interdependencies are often a mixture of symbiotic and competitive interdependence. Major competitors are also important suppliers, customers, or partners. For example, in the pharmaceutical industry, firms compete in the development of new technologies, but they also build on each other’s patents and utilize each other’s inventions, for example, through licensing agreements. Knowledge that has been produced by a company is commonly sold to competitors, and new knowledge is often produced in collaborative agreements, even among competitors (Powell, Koput, & SmithDoerr, 1996). Practitioner literature has given the name ‘‘co-opetition’’ for such simultaneous collaboration and competition (Brandenburg & Nalebuff, 1996). Although firms have alternative ways, such as joint ventures, interlocking directorates, cooptation, and even illegal collusion, to manage their resource dependencies (Selznick, 1949; Staw & Szwajkowski, 1975) , mergers and acquisitions have been identified to be as one of the most important ways to manage resource dependencies. In an analysis of inter-industry merger and acquisition patterns, Pfeffer (1972) shows that companies engage in acquisitions in order to reduce their dependencies through symbiotic, competitive, and diversifying acquisitions. In acquisitions motivated by symbiotic

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interdependence, a company acquires either suppliers or customers that it is dependent on through mutual resource exchange (Pfeffer, 1972, p. 384). Acquisitions of competitors reduce resource dependence caused by competition for scarce resources. Finally, diversifying acquisitions reduce a firm’s dependence on any single category of resources by increasing the emphasis of a firm’s operations in unrelated businesses. Research on the effect of resource dependence on merger and acquisition patterns has so far mainly focused on inter-industry causes of organizational dependence. The theoretical arguments of Pfeffer (1972) are not, however, specifically limited to the inter-industry context. Pfeffer’s resource dependence theory builds on the early sociological organization theory research tradition and, as such, claims a more general explanatory power beyond any specific research setting. Thus, while the data availability in the 1970s made it possible to at best study inter-industry patterns of firm exchange relationships with robust data, the present availability of extensive databases of interorganizational relationships and the recent theoretical and methodological advances in the areas of network theory and technological ecology make it possible to examine finer-grained dependence relations (Burt, 1992; Galaskiewicz, 1985; Gulati, 1998; Podolny & Stuart, 1995; Powell et al., 1996; Stuart & Podolny, 1996) also in an intra-industry context.

Technological Interdependence and Mergers and Acquisitions To examine resource dependencies in an intra-industry context, we turn to research in the area of technological ecology (Podolny & Stuart, 1995; Podolny et al., 1996). Podolny et al. (1996) introduce the concepts of ‘‘technological niche’’ and ‘‘technological position’’ in their research on technological evolution. They define technological niche to comprise ‘‘a focal invention, the prior inventions the focal innovation is based on, the subsequent inventions that build upon the focal innovation, innovations that are sufficiently close to the focal innovation in content that they help circumscribe the focal innovations technological contribution, and the technological ties among the inventions within that niche’’ (Podolny & Stuart, 1995, pp. 1228–1231). By analyzing ties between technological innovations, a technology space aggregating all technological niches can be constructed. A company’s technological position in the technology space, also referred to as the organizational niche of a company, can be defined as the set of technological niches occupied by the company (Podolny et al., 1996).

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The structure of technology space and the positions that firms occupy in it have been found to influence firm behavior. For example, Podolny and Stuart (1995) show that the level of competition within a technological niche, measured as the number of inventions with a direct link to a focal invention, and the status of the actors in that niche, are positively related to the likelihood of subsequent inventions. The authors conclude that companies do not merely invest in the most attractive areas of technology development, but they are also sensitive to the level of competition within a technological niche. Later research has also linked niche structure to the hazard of organizational dissolution (Podolny et al., 1996), and R&D decisions (Stuart, 1999). The structure of technological niches and the positioning of a firm in the technology space represent important sources of resource dependence. Overlapping positions in an industry’s technology space may constitute both competitive and symbiotic resource interdependencies. If a competitor or a supplier is fast to patent a critical key technology, the legal protection afforded by patents may restrict the future use of that technology and may end up limiting the development of related technologies.

Technological Overlap and Acquisitions The development of technologies that build on inventions of others is among the primary reasons for competitive and symbiotic interdependence between high-technology firms; companies sharing positions in same technological niches are dependent on each other. There are two primary reasons for this. First, competitors developing mutually substitutable technologies enable customers to switch suppliers (cf. Burt, 1992; Mason, 1957). Second, there is the threat of monopolization of key technological resources by competition through intellectual property rights protection (Levin, Klevorick, Nelson, & Winter, 1987). The threat that a competitor may patent nodal technologies creates uncertainties regarding the entire future technology path in a given technology area. Thus, given that competitors with overlapping technological positions are likely to be interdependent on each other, we expect acquisitions to take place between pairs of firms with a high degree of technological overlap (TO). Acquiring a firm with a highly overlapping technology position allows the acquirer to strengthen its position vis-a´-vis customers and reduces the risks of pre-emptive patenting of critical compounds by competitors (e.g. Lieberman & Montgomery, 1988).

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There are also other potential explanations for expecting a higher likelihood of acquisitions between firms with overlapping technological positions. First, according to economic efficiency arguments, elimination of overlaps between two firms can create synergistic gains. For example, the elimination of competing R&D projects aimed at developing similar technologies and combination of distribution channels would create savings in the combined firm. Second, according to R&D scale and critical mass arguments, a critical mass in R&D is needed in order to be able to create breakthrough innovations (Henderson & Cockburn, 1996). Several firms have explicitly used this reasoning as a basis for their acquisition decisions, although the empirical evidence to support the benefits has been contradictory. Third, according to the arguments of the resource-based view, combining related resources can also be expected to provide gains through resource redeployment between firms (Capron et al., 1998; Capron et al., 2001). Finally, according to the extensive research on diversification, related diversification has in many cases been argued to be superior to unrelated diversification, due to the lower risks involved in acquiring related resources (Chatterjee & Wernerfelt, 1991; Markides & Williamson, 1994; Ramanujam & Varadarajan, 1989). Since the different potential explanations on the effect of technological niche overlap on acquisition likelihood would all seem to point to the same direction, it would be difficult to argue otherwise. Thus, to verify the basic relationship and to set the stage for our finer-grained analyses, we hypothesize the overlap of two firms’ technological positions to be positively related to acquisition likelihood. Hypothesis 1. The overlap of two firms’ technological positions is positively related to the likelihood of acquisition occurring between the firms.

Technological Niche Crowding and Acquisitions To distinguish between the alternative explanations, we turn to examine the effect of crowdedness in the technological space. While TO represents the relative position of two firms in the technological space, it does not take into account the structural characteristics of the niches themselves. However, in light of sociological research, niche crowding is a salient feature in technological ecology (Podolny et al., 1996). Thus, consistent with

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previous research, we define technological niche crowding as the number of inventions building directly on a focal invention by citing it. When firms’ technological positions overlap in crowded niches there is likely to be a considerable number of suppliers for similar technological solutions. The more crowded a technological niche, the more companies are likely to possess mutually substitutable technological capabilities. Crowdedness makes it difficult for a firm to decrease its dependency by simply acquiring another company that occupies the same crowded niches. Acquiring other firms in highly competed arenas can be expected to reduce interdependence only marginally due to the reduction of competition. In contrast, when two firms co-occupy less crowded niches, fewer firms induce similar resource interdependence and an acquisition is likely to have a major effect. When considering again the competing arguments of economic efficiency, R&D scale, resource redeployment, and target familiarity, we see them equally important, but would expect them to apply independently of competition. These motivations are predominantly driven by considerations internal to the firm. Although intensive competition could be speculated to increase internal efficiency seeking, we would not expect technological niche crowding to have distinguishable effects on any of these complementary acquisition motivations. Thus, following the resource dependence reduction logic, we argue that the effect of dependency reducing acquisitions is higher when firms’ technological positions overlap in less crowded niches and lower when they overlap in more crowded niches. Consistent with this logic, we hypothesize that the less crowded the niches in which two firms have overlapping positions, the higher the likelihood of resource dependence reducing acquisitions. Hypothesis 2. The less crowded the technological niches in which two firms technological positions overlap the higher the likelihood of acquisition. Organizational-Level Crowding and Acquisitions In addition to the technological niche crowding, crowding can also be examined on the firm level. Organizational-level crowding (OC) corresponds to a situation where a firm operates predominantly in crowded technological niches. Podolny et al. (1996) argue that an organization’s market opportunities decrease as a function of niche crowding. For example, a firm may have problems of differentiating itself technologically from its competitors. For a firm that occupies predominantly crowded technological niches,

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acquisitions can reduce resource dependence in two main ways. First, they can be considered as an instrument to reduce the bargaining power of customers and suppliers by increasing the scale of the firm and by reducing the amount of competition (Eckbo, 1983; Ravenscraft & Scherer, 1987). Second, mergers and acquisitions may help the firm diversify to new technological niches that are less crowded. Thus, following this logic we hypothesize that OC makes a merger or acquisition more likely. Hypothesis 3. Organizational level crowding increases the likelihood of mergers and acquisitions. Prior Alliance Ties, Technological Niche Overlap, and Acquisitions We also examine alliance ties between firms and their effect on merger and acquisition patterns. Alliance ties can be a source of interdependence, but it is also a way to manage resource dependencies (Pfeffer, 1972; Selznick, 1949). Pfeffer and Salancik (1978) regard alliance ties as sources of symbiotic interdependence between firms. Collaborative agreements cause co-specialization and other kinds of interdependencies between firms. In alliances, firms often co-specialize by combining complementary technological assets that might be difficult to separate at a later point in time (Dyer & Singh, 1998). For example, in the pharmaceutical industry, one firm could specialize in the development of an active compound of a new drug and its alliance partner in dedicated drug delivery technologies. Over time, such co-specialization of assets and operations could make alliance partners increasingly interdependent and should therefore lead to acquisitions. A complementary rationale for alliances leading to acquisitions would be the real options logic. Entering into an alliance could be viewed as acquiring an option for a later acquisition of the alliance partner. As the two partners cooperate and become increasingly familiar with each other, one of the partners might choose to exercise the option of acquiring the alliance partner (Folta, 1998; Kogut, 1991). Thus, we hypothesize that the likelihood of mergers and acquisitions increases when two organizations become interdependent on and familiar with each other due to their alliance network ties. Hypothesis 4a. The existence of an alliance tie increases the likelihood of mergers and acquisitions. While alliances may be a source of symbiotic dependence, they can also be used as a means to manage resource dependence caused by overlapping technology domains (Gulati & Gargiulo, 1999; Oliver, 1990; Pfeffer &

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Nowak, 1976) in a similar manner as acquisitions. Alliances offer an alternative way to manage the interdependence on externally controlled resources by creating relationships with the owners of important resources (Galaskiewicz, 1985; Pfeffer & Nowak, 1976) and are often viewed as an alternative mode of governance to acquisitions (Wang & Zajac, 2007; Williamson, 1975, 1985, 1996). Instead of engaging in expensive acquisitions, a firm may choose to manage its interdependence on another firm by seeking to enter into an alliance with the firm (Balakrishnan & Koza, 1993). Empirical research supports this logic of reasoning (Wang & Zajac, 2007). An extensive body of research suggests that organizations build cooperative ties to access knowledge, resources, and capabilities held under the control of other organizations (Grant & Baden-Fuller, 2004; Gulati & Gargiulo, 1999). Similarly to merger and acquisition research, alliance research in the resource dependence tradition originally focused predominantly on interindustry resource dependencies. Consistent with the resource dependence theory, these studies (e.g., Berg & Friedman, 1980; Duncan, 1982; Pfeffer & Nowak, 1976) found a relationship between economic transactions across industries and the propensity to form alliances. More recently, these results have been extended to the intra-industry studies showing that countryspecific resource advantages (Shan & Hamilton, 1991), technological positions (Stuart, 1998), distribution of knowledge (Grant & Baden-Fuller, 2004), strategic capabilities (Nohria & Garcia-Pont, 1991), and the relative size and performance of firms (Burgers, Hill, & Kim, 1993) create dependencies that can explain alliance formation patterns. Given these arguments, we would expect that prior alliance ties decrease the effect of technological niche overlap on acquisition likelihood. For example, joint ventures would allow two similarly positioned firms to pursue new market opportunities and limit the competitive uncertainty associated with a technology race (Gulati & Singh, 1998). Thus, we hypothesize that the existence of an alliance between firms with technological niche overlaps decreases the effect of overlap on the acquisition likelihood. Hypothesis 4b. The existence of an alliance tie decreases the effect of technological niche overlap on the likelihood of acquisition.

EMPIRICAL SETTING AND METHODOLOGY To test our hypotheses, we analyze a longitudinal data set of public pharmaceutical companies, their patents, alliances, and acquisitions. We first

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gathered data of all pharmaceuticals companies listed in the Compustat files (including both US and non-US companies) during the years from 1989 to 1996. A panel of publicly listed companies was chosen to provide an access to reliable financial data. We obtained patent data from the NBER database on US patents for each firm. Since our hypotheses focus primarily on technological interdependencies we chose to include only technologically active companies that had successfully applied for patents during the four years prior to the time of potential acquisition. Altogether 358 distinct companies had obtained patents according to this criterion and thus qualified to be included in our sample. Since we were interested in the relational factors that explain acquisitions and mergers, we formed the complete set of company pairs for each of the years (1989–1996) comprising all the combinations of pharmaceutical companies listed in the Compustat files during a particular year. Pairing the companies yielded altogether 173,654 dyadic observations. Acquisitions and alliances among these firms were extracted from the SDC Platinum database.1 On the basis of the acquisition data, we identified 34 publicly traded company pairs that had merged or acquired each other. To verify that we had correctly identified all the intra-industry acquisitions, we also tracked firms that were de-listed during the period of our study to ensure that they had not been acquired. In the first phase, we performed all our analyses using niche-level measures. However, to eliminate the possibility of idiosyncratic biases due to predominant niche focus, we also at a later stage extended our analysis to more generic patent class based measures. The results of these robustness tests are reported in our results section.

Variable Definition and Measurement All our variables are specified for a company dyad in a given year. The patent-based measures utilize aggregate data from a moving window of five years before the year of the potential acquisition. This five-year time frame was utilized to take into account the potentially diminishing value of technological inventions (Stuart & Podolny, 1996). Dependent Variable Our hypotheses predict mergers and acquisitions in a specific firm dyad. The dependent variable is a dichotomous indicator representing the presence (1) or absence (0) of an acquisition for the given dyad and year. We encoded

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the acquisitions based on the year during which the acquisition was announced. Since our aim is to explain the managerial choice to conduct acquisitions and mergers based on resource dependence arguments, it is necessary to evaluate the effect of independent variables prior to the point at which the decision was made. Independent Variables As our independent variables, we use TO, TO adjusted by crowding, OC, and the existence of prior alliance ties between firms. Our independent variables measure both symbiotic and competitive interdependency, as well as the general environmental resource dependencies facing the company dyad. The main constructs, technological niche, technological position, and the crowding of technological and organizational niches, are measured using patents and patent citations. An individual technological niche is established by a patent that is cited by subsequent patents (Podolny & Stuart, 1995). The aggregate of all technological niches occupied by a firm in turn constitutes a firm’s technological position (Podolny et al., 1996). We follow the convention of prior research by naming the extent to which given two companies occupy the same technological niches as the TO of these companies (cf. Stuart, 1998; Stuart & Podolny, 1996). TO is a measure of the extent to which both firms cite the same prior patents. To ensure comparability, we adopted the measure of TO that has been widely used in prior studies (cf. Stuart, 1998; Stuart & Podolny, 1996). The variable citation is binary. It has a value of 1 if any of the patents held by the given company cite patent p and 0 otherwise. P citationa;p  citationb;p p P TOa;b ¼ citationa;p p

Our measure corresponds to the percentage of company A’s technological niches in which company B also operates. Since the measure is asymmetric for the two companies in the dyad, meaning that company A can occupy a different percentage of company B’s niches than company B of company A’s niches, we utilize the maximum TO between the two companies as our measure. This measure reflects the fact that although a large company is unlikely to be highly dependent on a small company, some parts of its operations could face resource dependence. We determine the crowding of a technological niche as the total number of patents citing the focal patent around which the niche is formed

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(cf. Podolny & Stuart, 1995). Technological overlap adjusted by crowding (TOAC) is a measure of niche overlap where TO is adjusted by the crowding of technological niches that two companies share with each other. To adjust for TO, we first calculate niche space, the opposite of niche crowding, for each niche that any two companies share using the following formula. NSp ¼

citationsa;p þ citationsb;p citationsp

Niche space equals 1 when only the companies in the dyad operate in the particular niche. The variable approaches 0 as third-party influence in the niche increases. Citationsa,p and citationsb,p are count variables that are defined as the number of company A’s and company B’s patents that cite a given prior patent p. The denominator is the total number of patents citing the patent p. The adjusted variable was calculated by multiplying the TO variable with the average niche space of the overlapping technological niches. Alliance is a binary indicator of a mutual alliance tie between two companies. The variable has a value of 1 if the companies had formed an alliance or a joint venture during the four years prior to the acquisition and a value of 0 if there was no alliance between the firms in that period. Organizational-level crowding was determined as the crowding of technological niches occupied by the company, weighed by the number of patents the company has in each particular niche, and divided by the total number of patents held by the company. Niche crowding is defined here as the share of patents in the niche filed by firms, and receives values from 0 (niche held exclusively by the focal firm) to close to 1 (the company has a highly contested position in the niche). Our formula for organizational crowding is shown below. P citationsa;p  ½1  ðcitationsa;p =citationsp Þ p OCa ¼ patentsa Our OC measure builds on a similar measure developed by Podolny et al. (1996) who defined OC for a sample of publicly held companies in the microelectronics industry. Podolny et al. (1996) only take the patents held by the firms in their sample into consideration in calculating OC. In contrast, we also included the patents by unlisted start-up companies and universities to reflect the possibility that all alternative sources of technology are potential sources of dependence in the pharmaceuticals sector.

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Control Variables We also included measures of industry segments, geographic co-location, and company sizes as controls into our regression specifications. In addition, we included year dummies to control for any time period specific differences in the frequency of acquisitions. Same industry segment control variable has a value of 1 when both companies are in the same industry segment of the pharmaceutical industry and 0 otherwise. It represents the differences in the fourth digit of the SIC industry classification codes of the acquirer and the target. Within the pharmaceutical industry, companies can be categorized primarily to one of the four sub-industries: medical chemicals, pharmaceutical preparations, in vitro, in vivo diagnostics, and biological products (excluding diagnostics). Geographic co-location determines whether the companies in a dyad had their headquarters at a close proximity to each other. A geographic colocation variable is included to control for the possibility that companies predominantly acquire targets located closer to them. Since geographic proximity has been found correlated with the choice of the organizational niche (Jaffe, Trajtenberg, & Henderson, 1993), the possible effects of firm co-location have to be accounted for. This dichotomous variable binary has value 1 if company headquarters are co-located in the same country (or state, in the United States) and value 0 otherwise. Largest company size (ln) and Relative size measures are used to control for the fact that large companies tend to conduct more acquisitions than small companies. Largest company size is determined as the logarithm of sales of the larger company in the dyad during the previous fiscal year for the larger of the two companies in the dyad. Relative size is determined as the sales of the smaller company divided by the sales of the larger company.

Analytical Method To test our hypotheses, we estimated logistic regression models with corrected coefficient estimates for rare events (King & Zeng, 2001). While logistic regression is frequently used for binary dependent variables, recent research (King & Zeng, 2001) has shown that for rare events, it results in biased coefficient estimates and underestimates the factors that predict a positive outcome. To address these biases, King and Zeng (2001) propose a set of procedures to correct coefficient estimates. This correction essentially introduces a weighing factor into the regression. King and Zeng

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(2001) show that their method is robust in the sense that it improves the results for rare events regression but arrives at the same results as traditional logistic regression for normal settings. The correction procedure is implemented in the RELOGIT Stata procedure (Tomz, King, & Zeng, 2002). We chose to apply this correction procedure since in the present study we estimate a model with only 34 acquisitions among the total number of 173,654 observations. The rare events regression model has been successfully applied in similar dyadic research settings also in earlier studies (e.g. Sorenson & Stuart, 2001).

RESULTS Table 1 shows the descriptive statistics and correlations of our sample. All correlation coefficients higher than 0.00 are statistically significant due to our large sample size. As expected, our measure of TO is highly correlated with TO adjusted by crowding. The size of the company is similarly highly correlated with the crowding of a firm’s technological positions. Separate tests with alternative model specifications indicate that these correlations do not cause major multicollinearity problems to our results.

Table 1.

Correlation Coefficients and Descriptive Statistics (n ¼ 173,654). Mean Standard

1 Acquisition 2 Technological overlap 3 Technological overlap adjusted by crowding 4 Average organizational niche crowding 5 Alliance 6 Same sub-industry 7 Same country 8 Largest company size (ln)

Minimum

Maximum

1

2

3

.00 .01

.01 .04

.00 .00

.00

.01

.00

.96 .04 .74

155.07

197.75

.00

3268.25 .00 .03 .01

.00 .36 .04 3.87

.06 .48 .19 2.66

.00 .00 .00 .00

4

5

6

7

1.00 1.00 .03

1.00 1.00 1.00 10.21

.04 .01 .00 .01

.06 .02 .02 .14

.05 .00 .03 .03 .03 .02 .00 .00 .00 .11 .07 .10 .07 .04

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Table 2 provides the results of our regression analyses. We interpret the results based on Model 3 that includes all the studied variables and interaction terms. In line with Hypothesis 1, a positive, statistically significant coefficient of TO confirms that TO predicts intra-industry acquisitions in our sample. Moreover, the results also show that the less crowded the technological niches, in which companies are active, the more likely the acquisition, as predicted in Hypothesis 2. As further predicted in Hypothesis 3, we find that independent of TOs, companies in crowded positions are the most likely to engage in mergers and acquisitions. Alliances are also positively related to the merger and acquisition likelihood, supporting Hypothesis 4a. To test Hypothesis 4b, we utilized the interaction term between the adjusted technological niche overlap and mutual alliance. A statistically significant negative interaction term supports our hypothesis. When companies have formed an alliance, the effects of Table 2.

Rare Events Logistic Regression on Acquisition.

Variable

Model 1

Model 2 4.00

Technological overlap

.78 (.39) 1.11 þ (.63) .16 (.08)

3.82 (1.20) 2.17 (1.05) 1.33 (.54) 3.25 (.65) 5.05 þ (2.70) .72 (.40) .93 (.78) .16 (.08)

10.31 (.55) 173,654

10.24 (.55) 173,654

(.89) Technological overlap adjusted by crowding 1.31 (.56) 3.17 (.58)

Average organizational niche crowdinga Alliance Alliance  technological overlap adjusted by crowding Same sub-industry Same country Largest company size (ln) Year dummies excluded Constant Observations

.79 (.38) 1.39 (.64) .25 (.07) 10.31 (.53) 173,654

Model 3

Notes: Standard errors in parentheses are below unstandardized coefficients. Robust estimators for variance are utilized. All models are significant on level po0.001. All tests are two-tailed. po0.05; po0.01; po0.001; þ po0.10. a The coefficient is multiplied by thousand.

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Acquisition likelihood (*1000)

2.5

Alliance

2

1.5

1

0.5

0 0

0.1

0.2

0.3

0.4

0.5

Technological Overlap Adjusted by Crowding

Fig. 1. The Effects of Technological Overlap and Alliances on Acquisition Likelihood.

technological resource dependencies are mitigated, and the acquisition becomes less likely. The moderation effects of alliances on the effect of TO is depicted in the Fig. 1. The moderation graph shows that the existence of an alliance tie not only reduces the effect of TO, but it in fact reverses the direction of its effect. To test the robustness of our results to alternative measures and sample selection criteria, we performed a range of robustness tests with alternative measures of TO, crowding of technological niches, crowding of firms’ technological positions, and indirect alliance network ties. We tested for the potential existence of non-linear relationships by including the second-order terms of our independent variables. Finally, we also examined the acquisition data qualitatively to ensure that our results were not based on outliers. On the basis of these robustness tests, our results on the technological niche level appear to be robust to alternative measures and model specifications. To also eliminate the possibility that our results are driven by our use of technological niche overlap as our primary measure of dependence, we also ran tests using a more conservative measure of technological interdependence, the patent class overlap, as a measure technological interdependence. The use of the more general patent class level measures enabled us to double our sample to 403,797 dyads.

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Furthermore, it allowed us to separate the effect of crowdedness to a separate variable instead of using it as an adjustment to our technological niche measure. The results of these additional rare events regressions analyses are shown in Table 3. Model 1 in Table 3 shows the control variables only. Similarly to our niche-level regressions, we find that the same sub-industry segment is a

Table 3. Variable Patent class overlap Patent class overlap crowding Overlap  crowding Overlap  crowding squared Alliance Overlap  alliance Year 1992 Year 1993 Year 1994 Year 1995 Year 1996 Same sub-industry Same country Relative size Constant Observations

Rare Events Logistic Regression on Acquisition. Model 1

Model 2

Model 3

Model 4

Model 5

Model 6

2.534 0.921 (0.833) (5.429) 0.005 (0.002) 0.023 (0.039)

23.189 2.591 2.636 (2.932) (0.824) (0.808) 0.029 (0.017) 0.528 (0.169) 0.003 (0.001) 3.364 4.036 (0.717) (0.733) 53.232 (47.008) 0.569 0.592 0.601 0.549 0.616 0.626 (1.079) (1.082) (1.083) (1.087) (1.085) (1.087) 0.470 0.447 0.382 0.475 0.407 0.403 (0.601) (0.602) (0.603) (0.608) (0.603) (0.603) 1.062 1.036 0.903 1.053 0.991 0.988 (0.490) (0.484) (0.484) (0.472) (0.473) (0.485) 0.539 0.518 0.223 0.492 0.493 0.489 (0.449) (0.448) (0.485) (0.521) (0.449) (0.449) 0.953 0.931 0.603 0.365 0.905 0.902 (0.527) (0.461) (0.461) (0.460) (0.458) (0.481) 1.150 1.133 1.125 1.117 1.106 1.105 (0.333) (0.334) (0.335) (0.333) (0.345) (0.345) 1.227 1.194 1.142 1.119 1.178 1.184 (0.503) (0.513) (0.521) (0.518) (0.512) (0.507) 1.496 1.480 1.494 1.540 1.519 1.544 (0.480) (0.481) (0.480) (0.497) (0.474) (0.476) 10.526 10.567 10.532 10.789 10.574 10.581 (0.571) (0.573) (0.572) (0.616) (0.572) (0.570) 403,797

403,797

403,797

403,797

403,797

Note: Standard errors in parentheses are below unstandardized coefficients. Significant at 5%; significant at 1%.

403,797

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positive determinant of an acquisition. Instead of controlling for the largest company size, we now include the relative size of the firms in the dyad measured by the sales of the smaller firm divided by the sales of the larger firm. This measure is also positively related to the acquisition likelihood implying that although the size of the largest firm in the dyad is a positive determinant of an acquisition, acquisitions tend to take place in dyads where both the acquirer and target are relatively equally sized. Model 2 provides additional support for our Hypothesis 1 on the positive effect of technological interdependence on acquisition likelihood with our measure of patent class overlap. Model 3 adds to the model specification the average crowding of the patent classes where the firms overlap. The direct effect of crowding is positive, but its linear moderation effect is nonsignificant. This appears to be, however, because patent class-level crowding is related in a U-shaped manner to acquisition likelihood. When adding the overlap moderation effect to the quadratic formulation of crowding in Model 4, we again find that the joint effect of technological interdependence and crowding is negatively related to the acquisition likelihood providing further support for our niche level findings on the effect of crowdedness. From the quadratic formulation, we also find that while crowding generally tends to reduce the effect of patent class overlap on acquisition likelihood, the joint effect appears to in fact increase the acquisition likelihood on very high levels of crowding. This kind of U-shaped effect of crowding is consistent with the resource dependence argumentation, with the exception that very high levels of crowding would eventually also appear to cause consolidation. Finally, we also confirm that on the patent class level the existence of an alliance tie increases the likelihood of an acquisition, as hypothesized (Model 5), but the moderation effect is not anymore significant (Model 6).

DISCUSSION AND CONCLUSIONS We set out to examine and extend Pfeffer’s (1972) resource dependency arguments in an intra-industry context and the work by Vanhaverbeke et al. (2002) on alliance and acquisition patterns. Using measures derived from social structural theory of technological change (Podolny & Stuart, 1995; Podolny et al., 1996) we found that firms with high technological niche overlap are more likely to engage in merger and acquisition transactions. We further found that such transactions are more likely if the firms’

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technological positions overlap in less crowded niches and when firms’ own technological positions are on average highly crowded. Technological crowding alone is related in a U-shaped manner to the acquisition likelihood. We also found strong evidence that prior alliance ties between a pair of firms increase the likelihood of merger or acquisition and weak evidence that alliances reduce the effect of technological interdependence on acquisition likelihood. Our findings make contributions to three streams of research: resource dependence theory, technological ecology research, and research on motives for mergers and acquisitions.

Implications for Resource Dependence Theory We re-examine and extend resource dependence theory in an intra-industry context. While resource dependence arguments have been repeatedly tested as explanations of acquisition behavior, previous studies have focused on the inter-industry context. Much of this emphasis has been driven by the availability of data on inter-industry transactions. Reliable intra-industry data on resource dependencies have been hard to find. By introducing measures from the technological ecology research of social structural theory, we can address this important gap in the literature. While technological resource dependencies are clearly not the only resource dependencies that firms face, they can be expected to be relevant in technology intensive industries. Research in the resource-based view of strategic management has shown that firm-level resource endowments play an important role in explaining firm behavior such as the formation of strategic alliances (Gulati, 1999) and diversification decision making (Markides & Williamson, 1994). Our measures of technological niche and patent class overlap and their interactions with crowdedness allow us to take steps in distinguishing between the resource scale and the related resource redeployment explanations from the somewhat less well empirically established resource dependence explanations (Casciaro & Piskorski, 2005). The main competing explanation for our resource dependence reasoning is that combining related technological resources provides R&D scale and scope-related advantages. There are examples of pharmaceutical firms’ CEOs citing R&D scale as a motive and empirical studies examining the R&D scale effect (e.g. Henderson & Cockburn, 1996), but its existence can also be debated (Zenger, 1994). We do not dispute the advantages from combining related R&D areas, be they driven by scale or scope advantages, but we

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argue – and also provide empirical support – that resource dependence arguments have similarly explanatory power in intra-industry acquisitions. Thus, we regard them as complementary rather than competing explanations. Were acquisitions entirely driven by the resource scale or scope advantages, they should take place irrespective of whether the overlapping areas are crowded or not. Should there be any effects of crowding, they should be positive since there would at least be an extensive supply of potential firms to acquire in the crowded niches. We do, however, find that crowdedness moderates the effect of overlap negatively. We see this finding as a support for our resource dependence argument, since in a crowded technology space, an individual acquisition would not be enough for reducing a firm’s dependence. To do that, an acquirer would need to engage in a series of acquisitions, such as for example Cisco Systems (Carpenter, Lazonick, & O’sullivan, 2003), to account for the large number of constantly emerging competitors.

Implications for Technological Ecology Research Our study also contributes to the technological ecology research. Sociological research has been central to our understanding of the importance of positions that organizations occupy in different networks. Structural theories based on network data have been employed to explain such varied phenomena as firm performance (Stuart, 2000), diffusion of corporate practices (Abrahamson & Rosenkopf, 1997), and the economic advantages of high status firms (Stuart, 2000). More recently, these perspectives have also been employed to explain different strategic behaviors, such as formation of alliances (Stuart, 1998) and venture capital syndication (e.g. Sorenson & Stuart, 2001). Our study adds to this stream of research in two ways. First, we extend social structural theory arguments to explain acquisition behavior. Acquisitions are important strategic decisions that have the potential to transform a firm (Karim & Mitchell, 2000). Our results, showing that a firm’s positioning in social structures, such as the technological space, affect acquisition behavior, constitute an important extension of the explanatory domain of social structural theory. Second, our finding that prior alliances ties moderate the relationships between technological position and acquisition behavior suggests that the different social networks in which a firm is embedded interact to influence firm behavior. Prior research in social structural theory has focused on the impact of a single social structure, such

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as technological space in which a firm is embedded, or alliance networks, to explain subsequent firm behavior. Our results suggest that ignoring the interactions of different social structures might lead to findings that omit important influences on firm behavior.

Implications for Research on Mergers and Acquisitions Acquisition motivations can be separated into industry level, firm level, and managerial motivations. Among these motivations, recent research has mainly focused on firm level and managerial motivations (e.g., Hayward & Hambrick, 1997; Trautwein, 1990; Yin & Shanley, 2008). Previous research on firm-level value creation motivations in turn has focused on financial synergy, advantages of scale, improved bargaining power, elimination of market overlaps, and utilization of complementary assets (Berkovitch & Narayanan, 1993). Research on managerial motivations argues that management might also be motivated to carry out acquisitions to broaden its empire and increase job security (Amihud & Lev, 1981; Deutsch, Keil, & Laamanen, 2007; Slusky & Caves, 1991). It has also been argued that the excitement of the acquisition process itself is an intrinsic motivator to engage in acquisitions (Haspeslagh & Jemison, 1991), and there has also been evidence of management’s overconfidence (Hambrick & Cannella, 1993; Haunschild, 1993; Roll, 1986). Our findings make two contributions to this stream of research. First we contribute to a small stream of studies that brings back the industry context as a motivation for mergers and acquisitions (Lin, Peng, Yang, & Sun, 2009; Oberg & Holtstrom, 2006; Yin & Shanley, 2008). By focusing on resource dependence and by arguing for an intra-industry context explanation, our findings suggest that access to and control of important technological resources within an industry may drive acquisitions. Particularly in an industry such as the pharmaceutical industry, in which competition is largely based on innovation, access to patents can be an important motivating factor for acquisitions (Cardinal, 2001; Miller, 2004; Nerkar & Roberts, 2004). Our study thus contributes also to a nascent literature that views acquisitions from the perspective of the knowledge base of the firm (e.g. Ahuja & Katila, 2001; McEvily & Marcus, 2005; Villalonga & McGahan, 2005). As a managerial implication of our findings, we bring up the importance of understanding the patent landscape where the firm is positioned to recognize the potential resource dependencies facing them. Mapping the patent landscape and a firm’s positioning in it can provide for

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management improved possibilities for devising acquisition and alliance strategies that combine both the resource-based and strategic positioning perspectives. Limitations and Future Research When interpreting the results of our study, some limitations must be considered. First, our sample is limited to the pharmaceutical industry, and more specifically to companies that are listed on a North American stock exchange. While this focus allows us to control for much unobserved heterogeneity, it might also limit the generalizability of our findings to other industries. In particular, technological interdependence as operationalized in this study is likely to play a significantly smaller role in less technology intensive industries. However, we believe that in these industries, other equally important intra-industry dependencies could potentially be identified. On the basis of our results, we can suggest several avenues for future research. First, we see our study replicated in other industry contexts to ensure the generalizability of our results. Such replicating studies could develop other measures for intra-industry interdependence to test the results in less technology-intensive industries. Second, our results suggest that future research on social structural theory should investigate interactions between different social networks a firm is embedded in. We expect such studies to provide further insight into when positions in different social networks complement each other or when they might limit firm behavior. Finally, we see performance implications of resource dependence reducing mergers and acquisitions as a relevant opportunity for future research. On the basis of the results of the present study, we can only speculate if acquisitions that address important resource interdependencies of the firm fare better or worse than other types of acquisitions.

NOTE 1. The SDC database is one of the most comprehensive source of alliance and acquisition data. While recent research (Bae & Gargiulo, 2005) has shown that the database has some limitations when studying smaller firms or event history analyses, these limitations are not a critical limitation in the current study due to its focus on publicly traded, larger firms, and yearly data.

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ACKNOWLEDGMENTS The authors acknowledge the helpful comments of Markku Maula, Christine Oliver, and Cameron Wilson. The authors also gratefully acknowledge the financial support from the Research Programme for Advanced Technology Policy (ProACT) of the Finnish Ministry of Trade and Industry and the National Technology Agency, Tekes.

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POLITICAL CONNECTIONS AND FAMILY BUSINESS DIVERSIFICATION$ Hsi-Mei Chung and Hung-Bin Ding ABSTRACT Personal political connections with politicians have positive contribution to the abnormal returns of firms (Hillman, Zardkoohi, & Bierman, 1999; Chung, 2006; Dinc, 2005; Faccio, 2006; Morck, Wolfenzon, & Yeung, 2005; Imai, 2006). Business owners and executives have incentives to invest in political connections because such relationship may enable their firms to gain access to key information not available to the competitors. However, the impact of political connections on the behaviors of firms has only received scant interest in the literature (Hillman, Withers, & Collins, 2009). The objective of this research is to examine the impact of formal and informal political connections on the scope of family business diversification. We focus on family business because of their unique access to family ties or family social capital to achieve business objectives (Sharma, 2004; Steier, 2003). We test our hypotheses using panel data from 35 Taiwanbased family business groups from 1988 to 2002. Our analysis shows that the informal political connections possessed by the parent generation owners of family business groups are better predictors of family business $

Both authors contributed to this paper equally.

Advances in Mergers and Acquisitions, Volume 9, 135–152 Copyright r 2010 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1108/S1479-361X(2010)0000009009

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diversification than the informal political connections established by the children generations owners. This result complements the resource dependence theory by suggesting that durable and non-transferable political connections possessed by family leaders have a unique effect in the corporate decision to diversify. Additionally, the personal ties between politicians and parent generation family leaders are ‘‘sticky.’’ They cannot be easily succeeded by the younger generations.

INTRODUCTION Environmental uncertainty is one of the main challenges in corporate diversification. Although the effects of interorganizational ties in uncertainty reduction have been widely studied by management researchers (Arregle, Hitt, Sirmon, & Very, 2007; Adler & Kwon, 2002; Salvato & Melin, 2008), the impact of political connections on the behaviors of firms has only received scant interest (Hillman, Withers, & Collins, 2009). Personal political connections with politicians have positive contribution to the abnormal returns of firms (Hillman, Zardkoohi, & Bierman, 1999; Chung, 2006; Dinc, 2005; Faccio, 2006; Morck, Wolfenzon, & Yeung, 2005; Imai, 2006). Business owners and executives have incentives to invest in political connections because such relationships may enable their firms to gain access to key information not available to the competitors. A connected individual may also use personal political connections to receive favorable tax rate, special protection of market, subsidies, special loan, and access to select valuable properties (Faccio, 2006; Imai, 2006). However, politicians are likely to demand reciprocity from their business friends in return for the special treatment (Siegel, 2007). Some of the reciprocity may require the connected businesses to diversify their products lines or to enter new markets. A family business group is a conglomerate whose parent organization and the subsidiaries are controlled by members of a family. Researchers have been actively documenting the differences between family firms and nonfamily firms in the recent years (Gallo 2004; De´niz & Sua´rez, 2005; Stavrou, Kassinis, & Filotheou 2007). One of the reasons family business groups are different from nonfamily ones is the involvement of family members in business operations and their use of family ties or family social capital to achieve business objectives (Sharma, 2004; Steier, 2003). Although the family social capital research has identified that family ties have both positive and negative effects in the performance of family firms

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(Salvato & Melin, 2008), we have little knowledge about the role of political connections of family members in corporate decisions. The objective of this research is to examine the impact of formal and informal political connections on the scope of family business diversification. We test our hypotheses using panel data from 35 Taiwan-based family business groups from 1988 to 2002. Our analysis shows that the informal political connections possessed by the parent generation owners of family business groups are better predictors of family business diversification than the informal political connections established by the children generation owners. This result complements the resource dependence theory by suggesting that durable and nontransferable political connections possessed by family leaders have a unique effect in the corporate decision to diversify. Additionally, the personal ties between politicians and parent generation family leaders are ‘‘sticky.’’ They cannot be easily succeeded by the younger generations.

THE POLITICAL CONNECTIONS AND DIVERSIFICATION Resource dependence theorists generally accept the notion that corporate political action is an important measure to manage the corporate dependence to select public policies (Pfeffer & Salancik, 1978; Hillman et al., 2009). Examples of such political actions may include, but not limited to, campaign contribution (Mullery, Brenner, & Perrin, 1995), lobbying, collaborating, and alerting the government (Meznar & Nigh, 1995), appointing retired government officials as directors (Pfeffer & Salancik, 1978), forging political connections through owner’s/manager’s personal ties (Peng & Luo, 2000), even becoming political appointee in the government (Brown & Dinc, 2005; Chung & Mahmood, 2006; Dinc, 2005; Faccio, 2006). Firms employ these activities to ‘‘alter the condition of the external economic environment’’ (Pfeffer & Salancik, 1978). Developing personal ties with government officials is a widely adopted mechanism to manage the uncertainties of the political environment. However, as the connections between a firm and the government establish a channel of communication between the connected parties, political connections are more critical for the management of political environment in the emerging economies, where the process of public policy making is less transparent than it is in developed nations (Dinc, 2005; Faccio, 2006; Imai,

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2006). Corporate–government political connections are often established through ‘‘position overlaps’’ (Chung & Mahmood, 2006), the participation of public affairs by the corporate leaders, including top executives and owners, because these individuals are at the positions to institutionalize and to capitalize such connections with corporate decisions. There are two main approaches to create position overlaps through public participations. The first one is assuming a post in the government, or formal connections. For example, many executives of the state-owned enterprises (SOEs) in China maintain a position in the government besides their managerial title in the company (Fan, Wong, & Zhang, 2007). The hybrid identity of managers allows the government to better monitor and regulate the SOEs while establishing a channel of communication for the managers to influence the governmental decisions (Chung & Mahmood, 2006). The second approach is the participation of policy forums such as advisory board or trade associations. These forums afford corporate leaders an institutional platform to develop personal relationship with regulatory agencies and key individuals from the government. The membership in these forums helps justifying the formal and informal interactions between business executives and representatives from the government. The second approach is also labeled as informal connection as the participants do not have to assume a formal governmental position to establish connections with the government officials (Chung & Mahmood, 2006). The political connections can be a great resource to the corporations. They enable firms to influence the governmental decision-making process to create favorable regulations (Pfeffer & Salancik, 1978). Also, the personal involvement of corporate leaders reduces environmental uncertainty because political connections allow businesses access to information of regulatory changes at very early stage or to better understand the general trends of regulations. Besides law making and enforcement, the government is a major source of business opportunities. The political connections between the business and the government can bring information benefit and more opportunities in expansion, especially in seizing the limited opportunities in the deregulated industries (Hillman, Zardkoohi, & Bierman, 1999; Chung, 2006; Dinc, 2005; Faccio, 2006; Morck et al., 2005), as the connected firm gains competitive advantage over its competitors that do not have equal access to such information (Hillman, Zardkoohi, & Bierman, 1999; Imai, 2006). The benefits derived from the personal political connections of corporate leaders are not limited to one single industry. The government is commonly viewed as an influential factor in the shaping of macro business environment (Golembiewski, 1985). The outcomes of governmental process such as

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antitrust law or trade policy have profound impact on multiple industries. Information access through political connections allows firms to pursue business opportunities beyond the scope of current operations. However, the government may also mandate the well-connected firms, the political allies in business, to enter new industries to fulfill the political promises (Sikorski, 1993; Shleifer & Vishny, 1994) such as investment in high-risk, high-return industries (Singh & Ang, 1999). Although business owners may be able to negotiate with the government for property protections or preferred supplier status, the firms need to carry out the policy promises of the government as a payback to the close relationship with the government. In summary, politically connected firms are more likely to enter new businesses.

FAMILY BUSINESS GROUPS AND POLITICAL CONNECTIONS The particularistic ties, such as kinship and friendship, provide bases of trust for business transactions. The influences of these ties distinguish family firms from nonfamily firms (Chang, 2006; Claessens, Djankov, & Lang, 2000; Fukuyama, 1995; Hamilton, 1997; Tsui & Farh, 1997; Whitley, 1992). One of the main characteristics of family business group is the use of particularistic ties to connect different business units within the group through the appointment of family members in key managerial position in the group (Go´mez-Mejı´ a, Haynes, Nu´n˜ez-Nickel, Jacobson, & MoyanoFuentes, 2007; Miller & Le-Breton-Miller, 2005). Select individuals may even be appointed to head multiple subsidiaries of the family business group. Such practice of overlapping appointment creates a mechanism of governance for family owners to control the directions of subsidiaries in the business group. The leaders of family business groups use kinship and family ties to coordinate affiliated firms of the family business group to develop synergies within the group (Go´mez-Mejı´ a et al., 2007; Salvato & Melin, 2008; Westhead & Howorth, 2006). The pervasiveness of family ties in the family business groups gives the leaders of family a central role to influence the strategic decision-makings of family business groups. Family leaders are usually synonymic to the active members of the parent generation because of their influences on the rest of the family. When the parent generation also actively manages the family business, they are in the position to capitalize the economic rent derived from personal political connections (Imai, 2006). On the other hand,

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the politicians could ‘‘extract benefits’’ from their family leader friends (Shleifer & Vishny, 1994) by influencing the family business group to enter unattractive markets for policy purposes. Even when the parent generation is not actively involved in day-to-day business decisions, their opinions may still be highly influential to the business decisions of younger successors (Sonnenfeld & Spence, 1989). In addition, a political connection is a strong tie, which needs to be carefully nurtured and maintained over time (Adler & Kwon, 2002). Such a close relationship may not be easily transferred to the younger successor after the retirement of the parent generation. There we hypothesize the following two pairs of relationships between the scope of diversification and the personal political connections possessed by the parent generation: Hypothesis 1. The formal political connections possessed by the parent generation family business leaders have positive impact on the scope of family business diversification before and after their retirement from the family businesses. Hypothesis 2. The informal political connections possessed by the parent generation family business leaders have positive impact on the scope of family business diversification before and after their retirement from the family businesses.

METHODOLOGY Sample Selection Based on the business group reports published by the China Credit Information Service from 1988 to 2002, we constructed a panel database to test our hypotheses. We obtain the governance and diversification data of top 100 business groups in Taiwan. This group of organizations accounts for above 70% of Taiwan’s GNP during the time period examined (China Credit Information Service, 2002). The business group report is published every other year before year 2000 and once a year after 2000. As the result, our panel data consists of 10 data points over the period of 1988–2002. We require that a business group must be ranked as top 100 at least eight years during the 14-year span to ensure that only high-performing business groups are included in this study. The result was a sample of 35 family business groups.

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We define a business group as family owned if it is managed and controlled by one family or coalition of multiple families. The family trees of family business groups are available in the business group report published by the China Credit Information Service (China Credit Information Service, 1988, 1990, 1992, 1994, 1996, 1998, 1999, 2000, 2001, 2002). Our definition is in agreement with previous studies (Gersick, Davis, Hampton, & Lansberg, 1997; Miller & Le-Breton-Miller, 2005).

Variables Dependent Variable (Y): Level of Diversification This study measures the level of a family business group’s diversification using the entropy method, which is a typical measurement technique for diversification (e.g., Hall & John, 1994; Hoskisson, Hitt, Johnson, & Moesel, 1993; Palepu, 1985). This technique takes into account the number of segments in which a firm (or business group in this case) operates and the relative importance of each segment in terms of its sales (Palepu, 1985). The entropy index is given by DU ¼ SkSkln(1/Sk), where Sk is defined as the share of sales in segment k and ln(1/S) is the relative weight of each segment k (the logarithm of the inverse of its sales). Independent Variable (X) (Political Connections): The Family Business Groups’ Political Connections By utilizing the method in previous research (Chung & Mahmood, 2006), this study categorizes the political connections into two groups, formal connections and informal connections. A family business group has a formal political connection when the founder(s) or the children of founder(s) occupy a full-time position as a cabinet-level political appointee, an elected official or representative, or a leadership position in the ruling party, the Kuomintang (KMT) before the year 2000 and the Democratic Progressive Party (DPP) after year 2000 in the time period examined. The formal political connection(s) of founder(s) is the sum of such connections held by all the founders. The formal political connection(s) of nonfounder(s) is the sum of such connections held by the children of the founder(s). The informal political connections are the positions held by family members in the nongovernmental trade associations. A family business group has an informal political connection when the founder(s) or the children of founder(s) occupy a leadership position in a trade association. The informal political connection(s) of founder(s) is the sum of such

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connections held by all the founders. The formal political connection(s) of nonfounder(s) is the sum of such connections held by the children of the founder(s).

Control Variables C1: The Year Effect The use of ‘‘period effects’’ or ‘‘year effects’’ is a possible method to diminish the contemporaneous correlation that may occur in the panel data; that is, when the residuals of units observed in each time period are correlated (e.g., see Khanna & Rivkin, 2001). In this research, the year effect is a dummy-coded variable to indicate the five years, i.e., y1988, y1990, y1992, y1994, y1996, y1998, y1999, y2000, y2001, and y2002. C2: Industrial Type of Business Group’s Core Company The core area of the business group plays a key role in determining its resource characteristics and has a significant effect on its product diversification decision (e.g., Markides & Williamson, 1994). Historically, the electronic manufacturing industry is the industry to rely most on expanding to multiproduct areas and globalization (Saxenian & Hsu, 2001). Given the uniqueness of electronic manufacturing industry, we code the core area of the business group into three categories: the electronic industry, nonelectronic manufacturing industry, and service industry. C3 & C4: Business Group Size and Age This study controls business group’s size and age that can potentially impact diversification decision (Chandler, 1962). The group’s size is defined as the total assets of the group taken over the years 1988 to 2002, respectively, and is employed by the natural logarithm transformation. The group’s age is computed by subtracting the date of the group’s founding from the years 1988 to 2002, respectively. C5: Past Performance The previous researches have highlighted that poor past performance motivates firms to search for diversification (Rumelt, 1974), and the possible influence from the poor past performance has been controlled in this research. In order to explore the possible influence of past performance, this research examines the business group’s return on assets (ROAs) in previous

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year. ROA is one typical index in measuring business group’s financial performance (e.g., Khanna & Rivkin, 2001; Luo & Chung, 2005). C6: The Family Business Groups’ Use of Family Ties in Affiliates Using the family trees of business group owner published by the China Credit Information Service, we identified which CEO positions of affiliated organizations are occupied by family members in a family business group. The percentage of family appointment in the business group is measured by the number of CEO’s family ties divided by the total number of affiliates in the group. This variable captures the relative importance of family ties in managing the affiliate firms within a family business group. C7: The Degree of Overlapping Investment between Owners and Managers in Family Business Group The overlapping investment represents the degree of shareholder interlocking among the various affiliates in a business group. The overlapping investment established by the core owner–managers is the foundation of interlocking ties among the affiliates within the group. The China Credit Information Service lists the key shareholders of affiliated firm within business groups profiled in the annual report. In this study, this variable was measured by computing for each affiliate the number of its key shareholders who were also key shareholders in other affiliates. This number was then accumulated for all of the affiliates in the business group and then weighted by the total number of affiliates in the business group. For example, if there were 30 affiliates in a business group (including the core company), this variable was computed by accumulating the number of common key shareholders for each of the 30 affiliates, and then divided this numerical value by 30 (the total number of affiliates). The aim of the weighting process is to take account of the fact that the total number of common shareholders in a business group is a function of the number of affiliates within that business group. The numerical value, if not scaled by the number of group affiliates, will be larger when there are more affiliates within a group. Therefore, the number of affiliates must be weighted to enable a meaningful comparison to be made between business groups that vary in their number of affiliates.

Data Analysis and Data Structure The research tests the proposed hypothesis using a generalized least-squares estimation method (the GLS regression method) with an autoregressive

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process of order one model (AR(1) disturbances model) implemented using STATA statistical software package. The use of panel data can overcome the limitations of the cross-sectional data, particularly the broadened time frame (Beck & Katz, 1995). Furthermore, this study utilizes the Hausman test to decide the appropriateness of fixed-effects (FEs) model or random-effects (REs) model (Baum, 2006). By utilizing Hausman test, it suggests that the random-effect GLS model is acceptable by using the current panel data. As shown in Table 1, among the 35 family business groups, 25 have core businesses in nonservice, manufacturing industries. The remaining companies are all in financial service industries and are among largest groups in this research. The family business groups with the core businesses in the food processing industries have the highest number of affiliates. From 1990 to 2004, the average level of diversification is 1.63 in these 35 business groups. The average number of political connections possessed by the family members in family business group is 2.85.

RESULTS The results of Table 2 indicate that a family business group’s level of diversification is positively related to its political connections. Furthermore, this variable is significantly correlated with the groups’ industries. In addition, the group’s diversification strategy is also significantly correlated to business group’s age, size, and its previous performance in family business group. Considered the relatedness with the family influence, the business group’s diversification is negatively related with the use of family ties in affiliates and the founder leadership status. Diversification is also positively related to the degree of overlapping investment. This research tests two models (M1 and M2) to investigate the causal effects of the control variables and the independent variables. The Wald Chi-square values are found to be significant for both models. None of the formal political connections possessed by the parent generation and the children generation leaders are significant in our models. Hypothesis 1 is not supported. Table 3 shows that the more informal political connections possessed by the parent generation leaders, the higher the level of diversification in these family business groups. In both leadership scenarios, neither of the formal and informal political connections possessed by the children generation is significant. The results of our analysis suggest that the parents’ political connection is a more important predictor of family business diversification, supporting hypothesis 2.

41.50 11.63 39.00 31.25 33.00 31.00 31.19 25.04

2 1

3

9 4 1 2 2

1 35

Others Summary

229,902.9 184,230.9

317,690.74 639,733.07 34,454.36 122,727.79 54,081.12

108,773.96

40,599.62 49,106.32

145,679.74 280,803.73 109,238.10 95,860.91

130,846.97 69,426.97 154,437.53

Size (Average Assets) (NT. Million)

1.90 1.63

1.40 1.28 1.25 1.42 1.46

1.66

1.52 1.49

1.76 1.57 1.75 2.03

1.72 1.72 1.76

Average Level of Diversification

0.40 0.30

0.29 0.26 0.20 0.23 0.44

0.30

0.26 0.30

0.39 0.40 0.18 0.24

0.30 0.31 0.31

Average % of Affiliate’s CEO Possessed by Family Ties

9.84 5.98

4.59 4.11 4.09 2.68 5.11

5.78

7.75 3.43

10.63 6.13 6.37 9.04

6.54 4.80 5.28

Average Degree of Overlapping Investment

6.50 2.85

3.99 6.40 0.60 0.78 1.43

2.00

0.60 1.90

2.90 1.30 1.44 1.43

2.32 2.55 4.26

Average Political Linkages Possessed by Family Members

All data calculated at year-end from 1988 to 2002. We calculate the data by averaging the within-group data over 14 years, and then calculate the average data within a specific industrial sector. Industrial sector definitions of business groups based upon nature of core company business. If the core company of the business group is both engaged in manufacturing and service sectors, this business group will be classified into other categories.

a

32.50 39.67 42.83 50.67

2 3 3 3

37 36.79

39.01 46.88 34.23

25 2 6

Average Founding Years

Family Business Group by Industrial Sectora.

Manufacturing Nonmetal Mineral Textile, apparel, and leather Food Chemical and plastic Transportation Electronic and household appliances Paper manufacturing Steel and metals equipment Electronic wire and mechanics equipment Service Financial service Logistics service Transportation service Constructing investment

Distribution of BG

Table 1.

Political Connections and Family Business Diversification 145

0.69

1.40

0.69 0.01

0.32

0.74

0.20

0.50 0.15 0.13 0.28 0.19 0.10

0.31 0.18

0.48 0.09

0.90

0.04

0.35

4

0.12

0.12 0.10

0.10 0.10

0.23 0.43 0.16 0.10

0.42 0.04

0.04

0.09

0.17

0.11

0.09

0.17 0.02 0.07 0.11 0.12 0.01 0.10 0.12

0.07

0.59

4.02

0.05

0.06

5

0.33

6

7

8

0.04

0.29 0.90

9

10

11

12

13

0.10

0.08

0.14

0.08

0.01

0.11

0.06

0.05

0.14

14

0.41 0.05

0.14 0.33 0.05 0.23 0.19 0.21

0.02

0.32 0.07 0.07 0.20 0.22 0.48 0.24 0.12 0.12 0.12 0.33 0.17 0.13 0.22 0.36 0.27 0.34 0.04 0.15 0.15 0.21 0.05 0.05 0.16 0.20 0.02

0.10

0.21 0.17 0.14 0.30 0.05 0.16 0.09 0.07 0.26

0.42 0.03

0.29 0.46 0.19 0.30 0.11 6239.19 9458.84 0.21 0.45 0.24 36.83 11.87 0.34 0.03 0.03 3.99 4.85 0.26 0.09 0.06

0.12

1.43

0.80

0.19

0.10

0.52

0.27

0.55

0.26

0.12

0.43

3

0.68

0.64

2

0.03

0.29

3.29

2.18

0.14

0.65 1.26

1

1.63 0.67

SD

Correlation Matrix.

Note: po0.05 (two-tailed); po0.01;. Group’s size is measured by group’s asset, and indicated by million U.S. dollar.

1. Diversification 2. Group’s formal political connections 3. Group’s informal political connections 4. Parent’s formal political connections 5. Parent’s informal political connections 6. Children’s formal political connections 7. Children’s informal political connections 8. Founder leadership 9. Electronic manufacturing group 10. Nonelectronic manufacturing group 11. Service group 12. Group’s size 13. Group’s age 14. Previous performance 15. Use of family ties in affiliates 16. Overlapping investment

Mean

Table 2.

0.11

15

0.57 (0.16) 0.56 (0.15) 0.46 (0.13) 0.44 (0.13) 0.45 (0.11) 0.27 (0.11) 0.11 (0.10) 0.05 (0.07) 1.49 (0.79) þ (dropped) 0.13 (0.16) 0.04 (0.02) 0.03 (0.21) 0.01 (0.01) 0.42 (0.18) 0.02 (0.01)

0.57 (0.16) 0.55 (0.14) 0.44 (0.13) 0.43 (0.12) 0.44 (0.11) 0.25 (0.10) 0.10 (0.09) 0.03 (0.07) 1.46 (0.86) þ (dropped) 0.11 (0.17) 0.04 (0.02) 0.01 (0.22) 0.01 (0.01) 0.36 (0.18) 0.02 (0.01) 135 22 0.65 0.39 0.49 555.86

Control variables Year 1990 Year 1992 Year 1994 Year 1996 Year 1998 Year 1999 Year 2000 Year 2001 Nonelectronic manufacturing Electronic manufacturing Service Business group’s size Business group’s age Previous performance Use of family ties in affiliates Degree of overlapping investment

Number of observations Number of groups R2-within R2-between R2-overall Wald chi-square

Note: Standard deviation data given in parentheses;po0.05; þ , po0.10; po0.01.

135 22 0.65 0.54 0.56 693.91

(0.05) (0.02) (0.12) (0.04)

(dropped)

M1-2

0.03 0.05 0.05 0.01

(dropped)

M1-1

Parent Leadership

(0.16) (0.14) (0.12) (0.13) (0.11) (0.10) (0.09) (0.07) (0.29) (0.34) (0.16) þ (0.03) (0.07) (0.01) (0.21) (0.01) 163 21 0.62 0.46 0.53 139.14

0.91 0.76 0.59 0.57 0.37 0.05 0.01 0.04 0.07 0.24 0.29 0.03 0.05 0.01 0.41 0.03

2.61 (0.61)

M2-1

M2-2

(0.17) (0.15) (0.13) (0.13) (0.12) (0.10) (0.09) (0.07) (0.28) (0.33) (0.15) þ (0.03) (0.08) (0.01) (0.20) (0.01)

(0.06) (0.03) (0.05) (0.02) þ

163 21 0.65 0.56 0.59 147.85

0.98 0.81 0.64 0.63 0.41 0.08 0.01 0.02 0.12 0.24 0.27 0.03 0.01 0.01 0.47 0.02

0.05 0.06 0.06 0.04

2.86 (0.62)

Nonparent Leadership

Impacts of Political Linkages on Diversification in Family Business Groups.

Constant Independent variables Parent formal political connections Parent informal political connections Children formal political connections Children informal political connections

Table 3. Political Connections and Family Business Diversification 147

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DISCUSSION AND CONCLUSIONS Diversification is a critical decision of strategic importance. In this research, we tested our hypotheses using panel data collected from family business groups in Taiwan. Based on our analysis, the informal political connections possessed by parent generation family leaders are drivers of corporate diversification. However, the analysis does not support the hypothesized relationship between the formal political connections and the diversification of family business groups. The analytical outcome suggests that informal connections are far more influential than formal connections to the diversification of family business groups. There are two possible explanations. First, nurturing and maintaining political connection require strong personal commitment and investment. The termed political appointees or political offices, while powerful, may not justify the investment to maintain these formal titles. Second, extensive anticorruption laws are not rare in newly democratized emerging economies (Faccio, 2006; Imai, 2006). Leveraging informal political connections for business interest is less likely to be detected by the law enforcement agencies and the public. Additionally, assuming formal political posts in the government may increase the legal liability and visibility of the family business groups. Even when the family business leaders have formal governmental titles, they may intentionally separate their political and business activities. Our research makes contributions to the recent revival of resource dependence theory. The resource dependence theory suggests that firms facing similar political environment are likely to respond to the environmental uncertainties in a similar fashion (Hillman et al., 2009). Although the forms of political connections may be similar between family and nonfamily business groups, the durability and transferability of political connections established by family leaders are quite different from those established by executives of nonfamily firms. When the latter leave the company, their personal ties with politicians cease to work for their former employers. However, this is not the case for family business leaders whose personal connections continue to affect key strategic decisions (e.g., diversification) of the family business group after their retirement. This study also contributes to the family business research by affirming the role of family ties in the behaviors of organizations. While some of the differences may be attributed to the family values and regional culture, as proposed in a recent study by Salvato and Melin (2008), the political connections established and possessed by the family leaders may also be a key predictor for new market entry.

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There are two major limitations of this study. As a newly democratized emerging economy, Taiwan shares many common institutional characteristics with many other emerging economies (Chung, 2006; Chung & Mahmood, 2006). However, the findings of our analysis may not be easily generalized to developed economies with stable and democratic political regimes such as the United States or the United Kingdom. Second, a common challenge to study family business is the identification of family firms. Although we are certain that all of the family business groups are family owned and family controlled, our source of data, China Credit Information Service, may not be able to identify all of the subsidiaries of these 35 family business groups over the period of 1988 to 2002. This problem is further complicated by family business owners’ efforts to keep the family affiliations of select subsidiaries secretive to avoid attentions from the government and the competitors (Chang, 2006; Chung, 2006). Further research on the effects of institutional condition in economies of different developmental stages and regional cultural tradition in our findings may further clarify the role and effects of political connections in the behaviors of family business groups.

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VALUE CREATION IN CORPORATE ACQUISITIONS: LINKING VALUE CREATION LOGIC, ORGANISATIONAL CAPABILITIES AND IMPLEMENTATION PROCESSES Richard Schoenberg and Cliff Bowman ABSTRACT We propose a typology of acquisition value creation logics derived from the dynamic capability literature and explore the organisational capabilities and implementation processes required for the effective delivery of three value creation logics: governance-based, cost-based and knowledge-based. We argue that each value creation logic calls for a specific and distinct set of acquirer capabilities and post-acquisition implementation processes. We put forward a contingency approach, where effective corporate acquirers make a conscious choice as to their predominant value creation logic based on a consideration of their organisational capabilities, which, in turn, defines the characteristics of appropriate target companies and the necessary implementation actions required to realise value post-acquisition. We discuss the implications for both acquiring firm executives and future M&A research. Advances in Mergers and Acquisitions, Volume 9, 153–175 Copyright r 2010 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1108/S1479-361X(2010)0000009010

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INTRODUCTION Value creation continues to be a central issue in any acquisition-based corporate development strategy (Tuch & O’Sullivan, 2007). Acquiring firm shareholders find that their companies’ acquisitions are value destroying in up to two-thirds of cases (Sudarsanam & Mahate, 2006), while, internally, acquiring firm executives report that only just over half of their acquisitions can be considered a success against the original financial objectives set for them (Schoenberg, 2006). Many acquisitions scholars attribute this mixed performance to both a lack of clarity regarding the value creation logic driving the acquisition and to the lack of a clear link between the value creation rationale and the subsequent post-acquisition implementation phase (see, e.g. Pablo & Javidan, 2004; Schweiger, Mitchell, Scott, & Brown, 2007). Indeed, it is not uncommon to find that the executive team that developed the acquisition strategy have no involvement after the deal is completed, or that those charged with integrating the acquired firm have no knowledge of the original justification for the transaction. Interestingly, the academic literature on mergers and acquisitions has developed with a similar separation. Strategy and finance research has tended to focus on value creation mechanisms and the determinants of acquisition performance, in particular the strategic and financial attributes of the combining firms (e.g. Seth, 1990; Capron & Pistre, 2002; Tuch & O’Sullivan, 2007). Meanwhile, organisational behaviour and human resource (HR) scholars have highlighted the process and behavioural aspects of post-merger integration, increasingly recognising the role of integration management, cultural assimilation and social identification with the combining companies (e.g. Dagnino & Pisano, 2008; Van Dick, Ullrich, & Tissington, 2006; Kavanagh & Ashkanasy, 2006). It is revealing that a metaanalysis of 93 prior empirical studies on the determinants of merger and acquisition (M&A) performance by King, Dalton, Daily, and Covin (2004), which incorporated the variables most frequently studied in the finance and strategy literatures, concluded: ‘Our results indicate that post-acquisition performance is moderated by variables unspecified in existing research. Thus, existing empirical M&A research has not clearly and repeatedly identified those variables that impact an acquiring firm’s subsequent performance’ (King et al., 2004, p. 188). A second meta-analysis, concerned with the influence of cultural compatibility on acquisition performance, reaches similar conclusions, finding that a large portion of the variance in M&A outcomes remains unexplained (Stahl & Voigt, 2008). Both

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meta-analyses call for a greater recognition of the process and organisational dimensions of acquisition value creation. In the text that follows we try to address this concern and propose a typology of acquisition value creation logics derived from the dynamic capability literature. We then explore the interrelation between each value logic and the organisational capabilities and implementation processes required for the effective delivery of each of the three value creation logics we identify. The argument we develop aims to make two primary contributions. First, we highlight that each value creation logic requires a specific and distinct set of acquirer capabilities and post-acquisition implementation processes. This raises the implication that effective corporate acquirers need to make a conscious choice as to their predominant value creation logic, which must be consistent with the firm’s organisational capabilities. Furthermore, the chosen value creation logic will define the characteristics of appropriate target companies and the necessary implementation actions required to realise value post-acquisition. We illustrate these implications with applications from practice. Second, our arguments underline the strong interrelationships that exist between acquisition strategy, organisational capabilities and post-acquisition integration. This reinforces the need for future M&A research to take a more holistic and interdisciplinary perspective that moves beyond traditional discipline-led boundaries, where financial value creation and implementation processes have typically been investigated separately. Our work is structured as follows. The next section develops a typology of value creation logics and discusses the characteristics of each of the three classes of logic identified. We then turn to the organisational capabilities required of an acquirer to deliver each of the value creation logics, in terms of pre-bid sensing, seizing the deal and transforming capabilities following completion. Finally, we explore the post-acquisition processes and actions that are required to implement each logic, exploring issues ranging from timescale and performance metrics to ‘day one’ actions and cultural and process integration.

A TYPOLOGY OF VALUE CREATION LOGICS Empirical research reveals that the average bid premium in corporate acquisitions is within the 20%–30% range (Goergen & Renneboog, 2003). In almost all cases the shareholders of a target company demand a premium over and above the current share price before they will agree to accept an

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acquisition offer. This premium for corporate control (Jensen & Ruback, 1983) places a major constraint on an acquirer’s ability to generate positive returns for its own shareholders as a result of an acquisition. In order to successfully create value the future cash flow stream of the acquired company has to be increased by an amount that exceeds the bid premium, plus the often overlooked costs incurred in integrating the acquisition and making the bid itself (Schoenberg, 2003). The dynamic capability perspective within the strategic management literature provides a rich theoretical framework to explore the value creation process, as it focuses on how firms refresh or change their stock of valuable resources and do so persistently (Eisenhardt & Martin, 2000; Helfat et al., 2007; Teece, Pisano, & Shuen, 1997; Teece, 2007). Drawing on this perspective, Bowman and Ambrosini (2003) elaborated three broad modes of corporate value creation, which can be classified as governance-based (within which they distinguished between provoked and encouraged learning), cost-based (scale benefits from consolidating activities) and knowledge-based (which includes leverage and creative integration). As we argue in the paragraphs that follow, these logics are directly applicable to value creation following an acquisition.

Governance-Based Value Creation Logic It is possible to create additional value within a newly acquired firm by changing the governance structure of the business in such a way as to provoke and encourage the learning of new processes and routines, which allow tasks within the firm to be performed more effectively and efficiently. ‘Provoked learning’ typically occurs when the corporate centre imposes strict financial targets on their acquired business units and primarily rewards them on the basis of their financial performance against these targets. ‘Encouraged learning’ occurs where the corporate centre incentivises experimentation and process innovation through the use of specific financial and non-financial rewards. Governance-based value creation logics are exemplified within private equity acquisitions. The acquisition is typically structured at the outset with clear and agreed financial and operational objectives, including the desired timeframe for their attainment. Tight financial budgets, including capital expenditure, consistent with these objectives are then imposed on the business, provoking the management to search for more productive ways of working and other efficiency savings. This is cleverly combined with the

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financial participation and equity ownership stake awarded to the operating management as part of the transaction, which reduces traditional agency conflicts and serves as a strong financial incentive to encourage the management to actively seek out and implement new ways of doing things and to improve efficiency (Sudarsanam, 2010). In terms of target company characteristics, the governance-based value logic can be applied to any business with scope for efficiency gains. No relatedness to the existing businesses of the acquirer is required, as value creation is precipitated primarily as a result of the governance regime under which the acquired business sits. Thus, individual businesses within a private equity fund’s portfolio can be entirely unrelated to each other. For example, in 2006–2007, TPG Capital acquired businesses ranging from a casino operator (Harrah’s Entertainment) to an electricity utility (TXU Energy) to a medical surgery provider (Surgical Care Affiliates). The principal operational risk (as opposed to financial risk) with this type of value logic is that the governance structure leads to short-termism within the acquired firm, as managers may be tempted to cut investment in futureorientated activities, such as research and development or staff development, in order to meet the immediate budget targets imposed on the business. Again, the private equity model aims to mitigate this risk through the managers’ ownership stake, which serves as an incentive to take account of the likely growth prospects perceived by the market when the private equity fund exits the business.

Cost-Based Value Creation Logic A second generic class of value creation logic is where the resources of the acquired firm are reconfigured in combination with those of the acquirer in order to achieve consolidation and economies of scale. This ‘resource sharing’ (Porter, 1987) or ‘reconfiguration’ (Bowman & Ambrosini, 2003) typically results in cost savings and can take two forms following an acquisition: centralisation of support activities or the consolidation and standardisation of core processes. Reconfiguration of support activities involves the consolidation of support functions from the newly acquired business to centralised provision, often referred to as a shared services model. Typically, this involves functions such as human resources, information technology (IT) and legal services, and primarily aims to create value through the cost reduction achieved by the elimination of duplicated provision. A second potential

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benefit is that concentration of the activity in a single location may facilitate the development of specific functional expertise such that it becomes a critical resource of the firm (Barney, 1991). Reconfiguration of core processes applies the same logic to the core operational processes of the firm. Following acquisition, core processes that the acquired firm shares with other businesses of the acquirer are standardised and managed centrally. This might include procurement and supply chain management, research and development, manufacturing operations, brand management or customer service provision. An example of these cost-based logics is provided by the UK’s Nationwide Building Society and its mergers with the Portland, Derbyshire, Cheshire and Dunfermline building societies, where overlapping branches are considered for closure, IT systems are consolidated to Nationwide’s central provision where possible and additional cost savings are captured from the rationalisation of other head office support functions. The 2007 merger with Portland Building Society also involved significant reconfiguration of core processes, including the migration of Portland savings accounts to Nationwide’s systems and the standardisation of branding to Nationwide. The merger is estimated to have generated d90 million synergies per year and ‘the benefits of scale from the merger will provide real opportunities to enhance our growth in core markets’ (Nationwide Annual Report, 2008, p. 8). The adoption of cost-based value creation logic necessitates that potential target firms share similar requirements in terms of either their support functions or core processes. The primary operational risk with this form of logic is that the perceived similarities are illusionary in reality. A complaint sometimes heard within companies with shared services is that the needs of individual businesses are only partially met by the centralised service, which can be perceived as remote and lacking in understanding of the precise requirements of a particular business unit. As the anecdotal expression states, ‘just because it says HR on the door, it doesn’t mean the same thing happens behind the door’. Our observation is that this operational risk may take time to manifest itself. Initially, the centralised provision may be correctly established to meet the requirements of each business unit, but over time this is compromised through a combination of changing needs at the business level and increasing standardisation of the centralised support service, often driven by the desire to cut costs at the centre. Reconfiguration of core processes carries a similar risk in that the adoption of, say, crossbusiness-unit manufacturing processes is likely to dictate a standard product specification, which may or may not meet the requirements of different national markets or customer groups.

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Knowledge-Based Value Creation Logic The third class of value creation logic is where an acquisition affords the opportunity to transfer or create valuable knowledge-based resources. Leverage involves the replication of a process or system that is operating in the acquirer into the acquired firm, or vice versa. This transfer of best practice is akin to the notion of skills transfer outlined by Porter (1987). Leverage might also take the form of extending an existing resource by deploying it into a new domain (Bowman & Ambrosini, 2003), for instance, the leveraging of CAT’s antibody therapeutics into AstraZeneca’s pharmaceutical distribution network following the latter’s acquisition of the former. A further value creation process in this class is creative integration, where existing knowledge-based resources from the acquirer and the newly acquired firm are co-ordinated and integrated, resulting in the emergence of a new resource or capability. For example, Gillette is well known for its multi-blade wet shaving technology. The company also acquired Braun, the electric grooming products business, in 1984 and then Duracell, the alkaline battery manufacturer, in 1996. The technologies of the three businesses were subsequently integrated to create the major new product category of Gillette Fusion Power, a five-blade wet razor that utilises battery-powered micro-pulses ‘to help reduce friction and increase razor glide’ (www. gillette.com). Clearly, the application of knowledge-based value creation logic requires the acquisition of appropriate target firms. In the case of leverage, the acquired firm must either be in a position to benefit from a critical resource or best practice possessed by the acquirer, or must possess a critical resource of its own that would be of value within the acquirer. In creative integration, the acquired firm must have distinct but potentially complementary knowledge-based resources, often technology. A further requirement in both cases is that there must be a capacity and willingness within the businesses to share and receive and it is here that the operational risk of these value creation strategies often lies. Szulanski (1996) identified three principal barriers to knowledge transfer within an organisation: a lack of absorptive capacity on behalf of the recipient, causal ambiguity regarding the exact nature of the knowledge to be transferred and an arduous relationship between the source of the knowledge and the recipient. All three of these may be applicable in an acquisition context but the latter two are especially relevant. The ability of a remote acquirer to accurately assess the exact nature of a particular resource, and therefore its applicability and transferability, prior to the

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acquisition may be limited. For example, differences in organisational and cultural contexts may create ambiguity surrounding the precise knowledge elements that lie behind the particular resource, with the result that detailed processes and routines may not be accurately understood, or translated, by those from outside the business itself (Kogut & Zander, 1992). This raises the danger that an acquirer will invest significant capital to obtain a resource that either isn’t appropriate for its intended context or cannot be successfully transferred. Similarly, the immediate post-acquisition period within the acquired firm is often characterised by uncertainty and anxiety regarding the acquirer’s exact intentions or motivations (Cartwright & Cooper, 1996). This can hinder the climate of openness and mutual respect necessary to support knowledge transfer and may fuel ‘not invented here’ syndrome, heightening resistance to any seemingly imposed new process or system. Capron and Pistre’s (2002) empirical research provides interesting insights into the direction of resource transfer and the ultimate value captured by the acquirer. Their results suggest that if only the target firm’s resources are redeployed, the acquirer is unlikely to capture any value overall. Operational value creation may occur post-acquisition, but the capital markets will have recognised the value of the target’s resources and competitive bidding will reflect this in the bid premium such that any abnormal returns to the acquirer will have been competed away. Conversely, Capron and Pistre (2002) found that acquirers, on average, do capture value overall where their own critical resources are redeployed to the target firm. Here, the capital markets may be less able to accurately forecast the leverage opportunities as the resources are proprietary to the acquirer and competitive bids are not in a position to reflect these unique value creation opportunities in the bid premium.

Key Characteristics of the Three Value Creation Logics We have seen from our descriptions above that each of the three classes of value logics represents fundamentally distinct approaches to post-acquisition value creation, with different implications in terms of target firm characteristics, organisational design and operational risks. These differences are summarised in Table 1. The approaches also vary in terms of their quantifiability, appropriability and imitability (see Fig. 1). Where the primary sources of value creation are cost savings from productivity and efficiency improvements provoked and

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Table 1.

Key Characteristics of the Three Classes of Value Creation Logics.

Characteristics

Governance-Based Value Creation

Cost-Based Value Creation

Primary source of Efficiency gains value creation through financial control and incentives Target firm Any business with characteristics scope for efficiency gains Operational risk Short-termism

Quantifiability Imitability Speed of value creation

Increasing Quantifiability and Appropriability

High High Short- to mediumterm

Knowledge-Based Value Creation

Consolidation of support activities or core processes

Transfer of best practice or creation of new resources from existing strengths Target requires related Target requires distinct operational activities/ but complementary processes resources/capabilities Inappropriate support Ineffectual transfer or services or transfer of standardisation inappropriate practices Medium–high Low–medium Medium–high Low–medium Short- to medium-term Medium- to long-term

Governance-Based (financial control)

Cost-Based (reconfiguration)

Knowledge-Based (leverage and creative)

Fig. 1.

Increasing Inimitability and Long Term Value Potential

Quantifiability, Appropriability and Inimitability of the Three Classes of Value Creation Logics.

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encouraged by changes to the governance structure, these can generally be quantified in advance and estimated with a degree of accuracy in the pre-bid planning stage (Sudarsanam, 2010). Of course, as we explained earlier, if these forecasted cost savings derive from cutting certain future-orientated budgets, for example, training, research and development or business development, there may be an operational risk in relation to the longer term viability of the acquired firm. In addition, productivity improvements anticipated prior to the deal may be only achievable with, for example, compromises to product or service quality, which again might increase operational risk. But, these risks not withstanding, the quantification of additional value within a governance logic is generally relatively straightforward. This is underlined by the frequency of multiple bids from competing private equity houses in any sale of a business where governance-based logic can potentially be applied. The cost savings from consolidation and scale within the cost-based reconfiguration logics can also be quantified and forecasted with a fair degree of accuracy at the pre-bid stage, although the implementation costs of the associated organisational restructuring introduce an element of uncertainty here. In contrast, where value creation depends on leveraging or creating tacit knowledge-based resources, the financial benefits are often much harder to quantify in advance and the operational risks to successful transfer mean that appropriation of the benefits is likely to be significantly harder to achieve. This has been confirmed in an empirical study of British cross-border acquisitions, which found that while acquirers generally achieved anticipated levels of resource reconfiguration, the degree of successful knowledge transfer consistently fell short of pre-bid expectations (Schoenberg, 2001). This result is perhaps not surprising as cost structures and associated physical resources are generally well understood and controlled and hence amenable to reconfiguration by executives. On the other hand, knowledge-based resources, which form the basis of leverage and creative logics, are frequently tacit in nature and poorly understood by management (Kogut & Zander, 1992). This raises the issue of competitive imitation and the timescale of value creation. We have argued that the value created by governance- and costbased logics is easier for an acquirer to quantify and appropriate than that created through knowledge-based logics. The corollary of this is that the former logics may also be easier for competitors to imitate. Thus, any cost advantage derived from making an acquisition based on governance- or cost-based logic may be relatively short lived; competitors are likely to be able to appropriate similar benefits through making a comparable

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acquisition. The benefits of knowledge-based logics may be more difficult for an acquirer to appropriate and therefore involve longer timescales but, if achieved, they will also be more difficult for competitors to imitate (Zander & Kogut, 1995) and thus any differential value created should be more sustainable. In practice, this means there is likely to be a short-term– long-term trade-off implicit in the selection of an acquirer’s value creation logic, as summarised in Fig. 1. We believe longitudinal empirical studies of these propositions would be a fruitful topic for future research.

ACQUIRER CAPABILITIES We now turn to the capabilities that an acquirer needs to successfully pursue each of the three classes of value creation logics. Teece argues that asset renewal requires ‘the capacity to (1) sense and shape opportunities and threats (2) to seize opportunities and (3) to maintain competitiveness through enhancing, combining, protecting, and, when necessary, reconfiguring the business enterprises intangible and tangible assets’ (2007, p. 1319). We adopt these categories to elucidate the organisational capabilities required of an acquirer to deliver each of the value logics in terms of pre-bid sensing, seizing the deal and transforming following completion.

Sensing and Seizing Capabilities Once the decision to pursue an acquisition-based corporate development strategy is made, the primary sensing capability required is that of target identification (Capron & Anand, 2007). As we have discussed above the characteristics of appropriate acquisition targets will depend on the value creation logic that is to be employed. Once a target has been identified, seizing the potential acquisition will depend on the acquirer’s capability to complete the transaction itself. Here, while the required capacity to negotiate the terms of the deal is likely to be independent of the value logic, the focal skills of the due diligence process will depend on the value creation logic envisaged. Accordingly, an acquirer that wishes to create value through revised governance arrangements will need to possess the ability to accurately evaluate the opportunities for further internal productivity and efficiency improvements within potential target companies and, critically, the ability

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of their managements to extract these given appropriate governance incentives. This, in turn, implies that the core due diligence skill will be financial, complemented with HR audit capability. Key due diligence questions for the governance logic are likely to be: What is the current operational cost structure and what is the scope for improvement? What is the current budgeting process and can this be tightened? What is the competency profile of the management team and the scope for incentivisation? In contrast, an acquirer seeking cost-based value creation will require the capability to sense what opportunities exist to consolidate and standardise support services and core processes across the combining businesses. This, in turn, requires a high degree of operations expertise and related skills such as activity mapping (Ambrosini, 2003). It is in these areas that due diligence capability will be required. Finally, knowledge-based value logics necessitate that acquirers’ can identify the critical resources possessed by potential target firms and then realistically evaluate the opportunities to leverage these within their own businesses, or vice versa. While sensing opportunities for the creative integration of complementary resources will often rely on intuition, the successful transfer of an existing knowledge-based resource has been shown to require not only the capacity to assess the codifiability and teachability of the process itself (Zander & Kogut, 1995) but also the ability to understand the social and organisational context in which the ‘best practice’ is embedded (Ambrosini, 2003). Accordingly, acquirers’ seeking to create value using this logic will need to possess particular strengths in conducting operational and organisational due diligence. Table 2 provides a summary of the sensing and seizing capabilities required for each class of value creation logic.

Transforming Capabilities In subsequent sections we discuss the post-acquisition implementation actions appropriate to the realisation of each value creation logic. Here, we will focus on the underlying culture or ‘way we do things round here’ (Schein, 1985) that provides the foundation for an acquirer’s transforming capability. The governance-based logic generally makes relatively low demands of the acquirer’s corporate culture. Once the appropriate governance structures are put in place, the newly acquired business is granted a high degree of operating autonomy, and cultural independence between the centre and its new business unit can safely be maintained. The

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Table 2. Capability

Sensing: Target identification

Capabilities Required to Pursue Each Class of Value Creation Logic. Governance-Based Value Creation

Ability to identify potential for further productivity and efficiency improvements through provoked/encouraged learning Seizing: Key due Financial diligence capability Transforming: Governance (hands-off) Acquirer corporate culture

Cost-Based Value Creation

Knowledge-Based Value Creation

Ability to identify critical Ability to identify resources and their opportunities for leverage opportunities/ consolidation and intuitive sensing of standardisation of complementary resources support activities and/ or core process Operational

Operational and organisational

Centralised, cost focused, Open, high-trust, vertical coordination innovative, social networks, horizontal coordination

other two classes of value logics, however, have distinct and opposing cultural requirements that are likely to be integral to the acquirer’s capability to successfully implement either cost-based or knowledge-based value creation. As one would expect, a cost-based value creation approach necessitates a corporate culture in which efficiency and centralisation are seen as core values. The process of consolidating support functions and sharing of core processes across business units is facilitated, where there is a widely held understanding of the cost benefits of removing duplication and the efficiency gains to be had from standardisation and consolidation. Well-developed vertical communication channels will also tend to be a feature of such a culture and are necessary to ensure that centralised provision is responsive to the market and operational requirements of each business unit. Where there is a dominant acquirer, their culture and systems would generally be imposed on the acquiring firm. This can make for swifter implementation of cost reductions, although there may be resentment and resistance from the acquiring firm’s staff. Over time, of course, as the corporation acquires more businesses, its culture necessarily evolves. Knowledge-based value creation demands a very different type of culture, however. The leverage of best practice or the creative integration of different technologies requires a corporate atmosphere in which individuals and work groups feel willing and empowered to contribute to intra-organisational

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pooling of skills and expertise and to take on new ways of working for themselves (Kostova, 1999). The appropriate communication channels and coordination mechanisms here are horizontal rather than vertical, with information and ideas flowing across business units. Empirical research on the organisational determinants of successful internal knowledge transfer emphasises the need for a positive relationship between the donor and recipient (Szulanski, 1996), as well as a willingness to learn on the part of the recipient (Inkpen, 1998). These both point to the need for openness and trust as key cultural attributes, which typically derive from strong social networks. Thus, a corporate culture that actively promotes the formation of social relationships across its businesses, and provides the organisational slack necessary for these to occur, is likely to provide a strong foundation for successful knowledge-based value creation. A UK technology company with globally recognised innovation capability provides a striking example. The firm has a cultural norm that each new employee must have lunch with at least 10 existing employees from outside their own area within their first month of employment. Again we have seen that each value creation logic requires a different set of organisational capabilities, as summarised in Table 2. The obvious implication that flows from this is that an acquirer’s choice of predominant M&A value creation logic must be informed by, and consistent with, its organisational capabilities. This suggests that senior executives need to develop a clear understanding of their organisation’s sensing, seizing and transforming capabilities as a precursor to any acquisition-based strategy and certainly before any target identification process begins. Where there is misalignment between the capabilities possessed and the desired value creation logic, either an alternative logic should be considered or a strategy formulated as to how, and if, the required capabilities can be developed. Throughout we have implicitly assumed that the acquiring firm’s executives are acting in the interests of their shareholders. Thus, we have finessed any agency issues (see, e.g. Seth, Song, & Pettit, 2000). However, where executive behaviours do not provide shareholder benefits, we need to be aware that these outcomes may be the result of bad luck, incompetence or the executives pursuing their own interests.

IMPLEMENTATION PROCESSES AND ACTIONS Ultimate acquisition success, of course, is dependent not only on the value creation potential of the combination but also on the suitability of the

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post-acquisition integration approach (Larsson & Finkelstein, 1999). Prior research has highlighted two critical stages in the integration process, planning and execution, and the key variables associated with each. In the planning phase decisions have to be made regarding the integration timescale (Angwin, 2004), performance goals and appropriate metrics to measure progress towards these (Burgelman & McKinney, 2006), and the leadership and membership of the integration team (Dagnino & Pisano, 2008; Ashkenas & Francis, 2000). The execution stage typically involves critical choices in terms of management and staff changes (Krug & Aguilera, 2005) and the extent of cultural (Kavanagh & Ashkanasy, 2006) and process integration (Burgelman & McKinney, 2006). Below we discuss the post-acquisition planning and execution choices that are appropriate to each class of value creation logic. Here, again we find that the required implementation varies significantly between the value creation logics, as summarised in Table 3. This reinforces not only the need for acquirers to ensure that their implementation actions are consistent with their chosen form of value creation, but also the importance of having clarity about the predominant value creation logic that they wish to pursue. The variance in the appropriate integration approach, which Table 3 highlights, means that pursuing more than one class of value creation logic simultaneously is likely to lead to a complex implementation challenge, with a very real danger that sub-optimal compromises will be made in the planning and execution of the post-acquisition integration. For example, if a cost-based restructuring with staff redundancies is pursued in the acquired company prior to implementation of an essentially knowledge-based value creation logic, the initial cost cutting is likely to erode trust, mutual respect and the openness of the remaining acquired firm employees to knowledge transfer. Furthermore, the leadership messages are likely to have been mixed and ambiguous, fuelling employees’ post-acquisition anxiety with potential loss of productivity (Cartwright & Cooper, 1996).

Implementation of Governance-Based Value Creation The post-acquisition goal of governance value creation is to install appropriate governance structures to provoke and encourage learning and achieve efficiency gains within the newly acquired business. We have discussed earlier that typically these will comprise budget targets and equity ownership stakes, which will be agreed during the bid negotiation as part of the overall deal structure (Sudarsanam, 2010). Post-acquisition progress

Acquirer board

No team (SBU autonomy)

Integration leadership

Integration team membership

Target firm executive change Target firm staff change Cultural integration Process integration (interactions required)

At target SBU discretion None None

Generally none

 Set budgets and incentives  Establish capital expenditure approval process  Appoint board member

1 month Financial – Budget targets

Integration timescale Performance metrics

Integration execution Day 1 actions

Installing governance and incentive structure

Integration planning Integration goal/primary task

Governance-Based Value Creation

Remove duplication of leaders from consolidated activities Losses from consolidated activities Assimilation/imposition Intensive and wide ranging for focal activities

 Identify activities for consolidation/standardisation  If possible, begin the change and target quick wins  Legitimise the integration team

Acquirer support function or operations leadership Support function/operations/ business leaders from each SBU

6–18 months Cost savings (activity based); standardisation

Restructuring support activities and/ or core processes to standardise and centralise

Cost-Based Value Creation

Reduce anxieties Make them feel valued Develop understanding/transfer plans Promote cross-SBU projects (including social interaction)

None (attitude change) Preservation/mutual respect Centre-facilitated cross-SBU knowledge interactions for focal practices and technologies

None (retain and respect)

   

Ensuring retention of critical resources; promoting sharing of these via codification/promotion of cross-SBU interactions/personnel transfers etc. 12–24 þ months Best practice adoption (leverage); new products/technologies (creative integration) Acquirer and SBU joint leadership (interactions facilitated) Emergent – Appropriate for focal practice/ technologies

Knowledge-Based Value Creation

Post-Acquisition Implementation Planning and Execution Processes Appropriate to Each Class of Value Creation Logic.

Implementation Processes and Actions

Table 3.

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is readily monitored against the agreed budgets. The new governance structures and budget controls will generally be implemented immediately upon completion, following which the new subsidiary tends to be granted full operating autonomy within the constraints of the agreed budgets. Thus, there is no requirement for cultural or process integration or the establishment of a formal integration team with this form of value creation.

Implementation of Cost-Based Value Creation Cost-based value creation sits at the opposite end of the integration spectrum, requiring significant organisational change. Here, the need is to reconfigure the support activities or core processes of the newly acquired business such that these are provided centrally, often by existing capacity within the acquiring firm. The integration is generally led by a senior operations executive from the acquirer and best practice advocates that significant planning of the desired outcomes and an action plan for the first 100 days is put in place prior to completion of the bid (Felman & Spratt, 2001). Indeed, where the bid is for a public company, the broad rationalisation plan and anticipated cost savings are often set out by the acquirer in their offer document. This allows the integration process to commence on day one following completion. Speed is viewed as important both to reduce employee uncertainly around the anticipated changes and to produce visible early wins, which can play an important symbolic role in promoting cultural assimilation of the acquired business (Felman & Spratt, 2001). Interestingly, while Angwin’s (2004) empirical study of speed in post-acquisition implementation did not find a correlation between speed and acquisition success in all situations, the study did reveal that successful process and cultural integration were both significantly associated with early action. Cost-based value creation obviously necessitates intensive integration of the support services or core operations that are to be consolidated. Job losses are common in the affected activities, as duplication is removed at both the management and staff levels. Cultural integration of the newly acquired firm is also an important feature, not only to promote common values within the shared operations, but also to facilitate implementation of the vertical control that is necessary for effective coordination between the centrally provided activities and the business units. Grupo Santander’s acquisition of Abbey National, the UK Bank, provides an illustration of this type of acquisition and its implementation. The objectives included consolidation of IT and customer account

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management to Santander’s existing IT platform, reducing costs significantly and instilling Santander’s performance-orientated culture (Moeller & Wells, 2005). Santander is reported to have commenced the integration planning four months prior to completion, allowing Abbey’s new CEO, who was the CFO of Santander, to outline expected changes to Abbey’s staff on day one. A new organisational structure, including the redundancy of the existing IT director, was announced within 10 days, and following a series of departmental audits and job evaluations, up to 2,000 staff jobs were shed by day 100. A new corporate logo, incorporating the Santander flame and typeface, was introduced in a similar timeframe. In parallel, a number of integration work teams were established to guide the detailed execution of operational integration with Santander processes, with this work continuing in the most complex areas for many months (Moeller & Wells, 2005).

Implementation of Knowledge-Based Value Creation A firm’s critical resources are often embedded in the social networks, tacit routines and culture of its organisation (Ambrosini & Bowman, 2001; Barney, 1986). The post-acquisition challenge of knowledge-based value creation is how to preserve these organisational characteristics, while achieving the interactions necessary to allow sharing and transfer of the critical resources to the acquirer’s other business units, or vice versa. This need for organisational preservation dictates that on the day of acquisition completion there will be few, if any, immediate changes. Rather, the leadership will want to reinforce the message that the motivation of the acquisition is to build and leverage the existing resources and know-how of the acquired firm. Consistent with this, job losses as a result of the acquisition are unusual and the imperative is frequently the retention of the firm’s human capital and their tacit knowledge. Similarly, the existing cultures of the two organisations will generally be preserved, although these will evolve over time as a result of the merger interactions. The integration is generally jointly led by parent and acquired company executives, to reinforce the mutual respect and desired openness required to facilitate knowledge exchange. The tacit and embedded nature of much organisational knowledge (Grant, 1996) dictates that the leverage process itself is often emergent in the months following the acquisition, in contrast to the predetermined and swift implementation of cost-based value logic. The importance in knowledge transfer of a positive relationship between donor and recipient

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(Szulanski, 1996) means that a useful starting point is the early promotion of social interactions between the newly acquired firm and the existing businesses of the acquirer. This can take many forms and may include corporate-wide conferences or training events, as well as more focused crossSBU project teams. These are frequently complemented with more formal transfer mechanisms, such as personnel transfers in the focal areas or integration sub-teams charged with codifying a particular process to enable its sharing. These interactions need to be supported by sufficient organisational slack to allow the knowledge exploration to occur (Szulanski, 1996), especially where the sharing and creative integration of technologies is desired. Appropriate control systems are also required to encourage collegiate behaviour and avoid protectionist business-unit-based attitudes. The positive role that an open and high trust corporate culture can play here has been discussed above. Pay and reward structures that incentivise managers and staff to look beyond their own SBU’s performance and to take a wider corporate perspective also have an important role to play. Rather than cost-based measures, the achievement of integration objectives is typically monitored against the successful adoption of best practices and, in the case of creative integration, the emergence of new technologies and products. Cisco Systems is an experienced implementer of knowledge-based value creation logic, having completed over 25 ‘technology and intellectual capital’ acquisitions in the mid-1990s. It viewed its primary implementation goals as the retention of target firm employees, the leverage of the acquired firm’s technical and product development skills and accelerated sales of existing target firm products through the leveraging of Cisco’s distribution capability (Wheelwright, Holloway, Tempest, & Kasper, 1999). A major factor in Cisco’s high employee retention was the care taken to ensure that compensation and benefits were maintained if not improved as part of the acquisition, including the grant of equivalent Cisco stock options and the payment of a retention bonus at the end of years one and two. Future career opportunities were also highly visible, with one-third of Cisco’s top management originating from previously acquired companies. The transition to the new employment policies would be jointly developed by Cisco HR managers and executives from the acquired firm. This joint approach extended to the transfer of Cisco best practices. Often a well-respected manager from the acquired firm was appointed as integration leader, to allay concerns over Cisco imposition and to help build the trust of other employees. This was supported by the transfer of a small number of employees to and from the new parent in each focal area in order to facilitate the sharing of process knowledge (Wheelwright et al., 1999).

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CONCLUSIONS Tables 1–3 have summarised the characteristics of each value creation logic and their implications for acquirer capabilities and post-acquisition implementation processes. Overall, we have argued for a contingency approach to corporate acquisitions, where the choice of predominant value creation logic is dictated by a consideration of the acquirer’s capabilities and the appropriate post-acquisition integration approach is contingent upon the chosen value creation logic. The practical value of a contingency approach is well recognised in the M&A literature, not least in the integration frameworks previously developed by Haspeslagh and Jemison (1991) and Schweiger and Very (2003). Our approach complements these by focusing directly on the value creation logic driving the acquisition, since value creation is the ultimate goal of any acquisition and the corporate strategy associated with it (Tuch & O’Sullivan, 2007). Tables 1–3 highlight that each class of value creation logic is different in nature, requires different capabilities and organisational configurations to execute successfully and necessitates different post-acquisition implementation processes and actions. This has important implications for scholarly research into M&A. First, our arguments highlight the clear interrelationship that exists between acquisition strategy, here defined as value creation logics, the organisational capabilities of the acquirer and the post-deal implementation phase. This reinforces the need for future M&A research to take a more holistic and interdisciplinary perspective that moves beyond the traditional boundaries of a discipline-led compartmentalised approach, where financial value creation and implementation processes are typically investigated separately. Second, the interdependence between value creation strategy and appropriate implementation processes suggests that future studies which investigate the role of individual implementation variables also need to take account of the value creation logic of the acquisitions studied. Several studies have established a bivariate relationship between acquisition performance and specific integration variables but these relationships are likely to be contingent on the value creation logic behind the acquisition, which should be included as a moderating variable in future implementation studies. The diversity of the value creation logics revealed in our summary tables in itself also reinforces our central argument that the three classes of value creation logics we have outlined are to a high degree mutually exclusive. This has the key practical implication of highlighting that any one organisation is unlikely to be able to successfully deliver more than one

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value creation logic simultaneously. Indeed, recent empirical research has established that acquisitions which predominantly employed a single value creation logic, whether that was cost-based reconfiguration or knowledge leverage, performed significantly better than those in which the acquirer sought to implement both simultaneously (Ambrosini, Bowman, & Schoenberg, 2010). This, in turn, suggests a number of pertinent questions for executives charged with leading corporate acquisitions. Does your organisation currently pursue a predominant form of value creation? Is your value creation logic aligned with your organisation’s capabilities? Are you acquiring target companies that can benefit from the value creation logic you are configured to deliver? Are your implementation processes consistent with your chosen value creation logic? Could your organisation’s capabilities, structures, systems and culture be further tailored to better facilitate this particular form of value creation? Executives who develop clear answers to these questions will be in the best position to maximise the realised value from their acquisitions and will have ensured that there is consistency between the value creation logic driving the bid, their organisational capabilities and the implementation approach pursued following completion.

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BEYOND KNOWLEDGE BASES: TOWARDS A BETTER UNDERSTANDING OF THE EFFECTS OF M&A ON TECHNOLOGICAL PERFORMANCE Giovanni Valentini and Alexandra Dawson ABSTRACT This chapter deals with the impact of mergers and acquisitions (M&A) on technological performance. We argue that, when it provides additional technological resources, M&A promote the creation of more value in the innovation process. Instead, when it allows the redeployment of complementary assets, M&A enable more value to be captured from the innovations, and hence foster firms’ incentives in the innovation process. Hypotheses are tested on a sample of deals that were completed in the U.S. ‘‘medical devices and photographic equipment’’ sector in the period 1988–1996.

Advances in Mergers and Acquisitions, Volume 9, 177–197 Copyright r 2010 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1108/S1479-361X(2010)0000009011

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INTRODUCTION To innovate, in addition to carrying out internal research and development (R&D), firms can acquire external knowledge and technologies, using a variety of agreements (Arora & Gambardella, 1990; Veugelers & Cassiman, 1999). A growing part of this knowledge sourcing activity is carried out through mergers and acquisitions (M&A). Chaudhuri and Tabrizi (1999, p. 123) argue that ‘‘[many high-tech companies] have caught the acquisition fever.’’ Despite the increasing popularity of M&A in high-tech industries, several studies suggest that M&A produce a negative effect on the technological performance of the merging firms (e.g., Hitt, Hoskisson, Ireland, & Harrison, 1991; Hitt, Hoskisson, Johnson, & Moesel, 1996). Others, however, highlight that M&A can enhance R&D processes and capabilities (e.g., Cassiman, Colombo, Garrone, & Veugelers, 2005; Capron, 1999), thus favoring the renewal of firms’ lines of business as well as their patenting output (Ahuja & Katila, 2001; Karim & Mitchell, 2000). In light of these contradictory results in prior research, understanding the contingent factors that influence and moderate the relationship between M&A and technological performance has become a key issue. This study aims at contributing to this stream of research by advancing and testing the idea that a two-way redeployment of complementary resources between acquiring and target firms plays a fundamental role in shaping post-acquisition technological performance. Such resources include not only upstream, technological resources but also downstream resources, that is, complementary assets1. The success of a firm’s innovation strategy depends on its ability to create and capture value from innovations. By providing additional technological resources, M&A promote the creation of more value in the innovation process, whereas by allowing the redeployment of complementary assets, M&A enable more value to be captured from the innovations and, in turn, foster firms’ incentive to innovate. M&A can therefore influence both the resources and the incentives at stake in the innovation process. This study explores how M&A can positively influence resources and incentives. Hypotheses are tested on a sample of 159 deals that took place in the U.S. ‘‘medical devices and photographic equipment’’ sector between 1988 and 1996, and find broad support. Three elements of novelty characterize this study. First, prior studies on the relationship between M&A and technological performance (e.g., Ahuja & Katila, 2001; Cloodt, Hagedoorn, & Van Kranenburg, 2006) have predominantly focused on knowledge bases as the sole relevant resource that is redeployable between merging firms to enhance post-M&A

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performance. In this chapter, we highlight the importance of complementary assets as an additional key variable to explain post-acquisition technological performance. Second, and related, previous studies have mainly adopted – implicitly or explicit – the perspective of the acquiring firm, focusing on when and how target resources can be beneficial to the bidders. In this study, we also highlight the synergies that can stem from the redeployment of resources from the acquiring firm to the target. Third, departing from prior related studies (Ahuja & Katila, 2001; Cassiman et al., 2005; Cloodt et al., 2006), a different and more precise measure of the relatedness of knowledge bases of acquiring and target firms is used.

THEORY AND HYPOTHESES This chapter studies the drivers of post-M&A technological performance. The theoretical analysis relies upon a simple principle: the outcome of organizational processes depends on the resources available in the process as well as on the incentives to use them (productively). The innovation process makes no exception: innovation output and technological performance depend on the resources available in the innovation process as well as on the incentives for their productive use. In this chapter, we argue that M&A can provide new resources and modify the incentives at stake, thus influencing the outcome of the innovation process and firms’ technological performance. The next step, therefore, is to identify the relevant resources and the incentives in the innovation process as well as the process through which M&A can modify them. Before discussing these issues, however, a short review of the literature on the effects of M&A on innovation is provided. Background Technological performance is strictly and increasingly related to firms’ viability and commercial success (Franko, 1989; Cho & Pucik, 2005). Yet the effects of M&A on the technological performance of merging firms have received relatively little attention, in particular when compared to the wide existing body of literature on the outcomes of M&A (Pesendorfer, 2003; Berggren, 2003). Also, prior empirical studies tackling this issue have often offered conflicting empirical evidence. Early studies (e.g., Hall, 1990; Hitt et al., 1991, 1996) generally argued that M&A are responsible for a decrease in technological performance. Two main arguments are proposed to account for this effect. First, the financial situation

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consequent to M&A may negatively influence R&D expenditures through higher leverage, lower level of investments – in particular of long-term investments such as those in research – as well as divestiture policy. These, alongside deeper crisis or failure (Sirower, 1997), can divert firms’ attention from R&D. Second, internal organizational changes due to M&A need to be considered. Acquisition intensity is predicted to be negatively related to the use of strategic systems of control, which employ long-term indicators and are usually associated with superior technological performance (Lerner & Wulf, 2006). Conversely, acquisition intensity is positively related to rigid financial controls, which are more short-term oriented, and may therefore discourage R&D investments, which are long-term bets almost by definition (Chakrabarti & Souder, 1987; Hitt et al., 1996). Moreover, the uncertainty brought about by the acquisition and the possible clash of cultures may foster the departure of key inventors in the organizations (Ernst & Vitt, 2000) and a decrease of the productivity of those who stay (Kapoor & Lim, 2007). However, one can wonder why, if M&A are responsible for a deterioration of technological performance, they have become a common growth strategy in high-tech sectors, in which technological performance is key to competitive advantage. In fact, the concern regarding the M&A impact is not unanimous. Capron (1999) shows that M&A can enhance innovation capabilities thanks to resources redeployment. As a consequence, acquisitions may favor the patenting output of the acquiring firms (Ahuja & Katila, 2001) and foster the renewal of their lines of business (Karim & Mitchell, 2000). The overall effect of M&A on technological performance may, therefore, depend on a number of contingencies. For instance, Puranam, Singh, and Zollo (2006) focus on the integration strategy, showing that when established firms engage in technology-grafting acquisitions of entrepreneurial firms, depending on the integration path adopted, M&A may either shorten the time-to-market of the first new product in the aftermath of the deal or result in more frequent subsequent product launches. Cassiman et al. (2005) show that technological and market relatedness between M&A partners distinctly affects the inputs, outputs, performance, and organizational structure of the R&D process.

M&A and Knowledge Bases There is widespread consensus around the fact that a firm’s innovativeness is significantly and positively related to its internal knowledge base

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(Ahuja & Katila, 2004; Griliches, 1998; Henderson & Cockburn, 1996). The innovation process, in Dierickx and Cool (1989) terminology, displays ‘‘assets mass efficiencies,’’ that is, adding increments to an existing asset stock is facilitated by possessing high levels of that stock. ‘‘Firms who already have an important stock of R&D know-how are often in a better position to [y] make further breakthroughs and add to their existing stock of knowledge than firms who have low initial levels of know-how’’ (Dierickx & Cool, 1989, p. 1508). Hence, the amount of knowledge produced, that is, the performance of the innovation process, is not merely determined by current R&D investments but also by the knowledge base available within the firm. The importance of a firm’s knowledge base is due not only to learning effects but also to the very nature of the innovation process, which can be characterized as an activity of recombinant search (Fleming, 2001). Schumpeter (1939) observed that innovation consists of either combining components in a new way or carrying out new combinations. Along the same lines, Nelson and Winter (1982, p. 130) highlighted how the creation of ‘‘any sort of novelty in art, science, or practical life consists to a substantial extent of a recombination of conceptual and physical materials that were previously in existence.’’ And a firm’s knowledge base is the primary source from where the recombinant search process starts. Acquisitions may allow a firm to enlarge its knowledge base. Specifically, M&A can provide access to technological resources otherwise not readily available because of the failure of the market for resources. This is even more likely when knowledge is the object of the transaction (Capron, 1999; Capron, Dussauge, & Mitchell, 1998) because of difficulties in the valuation of technological resources and potential opportunistic bidding or postcontract behavior (Arrow, 1962; Pisano, 1990; Williamson, 1985). As a result, by promoting the redeployment and reconfiguration of technological resources not accessible in alternative ways, M&A can enhance technological performance. The effect of an enlarged knowledge base consequent to M&A can be particularly relevant when the knowledge base of the target displays a moderate level of relatedness with that of the acquiring firm, being not too close, but not even too distant from it. To be put into use, new knowledge needs to be absorbed. The absorptive capacity argument suggests this process is easier when new knowledge is related to what is already known (Cohen & Levinthal, 1990). Similarity in knowledge bases favors communication and mutual learning thanks to common skills and similar languages (Lane & Lubatkin, 1998). Hence, relatedness between merging firms’

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knowledge bases facilitates their integration. However, the positive effect of relatedness may decrease when a certain threshold is surpassed. Ahuja and Katila (2001) argue that acquired knowledge base can improve performance (1) through cross-fertilization, that is, by providing ‘‘new’’ solutions to ‘‘old’’ problems and (2) by serving as the basis for new stimuli and information. When merging firms’ knowledge bases are too close, the positive impact of both virtuous processes may be of limited use. Conversely, inventors belonging to firms that have greater technological diversity are more likely to put together a previously untried combination (Fleming 2001, 2002), and firms are more likely to experience economies of scope (Cassiman et al., 2005; Henderson & Cockburn, 1996). In addition, merging not-too-similar knowledge bases may decrease workers’ resistance and disappointment about an M&A deal, since these are more pronounced in similar organizations with overlapping resources for the fear of being replaced (Harrison, O’Neil, & Hoskisson, 2000; Cassiman et al., 2005). In turn, this would reduce the costs of integration, an undoubtedly key issue for M&A success (Haspeslagh & Jemison, 1991). Taken together, these arguments concur to posit that knowledge bases with moderate degrees of relatedness provide the benefits of enhancing the variety of possible combinations that a firm can use, while maintaining the elements of commonality that facilitate absorption, interaction, and communication. Hypothesis 1. The relatedness of the knowledge bases of acquiring and target firms are curvilinearly (inverted-U shape) related to post-acquisition technological performance.

M&A and Complementary Assets Technological performance depends not only on the resources available and used but also on the incentives firms experience in the innovation process. In turn, these incentives are contingent upon the expected value that can be captured from innovation (Levin, Klevorick, Nelson, & Winter, 1987; Cohen & Levin, 1989).2 Yet profiting from technological innovation is not an easy task, and being an effective innovator requires more than just developing inventions: it requires getting those inventions to market and being able to appropriate the value they create. Invention is merely the first in a series of uncertain stages in the innovation process, and value appropriation is not automatic. History abounds with examples of firms in

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both low- and high-tech sectors that innovated but were not able to appropriate the results of their innovative activities. In synthesis, the ability of firms to capture value through innovation rests on two premises. First, it depends on the prospects of firms to preserve the ‘‘uniqueness’’ of their innovation, that is, on their ability to control the knowledge generated by the innovation itself. In this sense, the effectiveness of the intellectual property system plays a major role. Second, and often most importantly, it depends on the control firms have on the assets necessary to exploit the knowledge generated by innovation or ‘‘complementary assets’’ (Teece, 1986). Complementary assets typically include firms’ capabilities (e.g., manufacturing capabilities, sales expertise) as well as firms’ tangible and intangible assets (e.g., brand name, customer relationships, distribution channels). These assets, in some instances, allow firms to profit by innovation even if they are not unique. Suitable complementary assets, therefore, ameliorate the prospects of value appropriation in innovation. Firms that are better able to appropriate the value of their innovations will have higher expected profits from R&D activities. And higher expected profits lead to bigger effort in R&D activities and R&D-related capabilities development. Hence, if M&A can provide synergies in terms of complementary assets, firms will enjoy a renewed incentive in the innovation process given the prospects of higher profits. In turn, this will lead to higher productivity in innovation. Teubal, Avnimelech, and Gayego (2002) describe how the Israeli high-tech cluster in the data security sector developed thanks not only to start-up growth but also to the access to complementary assets provided by foreign acquiring firms. As M. Jones, global business manager of General Electric Medical Systems observed, ‘‘a big part of the value that we bring to the companies we buy is to be able to leverage our existing infrastructure, our distribution and service capabilities.’’3 We therefore predict the following: Hypothesis 2. Potential synergies in terms of complementary assets between acquiring and target firms are positively related to post-acquisition technological performance. The redeployment of complementary assets between acquirer and target may indirectly enhance technological performance by furthering firms’ ability to capture value from their innovations and, hence, their incentives in the innovation process. Yet this renewed incentive will work particularly when the conditions enabling the assimilation and use of the knowledge bases are met.

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If the merged knowledge bases are relatively equal in size, most of the knowledge resources of the combined firm will be devoted to the task of integrating the two knowledge bases. As the two approximately equal groups strive to integrate, fewer resources will be available for conducting the actual business of innovation (Ahuja & Katila, 2001). Conversely, if the acquired firm’s knowledge base is small relative to the acquirer, the modifications required for successful assimilation of the two knowledge bases are likely to be minor and therefore not very disruptive (Cloodt et al., 2006). Therefore, greater focus on the innovation process will be possible, and the potential synergies stemming from the availability of new complementary assets will be fully exploitable. This leads to predict that, ceteris paribus, the acquirer’s complementary assets would benefit to a greater extent from a target with a relatively smaller knowledge base, compared to that of the bidder. Hypothesis 3. The positive relationship between post-acquisition technological performance and complementary assets-related synergies decreases with the ratio of target-to-bidder knowledge bases.

METHODS Data The empirical analysis relies on a sample of 159 M&A deals. Data on the M&A deals were obtained from the SDC Platinum database. The final sample is composed by all the M&A deals reported in the SDC Platinum database such that  They were completed between 1988 and 1996. This period of time has two advantages. First, it ends just at the beginning of the latest M&A wave so that it is easier to disentangle the effect of single deals. Second, it does not contain any revolutionary technological change.  The acquirer had 38 as a primary 2-digit SIC code (‘‘medical devices and photographic equipment’’). The target, conversely, could belong to any SIC.  There is full financial data availability for acquirer and target in the Compustat database.  Both the acquirer and the target were U.S.-based companies.

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Table 1.

Sample Firms’ Descriptive Statistics. Acquirer

Employees (M) Sales (MM$) Assets (MM$) Advertising expenditures (MM$) R&D expenditures (MM$) Capex (MM$) Knowledge base (patents)

Target

Mean

Std. Dev.

Mean

Std. Dev.

28.00 4065.08 4886.46 74.25 179.13 288.93 179.08

91.43 14471.92 20160.04 289.13 656.49 1120.58 528.19

8.28 1029.39 988.93 3.90 37.45 59.22 71.82

26.32 3330.99 3752.94 14.15 127.29 335.33 268.33

The figures refer to the year preceding the deal, except those referring to knowledge stock, which considers all patents for which an application was filed in the five years preceding the deal. Note: MM, billions; M, millions.

Additional information about parent companies, affiliates, and associates was retrieved from companies’ website and ‘‘Who Owns Whom.’’ Descriptive statistics for bidders and targets included in the sample are reported in Table 1.

Dependent Variable and Econometric Issues Following a relatively established tradition across multiple fields (Hitt et al., 1991; Griliches, 1998; Stuart, 2000), we use patenting output as a proxy of technological performance. Patents have significant strengths as measures of technological performance. Not only do they represent an externally validated measure of technological novelty with clear economic significance (Scherer & Ross, 1990) but they have also been empirically shown to correlate very well with other possible measures of technological performance such as new products or innovation counts (Hagedoorn & Cloodt, 2003). Nonetheless, the use of patents also presents some limitations. Some inventions are nonpatentable and others are not patented (Levin et al., 1987). We tried to mitigate this concern by focusing on a single industrial sector. The external factors that affect the propensity to patent are likely to be stable within the same context (Ahuja & Katila, 2001), and in the ‘‘medical devices and photographic equipment’’ sector patents have been shown to constitute an effective and valuable way of appropriating the returns from R&D (Arora, Ceccagnoli, & Cohen, 2004).

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We measure post-acquisition technological performance as the number of successful patents applications filed by the combined entity over the first two years following the deal. We use the date of application because this control for differences in delays that may occur in granting patents after an application is filed. Also, while two years is a time frame long enough to assess change in technological performance, it is also short enough to minimize possible confounding effects. Moreover, as Hall, Griliches, and Hausman (1986) have shown, there is an almost contemporaneous relationship between R&D and patenting. If it leads to a patentable invention, the great majority of R&D conducted in a given year leads to an application within the same year in which the research is carried out. As a consequence, patent applications in the two years following the deal are a reliable measure of the R&D activity carried out in those two years. Patent data were obtained from the NBER U.S. Patent Citations Data File (Hall, Jaffe, & Trajtenberg, 2001) and the updates to the database were provided by professor Bronwyn Hall. While we are interested in post-acquisition performance, this has to be compared to a baseline. Consistent with Seth (1990), in this study we maintain that any measure of post-acquisition performance should focus on the acquiring and target firms considered together as a single entity using as a baseline the sum of what the two firms were accomplishing jointly but independently. The baseline we are using is, therefore, the sum of patenting output of the bidder and of the target over the two years preceding the deal. Post-M&A technological performance is modeled as: ¼ f ðPbefore ; X i ; Z i ; b; gÞ Pafter i i In essence, we model post-acquisition technological performance P as a function of pre-acquisition performance and two vectors of variables that may explain variations in technological performance with respect to pre-deal results – X and Z. These contain, respectively, variables indicating the relatedness of knowledge bases between target and acquirer and the possibility of complementary assets-related synergies, and a number of control variables. b and g are vectors of parameters to be estimated. The underlying idea is that the post-acquisition technological performance of the combined entity, once we control for pre-acquisition technological performance, is a function of deal-specific variables and before–after changes in some firm-level key variables. As said, technological performance is measured through patenting output. Patenting output is a count-data variable; hence, we estimate a negative binomial model (Cameron & Trivedi, 1998).

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Independent Variables Relatedness of Knowledge Bases Patent stocks represent a well-accepted indicator of knowledge bases. Several works from different disciplines ranging from industrial organization to management have used patents to proxy for knowledge bases (e.g., Arora & Gambardella, 1994; Ahuja & Katila, 2001; Silverman, 1999). Within this framework, measuring the relatedness of knowledge bases implies measuring their distance in the technological space. Building upon Jaffe (1986), the technological position of firm i can be characterized as a vector Fi ¼ (F1i, F2i, y, Fki), where Fji represents the proportion of patents belonging to technological class j that firm i has successfully applied for in the five years preceding the deal. Technological relatedness between the acquirer (A) and the target (T ) is then measured as the uncentered correlations of the technological vectors of the two firms A and T, that is, F A FT0 =½ðF A F T ÞðF AT Þ1=2 : This measure is bounded between zero and one. A value close to one indicates high relatedness of technological resources. Complementary Assets Synergies In the M&A literature, it has been shown both through case studies and through large sample studies (e.g., Harrison, Hitt, Hoskisson, & Ireland, 1991; Hitt, Harrison, Ireland, & Best, 1998) that the odds of synergies are well explained by complementary resource allocations. In their seminal study, Harrison et al. (1991) assess the odds of synergies between target and acquiring firm in terms of difference in their investment intensity profiles. Complementary assets are traditionally represented either by manufacturing capabilities or by sales and marketing resources (Teece, 1986). Accordingly, we measure the complementarity of complementary assets or the potential for complementary assets-related synergies, as the difference between acquiring and acquired firms in terms of the sum of capital expenditures and advertising expenditures scaled over firms’ total sales. Following Harrison et al. (1991), the year prior to the deal is the base year used in these calculations.

Control Variables Pre-acquisition Technological Performance Pre-acquisition technological performance is measured as the sum of the patents that bidder and target applied for over the two years preceding the deal.

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Change in Financial Leverage The opportunity cost of R&D may increase with firm’s leverage (Hall, 1990). Leverage is measured as debt financing over total financing. The change is calculated between the year after the deal and the year before the deal. Market Relatedness Not only can market relatedness lead to higher technology market power and thus to a higher appropriability (Cohen & Levin, 1989), but market relatedness has also been indicated as a driver of M&A success (Rumelt, 1974). Building upon McGahan and Villalonga (2005), inter alia, to assess market relatedness between target and acquiring firms we use SIC codes. We construct two dummy variables. Same4SICdigit is equal to one if acquiring firm and target have the same 4-digit SIC code (and zero otherwise), while Same2SICdigit is equal to one if the firms belong to the same 2-digit SIC. The category is missing if acquiring firm and target firm do not even share the 2-digit SIC code. Relative Size There is some empirical evidence hinting at the fact that the outcome of M&A depends upon the relative size of the merging firms in terms of both organizational size and knowledge base size. Following Capron (1999), relative organizational size between companies is measured as the ratio of bidder to target size in terms of sales. Drawing upon Ahuja and Katila (2001), relative size in terms of knowledge bases is measured through the ratio of target’s and bidder’s knowledge bases as described before. M&A Experience Acquisitions create complex organizational challenges, and both individual and organizational experience may be required to avoid integration problems (Haspeslagh & Jemison, 1991). Still, while several scholars stress its importance, there are no consistent findings on the relationship between acquisition experience and post-acquisition performance (King, Dalton, Daily, & Covin, 2004). We measure M&A experience as the logarithm of the count of the acquisitions undertaken by the firm from 1985 to the year before the year of the focal deal. Finally, we control for the before–after difference in R&D expenditures and include year dummies to account for unobserved specific year factors. Table 2 presents the correlation matrix of the main variables used in this study.

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Correlation Matrix.

Table 2. 1 1. Post-acquisition technological performance 2. Post/pre-M&A deal difference in R&D expenditures 3. Knowledge base relatedness 4. Complementary assetsrelated potential synergies 5. Same4SICdigit 6. Same2SICdigit 7. Change in financial leverage 8. Ratio of organizations’ size 9. Ratio of knowledge bases 10. M&A experience

2

3

4

1 0.01

1

5

6

7

8

9

10

1 0.01

1

0.16 0.17 0.01 0.30

0.08 0.17 0.14 0.14 1 0.03 0.10 0.08 0.04 0.38 1 0.09 0.15 0.02 0.27 0.03 0.09 1 0.26 0.03 0.05 0.17 0.08 0.09 0.05 1 0.05 0.01 0.15 0.03 0.05 0.18 0.09 0.28 1 0.14 0.01 0.14 0.06 0.16 0.04 0.08 0.22 0.09 1

RESULTS Table 3 reports the results of the negative binomial regression, with postacquisition performance as the dependent variable. Hypothesis 1 predicts that the relatedness of the knowledge bases of acquiring and target firms is curvilinearly related to post-acquisition technological performance, displaying an inverted-U shape. The parameter estimate of knowledge base relatedness is positive and significant ( po0.05), while that of its square is negative and significant ( po0.1). These coefficients indicate that the effect of knowledge base relatedness is initially positive, but it turns into negative after a threshold is surpassed as excessive relatedness diminishes the potential beneficial effects due to cross-fertilization (Ahuja & Katila, 2001). Simple calculations show the maximum is achieved for a value of knowledge relatedness of about 0.77. (The measure of knowledge base relatedness is bounded between 0 and 1 by construction.) Hypothesis 2 predicts that complementary investment profiles in terms of complementary assets are positively related to post-acquisition technological performance. The parameter estimate of complementary assets-related synergies is positive and significant ( po0.1). We also conjectured that this positive effect may diminish when the target knowledge base is approximately of the same size of that of the acquiring firm. The parameter estimate of the interaction between the two terms – ratio of target to acquiring firm knowledge base and complementary assets – is negative and significant ( po0.05), thus supporting Hypothesis 3.

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Table 3.

GIOVANNI VALENTINI AND ALEXANDRA DAWSON

Negative Binomial Regression: Determinants of Post-Acquisition Technological Performancea.

Constant Pre-deal joint technological performance Post/pre-M&A deal difference in R&D expenditures Knowledge base relatedness Knowledge base relatedness squared Complementary assets-related potential synergies Complementary assets-related potential synergies  ratio of knowledge bases Same4SICdigit Same2SICdigit Change in financial leverage Ratio of organizations’ size (target over acquirer) Ratio of knowledge bases (target over acquirer) M&A experience Year dummies Likelihood-ratio (LR) Chi-squared Pseudo R-squared

0.23 (0.40) 0.005 (0.00) 0.26 (0.77) 4.4 (1.46) 2.83 (1.57) 0.09 (0.05) 0.04 (0.02) 0.33 (0.33) 0.66 (0.28) 1.82 (0.70) 0.04 (0.05) 0.00 (0.00) 0.59 (0.22) Included 154.7 0.11

po0.10; po0.05; po0.01. a

N ¼ 159; standard errors in parentheses.

Parameter estimates of control variables also provide some interesting insights. In particular, market relatedness seems to play a role similar to that of knowledge base relatedness: as the parameter estimate of Same2SICdigit indicates a moderate, intermediate level of relatedness favors technological performance. Cassiman et al. (2005) have noticed how M&A between direct competitors very rarely leads combining firms to explore new technological fields, while diversifying M&A may provoke broader problems of integration and performance (Rumelt, 1974; Haspeslagh & Jemison, 1991). Quite surprisingly, the parameter estimate of the variables capturing

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changes in leverage is positive. We may speculate that this is due to a significant recourse to debt financing in order to acquire particularly valuable targets, which are then more likely to improve technological performance.

DISCUSSION AND CONCLUSION M&A represent an investment intended to create economic value, primarily through the development of synergies. In this chapter, we have shed some new light on the determinants of synergies in the innovation process, which can enhance post-acquisition technological performance. First, M&A may enlarge firms’ knowledge bases, thus creating opportunities for synergies in the knowledge production function, leading to novel technological combinations and bringing about economies of fitness and scope that decrease the cost of innovation (Capron, 1999; Larsson & Finkelstein, 1999). Second, additional synergies may be obtained through the redeployment of complementary assets (Teece, 1986). Complementary assets matter because inventions are typically an intermediate good and need to be packaged into products or services to yield value. Enhanced appropriability conditions, through additional complementary assets, increase the incentive of firms in the innovation process. M&A, therefore, change the two most relevant drivers of the innovation process outcome, as of any other organizational process: the resources available and the incentives at stake. The results of the empirical analysis support this view and show that when target firms display a knowledge base that is neither too close nor too distant from that of the acquiring firm, post-acquisition technological performance is enhanced. Moreover, post-acquisition technological performance is positively affected also when different resource profiles in terms of complementary assets between acquiring and target firms are observed. Several limitations of this study warrant attention. First, this study only examines one industry. Second, we observed technological performance for a post-acquisition period of only two years. Finally, M&A success should be considered both as a function of the potential benefits stemming from the combination of the involved firms as well as of organizational integration, which translates potential fit into real synergies. Notwithstanding its limitations, this study adds to the literature in multiple ways. At a general level, this study contributes to the M&A and market for corporate control literature. Along the lines of a recent meta-analytic study, which suggests that ‘‘of the available options, complementary resources [emphasis added]

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may be a promising theoretical foundation for continued M&A research’’ (King et al., 2004, p. 197) on post-acquisition performance, this study provides some evidence that the complementarity of resources between acquirer and target positively influences technological performance. Since the seminal study of Rumelt (1974) on relatedness and diversification, it has been commonly argued that synergies in M&A may be achieved because of similarity in acquiring and targeting resources. However, the evidence concerning the (monotonic) positive effect of relatedness on M&A performance is not consistent. Chatterjee (1986), Lubatkin (1987), Lubatkin and O’Neill (1987), and Chevalier (2000), among others, reject this hypothesis. At the same time, some theoretical and empirical studies (e.g., Capron & Pistre, 2002; Harrison et al., 1991; Hitt et al., 1998; Harrison, Hitt, Hoskisson, & Ireland, 2001; King et al., 2004) suggest that resource complementarity, and not similarity, is associated with higher performance in acquisitions. Accordingly, we find that knowledge bases that are neither too close nor too distant (i.e., that complement each other) maximize post-acquisition technological performance, and that diverse complementary profiles in terms of complementary assets promote patenting output. Furthermore, this study focuses on an understudied post-acquisition outcome, that is, technological performance. This chapter presents interesting implications for methods, measurement, and theory. From a methodological standpoint, while in the past the acquiring firm or the target firm have been predominantly used as the unit of analysis (Ahuja & Katila, 2001; Ernst & Vitt, 2000), in this chapter we argue that a suitable measure of post-acquisition performance should focus on the acquiring and target firms considered together as a single entity, using as a baseline what the two firms were accomplishing jointly but independently. From a measurement perspective, the measure of knowledge base relatedness used in this study refines that often used previous studies (e.g., Ahuja & Katila, 2001). While their measure evaluates the extent to which bidder and target built their knowledge on the same ground, that is, the extent to which their knowledge base was built recombining the same pieces of knowledge, the measure we use in this chapter focuses on the outcome of past innovative efforts of bidder and target, and builds upon the knowledge actually produced by the firms across technological classes. From a theoretical perspective, this study highlights that technological performance is associated not only with the technological resources available but also with the incentives to use these resources productively,

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and it further highlights the special role played by complementary assets in this sense. In the past, strategy research in general, and resource-based view more specifically (e.g., Barney, 1991), has stressed the importance of firmspecific resources in determining performance. However, one criticism that has been raised about the resource-based view of the firm (see Bromiley & Fleming (2002)) is that it assumes perfect ‘‘coaching’’ of resources. If there has to be a clear relationship between resources and performance, decision makers cannot differ in the quality of their decisions. This study shows that, if resources level is kept constant, change in incentives determined by the redeployment of complementary assets – and thus coaching – matters. The combination of both a knowledge-based and an incentive-based perspective to explore technological post-acquisition outcomes has been also advocated by Kapoor and Lim (2007) in their study on post-acquisition inventors’ productivity.

NOTES 1. Complementary assets are the assets necessary to bring an invention to the market and exploit commercially the knowledge generated by innovation (Teece, 1986). Complementary assets typically include firms’ capabilities (e.g., manufacturing capabilities, sales expertise) as well as firms’ tangible and intangible assets (e.g., brand name, customer relationships, distribution channels). 2. True enough value capture and profits from the commercialization of inventions do not constitute the only drivers of firms’ incentive in the innovation process. Research spending is often also the admission ticket that firms pay in order to enter a network of scientific information (Rosenberg, 1990). Firms with in-house R&D capabilities are more effective at scanning the environment and detecting valuable opportunities (Arora & Gambardella, 1994) as well as more effective at internalizing them (Cohen & Levinthal, 1990). Yet, firms primarily invest in R&D to profit from the commercialization of technological innovations. 3. See T. Khanna, ‘‘General Electric Medical Systems, 2002,’’ Harvard Business School Case 9-702-428.

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ALLURE AND DANGER OF THE BOUTIQUES: THE INFLUENCE OF THE SPECIALIZATION OF INVESTMENT BANK ON THE ACQUIRER’S PERFORMANCE Alexander Sleptsov ABSTRACT This chapter looks at the role the investment banks play in the acquisition process. The existing literature presents a conflicting account of the banks’ advice on the performance of the acquiring firm. By distinguishing between two different types of investment banks – bulge bracket and boutique firms – the chapter shows that the acquirer’s performance may be a function of the interaction between the acquirer’s choice of the bank’s type and the acquirer’s experience. More specifically, it appears that while the inexperienced acquirers can benefit from the deeper acquisition expertise of the boutique banks, the experienced acquirers can benefit more from the broader information search capabilities of the bulge bracket banks. Over the past decade and especially in the last two years the business and popular media produced numerous reports that vividly painted investment banks as self-interested, money-grubbing, hubris-infected risk-takers that Advances in Mergers and Acquisitions, Volume 9, 199–212 Copyright r 2010 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1108/S1479-361X(2010)0000009012

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cannot be expected to consistently create substantial economic value. That view of the investment banks as purely self-interested actors who tend to opportunistically disregard the interests of their clients has also been reflected in the academic research, in both finance (e.g., Rau, 2000) and strategic management (e.g., Hayward, 2003). At the same time, there exists a more benign view of the banks’ role and behavior; they can be seen as conduits of useful information and expertise. For instance, in the area of mergers and acquisitions (M&A) advice, the investment banks can ‘‘sell’’ their accumulated expertise on M&A to the acquiring firms in a mutually beneficial manner (Eccles & Crane, 1988). This view is reinforced by the fact that the investment banks’ services are often utilized not only by the target firms, which often require banks’ expertise simply to demonstrate that they follow their fiduciary obligations, but also by many acquirers. The large variation in the performance of the acquirers that use such banking services (Baker, 1990; Rau, 2000; Servaes & Zenner, 1996; Hayward, 2003) suggests that not all of the acquirers’ decisions to retain acquisition advisors turn out to be quite justified. I believe that the use of the information-transfer perspective can shed some light on the performance effects of retaining investment banks as lead financial advisors. In this chapter, I discuss how the choice of a particular type of the acquisition advisor may affect the usefulness of the acquisition information that the acquirer can utilize, hence affecting its acquisition performance. Specifically, I consider the implications of the acquirer’s choice to use either a large bulge-bracket advisor, such as Goldman Sachs or Morgan Stanley versus a smaller ‘‘boutique’’ bank that more narrowly specializes on the financial advisory services, such as Lazard or Houlihan Lokey. Below I discuss the direct effects of such a choice, as well as the interactions between the type of the advising bank and some common acquisition characteristics.

INFORMATION PROCESSING IN ACQUISITIONS: THE ROLE OF ADVISORS Firms, in general, need constant inflow of external information to make strategic decisions (Granovetter, 1985; Stinchcombe, 1990). Firms may be particularly effective in making strategic decisions when they have a balance between their ability to access large amounts of sufficiently heterogeneous information and their ability to process such information effectively (Sleptsov & Anand, 2008). Better access to a wide variety of data and information enhances the firm’s pool of potential decision alternatives;

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being able to process it allows the firm’s managers to effectively utilize all the information collected in their decision-making process. At the same time, if such a balance is lacking, the performance implications may be negative. If the firm can easily and quickly access large amounts of information without the requisite ability to process it in a meaningful way, it may experience a cognitive overload. Such an overload creates a significant problem since managers often face the difficult task of picking priorities among multiple agendas and strategies (Cyert & March, 1963; Dutton & Ashford, 1993). Additionally, whenever the decision-makers are presented with excess or redundant information, they may make worse decisions than without such information (Kahneman, Slovic, & Tversky, 1982). Conversely, a firm’s set of alternative strategic actions may become too restricted if it can process and analyze the collected information well, but do not possess the means of collecting sufficient amounts of input information; in case of planning an acquisition, such a firm may fail to consider potentially viable alternative targets or methods of financing. Therefore, it appears reasonable to expect that the firm is more likely to make better strategic decisions in general and acquisition decisions in particular if it can balance the amount of information it collects with its ability to analyze it effectively. Collecting and utilizing acquisition information is a complex and ambiguous task (Reuer & Koza, 2000), as evidenced by the substantial variance in performance for acquiring firms (e.g., Singh & Montgomery, 1987; Bradley, Desai, & Kim, 1988). As one McKinsey consultant noted, ‘‘acquirers must cope with an acute lack of information y they usually have little data about the target company; limited access to its managers, suppliers, channel partners and customers; and insufficient experience to analyze it properly.’’ The relative infrequency of acquisition activity compared to many other strategic decisions made by firms (Haspeslagh & Jemison, 1991; Haleblian & Finkelstein, 1999) suggests that even the most prolific acquirers often need an external help in accessing and analyzing information in order to evaluate potential targets and transaction structures more effectively. One such source of information for acquirers is investment banks (Eccles & Crane, 1988), which actively participate in many acquisitions (McLaughlin, 1990). Investment banks, sometimes described as ‘‘information producers’’ (Chemmanur & Fulghieri, 1994, p. 58), constantly monitor target pools and practice a variety of acquisition techniques. Many investment banks maintain a large cadre of managers whose only designated role is to manage and optimize information flows

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(Eccles & Crane, 1988). Investment banks have long been shown to have cost advantages over acquirers in information gathering and processing through scale economies, economies of specialization, and other reductions in search costs (Benston & Smith, 1976). As a result, investment banks tend to know the pools of potential acquisition targets and practical ways to structure and finance acquisitions much better than many potential acquirers – thus, they can considerably enhance the acquiring firm’s ability to gather all relevant information. Furthermore, some investment banks can provide substantial help to their clients in analyzing and making sense of the vast amounts of collected acquisition-related information. For instance, the banks, at least in theory, can narrow down the list of targets so as to exclude the ones that appear to be a poor strategic fit for the acquirer; they can also recommend financing options optimized for a particular deal and a particular capital structure of the acquirer. This information processing at the level of the investment bank transfers some of the burden of the acquisition decision-making from the acquirer to its advisor. Given the information-gathering and information-processing benefits that can potentially accrue to the investment banks’ M&A clients, it comes across as somewhat of a surprise that in many advisor-led acquisitions the acquirers seem to systematically underperform (Servaes & Zenner, 1996; Hayward, 2003). Some earlier studies, however, did find positive performance effects of having an acquirer’s advisor (e.g., Bowers & Miller, 1990). The inconsistent findings may be partially because the literatures addressing the role of the investment banks in acquisitions largely treat the banks as a relatively homogenous group of actors, distinguished mostly by the variation in their reputation. Reputation is often measured by the rankings in the industry’s league tables, which results in the higher status assigned to the largest banks. At the same time, it has long been acknowledged that there are two distinct broad types of investment banks active in the M&A advisory services: major-bracket (bulge-bracket) banks and boutique banks (examples of the latter are Rothschild and Lazard). These types of banks are different not only in size – boutique banks are usually considerably smaller – but also in the proportion of the revenue derived from the advisory business. While bulge-bracket (major-bracket) banks usually provide broad financial services, including trading, debt and equity underwriting in addition to the advisory services, boutique banks usually concentrate on the financial advisory services alone. Accordingly, one may expect the systematic difference in the different types of banks’ willingness to gather and process the acquisition-related information for their M&A clients. Major-bracket

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banks that provide underwriting services for the large corporate clients oftentimes expect the client firms to retain them for the acquisition advice. The banks then treat the M&A assignments as their ‘‘just reward’’ for typically lower-margin underwriting deals (Eccles & Crane, 1988), which reduces their willingness to invest more resources in conducting a meaningful analysis of the collected information. Major-bracket banks are hence understandably keen on the initiation and completion of the acquisition deals (Rau, 2000; Hayward, 2003). In order to generate new advisory contracts, the banks constantly supply their past clients with numerous detailed acquisition proposals, as well as detailed description of the completed transactions. Such a large information volume combined with lower motivation to process it in a way useful for the current client, plus lower level of large banks’ specialization compared to the boutique banks, may lead to the imbalance between the acquirer’s ability to gather and process the acquisition information. This effect is illustrated by the finding by Beckman and Haunschild (2002), who found that the acquirer’s use of two of the largest investment banks – Morgan Stanley and Merrill Lynch – was associated with higher acquisition premiums paid by the acquirer, indicating potentially negative performance outcomes (Sirower, 1997). Conversely, since the bulk of the boutique banks’ business comes from the advisory services, they tend to be more specialized and put more emphasis on conducting a meaningful, deep analysis of the collected information. Since such banks cannot count on a steady stream of underwriting assignments to solidify their relationship with each particular client, they may be more highly motivated than bulge-bracket banks in the positive outcome of each given acquisition, and they also may spend more effort in developing acquisition strategies specifically tailored for each of their (fewer) clients. The boutique banks, unlike the bulge-bracket banks, more often must win M&A advisory contracts purely ‘‘on merit,’’ by consistently offering advice of superior quality. In essence, the smaller size of the boutique banks can somewhat limit their ability to compete with the bulge-bracket banks on the sheer volume of the collected acquisition information, while their higher motivation to help their clients to solve the acquisition problem in an optimal way elevates their value in terms of information processing. This should result in a systematically better information-transfer balance for the acquirer; the boutique banks’ clients should be able to utilize all of the collected information more effectively. Thus, it appears reasonable to expect that the acquirers that use the services of the boutique banks should outperform the acquirers that retain the bulgebracket advisors.

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Although the predicted central tendency – that boutique banks should create more value for their M&A clients – appears plausible, it does not explain why the bulge-bracket banks continue to retain such a commanding market share in the M&A advisory business over the years (more than 80% by the annual deal volume, according to Thomson Reuters). One possible explanation is that the information-gathering and information-processing needs of the acquirers can vary across the firms, resulting in a situation where the choice of a boutique advisor cannot be considered a dominant strategy for every acquiring firm. If an acquirer faces a notable deficiency in its ability to gather the acquisition-related information, but not in processing it, it may prefer the bulge-bracket advisor. Such an advisor’s exposure to a greater number and variety of completed acquisitions would better enhance the acquirer’s decision pool of targets and acquisition techniques. If, on the other hand, the acquirer has a relatively low ability to process collected information, it may prefer the boutique advisor in order to avoid cognitive overload. This line of thinking suggests that there are two factors that can condition the information-processing needs of the acquiring firm: its size and its experience in making acquisitions. In terms of size, the smaller acquirers less often have a dedicated corporate development function in their organizational structure. Thus, while their information-gathering needs should be significant, they tend to face a much lower threshold at which their information-processing ability in the context of acquisition decision-making becomes completely overwhelmed. In other words, other things being equal, the smaller acquirers should benefit more from retaining a boutique, specialized advisor and less from retaining a bulge-bracket advisor. The acquisition experience can also substantially affect the informationtransfer needs of the acquiring firm. The existing research has shown that the acquirers can draw inferences from their prior acquisition experience, albeit in a nonlinear manner (Haleblian & Finkelstein, 1999). Such nonlinearity can be explained by the negative transfer effects that occur because although many acquisitions appear to be similar to each other, they, in fact, can have significantly different underlying characteristics (Finkelstein & Haleblian, 2002). After accumulating a sufficiently large sample of the completed deals, however, the acquirers start to avoid erroneous generalizations between dissimilar transactions, achieving a more effective learning and thus a better performance over time. The learning entails creating specific decision rules related to acquisitions; such rules can be explicitly recorded (Zollo & Winter, 2002) or tacitly embedded in the organizational routines. The accumulation of the intertwined decision rules over time may significantly enhance the acquiring firm’s ability to process

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Acquirer’s Size (-)

The Choice to Retain a Boutique Advisor

+

Expected Acquisition Performance

Acquirer’s Prior Acquisition Experience (-)

Fig. 1.

Hypothesized Relationships.

acquisition-related information, thus increasing the relative importance of the information gathering and reducing the relative importance of the information processing for the more experienced acquirers. Thus, it appears reasonable to expect that the acquiring firms with no or very little prior acquisition experience should benefit more from retaining the boutique bank advisors, while highly experienced acquirers can benefit more from retaining the bulge-bracket banks. The hypothesized relationships are represented graphically in Fig. 1.

TESTING THE HYPOTHESIZED RELATIONSHIPS In order to empirically test the relationships between the choice of the boutique or bulge-bracket advisor and the acquirer’s expected performance, I collected information on domestic acquisitions completed between 1991 and 2006 from the SDC Platinum database. To ensure the data reliability, I excluded very small acquisitions (where the deal value was less than $30 million). In the existing research on acquisitions, the threshold values under which the deals were excluded from the samples often vary between $10 million (Haleblian & Finkelstein, 1999) and $100 million (Hayward & Hambrick, 1997). The transaction values in the present sample range from $30 million up to $89 billion, with the mean value of $596 million. I excluded the acquisitions with missing data, as well as the acquisitions made by the same firm in quick succession (with less than two weeks between announcements), as it would not be possible to reliably determine if the markets predominantly react to just one of those transactions. After deleting

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those transactions, there were 2,356 acquisitions made by 1,268 unique acquirers in the sample. The dependent variable is the expected acquisition performance of the acquirer. I use the event study methodology to measure the expected performance as the abnormal returns that accrue to the acquirer upon the acquisition announcement and capture the market expectations of future performance of the acquisition. The appropriate use of the methodology is usually seen as dependent on three key assumptions: markets are efficient, the events in question are unanticipated, and there were no confounding events during the event window used in the study (McWilliams & Siegel, 1997). I assume that the semistrong form of the efficient capital market hypotheses holds – that is – that stock prices quickly adjust to reflect all publicly available information about the economic value of a firm (Fama, 1991). When an acquisition is announced, the capital markets adjust the value of the acquirer according to the newly released portions of information, such as identities of the acquirer and the target, as well as the terms of the planned transaction. Existing empirical evidence suggests that the market reaction is generally indicative of the subsequent performance of the acquirer–target combination (Ravenscraft & Pascoe, 1989; Healy, Palepu, & Ruback, 1992; Kaplan & Weisbach, 1992; Anand & Singh, 1997). For example, it has been shown to explain 46% of the variation in the economic value added (Sirower & O’Byrne, 1997), as well with the future profitability and cash flow returns (Kaplan, 2000), the length of the acquisition process, and its final outcome (Jindra & Walkling, 2004). Still, it must be noted that this measure of performance gauges the investors’ expectations about the future gains from the acquisitions rather than the observed posttransaction performance. In the computation of the measure for the dependent variable, I determined the unanticipated capital market reactions by measuring the risk-adjusted abnormal returns to the acquirer in a 2-day window around the acquisition announcement (the day prior to the announcement and the day of announcement of the deal). Since the movement in market price of an individual stock is affected by many variables, one has to control for the overall movement of the market as well as for the level of risk of each stock (by taking into account the day-to-day variability in its price). The adjustment for risk uses the market model: Rit ¼ ai þ bi Rmit þ it where Rit is the daily stock return for the stock i on day t; Rmit is the daily return of the market portfolio; ai and bi are the coefficients in the model for

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stock i; and eit is the disturbance term, assumed to be normally distributed. This model is estimated for 180 days (730 to 551 relative to the day of the announcement). I used CRSP stocks database to collect the required data. Using the coefficients given by the above equation, I then calculate the expected returns of the acquirer for each day in the study window. The abnormal returns are then calculated by subtracting the expected returns from the actual returns. These returns are added up for both days in the window to obtain cumulative abnormal returns. For the sample used in this study, the mean cumulative abnormal return was negative (0.039), and not significantly different from zero, consistently with previous findings on the acquisition studies. I use a dichotomous dummy variable coded 1 if the advisor for the focal transaction was classified as boutique bank, 0 otherwise. In the time period under consideration, the acquirers were advised by 14 different bulgebracket (major-bracket) and 27 different boutique investment banks. I measure the acquisition experience of the acquirer as a simple count of all prior acquisitions that the focal firm completed in the 10-year period prior to the focal event. Since the relationship between the acquirer’s performance and its experience may have a curvilinear character (Haleblian & Finkelstein, 1999), I include both the linear and squared term. I measure the absolute size of the acquirer by using its fair market value two weeks prior to the announcement of the focal acquisition. I also control for a number of variables that have been shown to affect the acquirer’s expected performance. These variables include the relative size of the target to the acquirer (e.g., Agrawal, Jaffe, & Mandelker, 1992) measured as a ratio of its market values two weeks prior to the announcement of the acquisition, and acquisition experience of the acquirer. The expected performance of the acquirer may also be affected by the level of acquisition complexity. The complexity significantly depends on the method of financing: the stock-financed acquisitions tend to be more complex (Hayward, 2003). To control for this effect, I use a dummy variable that takes on the value of 1 if the acquirer used common stock as a form of payment for the target, 0 otherwise. I also control for relatedness between acquirers and targets. In line with many existing acquisition studies, we used the method suggested by Sirower (1997). This is a ratio between the number of the identical SIC codes and the number of the distinct SIC codes. The codes are considered identical if the first three digits are the same. I control for the previous acquisition performance of the focal acquirer by using two variables calculated as the mean and the variance of the abnormal returns earned by the acquirer on the announcement of its prior acquisitions. I use

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calendar year dummies to control for the differences in general economic environment in the years 1991–2006. In order to mitigate possible multicollinearity problems, I use mean-centered variables (Jackard, Wan, & Turisi, 1990). In this sample, I analyze multiple acquisitions made by the same acquirers in different points in time over the 16-year period. Such cross-sectional time series data may contain both autocorrelation (Binder, 1998) and heteroskedasticity problems. Because of the possible autocorrelation within each data panel, I use Prais-Winsten transformation in the feasible generalized least squares regression models.

RESULTS The descriptive statistics are presented in Table 1. It is interesting to note that although the choice of the boutique advisor is positively correlated with the expected performance of the acquirer, the correlation coefficient is rather small. The abnormal returns are strongly and negatively correlated with the use of common stock to finance acquisition, consistent with previous research.

Table 1.

car_10 boutique aqexp aqexpsq aqmktval relsize pmean10 pvar10 stockused rel_3

pvar10 stockused rel_3

Descriptive Statistics and Correlations.

car_10

boutique

aqexp

aqexpsq

aqmktval

relsize

pmean10

1.0000 .0154 .0423 .0231 .0376 .0054 .0713 .0230 .1379 .0368

1.0000 .0092 .0061 .0606 .0085 .0022 .0119 .0630 .0029

1.0000 .8094 .3445 .0265 .0782 .0631 .0613 .0496

1.0000 .2430 .0127 .0373 .0358 .0323 .0381

1.0000 .0238 .0418 .0402 .0403 .0543

1.0000 .0076 .0067 .0124 .0035

1.0000 .1540 .0059 .0188

pvar10

stockuBd

rel_3

1.0000 .0240 .0091

1.0000 .1393

1.0000

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Table 2.

Results of Prais-Winsten Regression.

Variable

Model 1

Model 2

Model 3

Model 4

Constant

.884 (.948) .004 (.006) .084 (.001) .001 (.000) .012 (.1563) .005 (.003) .047 (.028) 1.158 (.159)

1.26 (.314) .004 (.006) .105 (.050) .001 (.001) .383 (.280) .006 (.004) .108 (.051) 1.78 (.266) .511 (.655)

1.19 (.317) .004 (.006) .095 (.049) .001 (.001) .365 (.281) .006 (.003) .108 (.051) 1.78 (.265) 1.585 (.725) .183 (.073)

1.3 (.315) .004 (.006) .10 (.050) .001 (.001) .378 (.280) .006 (.003) .108 (.051) 1.8 (.265) .638 (.717)

Relative size Experience Experience squared Relatedness Variation in previous performance Mean of previous performance Stock financing Boutique advisor Boutique advisor  experience Boutique advisor  acquirer’s size n R2 w2

.000 (.000) 2356 .016 83.99

2356 .030 84.50

2356 .036 106.8

2356 .031 86.90

Dependent variable: Cumulative abnormal returns, 2-day window. Standard errors are in parentheses; Year dummies included in all regressions, but not shown. po.10; po.05; po.01.

The results of the Prais-Winsten regressions are summarized in Table 2. Model 1 includes only control variables. In line with previously reported empirical studies of the acquiring firm’s performance, the use of common stock financing has a significant negative effect on the performance. The coefficients for the acquisition experience variables are in agreement with the empirical results reported in earlier studies: the linear term is negative and significant, while the squared term for the experience is positive and strongly significant, providing an evidence of a U-shaped relationship linking the experience to the focal performance. Relative size of the target and the acquirer, as well as the degree of the acquirer–target relatedness, does not

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have a significant effect on the expected performance. Interestingly, both the mean and the variation of the previous performance generally tend to have significant performance effect: positive for the mean and small negative effect for the variance. The coefficients for the year dummy variables (not shown in the table) were not significant except for the year 2001, which was negative and significant. Model 2 does not support the baseline conjecture that the choice of the boutique advisor should be on average associated with a better performance by the acquirer. However, adding a variable that interacts the boutique choice with the acquisition experience (Model 3) demonstrates that such a contingency remains plausible: the negative coefficient for the interaction term indicates that the less experienced acquirers can benefit from retaining a boutique bank as their lead financial advisor. Model 4, on the other hand, does not support the conjecture that smaller acquirers should benefit from the boutique advisors – although the coefficient for the interaction terms is negative, as predicted by the arguments above, it is only borderline significant, and also very small in absolute value.

DISCUSSION AND CONCLUSION The results of the empirical tests provide support for one of my hypotheses: less experienced acquirers can benefit more from selecting a boutique advisor, perhaps because its deeper involvement in the decision-making process during the development of the acquisition proposal and more focused and selective information gathering can help minimize the negative consequences of the cognitive overload that the inexperienced acquiring managers can otherwise experience. At the same time, the more experienced acquirers with presumably better developed acquisition decision-making routines should be better off selecting a bulge-bracket bank as their advisor – in order to enhance its ability to collect all pertinent information related to the planned acquisition. Accordingly, the baseline prediction that the use of a boutique advisor is an unconditionally better choice does not receive an empirical support. These findings hopefully shed light on the contradictory role of the investment banks in the acquisition process – it appears that selecting a type of banker that is the most appropriate for a particular level of the given acquirer’s experience can make a material difference in the acquiring firm’s performance. Another implication of the results is that as the initially inexperienced acquirer starts to accumulate acquisition experience, its

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optimal advisor strategy may involve not sticking with the original advisor for very long, but switching at some moment in time to a different type of the advisor (from boutique to a major-bracket bank).

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