The impact of mergers and acquisitions on the innovativeness
of the acquiring firm in the European Pharmaceutical industry
University of Groningen, Faculty of Economics and Business
Master thesis MscBA, specialization Strategy and Innovation
19 March, 2012
Jacob Hedzer Fijlstra
2 Foreword
In front of you is the master thesis written by Jacob Hedzer Fijlstra. I wrote this thesis in order for me to graduate as MscBA, specialization Strategy and Innovation. I chose the topic of my thesis because I always enjoyed Mr. McCarthy colleges about mergers and acquisitions a lot and because I was intrigued by the movie Wall Street Never Sleeps. Therefore I decided I wanted to focus my research on mergers and acquisitions. The result is in front of you and I hope you will enjoy reading my thesis as much as I enjoyed writing it.
I would like to thank Killian McCarthy for his guidance while making my master thesis. We had a few bumps on the road but together we always managed to figure things out and I am very grateful for the way he was always willing to help me.
3 Abstract
A lot of ambiguity exists in the current literature on the effects of mergers and acquisitions on the innovativeness of firms. Hitt et al. (1991) for example have shown that there is a negative effect of mergers and acquisitions on the innovativeness of acquiring firms. Prabhu et al. (2005) on the other hand, believe that under certain conditions mergers and acquisitions can function as a tonic for innovation. The aim of this study is to examine whether mergers and acquisitions have a positive or a negative effect on the innovativeness of acquiring firms, or that there is no relationship at all. Whether relatedness of the acquiring firm with the target firm has a positive moderating effect on the negative effect of mergers and acquisitions on the innovativeness of the acquiring firm or not is tested as well. The hypotheses are tested on mergers and acquisitions from the European Pharmaceutical industry between 2000 and 2007. The mergers and acquisitions are derived from the SDC database, the patent data from the European Patent Office and the complementary data on the firms involved from Datastream. The results are that mergers and acquisitions do have a negative effect on the innovativeness of the acquiring firm, but relatedness does not seem to play a significant role in that
relationship.
4 Table of contents
Chapter 1: Introduction 6
Chapter 2: Literature review 8
2.1 Merger and Acquisition motives and problems 8
2.2 Innovativeness 10
2.3 Mergers and acquisitions’ influence on innovativeness 14
2.4 Relatedness 18
2.5 Research question, conceptual model and hypotheses 20
Chapter 3: Data and Methods 22
3.1 Sample 22 3.2 Dependent variable 23 3.3 Independent variable 23 3.4 Controls 23 3.5 Model 23 Chapter 4: Results 24
4.1 Model and descriptive statistics 24
4.2 Logit models for each combination of years 25
4.3 Logit models for each combinations of years including relatedness 27
Chapter 5: Discussion 29
5.1 Industry and sample 29
5.2 The negative effect of size 29
5.3 Mergers and acquisitions have a negative effect on the 30
innovativeness of the acquiring firm
5.4 Not much has been learned 33
5.5 Relatedness does not play a moderating role in the negative 34
relationship between mergers and acquisitions on the innovativeness of the acquiring firm
5.6 Limitations 34
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References 37
6 1. Introduction
Clayton (2010) finds that around 70 – 80% of all mergers and acquisitions do no create value above the annual cost of capital. M&A failure rates are at approximately 50% or higher for nearly four decades. Global M&A activity has climbed from 1.9 trillion dollars in 2004 to 4.35 trillion dollars in 2007 (Clayton, 2010). A lot of ambiguity exists in the current literature on the effects of mergers and acquisitions on the innovativeness of firms. The aim of our study is to examine whether mergers and acquisitions have a positive or a negative effect on the innovativeness of acquiring firms, or that there is no relationship at all.
Quite some research has been done in the past already regarding the matter. Hitt et al. (1991) have shown that there is a negative effect of mergers and acquisitions on the
innovativeness of acquiring firms. Ahuja, G., & Katila, R. (2001) and Zhao (2009) have come to the same conclusion. Prabhu et al. (2005) however, believe that mergers and acquisitions don’t necessarily have to be a so called “poison pill” for innovation. They argue that, under certain conditions, mergers and acquisitions can act as a tonic for innovation.
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We will try to make a contribution to the literature by investigating this important question. To test this, we will first write a literature review of what has already been written regarding our topic. We will then construct a sample of mergers and acquisitions to test our hypothesis. We will use the SDC database to construct a sample of mergers and acquisitions. We will use Datastream for complementary data on firms such as return on assets and size. The European Patent register will be used to collect patent data on the acquiring and target firms of our sample. When our database is completed, we will use the logit model to analyze it, by predicting the probability of an increase or a decrease of patent intensity for all
combinations of years.
We find evidence for our first hypothesis. This means that we agree with vast majority of the literature that believes that mergers and acquisitions have a negative effect on the innovativeness of the acquiring firm. We did not find evidence for our second hypothesis, which states that relatedness of the acquiring firm with the target firm has a positive
moderating effect on the negative effect of mergers and acquisitions on the innovativeness of the acquiring firm. We find evidence that size does play a negative role in determining the probability of an increase or a decrease of patent intensity. Return on assets only seems to play a significant in the two years before a merger and two years after a merger.
8 2. Literature review
2.1 Merger and Acquisition motives and problems
Mergers and acquisitions have been defined to be the purchase of entire companies or assets by another company (Ahern & Weston, 2007). The aim of the merger or acquisition is that the new combination will be more productive than the separate parts (Ahern & Weston, 2007). The terms merger and acquisition mean slightly different things. When one company takes over another and established itself as the new owner, it’s called an acquisition. A merger happens when two firms agree to proceed as a single new company instead of remain separately owned and operated.
The volume of mergers and acquisitions is measured in the billions of dollars each year. The number of mergers and acquisitions has increased with each decade beginning with the 1960s (Prabhu et al., 2005). Companies have several reasons for choosing to merge. Stahl (2010) argues that firms may choose to merge to capture information spillovers, thereby enhancing the returns to innovation, or to dampen competition. The former refers to building upon one another’s innovations. Following theory, efficiency related, market power,
disciplining, agency costs and diversification are other motives to merge (Zhao, 2009). Hitt et al. (1998) also identify three possible reasons for acquisitive growth strategies. The first reason is that merged firms might achieve greater market power through increased market share of multipoint competition. The second is that the merged firm gains economies of scales or scope by combining complementary capabilities of the two firms. Third the merged firm can access capital at lower costs. Acquisitions could offer immediate entrance to a new market or a larger share of the market. The risks are more certain than those of internal innovation for example (Hitt et al., 1990). Other motives for acquisitions are the desire to obtain access to distribution channels, to gain entry into new markets or to obtain financial synergies or market power (Ahuja, G., & Katila, R., 2001). Alexandridis & Petmezas & Travlos (2010) claim that the fundamental aim of M&A’s is the generation of synergies that can foster corporate growth or increase market power.
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motives. The non technological motives may provide no technological inputs to the acquiring firm and therefore cannot be expected to improve its innovation output.
Mergers and acquisitions often mean transaction costs that result in acquiring or merging firms not realizing gains from their activities (Barney, 1988). Jensen (1988) observed that returns from acquisitions to acquiring firms vary closely around zero. Acquiring and merging firms may not easily or accurately predict potential synergy between the targeting and acquired firm assets. This situation may lead to problems in integrating the acquired assets into the acquiring firm. That can lead to an ineffective integration process that may harm internal innovation efforts (Hitt et al., 1996). Clayton (2010) states in his article that the unpredictable behavior of mergers and acquisitions remains a mystery. He observes, in
general, poor financial returns and high failure rates of mergers and acquisitions. Clayton further argues that around 70-80% of mergers and acquisitions do not create value above the annual cost of capital. Clayton (2010) cites other articles in which is estimated that M&A failure rates are at approximately 50% or higher for nearly four decades. Clayton (2010) sees global M&A activity climbing from 1.9 trillion dollars in 2004 to 4.35 trillion dollars in 2007. The numbers decline in the succeeding years due the financial crisis. Clayton (2010) must conclude that fifty years of M&A research have had no impact on the failure rates. Acquiring firm’s shareholders, however, gain either normal returns or significant losses around the announcement of acquisitions (Alexandridis & Petmezas & Travlos, 2010). Berger & Ofek (1996) focused in their study on diversification and find evidence of value loss from
diversification. The authors find that diversified firms destroyed around fifteen percent of the value it would have created if operated as stand-alone business (Berger & Ofek, 1996). Bruner (2002) observes that it is a popular view that mergers and acquisitions are unprofitable. Bruner (2002) further observes that most researchers believe that target
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evidence that M&A activities create valuations or synergies. M&A is also not capable of reducing costs or improving synergies (2000). Size and complexity increases with the size of the target of the merger or the acquisition (Kane, 2002). Chuang-Yuang & Hung-Ta (2010) further note that mergers and acquisitions can increase size and market power, but does not guarantee improved performance. Lakshman (2011) blames poor post acquisition integration for a large portion of the M&A failures. Andre & Kooli & L`Her (2004) observe a growing concern among financial economists over the prices that are paid for mergers and
acquisitions. They are also concerned about how the transactions impact future corporate performance. Swaminathan & Murshed & Hulland (2008) state that 60% - 80% of all mergers and acquisitions tend to fail to create value. They further argue that many researcher have made an attempt to explain merger success or failure, but have not succeeded thus far. Some researchers believe similarity between merging parties is of importance, others believe complementarities are more important (Swaminathan & Murshed & Hulland, 2008). Moeller & Schlingemann & Stulz (2005) state that acquiring firm shareholders lost 12 cents around acquisitions announcements per dollar spent on acquisitions in the period between 1998 and 2001. That accumulates for a total loss of 240 billion dollars. Firms that make bad
acquisitions perform poorly afterwards as well (Moeller & Schlingemann & Stulz, 2005). Ji-Yub & Jeraryr & Finkelstein (2011) argue that acquiring firms pay high acquisition
premiums. However, it becomes increasingly difficult to create sufficient value. Reasons for mergers and acquisitions are, according to the authors, to create potential synergies or the hubris of CEOs (Ji-Yub & Jeraryr & Finkelstein, 2011). Ji-Yub & Jeraryr & Finkelstein (2011) further observe that managers of firms that want to grow desperately are vulnerable to overpaying for acquisitions.
2.2 Innovativeness
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industries (Hitt, Hoskisson, Johnson & Moesel, 1996).
Feldman (2000) makes a simple distinction in defining innovation; process and product innovation. Process innovation is incorporating new technology into the methods of production, for example to achieve lower productive costs or improve quality (Feldman, 2000). Product innovation speaks rather for itself, the creation of new products in the range of radical and incremental improvements. Feldman (2000) points out that typically counts of either patents or new product announcements are the only data available. There has been a lot of discussion in the literature about what the most comprehensive way is to measure a
company’s innovativeness. Examples of indicators are R&D expenditures, patent counts, patent citations and new product announcements.
Patent data has been widely accepted as a proxy measure for innovation according to Adams, Bessant & Phelps (2006). They have identified factors that account for innovativeness as well that are inadequately represented in measurement terms, such as process and
organizational innovations (Adams, Bessant & Phelps, 2006). A patent is a legal statement that the idea embodied in the patent represents a novel and useful contribution over and above the previous state of knowledge (Duquet & MacGarvie, 2005). Acs & Audretsch (1988) argue in their article that new sources of data to measure innovation include measures of patented inventions. An alternative would be patent citation analysis.
Patent citations hold great attraction for the study of knowledge flow (Duquet & MacGarvie, 2005). Citations are mainly used for the study of knowledge flows. Citations are also used as a proxy for patent value or importance. Jaffe (1986) was the first author to estimate R&D spillover using the method of patent citation analysis. Jaffe (1986) also used patent citations a so called “paper trail” to track the direction and intensity of spillovers. Patent citations are only a measure of knowledge flows (Botazzi & Peri, 2003). Feldman (2002) claims that the relationships between the originating patents and the citing patent are used to identify knowledge spillovers. Fung & Chow (2002) argue that patent citation is a good measure to research the benefits that one inventor receives from the innovation of others.
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saying that patents are indeed a good measure of innovation. Blundell & Griffith & van Reenen (1999) identify that patents are not always implemented as innovations and many innovations are not patented (for example protected through secrecy). Blundell & Griffith & van Reenen (1999) conducted a study using a count of patents as the innovative output of British manufacturing firms. Even though the authors are aware of the well known problems with patent counts, they still believe it is a trustworthy measure to measure innovativeness (Blundell & Griffith & van Reenen, 1999). Salamon & Shaver (2005) have identified a large number of studies that used patent data and patent counts in industrial research on technology and innovation. The examples they name are for example Scherer (1965), Comanor and Scherer (1969), Basberg (1982, 1987), Henderson and Cockburn (1994, 1996) and Hall et al.. (2001). Salamon & Shaver (2005) chose in their article for a measure of total patent
applications (whether they were granted or not) instead of the total application count that were later granted. “Patent counts of applications filed later granted may understate the number of innovations actually achieved by a firm” (Salomon & Shaver, 2005, p439). Because a patent application is not costless, the authors expect that patent application reflect a firm’s belief it innovated. The authors identify a benefit of this measure that it captures the number of
innovation for which the firm believes it is worthwhile protecting (Salomon & Shaver, 2005). Archibugi & Pianta (1996) have come up with advantages and disadvantages of patents. Advantages are that patents are a direct outcome of the inventive process, especially of those inventions which are expected to have commercial impact, obtaining patent protection is time-consuming and costly, making it likely that applications are filed for those inventions which are expected to outweigh these costs, patent statistics are available in large numbers and for long time series and patents are public documents (Archibugi & Pianta, 1996). Disadvantages are that not all inventions are technically patentable and not all inventions are patented
(Archibugi & Pianta, 1996). The authors have conducted empirical surveys and these suggest that a large share of firm’s inventions are patented (Archibugi & Pianta, 1996). Their study on a sample of US firms showed that firms apply for about 66%-87% of their patentable
inventions. Archibugi & Pianta (1996) observe that the use of patenting as an indicator of technical innovation has grown over time due to their availability at low cost and in large numbers. Trajtenberg (1990) observes that patents seem to be the only manifestation of inventive activity covering every field of innovation in most countries over longer periods of time. The author questions the use of patents, however, as a not informative source of
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indicators of the inputs to the innovative process as measured by R&D expenditures and he finds evidence for this. Trajtenberg (1990) recognizes the importance of patent counts. He argues that a larger number of patents presumable indicates that much research efforts have been invested by the R&D staff. Patent counts may play an important role in studying the emergence of new products. Acs & Anselin & Varga (2002) find empirical evidence that suggest that patents provide a fairly reliable measure of innovative activity. Patent
applications reflect the inventor’s interest in obtaining protection and show his evaluation of the importance of his invention (Basberg, 1987). Acts & Audretsh find empirical evidence that patents provide a fairly reliable measure of innovative capacity. Patented inventions, as they argue, provide a fairly good, although not perfect, representation of innovative activity. Hagedoorn & Cloodt (2003) published an article which is very interesting for this study. The authors have identified multiple indicators to measure the innovative performance of a company; R&D inputs, patent counts, patent citation and new product announcements. They find a strong statistical overlap between these indicators. The authors go as far as saying that using any of these indicators to measure the innovative performance of companies
suffices in high-tech industries (Hagedoorn & Cloodt, 2003). Hagedoorn & Cloodt (2003) discuss that there appears to be hardly a clear understanding of the concept and measurement of innovative performance. Patents, as they claim, can be a more than acceptable indicator of innovative output.
Figure 1
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high ratio for new product introduction, the larger the intersection in the Venn diagram (Hagedoorn & Cloodt, 2003, p1367). So what they are saying is that a single indicator, such as patent counts, is very appropriate in an industry with high R&D intensity, high patent intensity and high ratio new product introduction. For example the pharmaceutical industry. Hagedoorn & Cloodt (2003) observe that in large parts of the economics literature, “raw patent counts are generally accepted as one of the most appropriate indicators that enable researchers to compare the inventive or innovative performance of companies in terms of new technologies, new processes and new products” (Hagedoorn & Cloodt, 2003, p 1368). Even somewhat critical authors have admitted that patents can be an appropriate indicator in many high-tech sectors. Hagedoorn & Cloodt (2003) also discussed the difference between raw patent counts and patent citations. Raw patents counts generate a purely quantitative measure, whereas patent citation also includes the quality of a patent. Hagedoorn & Cloodt (2003) conclude their article with a few interesting findings. They argue that their research suggest that there is no systematic disparity amongst R&D inputs, patent counts, patent citation and new product announcements. This means taking any indicator will be as good as the other and generate the same innovative performance outcome because of the great overlap of the four indicators in high tech sectors (Hagedoorn & Cloodt, 2003).
In previous studies of the effect of mergers & acquisitions on the innovativeness of acquiring companies, many researchers chose patent counts as a measure of innovativeness. Prabhu et al.. (2005) find that there is a dramatic reduction in patent intensity in the first year after the acquisition. Hitt et al. (1990) claim that the absolute number of patents and number of patents adjusted for size decreased after acquisitions. Hoskisson & Hitt (1988) observed a negative relationship between diversifying acquisitions and patent intensity. Hagedoorn and Duysters (2000) examined the effect of acquisitions on innovativeness measured by the number of patents.
2.3 Mergers and acquisitions’ influence on innovativeness
The merger process often absorbs significant amounts of managerial time and energy, and consequently, diverting the managerial attention from other activities, such as innovation (Hitt et al., 1996). The members of the top management team may be distracted from the internal activities, and especially the long-term decisions are postponed, such as the
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firms (Hitt et al., 1996). A quote in the article of Katz & Shelanski (2005, p110) is:
“innovation can itself be an important dimension of market performance that is potentially affected by a merger”. In the US, merger policy has increasingly focused on innovation, although exactly what the new focus in merger policy means or how it translates into enforcements has proven difficult to ascertain (Katz & Shelanski, 2005). Some people, however, object to a transaction on the grounds that it will lead to a loss of competition that would otherwise have stimulated motivation. “Innovation can dramatically affect the
relationship between the pre-merger marketplace and what is likely to happen if the proposed merger is consummated” (Katz & Shelanski, 2005, p110). To give an example of that, market shares are often used as a measure of market power. But what if innovation leads to the displacement of a supplier that appears to be dominant in the current situation? This raises the question about how a merger analysis should form predictions about the post-merger situation (Katz & Shelanski, 2005). So the authors identify in their article two ways that may factor into merger analysis: the developing role of innovation and the presence of innovation that can fundamentally alter the nature of the appropriate analysis even if one focuses on
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uncertain and occur over time. Even though a coherent and effective approach to innovation in merger policy will be difficult, analysis suggests that it should be possible. Stahl (2010) argues that mergers within an industry lead to larger, less competitive firms. Jensen (1986) developed a theory called the free cash flow theory. It entails that free cash flow is cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital. When an organization generates substantial free cash flow, conflicts of interest between shareholders and managers over payout policies arise (Jensen, 1986). Rather than to pay out cash to shareholders, managers are more inclined to make investments to expand an organization beyond its optimal size in order for them to keep or increase their power. This also means making acquisitions. Jensen (1986) observed a number of acquisitions in the oil industry that were a result of free cash flow. He finds that these acquisitions turned out to be among the least succesful of that decade. The free cash flow theory implies managers of firms with unused borrowing power and large free cash flows are more likely to undertake low-benefit or even value-destroying mergers. According to Jensen (1986) diversification programs fit this category and the theory predicts they will generate lower total gains. In his article, Jensen (1986) concludes by saying that the theory predicts that takeovers financed with cash and debt will generate larger benefits than those financed with stock. Prabhu et al. (2005) state that acquisitions often serve as a substitute for innovation, which may cause neglect of internal research and development (and thus
innovation). The authors state that acquisitions often lead to increases in leverage,
diversification, and absorb significant amounts of executive time, which may lead to reduced managerial commitment to innovation. This is also confirmed by Hitt et al. (1990).
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innovation output (innovativeness). The first one is that managers may prefer to pursue acquisitions rather than develop innovations through internal operations. The second reason for a negative effect of acquisitions on investments in R&D relates to the additional levels of debt that firms absorb to complete acquisitions. Lack of internal capital causes less
investments in R&D. The third reason is the substantial amounts of senior executives` time and energy required to first negotiate and then complete acquisitions. Also target firm managers become absorbed in negotiating the deal or fighting the takeover attempt. Other managers keep operating but without making long term plans or investments. Summarizing Prabhu’s et al. (2005) findings, time and energy absorption, combined with managerial risk aversion, may result in lower resource allocations to R&D and thus hamper innovation. Prabhu et al. (2005) claim that evidence suggest that an emphasis on acquisitive growth may result in risk-averse managerial mindsets. This can cause managers to reduce their
commitment to innovation. A quote from their article is: “This commitment, defined as a managerial willingness to allocate resources and champion activities that lead to the development of new products, technologies, and processes consistent with marketplace
opportunities, may be critical to internal product development activities.” (Prabhu et al., 2005, p29). This is also confirmed by Burgelman (1983). A consequence of lack of commitment of top executives to innovation is that they will offer fewer rewards or incentives to those desiring to create and champion internally based product innovations (Prabhu et al., 2005). The transfer of new product ideas to marketable products is therefore less likely to occur. Prabhu et al. (2005) conclude by saying that acquisitions may lead to lower innovation. Unless acquisitions are well planned and targeted, they may injure a firm’s innovation capabilities. Acquisitive growth strategies do not enhance the financial performance of acquiring firms and may adversely affect innovation (Hitt & Harrison & Ireland & Best, 1998).There is evidence that acquisition activity can lead to reductions in internally
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acquisitions are financed, the resources remaining for managerial allocation may become constrained. Hitt et al.l (1990) have developed a model that proposes that the acquisition process, and the resulting conditions after the acquisition is consummated, affect managerial commitment to innovation. The reasons they come up with are the extent to which
acquisitions serve as a substitute for innovation, energy and attention required during
negotiations, increased use of leverage, increased size, and greater diversification. These are, the authors claim, effects because of which manager may reduce their commitment to
innovation. Meyers (1984) finds two major barriers to innovation; lack of capital and an avoidance of risk. This is why there may be a preference to use debt to fund acquisitions instead of supporting R&D activities. Hitt et al. (1990) argue that internal development may be perceived by managers to entail high risk because of the low probability of innovation success and the length of time required for innovation to provide adequate returns. Pitts (1977) finds evidence that firms following an acquisitive strategy invest less in R&D than did internal growth firms. And this could lead to less innovative output. Stahl (2010) finds that internal citations increase in the years leading up to a merger, but then decline in the years following a merger. This implies that innovation does affect merger decisions, but more to dampen the competition rather than to capture information spillovers. Ahuja, G., & Katila, R. (2001) claim that in general acquisitions have a negative impact on the post acquisition innovation output of acquiring firms. The reasons Ahuja, G., & Katila, R. (2001) provide for this negative impact are the ones presented in the article of Hitt et al. (1991, 1996) and have been mentioned already. Acquisitions can disrupt the established routines of the acquiring firm and also those of the acquired firm leading to reduced productivity. The integrating process entails far-reaching disruption, and involves significant managerial attention and transactions costs (Ahuja, G., & Katila, R., 2001). Zhao (2009) finds that firms engaging in acquisition activities are less innovative. Zhao (2009) finds that bidding firms are less innovative and often experience a significant decline in technological innovation before the bid compared to similar non bidding firms. Thus according to Zhao (2009), acquisition activity has a negative impact on the innovativeness of companies.
2.4 Relatedness
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and of diversifying acquisitions on R&D outputs or patents. Managers may use acquisitions as a substitute for innovating, acquiring technology or products new to their firms but not
necessarily to the market (Hitt et al., 1990). Prabhu et al.. (2005) suggest that the innovation outcomes of acquisitions (or mergers) are driven by the pre-acquisition knowledge of the acquirer and its similarity with target’s knowledge. The authors find that the reductions in the number of patents to be particularly acute in diversifying acquisitions, meaning where target and acquiring firms are industry unrelated to each other. Managers are managing business they do not understand, and as a result firms lose their competitive advantage. As the managers rely on financial controls (because they lack appropriate understanding of the business), managers become less interested in developing and championing new products. These findings are confirmed by Ahuja & Katila (2001). This results in reductions to innovation and commercializing it and explains why Prabhu et al. (2005) find lower patent intensity after diversifying acquisitions. The authors find that firms with sufficient internal knowledge and fit, acquisitions or mergers can act as a so called tonic for innovation. Prabhu et al. (2005) suggest two independent routes to increased innovation: for firms to concentrate on building internal knowledge or acquire it through acquisitions or mergers. This additional knowledge, which they would otherwise may not have had, might boost innovation. Prabhu et al. (2005) conclude that successful innovation strategy requires a well formed combination of internal and external knowledge. In their article they have shown that in the context of
mergers and acquisitions, the two sources of knowledge interact in a dynamic fashion to produce innovations. Acquisition does not need to be negative influence on innovation, the knowledge-based view of Prabhu et al. (2005) in their article suggest the opposite. According to Jensen (1986) diversification programs will generate lower total gains.
Not all acquisitions mean a ‘poison pill’ for innovativeness. Some acquisitions may well be used to complement or enhance R&D and innovation (Prabhu et al., 2005). This is for example the case when firms acquire a company with a complementary patent, process, product market or other specialized skill or capacity not possessed by the acquiring firm. Also, firms may acquire companies with new technologies. Prabhu et al. (2005) claim that this is particularly effective when a large firm, with developed manufacturing and distribution systems, acquires a smaller firm with a developed innovative capacity. Synergy is created by each firm complementing the other. Acquisitions should be aimed at enhancing or
maintaining the firm’s core competences. This will probably mean acquisitions in related businesses. Ahuja, G., & Katila, R. (2001) conclude their article by saying that under
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great volume of acquisition activity is supporting this finding the authors believe. “Obtaining technological assets from external sources and matching them with internally developed assets to enhance their productivity can work, at least insofar as the frequency of innovation output is concerned.” (Ahuja, G., & Katila, R., 2001, p216). A balance on both size and relatedness of acquisitions is favored (Ahuja, G., & Katila, R., 2001) Hagedoorn and Duysters (2000) also examined the effect of acquisitions on innovativeness measured by the number of patents. They find that acquisitions can contribute to increases in innovation activities if there is organizational and strategic fit of the companies involved.
The vast majority of the literature seems to indicate that mergers and acquisitions have a negative impact on the innovativeness of the acquiring company. However, there is still ambiguity regarding the matter. Prabhu et al. (2005) for example argue that mergers and acquisitions can be a tonic for innovation. Hitt & Ireland & Harrison & Hoskisson (1991) find that little research has examined acquisition’s effects on R&D inputs and outputs. In their article they quote the Charles River Associates who concluded that there is not enough available data to testing hypotheses concerning the effects of mergers and acquisitions. Zhao (2009) finds it surprising that there little empirical study on the interaction between mergers and acquisitions and innovativeness. Zhao (2009) continues by saying that little is known about the relation between firms’ acquisition activities and innovation performance and also how acquisitions affect firms’ innovation efforts is not clear from the literature (Zhao, 2009). Zhao (2009) concludes by stressing that whether acquisitions can help firms’ innovation efforts is an important empirical question. Jensen (1986) does not make a direct link with the implications for innovativeness of the free cash flow theory. Katz & Shelanski (2005) claim that academic research could make an important contribution by conducting industry-specific studies that provide a better understanding of the history and conditions for innovation in the case of mergers. Still, lots of research has to be done to be fully able to assess whether mergers and acquisitions have a negative or a positive impact on the innovativeness of the involved companies. I will try to make a contribution to the literature by investigating this important question in the European Pharmaceutical industry.
2.5 Research question, conceptual model and hypotheses
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negative effect on the innovativeness of the acquiring firm? And does relatedness of the target firm with the acquiring firm have a positive moderating effect on the negative relationship between mergers and acquisitions and the innovativeness of the acquiring firm? We develop the following conceptual model:
We will test the following hypotheses:
H 1: Mergers and acquisitions have a negative effect on the innovativeness of the acquiring firm.
22 3. Data and methods
3.1 Sample
To test our hypotheses, we need to construct a database containing mergers and acquisitions with complementary data on the firms involved. To collect mergers and acquisitions, we will use the SDC database. This database contains information on more than 600.000 mergers and acquisitions. We have selected all mergers and acquisitions that took place in the European Pharmaceutical industry in the period between 2000 and 2007. After excluding spin-offs, divestures and recapitalizations, 300 mergers and acquisitions remained. The sample dropped to a total of 112 mergers and acquisitions after removing the mergers on which no complete data could be found. Data were collected on 112 completed mergers and acquisitions from the European Pharmaceutical industry in the period between 2000 and 2007. We collected data on the acquiring and the target firm three years prior to the merger and for three years after the merger was completed. This period was chosen because of the availability of the
23 3.2 Dependent variable
The measure of innovative output of the acquiring firm is measured by raw patent counts given weight by dividing them by the total number of employees of the acquiring firm. Patent data was collected from the EPO, the European Patent Office, by searching for patent counts in the European Patent Register. The European Patent Register contains all the publicly available information on European patent applications as they pass through the grant procedure. Patent counts were based on the filing date, rather than the granted date. The reason for that is that the granting process takes an average period of 18 months (Salomon & Shaver, 2005). Therefore we measure the filing date of the patent, the actual application date of the patent, to be able to detect the direct impact of mergers and acquisitions on the
innovativeness of the acquiring company.
3.3 Independent variable
The independent variable for this study are mergers and acquisitions. We have constructed a database with 112 mergers and acquisitions. We will test if the event of the merger or
acquisitions has caused a change in the patent intensity pattern of the acquiring firm. We have predicted a negative effect and this will be tested by looking at the patent intensity of the acquiring firm three years prior to the merger or acquisition and three years after the event.
3.4 Controls
We controlled for several variables that may affect patent intensity. These variables are firm size, return on assets, and the level of relatedness, which also functions as moderator on the effect of mergers and acquisitions on the innovativeness of the acquiring firm.
3.5 Model
24 4. Results
4.1 Model and descriptive statistics
To test the database that was constructed for this study we have used the logit model. We will start with the descriptive statistics about the variables that were used to conduct the analysis to test the first hypothesis. We have used the logit model to predict whether patent intensity would increase or drop after the merger or acquisition, for each combination of years, which are three years before and after the merger, two years before and after the merger and one year before and after the merger. The variables in the descriptive statistics table are diff, RoaDiff, SizeDiff and relatedness target. Diff is the variable that stands for the difference in patent intensity for each combination of years. RoaDiff stand for the difference of return on assets (ROA) for each combination of years. SizeDiff stands for the difference in logarithm of size for each combination of years.
Descriptive Statistics
N Minimum Maximum Mean Std. Deviation
Diff-3_3 112 ,00 1,00 ,3393 ,47559 Diff-2_2 112 ,00 1,00 ,2768 ,44942 Diff-1_1 112 ,00 1,00 ,3214 ,46912 RoaDiffYear-3_3 112 -,77 1,69 ,0397 ,27929 RoaDiffYear-2_2 112 -,61 ,55 ,0241 ,15616 RoaDiffYear-1_1 112 -,48 1,05 ,0226 ,17902 SizeDiffYear-3_3 112 -2,58 3,75 ,6616 ,99643 SizeDiffYear-2_2 112 -1,22 2,88 ,5868 ,82026 SizeDiffYear-1_1 112 -,89 2,51 ,3914 ,59829 Relatedness_target 112 ,00 1,00 ,7500 ,43496 Valid N (listwise) 112
25 4.2 Logit models for each combination of years
We have used three logit models to estimate the database we constructed. The dependent variable is the difference in patent intensity for three years before the merger and three years after the mergers, two years before the merger and two years after the merger and one year before the merger and one year after the merger. The control variables that have been used are the difference in return on assets for each combination of years and the difference in
logarithm of size for each combination of years. For size we have the taken the natural
logarithm of the absolute number because the difference between the numbers were too big to be usable. We also planned on controlling for liquidity, but these numbers differed too much as well. Taking the natural logarithm by dividing negative and positive numbers is not possible and because of that the numbers of usable mergers and acquisition would drop so dramatically that we decided to leave this variable out. The level of significance is
alpha=0,05.
Variables in the Equation
B S.E. Wald df Sig. Exp(B)
Step 1 RoaDiffYear-1_1 -1,344 1,446 ,863 1 ,353 ,261 SizeDiffYear-1_1 -1,895 ,652 8,446 1 ,004 ,150
Constant -,206 ,249 ,684 1 ,408 ,814
The logit model for one year before the merger and one year after the merger is being tested here. ROA is not significant in this model (z=0,863, p=0,353). So the difference in ROA between one year before the merger and one year after the merger does not play a role in determining the probability of an increase or a decrease of the patent intensity. The difference in size is significant for one year before and one year after the mergers (z=8,446, p=0,004) meaning that size does play a role in determining the probability of an increase or a decrease of the patent intensity. The effect of size is negative meaning that the bigger the firm gets, the bigger the probability becomes that patent intensity will drop. Because of a merger or
26
Variables in the Equation
B S.E. Wald df Sig. Exp(B)
Step 1 RoaDiffYear-2_2 -3,620 1,878 3,715 1 ,054 ,027 SizeDiffYear-2_2 -1,679 ,521 10,392 1 ,001 ,187
Constant -,271 ,269 1,016 1 ,313 ,763
The logit model for two years before the merger and two years after the merger is being tested here. ROA is almost significant in this model (z=3,715, p=0,054). The difference in ROA between two years before the merger and two years after the merger does seem to play a role in determining an increase or a decrease of the patent intensity. The difference in size is significant for two years before the merger and two years after the merger (z=10,392,
p=0,001). Just like the former model size does play a role in determining the probability of an increase or a decrease of the patent intensity. The effect of size is, just like the former model, negative. This again means that the bigger the firms gets, the bigger the probability becomes that patent intensity will drop.
Variables in the Equation
B S.E. Wald df Sig. Exp(B)
Step 1 RoaDiffYear-3_3 -,124 ,732 ,029 1 ,866 ,883 SizeDiffYear-3_3 -,317 ,219 2,084 1 ,149 ,728
Constant -,469 ,236 3,945 1 ,047 ,626
27
the first two years before and after a merger, but becomes insignificant in the difference between three years before and after a merger. ROA only appears to play a role in the
difference in patent intensity in two years before and after the merger. We find no significant evidence for the other combination of years. We can confirm the first hypothesis that mergers and acquisitions have a negative influence on the innovativeness of acquiring firms.
4.3 Logit models for each combinations of years including relatedness
We will now test the second hypothesis by adding the variable relatedness of the target. We constructed a dummy variable, relatedness_target, to be able to test relatedness. Value 1 stands for the target being related to the acquiring firm and value 0 stands for the target being unrelated to the acquiring firm. The SIC codes of all acquiring firms lie between 2834 and 2836. We have defined a target being related to the acquiring firm as all target SIC codes between 2830 and 2839 (value=1). We have defined a target being unrelated to the acquiring firm as any SIC code that does not have a value between 2830 and 2839 (value=0).
Variables in the Equation
B S.E. Wald df Sig. Exp(B)
Step 1 RoaDiffYear-1_1 -1,196 1,494 ,640 1 ,424 ,303 SizeDiffYear-1_1 -1,907 ,655 8,487 1 ,004 ,148
Relatedness_target ,230 ,516 ,198 1 ,656 1,258
Constant -,378 ,461 ,670 1 ,413 ,685
28
Variables in the Equation
B S.E. Wald df Sig. Exp(B)
Step 1 RoaDiffYear-2_2 -3,678 1,874 3,853 1 ,050 ,025 SizeDiffYear-2_2 -1,701 ,529 10,322 1 ,001 ,182 Relatedness_target ,569 ,557 1,042 1 ,307 1,766
Constant -,696 ,502 1,921 1 ,166 ,499
From the model for two years before the merger and two years after the mergers can be concluded that relatedness does not play a significant role in determining the probability of an increase or a decrease of the patent intensity for the acquiring firm (z=0,198, p=0,656)1.
Variables in the Equation
B S.E. Wald df Sig. Exp(B)
Step 1 RoaDiffYear-3_3 -,144 ,732 ,039 1 ,844 ,866 SizeDiffYear-3_3 -,331 ,220 2,271 1 ,132 ,718
Relatedness_target ,400 ,482 ,689 1 ,407 1,492
Constant -,763 ,431 3,137 1 ,077 ,466
From the model for three years before the merger and three years after the mergers can be concluded that relatedness does not play a significant role in determining the probability of an increase or a decrease of the patent intensity for the acquiring firm (z=0,689, p=0,407). Summarizing do we not find any support for the second hypothesis which states that relatedness has a positive moderating effect on the negative relationship between mergers and acquisitions and the innovativeness of the acquiring firm. Therefore we reject hypothesis two.
1
29 5. Discussion
5.1 Industry and sample
We have tested our hypotheses on the European Pharmaceutical industry. We find that the data for the European industry in the period we selected is limited. We started off our research with 300 usable mergers & acquisitions in the European Pharmaceutical industry. The criteria that were used to selected these have been described in the data and methods section. We ended up testing our hypotheses on 112 mergers and acquisitions. First, we had to remove all mergers and acquisitions on which the data in the preliminary database was not complete. Then we had to remove all mergers and acquisitions on which no patent data could be found. Finally, we had to remove all mergers and acquisitions on which no complementary data could found, such as size, return on assets and liquidity. That left us with 112 usable mergers and acquisitions to test our hypotheses on.
5.2 The negative effect of size
Every study studying the effect of merger and acquisitions on the innovativeness on the
acquiring firm has controlled for the effects of size. For example Prabhu et al. (2005). We find in the literature that most authors believe that size and complexity increases with the size of the target of the merger of the acquisition (Kane, 2002). Chuang-Yuang & Hung-Ta (2010) have noted that mergers and acquisitions can increase size but that it does not guarantee improved performance. Katz & Shelanski (2005) have identified research that demonstrates that industry specific factors play important roles in mediating the relationship between firm size on the one hand and the pace of innovation on the other. We find support for these believes. We have tested our hypotheses and our results show that size plays a significant role in predicting the probability of an increase or a decrease of patent intensity one year before and one after a merger or acquisition and two years before and two years after a merger or acquisition. The effect of size is negative meaning that the bigger a firm gets, the bigger the probability becomes that patent intensity drops. Because of a merger or acquisition a firm will grow and therefore have a negative impact on the probability of an increase of the patent intensity. We have therewith shown that size plays a significant negative role in determining the probability of an increase or decrease of patent intensity in the combinations of years for one before and one year after and two years before and two years after a merger or
acquisition.
30
innovative the firm becomes. Previous literature already found evidence for this phenomenon en we find evidence for this phenomenon as well. Firms should be aware of this problem and make sure they do not fall in this well known pitfall. Mergers and acquisitions result in bigger companies. When a firm knows beforehand know that this will lead to less innovation, they should be prepared and develop procedures or other programs to make sure it does not hurt their innovation efforts.
5.3 Mergers and acquisitions have a negative effect on the innovativeness of the acquiring firm
The first hypothesis of our study is: mergers and acquisitions have a negative effect on the innovativeness of the acquiring firm. We find support for this hypothesis. We have tested the hypothesis using a logit model to predict the probability of an increase or decrease of patent intensity for three sets of combination of years: three years before and three years after the merger or acquisition, two years before and two years after the merger or acquisition and one before and one year after the acquisition. This time span is based on the study of Hitt et al. (1991), whom conducted a similar study in 1991. Summarizing we can state that the effect of mergers and acquisitions on the innovativeness of the acquiring firm is the biggest in the difference in the year leading up the merger and the first year after the merger and two years before the merger and two years after the merger. The impact of mergers and acquisitions has for all combination of years a significant negative impact on the patent intensity of the
acquiring firm. The following graph displays all predicted patent intensity probability dots for all combination of years. The X axis represents all mergers and acquisitions for each
combination of years. The Y axis represents the probability of an increase or a decrease of patent intensity.
31
Practically all predicted probabilities lie beneath the 50% line which means that there is a bigger probability of a decrease of patent intensity than an increase of patent intensity. We find evidence that size plays a significant role in the difference in patent intensity for the first two years before and after a merger, but becomes insignificant in the difference between three years before and after a merger. ROA only appears to play a role in the difference in patent intensity in two years before and after the merger. We find no significant evidence for the other combination of years. We accept the first hypothesis that mergers and acquisitions have a negative influence on the innovativeness of acquiring firms. We therefore support the literature by stating that mergers and acquisitions lead to a worsening in patent realization. When we go back to the literature, we can conclude that we have confirmed what most authors already believe; mergers and acquisitions have a negative influence on the
32
up to a merger, but then decline in the years following a merger. Acquisitions can disrupt the established routines of the acquiring firm and also those of the acquired firm leading to reduced productivity. The integrating process entails far-reaching disruption, and involves significant managerial attention and transactions costs (Ahuja, G., & Katila, R., 2001). Acquiring and merging firms may not easily or accurately predict potential synergy between the targeting and acquired firm assets. This situation may lead to problems in integrating the acquired assets into the acquiring firm. That can lead to an ineffective integration process that may harm internal innovation efforts (Hitt et al., 1996). Prabhu et al. (2005) state that
acquisitions often serve as a substitute for innovation, which may cause neglect of internal research and development (and thus innovation). The authors state that acquisitions often lead to increases in leverage, diversification, and absorb significant amounts of executive time, which may lead to reduced managerial commitment to innovation. Prabhu et al. (2005)
identify three possible reasons that may explain the potential negative effect of acquisitions on innovation output. The first one is that managers may prefer to pursue acquisitions rather than develop innovations through internal operations. The second reason for a negative effect of acquisitions on investments in R&D relates to the additional levels of debt that firms absorb to complete acquisitions. Lack of internal capital causes less investments in R&D. The third reason is the substantial amounts of senior executives` time and energy required to first negotiate and then complete acquisitions. Also target firm managers become absorbed in negotiating the deal or fighting the takeover attempt. This is an enumeration of the most important reasons of why mergers and acquisitions have a negative effect on the
innovativeness of the acquiring firm. If these hold true for the sample in our study should be pointed out by future research.
33 5.4 Not much has been learned
Hitt et (1991) find similar results to the results in our study. The study by Hitt et al. (1991) took place in a period around 20 years prior to this study. We have made a comparison by putting their graph of average patent intensity of the three years before and the three years after the acquisition (left) next to our graph (right) with the results with the same parameters. There are some striking similarities and a few differences.
Hitt et al. (1991) find that patent intensity rises three years before the merger or acquisition, then drops in the second years before the merger or acquisition and rises again in the year leading up to the merger or acquisition. In the year after the merger or acquisition the patent intensity drops dramatically and stays on this level in the second and third year after the merger or acquisition. We find that patent intensity rises in the third and second year before a merger or acquisition, patent intensity starts to drop dramatically in the year leading up to the merger or acquisition and keeps dropping in the year after the merger or acquisition. The patent intensity then stays on this same level in the second and third year after the acquisition. We can conclude from this that the results that Hitt et al. (1991) find for their sample of a range of industries in a different period of time, mostly apply for the European
Pharmaceutical industry as well in the period between 2000 and 2007.
34
think that if researchers show that merger and acquisitions are bad for innovation, firms would try and work their way around this well known pitfall. Our results show that this is not the case and the question is, when will firms learn?
5.5 Relatedness does not play a moderating role in the negative relationship between mergers and acquisitions on the innovativeness of the acquiring firm
The majority of the literature believes that in general, markets react negative to diversifying acquisitions, as well is there a negative relationship between diversifying acquisitions and patent intensity (Hoskisson & Hitt, 1988). Hitt et al. (1990) find evidence for the negative effects of acquisitions on R&D investments and of diversifying acquisitions on R&D outputs or patents. Prabhu et al. (20025) find that the reductions in the number of patents to be particularly acute in diversifying acquisitions, meaning where target and acquiring firms are industry unrelated to each other. Prabhu et al. (2005) find that firms with sufficient internal knowledge and fit, acquisitions or mergers can act as a so called tonic for innovation. Ahuja, G., & Katila, R. (2001) conclude their article by saying that under appropriate circumstances acquisitions can have a positive impact on innovation output. A balance on both size and relatedness of acquisitions is favored (Ahuja, G., & Katila, R., 2001) Hagedoorn and Duysters (2000) also examined the effect of acquisitions on innovativeness measured by the number of patents. They find that acquisitions can contribute to increases in innovation activities if there is organizational and strategic fit of the companies involved. We have hypothesized that relatedness between the acquiring firm and the target firm has a positive moderating effect on the negative relation between mergers and acquisitions on the innovativeness of the acquiring firm. We find no support for this hypothesis. For neither of the combination of years there was a significant effect on the patent intensity of the target being related to the acquiring firm or not. We therefore have to disagree with the vast majority of the literature that
diversification has a bigger negative effect on the patent intensity of the acquiring firm than non diversifying acquisitions.
5.6 Limitations
35
comes with its limitations. We have used raw patent counts to measure the innovative output of the acquiring firm. A strength of our study is that we have shown that using this measure is valid in this particular industry. There is quite some discussion in the literature about whether raw patent counts are a valid measure of the innovativeness of a firm. Griliches (1980) for example, has observed that patents are a flawed measure of innovative output. Reasons are that not all new innovations are patented and patent differ in their economic impact. However, Acs & Audretsch (1988) argue, the correlation between the output measures, total
innovations, and patents is greater than that between the R&D measures and patents.
Hagedoorn & Cloodt (2003) have shown that for high tech industries taking any indicator will be as good as the other and generate the same innovative performance outcome because of the great overlap of the four indicators in high tech sectors (Hagedoorn & Cloodt, 2003). But there are only few industries in which this measure suffices. To test our hypotheses in other industries, other measures of innovative output will have to be used as well. For example a combination of patent counts, patent citation analysis and R&D expenditures. Our industry is also limited to Europe. This is a strength in the sense that not much research has been
36 6. Conclusion
Around 70 – 80% of all mergers and acquisitions do no create value above the annual cost of capital. M&A failure rates are at approximately 50% or higher for nearly four decades. The overall belief is that mergers and acquisitions are bad news. The aim of this study was to examine whether mergers and acquisitions have a positive or a negative effect on the innovativeness of acquiring firms, or that there is no relationship at all. We have used raw patent counts to measure the innovative output of the acquiring firm. This measure comes with its limitations but we have shown that for the particular industry we have studied the measure suffices. We show that mergers and acquisitions have a negative influence on the innovativeness of the acquiring firm. We also find that relatedness does not play a moderating role in the negative effect of mergers and acquisitions on the innovativeness of the acquiring firm. Hitt et al. (1991) already showed in 1991 that mergers and acquisitions are bad for innovation. More than twenty years later we find that this is still the case, and even worse. Where Hitt et al. (1991) find some good news, the rise of patent intensity in the year leading up to the merger or acquisition, we find that is has become worse. Patent intensity starts to drop in the year leading up to the merger and acquisition and does not recover in the years after the event. This implicates that nothing has been learned over the past twenty years and that the effect of mergers and acquisitions on the innovativeness of the acquiring firm has become even worse. We are aware of the limitations our study is subject to. Our study is limited to the European Pharmaceutical industry in the period between 2000 and 2007. We have chosen this industry and period because not much research regarding this topic has been conducted there. We have also acknowledged the weaknesses of using patent data as our innovative measure but have shown how it suffices for this particular industry. A comparable study in a low-tech industry should consider using multiple indicators of innovative
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44 Appendix
