ESSAYS ON CORPORATE STRATEGY: EVOLUTION

OF CORPORATE CAPABILITIES AND

THE ROLE OF INTANGIBLE ASSETS

DISSERTATION

Presented in Partial Fulfillment of the Requirements for

the Degree Doctor of Philosophy in the Graduate School
of The Ohio State University

By

Asli Musaoglu Arikan, MBA

*****

The Ohio State University

2004

Dissertation Committee: Approved by

Professor Jay Barney, Adviser

Professor Karen Wruck

Professor David Hirshleifer _________________________

Professor Anita McGahan Adviser

Professor Konstantina Kiousis Business Administration Graduate Program

Professor Oded Shenkar

i
 Copyright by

Asli Musaoglu Arikan

2004

i
 ABSTRACT

This dissertation is comprised of in depth analysis on the broader topic of

corporate strategy with emphasis of the role of intangible assets. The first chapter looks at

the performance implications of acquiring firms that have highly intangible assets

structures. The second essay looks at dynamic characteristics as well as outcomes of

developing intangible yet valuable corporate level capabilities in relation to managing

alliances and acquisitions. The final section looks at the role of intangible assets in

contracting between and within firms by utilizing property rights theory and the resource

based view.

A consistent finding regarding mergers and acquisitions (M&A) is that: on

average shareholders of target firms earn significant economic gains whereas

shareholders of acquiring firms break-even (Jensen and Ruback, 1983; Jarrell et. al.,

1988). Despite this general finding M&A activity has persisted, increasing in number and

transaction value because, managers often perceive M&A activity as a mechanism for

growth (e.g. Penrose, 1959). Therefore, it is natural to ask, `What type of assets are worth

buying?'

This paper investigates the long-run performance effects of acquiring intangible

versus tangible targets. Intangibility of target is proxied by multiple measures based on

ii
R&D, advertisement and human capital stocks, and the Tobin's q 1-year prior to the

corporate event. Using a sample of M&A transactions spanning a 4 year period (1988-

1991), long-run-buy-and-hold expected returns are calculated by constructing portfolios

of cohort firms that pursue M&A activity and tracked for 5 years. Each firm's long-run-

abnormal performance is calculated as the excess return to the benchmark portfolio.

Results show that on average, acquirers of intangible targets earn negative abnormal

returns, whereas acquirers of tangible targets break-even. However, for the whole sample,

there is no evidence of long-run abnormal returns.

Existence of asymmetric misvaluation between M&As of intangible versus

tangible targets is tested by regressing short-run returns on the buy-and-hold long-run

returns. Results provide evidence for market overreaction to the announcements that

involve highly intangible targets. Overall, findings suggest that on average, ownership

claim to the target's intangible assets via M&A does not transfer the associated economic

value.

In the second section I investigate how long it takes for publicly traded firms

within the United States to develop corporate capabilities for conducting alliances and

acquisitions effectively. The development of corporate capabilities has been difficult to

study directly because little information has been available on the accumulation at the

corporate level of performance-enhancing knowledge. The research reported here relies

on a dataset that tracks the behavior of the 3,595 firms that went through an initial public

iii
offering (IPO) between 1988 and 1999 to show how quickly corporate capabilities

developed from the earliest years of firm formation.

In particular, we conduct an event-study analysis to investigate how the abnormal

returns to alliance and acquisition announcements changed as the firms accumulated

experience in conducting deals of each type. The results suggest that firms accumulated

capabilities for executing and managing both alliances and acquisitions, and that

investors came to expect that firms would continue to exploit their specialized

capabilities into the future.

Finally I provide discussion of the theoretical implications of the empirical

findings and contribute to the literature on corporate strategy and resources based view

by incorporating insights from the property rights literature which can be considered as

the recent development extension of transaction cost economics.

iv
Dedicated to my grandmother, Guzide Egilmez

v
 ACKNOWLEDGMENTS

I wish to thank my adviser Jay Barney, and my committee members David

Hirshleifer, Konstantina Kiousis, Anita McGahan, Oded Shenkar, and Karen Wruck for

their intellectual support, encouragement, and enthusiasm which made this thesis

possible.

I am grateful to Ilgaz Arikan for his continued support and stimulating discussions

on all aspects of my research interests.

I wish to also thank to Laurence Capron, Russ Coff, Ken Hatten, Anne-Marie

Knott, Harbir Singh, Ralph Walkling, Julie Wulf, and Bernard Yeung for their helpful

comments. The author also benefited from discussions with Josh Lerner, Dan Levinthal,

Jan Rivkin, Anju Seth, Jamal Shamsie, Scott Shane and Sid Winter. All the errors remain

mine.

vi
 VITA

December 1, 1972…………Born – Izmir, Turkey

1994……………………….BS Istanbul technical University, Istanbul Turkey

1997 ………………………MBA University of North Carolina

2003-Current ……………..Instructor, Boston University

PUBLICATIONS

Barney J.B., Arikan A.M. 2002. The resource-based view. Origins and implications. In
Hitt M.A., Freeman R.E., Harrison J.S. (eds.), Handbook of Strategic
Management. Blackwell Publishers: Oxford, UK; 124-188.

Arikan, A.M. 2002. Does it pay to capture intangible assets through mergers and
acquisitions? Academy of Management Meetings Best Paper Proceedings

Arikan, A.M. 2003. Does it pay to capture intangible assets through mergers and
acquisitions? In Strategic Management Society Book Series on M&A Summit

Arikan, A.M. 2003. Cross-border mergers and acquisitions: What have we learned? In
B.J. Punnett, and O. Shenkar (Eds.) 2nd Edition of Handbook of International
Management Research, University of Michigan Press

FIELDS OF STUDY

Major Field: Business Administration

Minor Field: Financial Economics

vii
 TABLE OF CONTENTS

Page
Abstract ............................................................................................................................... ii
Dedication .......................................................................................................................... vi
Acknowledgments.............................................................................................................. vi
Vita…………………........................................................................................................ vii
List of Tables ...................................................................................................................... x
List of Figures ................................................................................................................... xii

Chapters:

1. Introduction............................................................................................................. 1
2. What Type Of Assets Is Worth Buying Through Mergers & Acquisition? ........... 5
2.1 Resource-Based View And Competitive Advantage........................................ 8
2.2 Controls For Other Factors ............................................................................. 11
2.2.1 Agency Motives ............................................................................... 12
2.2.2 Information Asymmetry And Financing Of Intangible Assets........ 14
2.2.3 Market Over- Or Under-Valuation Of Growth Opportunities......... 17
2.3 Methodology And Data................................................................................... 20
2.3.1 Valuation Of Intangible Assets........................................................ 21
2.3.2 Which Measure Of Performance?.................................................... 24
2.3.3 Why Not Traditional Event Methodology? ..................................... 26
2.3.4 Long Run Buy & Hold Abnormal Returns ...................................... 29
2.3.5 Calculating Reference Portfolios ..................................................... 31
2.4 Data ................................................................................................................. 32
2.5. Results............................................................................................................ 36
2.6 Discussion And Conclusion............................................................................ 44
3. How Long Does It Take To Build Corporate Capabilities For Conducting
Alliances And Acquisitions?................................................................................. 50
3.1 Antecedents..................................................................................................... 51
3.2 Theory And Hypothesis .................................................................................. 53
3.2.1 Industry And Time Effects............................................................... 58
3.3 Data ................................................................................................................. 59
3.4 Descriptive Statistics....................................................................................... 61
3.5 Methods........................................................................................................... 64
3.6 Results............................................................................................................. 66

viii
 3.7 Conclusion ...................................................................................................... 72
4. Why Do We Observe Heterogeneous Governance Choices For Similar
Transactions? Theoretical Issues In Corporate Strategy....................................... 73
4.1 Overview......................................................................................................... 74
4.2 Theoretical Background.................................................................................. 78
4.2.1 Transaction Cost Economics............................................................ 78
4.2.2 Property Rights Theory.................................................................... 80
4.2.3 Capabilities View Of The Firm And Agency Costs ........................ 82
4.2.4 Hybrid Forms As Real Options........................................................ 83
4.3 Model Setup And Intuition ............................................................................. 84
4.4 A Real World Example................................................................................... 92
4.4.1 Who Should Own What? ................................................................. 94
4.4.2 Case 1: Agent B1 j (Manufacturing Division Of Pfizer) Owns T
Target B2 'S (Arqule's) Assets........................................................ 95
4.4.3 Case 2: Target B2 (Arqule) Continues To Own Its Assets ........... 96
4.5 Discussion ....................................................................................................... 97

List Of References ............................................................................................................ 99

ix
 LIST OF TABLES

Table Page

1. Measures of Intangibility – Part 1........................................................................... 116

2. Measures of Intangibility –Part 2............................................................................ 117

3. Variable Descriptions.............................................................................................. 118

4. Descriptive Statistics............................................................................................... 119

5. Correlation Matrix for Target Variables ................................................................. 120

6. Correlation Matrix .................................................................................................. 121

7. Test of Median Equality for the 60-Month Average Buy-and-Hold Abnormal

Returns .................................................................................................................... 122

8. Descriptive Statistics for the Average Monthly Buy-and-Hold Abnormal Returns

[BHAR jt ]............................................................................................................... 123

9. Sample Descriptio ................................................................................................... 130

10. Number of Alliance for each IPO year ................................................................... 131

11. Number of M&A for each IPO year ....................................................................... 132

12. Mortality Rates of Firms and Deal Frequency........................................................ 133

13. Average number of M&A deals per firm for each year following the IPO event .. 134

14. Descriptive Statistics for CARs per deal over -5,…,+5 days around the deal
announcements........................................................................................................ 136

15. Descriptive Statistics for CARs per M&A deal over -5,…,+5 days around the deal
announcements........................................................................................................ 137

x
16. Descriptive Statistics for CARs per Alliance deal over -5,…,+5 days around the deal
announcements........................................................................................................ 138

17. Descriptive Statistics for CARs-5,…,+5 following the IPO year ............................... 139

18. Logit Analysis of Deal Type Choice (Alliance=1, M&A=0) and Past experience in
the same-type deals ................................................................................................. 140

19. Logit Analysis of Deal Type Choice (M&A=1, Alliance =0) and Past experience in
the same-type deals ................................................................................................. 141

20. Logit Analysis of Deal Type Choice and Market Reaction to the same-type deals 142

xi
 LIST OF FIGURES

1. Cumulative Abnormal Returns Around the Announcement Day, t=0.................... 124

2. Average Monthly Abnormal Returns to the Acquirers with announcement year of

1988......................................................................................................................... 125

3. Average Monthly Abnormal Returns to the Acquirers with announcement year of

1989......................................................................................................................... 126

4. Average Monthly Abnormal Returns to the Acquirers with announcement year of

1990......................................................................................................................... 127

5. Average Monthly Abnormal Returns to the Acquirers with announcement year of

1991......................................................................................................................... 128

6. Average Monthly Abnormal Returns to the Pooled Acquirers with announcement

years in 1988-1991.................................................................................................. 129

7. Model Payoffs ......................................................................................................... 143

8. Corporate Capability as a System of Governance Mechanisms ............................. 144

xii
 CHAPTER 1

INTRODUCTION

Firms can be viewed as bundles of resources (Rumelt, 1984) that can be broadly

partitioned into tangible and intangible resources. Intangible resources are less likely to

be redeployable in a second-best use without losing value. Therefore investments in

building/acquiring intangible assets are riskier than building/acquiring tangible assets.

``Given the role of both tangible and intangible assets of the firm, a strategist should

choose projects that are within the firm's area of expertise and appropriate to its skills''

(Itami, 1987: 159).

However, firms intending to grow are more likely to create deviations from this

ideal fit to accumulate intangible assets by, for example, following an overextension

strategy. First, firms that overextend know that they will not be able to do the new

business effectively when they enter the new market; second, they know that they will

eventually have to get into this new area; and third, those firms make sure that the

intangible assets accumulated will be applicable beyond the segment that they were

initially accumulated. M&A activity serves as an investment mechanism to achieve

1
 growth while possibly accumulating intangible assets1.

A consistent finding regarding mergers and acquisitions (M&A) is that: on

average shareholders of target firms earn significant economic gains whereas

shareholders of acquiring firms break-even (Jensen and Ruback, 1983; Jarrell et al.,

1988). Despite this general finding M&A activity has persisted, increasing in number and

transaction value because, managers often perceive M&A activity as a mechanism for

growth (e.g. Penrose, 1959). It is natural ask, `What type of assets are worth buying?'

Lang and Stulz (1994) suggest that firms with valuable future growth

opportunities have highly intangible assets. Intangible assets, such as managerial talent,

corporate culture, R&D expertise, and brand capital have also been identified as sources

of competitive advantage (e.g. Veblen, 1908; Grabowski and Mueller, 1978; Prahalad

and Bettis, 1986; Barney, 1991). Thus, target firms with such assets appear very

attractive to buyers. Can a buyer extract economic value associated with its target's

intangible assets?

This chapter investigates the long-run performance effects of acquiring intangible

targets versus tangible targets. Using a sample of M&A transactions spanning a 4 year

period (1988-1991), long-run-buy-and-hold expected returns are calculated by

constructing portfolios of cohort firms that pursue M&A activity in the 5-year post-event

period. Each firm's long-run-abnormal performance is calculated as the excess return to

the benchmark portfolio. Intangibility of the target's assets is proxied by Tobin's q 1-

1
Strategic alliances can be another external method to accumulate intangible assets and create growth
opportunities. However, the economic value associated with such growth opportunities is endogenous. The
firm's commitment to the alliance-related activities affects the value created. In the case of M&As,
ownership and control rights of the buyer are more closely aligned.

2
year prior to the corporate event. This classification is robust to other measures of

intangibility, such as R&D and advertising stock, and human capital intensity. Results

show that on average, acquirers of intangible targets earn negative abnormal returns,

whereas acquirers of tangible targets break-even. The average long-run abnormal

performance of a buyer in the sample confirms the stylized fact that acquirers break-even

at best.

The evidence on overconfidence is such that the individuals tend to be more

confident in decision making situations where the feedback is delayed or inconclusive

(Einhorn, 1980). The performance implications of M&As involving highly intangible

targets are more likely to have delayed feedback or be inconclusive. Also the expected

returns to such corporate events are harder to forecast. Thus, M&As of highly intangible

targets are more likely to create situations where overconfidence can play a role in

forming expectations. Moreover the behavioral model of Daniel, et. al. (1998) asserts that

investors are more confident about their private signals and overreact to such

information. In the same spirit with this model and above explanations, one would expect

the M&A activity involving targets with intangible assets to trigger misvaluation due to

overreaction.

Existence of asymmetric misvaluation between M&As of intangible versus

tangible targets is tested by regressing short-run returns on the buy-and-hold long-run

returns. Results provide evidence for market overreaction to the announcements that

involve highly intangible targets. The market overreacts to the announcements regarding

intangible targets and corrects its initial response over time. On the other hand, there is no

evidence of a misvaluation regarding the M&As of highly tangible targets. However this

3
is not sufficient evidence to say that the overall market is inefficient. Market efficiency

suggest that there are classes of events that might be priced based on overreactions or

underreactions to information, but on average these effects are cancel each other out

(Fama, 1998). On the other hand, it is fair to say that the long-run underperformance of

buyers of intangible targets imply that firms that develop an expertise to manage M&As

of such targets can create competitive advantage.

The second chapter is organized as follows. In the first section, the theoretical

background and the hypotheses are presented. In the second section methodology used

and the data are discussed. In the third section, the main results are presented. Fourth

section includes the theoretical discussion of and empirical tests for other confounding

effects. In the fifth section, the relevant robustness tests and their results are presented. In

the final section theoretical and managerial implications of the findings are discussed

4
 CHAPTER 2

WHAT TYPE OF ASSETS IS WORTH BUYING THROUGH MERGERS &

ACQUISITION?

Assets fall into three categories (Lindenberg and Ross, 1981): i) those that are

sold in the market and constitute what is traditionally known as the capital stock, ii)

special factors of production which lower its costs relative to those of competitive or

marginally competitive firms2, and iii) special factors of production that the firm

possesses, which act as barriers to entry and generate abnormal returns. Intangible assets

are more likely to fall into the third category; such assets would have different economic

value for different owner-firms, thus creating resource heterogeneity and

nonredeployability. Intangible assets are information-based resources such as technology,

know-how, innovativeness, patents, brand equity, employee motivation and commitment,

customer service, corporate culture, and management skills. Tangible assets, such as the

plant, equipment, raw materials, and financial capital, have to be present for the business

operations to take place whereas intangible assets are necessary for competitive success

2
Such resources are valued at their cost-reducing abilities (e.g. a river whose water acts as a natural
coolant).

5
 (e.g. Prahalad and Bettis, 1986). It is also the case that well-managed firms with

highly intangible assets have unrealized growth potential for future. Well-managed

bidders (high Tobin's q ) benefit positively from tender offers especially if the targets

were poorly managed (low Tobin's q ) (Lang et al., 1989). However, well-managed

targets benefit less than the poorly managed targets from a tender offer. Two possible

explanations for this finding are offered (Lang et al., 1989). First, already well-managed

targets cannot be improved further through takeovers. Second, the fact that the bidder

succeeds in acquiring such a high q target may mean that the target is not as valuable as

the bidder initially thought. In both explanations, there is the underlying assumption that

the motivation for the takeover is to improve the quality of the management of the target

firm. Based on this assumption, the ``surprise'' factor of announcing a takeover would be

less pronounced since the market also would most likely predict that the target is not

well-managed and who the potential buyers would be.

Another possible reason why firms would want to buy targets with high

intangibles is to internalize the target firms' growth potential. Bidder firms can grow

through buying highly intangible targets ( q′ > 1 ) by funding, otherwise not funded,

positive net present value (NPV) projects3. Acquirers that buy targets with less

3
If high
q′ measures the growth opportunities stemming from intangible assets, above and beyond the
tangible assets, why would the target firm be willing to sell the firm? For target firms with high intangibles,
as the degree of nonredeployability increases, it will be inefficient for debt holders to finance new
investments because the increasing risk of default, coupled with high uncertainty regarding the flow of
project cash-flows, would lead expected value of the debt holders' claims to decline. In such cases target
firms would have to forego some of the positive NPV projects because of financing. Where projects face
market breakdowns it is efficient to finance it through equity. Therefore equity financing is an endogenous
response to governance needs of suppliers of finance (in this context the bidder firms) who invest in
nonredeployable projects. These suppliers are the residual claimants who are awarded `control' over the
board of directors.

6
deployable assets foresee some positive NPV projects that only the merged company

could undertake. In this case, the information is most likely to be private to the buyer

firm. Therefore the ``surprise'' factor of an announcement of a takeover of a well-

managed target (high Tobin's q ) would be greater since the market becomes aware of

new information.

Hypothesis 1a: Abnormal returns to highly tangible targets in the pre-announcement

period would be higher than the returns to highly intangible targets.

Hypothesis 1b: Announcement-day abnormal returns to highly intangible targets would

be higher than the returns to highly tangible targets.

Intangible assets of a firm, such as R&D projects, patent stocks, and human

capital are more likely to be undervalued by the market when they are bought by another

company. Such assets would generally have high target-firm specificity and therefore

lower second-best use, which in turn leads to the undervaluation. This expected

undervaluation is common to both the market and the potential buyers. Given this adverse

setup, if the market observes a bid for a highly intangible target, in theory it should signal

the buyer's expectations to redeploy the target's intangible assets and create new growth

opportunities. Potentially, buying a firm with high intangibles is a more noisy way to

obtain a particular subset of intangible assets. Even though successful post-event

integration of targets with highly intangible assets as opposed to targets with highly

tangible targets is more problematic, this is also expected by the market participants as

7
well as the buyers. Therefore, this difference should have less bearing on the post-event

long-run abnormal performance of buyers 4.

Overall, intangible sources of firm value are of a differential character, in that the

advantage of those firms who own them may lead to competitive disadvantage of those

who do not (Veblen, 1908). Conversely, tangible resources would not lead to competitive

advantage over firms that lack such resources5. The main reason is that the price charged

by the owners of those tangible resources in factor markets would be equal to the income

that would be generated by the buyers of those resources in product markets. Also if the

assets of the target have high redeployability (high ratio of tangibles), then acquiring such

targets would be, on average, equivalent to internally developing the same resources

because the costs associated with both methods would be approximately the same.

2.1 Resource-Based View and Competitive Advantage

There has been a systematic effort to distinguish the types of assets (tangible or

intangible) and their effect on the firm's competitiveness (e.g. Coff 1999a, 1999b; Delios

and Beamish, 2001; Finkelstein and Haleblian, 2002; Hall 1992, 1993; Hitt et al., 1990,

4
What could make a difference is if managers' and the market's expectations of post-event integration of
highly intangible targets differ significantly. Managers may either have favorable private information that
justifies the acquisition of highly intangible target, or act in self-interest as a result of agency conflicts
(Jensen, 1986) specific to the context of buying highly intangible targets. These two factors affect long-run
abnormal firm performance in the opposite directions. However, the related theories are less explicit about
the aggregate direction.

5
What about the highly synergistic acquisitions even though the target's assets are highly intangible? There
is no theoretical reason to believe that the probability and the magnitude of post-event synergies would
systematically differ in cases where the target is highly tangible versus intangible. The only assumption
required to follow through with this logic is the following: the potential for synergies is equally likely to
exist for both the acquirers of highly intangible targets as well as highly tangible targets.

8
1991a, 1991b; Mowery et al., 1998). For example, Prahalad and Bettis (1986)

emphasized a ``dominant logic'' as an intangible asset that could be shared between firms

through diversification to create economic value. Firms that develop their core

competency, defined as ``the collective learning in the organization, especially how to

coordinate diverse production skills and integrate multiple streams of technologies'', are

more likely to have a strategic advantage over their competitors (Prahalad and Hamel,

1990:82).

According to the resource-based logic, resources that are rare, valuable, and

inimitable are the real sources of competitive advantage (Barney, 1991a, 1991b; Barney,

1986; Conner, 1991; Rumelt, 1984; Wernerfelt, 1984). Of these firm-specific resources,

intangible assets are more likely to be the source of sustainable competitive advantage6

because they are harder and more time-consuming to accumulate, provide simultaneous

uses, and are both inputs and outputs of business activities. Another characteristic of

these intangible assets is that they are likely to be causally ambiguous (Dierickx and

Cool, 1989) making them less likely to be imitated by competitors (Barney, 1991a).

Therefore firms that seek to internalize intangible assets through acquiring highly

intangible targets are, on the one hand, trying to internalize new growth opportunities, but

on the other hand more likely to suffer from potential pricing, integration and

maintenance problems of the targets due to causal ambiguity, complexity and tacitness of

the very same intangible assets.

6
Villalonga (1999) tested this assertion by using the predicted value from a hedonic regression of Tobin's q
as a measure of resource intangibility and found supporting results.

9
 Knowledge, one of the most important firm-specific intangible assets, has been

developed as a reason for a firm's existence (Liebeskind, 1996; Spender, 1996)7. Highly

firm-specific knowledge would be harder to transmit because fewer parties other than the

innovator can benefit from the application of that knowledge (Henderson and Cockburn,

1996; McEvily and Chakravarthy, 2002). If the firm is an accumulation of idiosyncractic

knowledge that is valuable, what are the methods of developing that firm-specific

knowledge base? One of the direct methods is to pursue M&A activity and try to

internalize knowledge intensive targets. Such target firms are necessarily the ones with

highly intangible asset stocks. Buying a firm with high intangibles is a more noisy way to

obtain a particular subset of intangible assets8.

Although resource-based view and other related approaches to defining sources of

competitive advantage favor the accumulation and utilization of intangible assets, one

cannot extend these arguments to suggest any systematic differences between the two

M&A strategies: buying highly tangible versus intangible targets. If one argues that

7
Leibeskind conceptualized firms as structures to keep knowledge proprietary (1996). This assumes, in
essence, that there is a fully efficient market for knowledge, and that without the firm the knowledge would
have been diffused which in essence is similar to Porter's idea of entry barriers (1980). Conner and
Prahalad (1995) developed a resource-based theory of the firm based on knowledge as a valuable asset. The
main argument is that, absent opportunism, firm organization would provide a better mechanism to allow
an owner to provide his/her knowledge as input in the team production setting with higher value than in a
market setting. Information and knowledge are factors of production that could be sources of competitive
advantage. However, these factors of productions are also very hard to price; moreover their value is
context- and owner-specific. Given this, how would a strategic factor market for knowledge, and more
generally intangible assets, work? I argue that the firm is an internal market for knowledge that decreases
the inefficiencies of the external market for knowledge. Once an individual offers his/her knowledge to the
team production, the internal processes would translate it into a firm-specific knowledge base (Kogut and
Zander, 1992).

8
An alternative and more precise way would be to develop intangible assets internally through firm-specific
processes such as employee training and R&D. In this case, because the direct method of internal
development would be more precise and less risky, the expected rate of return would more likely be lower
when compared to the expected rate of return to the acquirers of highly intangible targets.

10
buying highly intangible targets would more likely be a source of competitive advantage,

then as a corporate strategy it constitutes a ``rule for riches'' and generates no sustainable

competitive advantage (abnormal returns). This is analogous to the performance

implications of related versus unrelated acquisitions (Seth, 1990a; Singh and

Montgomery, 1987; Clark and Ofek, 1994). Empirical evidence supports the theoretical

argument that both related and unrelated acquisition strategies can create significant

synergies.

As mentioned above, targets, on average, appropriate most of the economic value

associated with the acquisition synergies, while buyers on average breakeven (e.g. Jensen

and Ruback, 1983; Lubatkin, 1983, 1987; Agrawal et. al., 1992). Buyers can create

sustainable competitive advantages only if there are unique, valuable and inimitable

synergies with the targets (neither the target nor other bidders have this information) at

the time of the acquisitions (Barney, 1988). However, this condition can equally apply for

acquisition strategies of both highly tangible and intangible targets.

Hypothesis 2: On average, there is no systematic above-normal performance differences

between buying intangible versus tangible targets.

Hypothesis 3: On average, corporate strategies of buying intangible or tangible targets

cannot be a source of systematic competitive advantage.

2.2 Controls for Other Factors

11
 There are three alternative explanations9 that could affect the performance of

M&A strategies: agency motives, financing and tax treatments, and behavioral

explanations regarding market reactions. Controlling for these alternative explanations

also serves as robustness checks for the tests of the above hypotheses.

2.2.1 Agency Motives

It has been widely discussed that M&A strategies could be motivated by self-

interested managers. The relevant question in this context is would agency motives, such

as the use of free cash flow (or cash reserves) to increase the size of the firm (Jensen,

1986), systematically lead managers to pursue targets with highly intangible assets as

opposed to targets with highly tangible assets? Managers, who want to be viewed

favorably, have an incentive to delay or advance the project resolution. This type of

manipulation of information arrival can be achieved by greater investment in execution

projects (which tend to resolve early) than exploratory projects (which tend to resolve

late) (Hirshleifer et al., 2001). High ability managers are more likely to choose execution

projects and low ability managers are more likely to choose exploratory projects.

M&A activity of highly tangible targets would be similar to the execution projects

in the sense that the project resolution (realization of synergies) is less likely to be

delayed. However, M&A of highly intangible targets would be akin to exploratory

projects where the resolution of outcomes arrive later. Therefore, if the agency motives

play a differential role in target selection, then low ability managers are more likely to

9
I would like to thank Anita McGahan and Karen Wruck for providing useful insights.

12
pursue highly intangible targets to take advantage of the longer horizon of project

resolution. Also cash reserves increases the likelihood of engaging in M&A activity and

cash-rich bidders destroy 7 cents in value for every excess dollar of cash reserves held.

(Harford, 1999).

Based on the above discussion, the buyers that pursue targets with highly

intangible targets are expected to be firms with low ability managers and higher free cash

flows or cash reserves prior to the acquisition when compared to the buyers of highly

tangible targets. As a result, buyers of highly intangible targets are expected to

underperform in the long-run. However, this is only a necessary but not sufficient

condition to cause a systematic abnormal performance between the two types of

acquisition strategies. For such inefficient capital allocations to persist over time, there

have to be other systematic factors that impede corrections to irrational expectations. If

there are such impediments, than it is plausible to entertain the existence of irrational

expectations of firm performance when M&A of intangible targets are concerned.

For the purposes of testing for agency motives in this context, the following

hypotheses are developed:

Hypothesis 4a: If buyers of target firms with highly intangible assets have significantly

higher levels of pre-event free-cash-flows or cash reserves then such targets tend to

attract firms with costly agency problems.

Hypothesis 4b: If the market does not expect agency motives to systematically drive the

acquisition of targets with highly intangible versus tangible assets then there should

13
 be no significant differences between the market reactions to the two types of M&A

announcements.

2.2.2 Information Asymmetry and Financing of Intangible Assets

There are two main concerns that might affect the long-run performance of buyers

adversely. The first one is related to the increased debt burden of the buyers to finance

large transactions, such as M&A of highly intangible targets that also have large market

capitalizations. The second one is related to the adverse effects of information

asymmetries. If the highly intangible targets are already overvalued then the buyers of

such targets end up paying an excessive amount of premium.

Target firms that have highly intangible targets have unrealized but valuable

growth opportunities. How can these firms finance their growth opportunities, such as

R&D projects? First, retained earnings can be used. Second, the firm can seek external

financing from debt and/or equity financial markets. Since governance is costly, the

general rule is to reserve complicated forms of financing for complicated investments

(Williamson, 1991, 1988). `Expressed in terms of asset specificity, fungible assets can be

leased, semi-specific assets can be debt financed, and equity is the financial form of last

resort to be used for assets of a very nonredeployable kind' (Williamson, 1991: 84)10.

Nonredeployability also suggests that the value of the assets in its first-best use is

significantly higher than the value of that same asset in its second-best use. Therefore, we

would expect nondeployable assets that are financed by equity to be intangible assets.

10
Emphasis added.

14
Overall, firms with highly intangible assets have a lower concentration of debt financing.

Titman and Wessel (1988) find a negative relationship between the measures of

uniqueness (e.g. high R&D expenditure) and its debt ratio (Debt/Equity). Specifically,

firms with low employee turnover and large R&D expenditures have relatively low debt

ratios. R&D intensive firms receive higher returns to firm shares following new debt

issues (Alam and Walton, 1995; Zantout, 1997).

There are two methods of equity financing: a target firm can either issue new

equity (seasoned equity offering-SEO) or be bought out by another company. There are

differences between the two methods of financing. First, there is well-documented

negative stock market reaction to announcements of SEOs for the issuing firm. The

dominant explanation for this empirical regularity is based in information asymmetry

between the firm's insiders and outsiders. Myers and Majluf (1984) show that with

information asymmetry, insiders have an incentive to issue new equity when the firm is

overvalued. The stock market knows this, and therefore discounts the firm that issues

SEO. Second, especially for firms with highly intangible assets, financing through SEO is

not preferred because of adverse effects of disclosing proprietary information about the

firm's projects that were to be financed with the proceedings. The only other method of

equity financing is through M&As.

Hypothesis 5: Buyers of highly intangible targets will decrease debt ratio when compared

to the buyers of highly tangible targets in the post-M&A period.

According to Modigliani-Miller theorem (1958, 1961), firms should be indifferent

15
between internal and external sources of financing for the marginal R&D project since in

both cases the cost of capital would be the same. However, as widely researched, this

theorem fails in practice due to several reasons. As discussed in detail by Hall (2002), the

divergence between the internal and the external cost of capital is due to the information

asymmetries between the inventor and the investor, moral hazard on the part of the

inventor due to the separation of ownership and control, and tax considerations.

Asymmetric information creates a ``lemons'' market (Akerlof, 1970) for R&D

project financing because the investors have a hard time distinguishing good projects

from the bad ones when the projects are long-term R&D projects (Leland and Pyle,

1977). Therefore investors require a ``lemons'' premium (Hall, 2002). In the case of

highly intangible targets, buyers would require a premium for the ``lemons'' problem

associated with the information asymmetry between the target (inventor) and the acquirer

(investor). On the other hand, a takeover would decrease the moral hazard problems that

would have been present for the other potential investors if the target firm had issued

equity or new debt instead of being acquired.

Empirically there seem to be limits to leveraging strategy in R&D intensive

industries such that the leveraged buy-outs in the 1980s that were financed by high levels

of debt were almost exclusively in industries where R&D intensity was insignificant

(Hall, 2002, 1994, 1990; Opler and Titman, 1994). Tax treatment of R&D lowers the

required rate of return, because the effective tax rate on R&D assets is lower than that on

other types of tangible assets (Hall, 2002). On average, although these two effects act in

opposite directions, the rate of return expected by the buyers of highly intangible targets

would be higher than the expected rate of return expected by the buyers of highly

16
tangible targets.

Moreover, buyer's of highly intangible targets expect to have post-event

integration problems (e.g. Greenwood et al., 1994). This expectation increases the

riskiness of fully realizing the expected synergies. As a result, buyer's expected rate of

return increases, and the price (premium) to be paid decreases. The effective tax rate on

R&D assets is lower than tangible assets such as plant, property and equipment because

R&D is expensed as it is incurred (Hall, 2002). This would mean that the rate of return

for such investment would be lower.

In comparing the acquisition of highly tangible targets versus highly intangible

targets, while moral hazard, post-event integration, and the ``lemons'' problems are more

severe for the case of intangible assets, tax considerations are more favorable. As the

riskiness of a project increases, the expected rate of returns increases. As the expected

rate of return increases the investor is willing to pay less.

Hypothesis 6: Buyers of highly intangible targets will pay a lower premium in

comparison to buyers of highly tangible targets.

2.2.3 Market Over- or Under-Valuation of Growth Opportunities

Firms are producers of tangible and intangible information about themselves.

Investors utilize firm-generated as well as other sources of information to decide on a

17
course of action in both financial and labor markets11. Tangible information is explicit

performance measures such as book-to-market ratio of equity, earnings, and sales,

therefore any information generated by using financial statements will be tangible

(Daniel and Titman, 2001). However, this definition of tangible information may not

correspond one-to-one to the tangibility of the asset base. In essence, the validity of this

tangible information is more in question when the firm's asset base is highly intangible. A

firm with highly tangible assets is more likely to provide all the relevant information

about its nature as tangible information in the form of financial statements.

On the other hand, a firm with highly intangible assets, has a harder time

reporting information about itself in the form of financial statements; rather, it is more

likely to produce intangible information such as reputation or corporate culture (e.g.

Louis et al., 2001). Moreover a common ratio, such as book-to-market, will be downward

biased due to the lack of a book value of intangible assets in the numerator. This bias

taints its validity as a measure of tangible information. Investors are more likely to

overreact to intangible information, but rationally react to the tangible information

(Daniel and Titman, 2001). Distinctions between public versus private information follow

a similar logic (Daniel et al., 1998). Private information, such as the growth opportunities

of a firm, would be more ambiguously defined and is heterogeneous among investors12.

11
For example, public firms, by law, produce more tangible information which is coded in financial
statements. On the other hand private firms do not produce as much tangible information and yet the
investors might benefit from other types of intangible information like reputation to form their expectations
about the firm's performance.

12
The behavioral model of Daniel et al. asserts that investors are more confident about their private signals
and overreact to such information (1998).

18
 If we allow for the possibility of investor irrationality in the form of

overconfidence, stock prices reflect both systematic risk and misperceptions of firm's

prospects (Daniel et al., 2001)13. Therefore, it is reasonable to expect mispricings due to

overconfidence to be more severe for firms with highly intangible assets, such as R&D

firms with relatively long-run projects (Daniel et al., 2001; Chan et al., 1999; Leland and

Pyle, 1977).

The mispricing will be equivalent to the divergence between the market's initial

reaction to the announcement and the post-event long-run stock market performance of

the buyers14.

Hypothesis 7: Market is more likely to correctly evaluate and price the buyer's synergies

with the highly tangible target.

Hypothesis 8: Market is less likely to correctly evaluate and price the buyer's synergies

with the highly intangible targets.

13
The evidence on overconfidence is such that the individuals tend to be more confident in decision making
situations where the feedback is delayed or inconclusive (Einhorn, 1980).

14
However this divergence could be due to the revelation of unexpected but negative news after the event,
which could not have been incorporated into the market's reaction at the time of the announcement. This
case also requires the assumption that the unexpected but negative reaction to bad news is much more
severe than the unexpected but positive reaction to good news. Conversely, holding the severity of the
reaction equal for both cases, the likelihood of unexpected negative news should be significantly higher
than the likelihood of unexpected positive news.

19
Hypothesis 8a: Negative deviation between the market's initial response and the long-run

performance of the buyers represent market overreaction.

Hypothesis 8b: Positive deviation between the market's initial response and the long-run

performance of the buyers represent market underreaction.

2.3 Methodology and Data

Management and financial economics literature consist of many event studies that

detect abnormal stock returns following major corporate events or decisions, such as

earning announcements, acquisitions, stock splits, or seasoned equity offerings. However,

studies that are concerned with long-run abnormal returns in the context of M&A are

fewer in number15. Modified Tobin's q is used as a proxy for the measure of intangible

assets in the target firms which will be discussed in detail. The analysis is concerned with

measuring abnormal economic performance. The most important step in measuring

abnormal performance is to define a theoretically sound benchmark to proxy the expected

performance. First, a brief discussion of modified Tobin's q will be provided. Second, the

traditional method of calculating long-run abnormal returns will be discussed. Second,

15
The main concern in these event studies is to determine whether there are abnormal returns associated
with the firm-specific events. There is considerable variation among these studies regarding the calculation
of abnormal returns and the statistical tests carried out to detect the presence of abnormal returns. Refer to
McWilliams and Siegel (1997) for a detail discussion of event studies. Some representative studies are
Seth, (1990a, 1990b), Lahey and Conn (1990), Conn et al. (1991), Haleblian and Finkelstein (1999).

20
the shortcomings of this method will be presented. Barber and Lyon (1997) provide

evidence that the common techniques used to calculate short-run abnormal returns, when

applied over a longer horizon, are conceptually flawed and/or lead to biased test statistics.

Finally, the data and the methodology used in this study will be discussed.

2.3.1 Valuation of Intangible Assets

In this paper, we use 1-year pre-event Tobin's q (Tobin, 1969) as an indicator of

the target's intangible assets (Daniel et al., 2001; Klock and Megna, 2000; Loughran and

Vijh, 1997; Lang et al., 1989). True q ratio of i th firm is defined as the market value

of all financial claims on the firm, MVi , relative to the firm's total assets calculated as

the sum of the i th firm's replacement values of tangible assets Ti and intangible assets

Ii .

MVi
qi ≡
Ti + I i

In competitive markets with linear homogeneous production technology that

employs optimal level of capital stock16, the i th firms true equilibrium q ratio will be

16
The assumption on homogeneous production technology allows us to study firms in equilibrium. Both
acquirers and targets are incumbents in their industries, and every firm has an existing base of capital.

21
equal to 1 (Megna and Klock, 1993). The MVi of the target firm is measured as the

sum of all outstanding claims on the firm including book value of debt Di and preferred

stock Pi , and market value of common equity C i . Book value of total assets is denoted

as Ai .

MVi ≡ Di + Pi + C i , where
Di ≡ Current Liabilities − Current Assets
+ Book value of Inventories + Long - term Debt

Since in reality we do not have the theorized homogeneity due to differences in

tax provisions, depreciation schedules, heterogeneous production functions given firm-

specific resources and capabilities, etc., the true equilibrium value of i th firm's q

defined by q ' is unobservable. Therefore one observes

MVi
q i′ ≡
Ti

The replacement cost of tangible assets of i th firm is approximated by Ai ,

book value of total assets, because the replacement value of intangible assets is not

reflected in the Ai . This approximation follows Chung and Pruit (1994). Although it is

not as accurate as the Lindenberg and Ross's (1981) algorithm, due to differences in the

calculation of the replacement value of assets, both are highly correlated (Lee and

Tompkins, 1999; Bharadwaj et al., 1999). Also, the advantage of this approximation is
22
that bidder firms and the investors are more likely to use this simpler formula that

requires publicly available financial and accounting data. It is reasonable to assume that

the observed q′ values will approximate the portion of market value of the firm

explained by the firm's tangible assets. If q′ is greater than 1 then there are firm-

specific valuable intangible assets contributing above and beyond the firm's tangible

assets.

A q′ that is less than 1 would suggest that the firm's tangible resources and

capabilities are underutilized or that there are value destroying intangible resources (e.g.

bad management). Such intangible resources, in theory, would have negative replacement

value. If we can fully explain the market value of a firm based on its tangible resources

then the firm's q′ is equal to 1 . In the mean time, the equilibrium value of q′ for any

firm will change from year to year as there are changes in the mix of the old capital, new

capital, and intangible capital, as well as changes in the macroeconomic and regulatory

environment (Megna and Klock, 1993). Another source of change in q′ is M&As that

are most likely to alter the mix of a firm's asset base and its economic value.

Accounting based measures of intangibility are based on R&D and advertisement

expenditures (Lev and Sougiannis, 1996; Louis et al., 2001), and labor costs (Qian,

2001). Each firm's R&D (advertisement) capital is estimated from its pre-event history of

R&D (advertisement) expenditures based on Lev and Sougiannis (1996) and Louis et. al.,

(2001) as follows17:

17
The financial information is taken from the COMPUSTAT/CRSP merged database provided by Wharton
Research Database Services. R&D expenditure is annual data item 46; sales is annual data item 12; net
income is annual data item 172; dividends and book value of common equity are measured as annual data
items 21 and 60.
23
 RDCit = RDit + 0.8 ∗ RDit −1 + 0.6 ∗ RDit − 2 + 0.4 ∗ RDit −3 + 0.2 ∗ RDit − 4
ADVCit = ADVit + 0.8 ∗ ADVit −1 + 0.6 ∗ ADVit − 2 + 0.4 ∗ ADVit −3 + 0.2 ∗ ADVit − 4

where RDC it and ADVCit are the R&D and advertisement capital respectively

for firm i in year t. These estimates of R&D and advertisement capital measure the

proportion of past spending that is still productive in a given event-year t = {−5,.., 0}

based on current and past R&D and advertisement expenditures of RDit and ADVit .

This approximation assumes that the productivity of each dollar of spending declines

linearly by 20% a year. As a robustness check the approximations are recalculated by

using a 15% capital amortization rate that is used by Hall et. al. (1988) for the database

compiled on R&D activity. The results are qualitatively unaffected. The intangibility of

the target firm is measured by the estimated R&D (advertisement) expense as a

percentage of either total sales, and cost of goods sold. These ratios are recalculated using

R&D (advertisement) capital. Other measurers include Tobin's q′ , 4 -digit SIC

adjusted leverage ratio, total intangibles (R&D and advertisement capital) as a percent of

cost of goods sold, and cash as a percent of sales. As discussed earlier as the intangibility

of a firm's assets increases, its debt ratio decreases whereas its cash reserves increases to

fund projects internally. In Table-1 the descriptive statistics (in Panels A and B) and

between-group equality tests are reported.

2.3.2 Which measure of performance?

Strategic management is concerned with improving firm performance. Thus any

strategy such as M&A activity, is assumed to have an effect on firm performance, which
24
is the main concern of this paper. Performance can be measured (accounting versus

economic performance) in multiple ways over various lengths of time (short-run versus

long-run). In M&A what is the relevant performance measure that would allow detection

of sustainable competitive advantage? This line of inquiry allows whether or not

acquiring firms internalize the economic value associated with the intangible assets of the

target firm.

Intangible assets of a firm are akin to latent assets (Brennan, 1990) in the sense

that they cause a potential bias in the firm's market value mainly because they are

expensed in the accounting statements. It would be the case that the accounting measures

would understate the true return in the early years for investments in capacity, new

product R&D, etc.18. On the other hand, firm value can be viewed as being generated by

its tangible assets and intangible assets. Accounting measures that use book values of the

firm's assets would cause a downward bias in the performance measures as the

concentration of firm-specific productive intangible assets increases. This downward bias

would be most severe in the short-run because those development projects would not

generate any income in the early years. Overall, based on the extensive literature on the

drawbacks of using accounting measures, economic measures of performance based on

stock returns will be employed in this paper.

18
This is especially critical for the valuation of growth opportunities of firms. Although, by conventional
accounting measures a highly intangible target may appear to be trading at a premium, for the buyer
company the price paid can be justifiable.

25
 2.3.3 Why not traditional event methodology?

The traditional approach in corporate event studies is to calculate Cumulative

Abnormal Returns ( CAR ). A security's performance can only be considered `abnormal'

relative to a particular benchmark (Brown and Warner, 1980). Therefore a model

generating normal returns (exante expected returns) has to be specified. Almost

exclusively all event studies of this kind apply the Capital Asset Pricing Model (CAPM)

or market model19 to estimate the normal returns. This method focuses on average market

model residuals of the sample securities for a number of periods around the event date.

The null hypothesis is such that if there are no significant effects associated with the

corporate event, CAR s will be a random-walk.20 The operationalization is as follows.

First, we define Rit as the month t simple return on a sample firm i , E ( Rit ) as the

month t expected return for the sample firm, and ARit as the abnormal return in

month t . To calculate E ( Rit ), we regress Rit on the market portfolio R Mt over an

estimated period of t = −1L − k days preceding the event as Rit = a i + bi RMt , where

a i and bi are the ordinary least square parameter estimates.21 Then

19
Refer to Chatterjee et al. (1999) for a discussion of the CAPM and the strategic theory of risk premium.

20
The average residual in the event time are independent and identically distributed, with a mean of zero.

21
It is important to notice that the coefficient a i is in fact the systematic risk factor, β in the CAPM.

26
E ( Rit ) = a i + bi R Mt is calculated for t = 0 Lτ periods after the announcement.

ARit = Rit − E ( Rit ) for t = 0 Lτ

Cumulating across τ periods yields a CAR :

τ
CARit = ∑ ARit
t =1

Generally these studies identify τ = ±5 or some other shorter window of

analysis around the event date of t = 0 . The main argument behind this identification is

that the stock prices reflect the discounted economic value of all future expectations. As

discussed earlier, M&A activity is an event that is much more complex than any other

corporate event such as an earnings announcement. Also the nature of the event is

conducive to exacerbate any potential investor biases such as overconfidence. Therefore

studies as early as 1974 have started looking at longer post-event periods to gauge long-

run performance effects of M&A activity.22 All of these studies used CAR and overall

document negative CAR for mergers and positive CAR for tender offers. Also most of

these studies document a less than 3% CAR in magnitude for combined M&A activity

with varying signs.

22
Refer to Mandelker (1974), Dodd and Ruback (1977), Langetieg (1978), Asquith (1983), Bradley et. al.
(1983), Malatesta (1983), Agrawal et. al. (1992), Loderer and Martin (1992), Gregory (1997), Loughran
and Vijh (1997), Rau and Vermaelen (1998). These studies are reviewed in detail by Bruner (2001).

27
 There are four major types of biases documented when using CAR methodology

to determine long-run abnormal returns (Barber and Lyon, 1997). First, CAR s (summed

monthly) ignore monthly compounding, which leads to a measurement bias in the

calculation of long-run abnormal returns. Consequently, the t-statistics would be

negatively biased. Second, new listings and survivor biases occur because sampled firms

are tracked for a long post-event period, but firms that constitute the index (e.g. S&P500,

equally-weighted or value-weighted market indexes) typically include firms that begin

trading subsequent to the event month or firms that are delisted subsequently.

Especially with the new listed firms, which are mainly IPOs, the index

incorporates the underperformance of these firms and results in a downwardly biased

estimate of the long-run return from investing in a passive (not rebalanced) reference

portfolio in the same time period. Third, rebalancing bias arises because the compound

returns of a reference portfolio (proxied by a market portfolio, e.g. equally weighted

market index), is generally calculated assuming periodic (e.g. monthly) forced

rebalancing to maintain equal weights. This rebalancing inflates long-run return on the

reference portfolio. Skewness bias arises because the distribution of long-run abnormal

stock returns is positively skewed, which also contributes to the misspecified test

statistics. An alternative method for calculating long-run buy-and-hold abnormal returns (

BHAR ) that eliminate these biases will be briefly discussed next.

Two other sources of bias that affect the test statistics in long-run performance

studies of both types ( CAR vs. BHAR ) are due to the cross-sectional dependence

between firms and the validity of the asset pricing model used to estimate abnormal

returns. In this paper the expected returns are not estimated by a model such as CAPM;

28
therefore, the validity of the model is an irrelevant issue. However cross-dependence

might be a source of bias in BHAR studies. The main problem is that cross-sectional

dependence inflates test statistics because the number of sample firms overstates the

number of independent observations. It is especially problematic if there is calendar date

clustering (e.g. a high number of announcements per a specific event date) or industry

clustering23.

As long as there is no additional industry clustering or unusual pre-event return

performance, the approach used in this paper also eliminates the biases due to cross-

sectional dependence and `bad model'. Moreover reference portfolios are formed in each

sample-year, which also accounts for any cross-sectional dependence due to the event

year (e.g. hot versus cold periods for M&A activity). The method used in this paper to

calculate returns to reference portfolios formed by similar firms in terms of their size, as

well as their book-to-market ratios as a proxy of long-run expected returns to a firm that

engage in M&A will be discussed further in detail.

2.3.4 Long Run Buy & Hold Abnormal Returns

The first issue is to decide on an unbiased measure of abnormal returns that

reflects the investor behavior accurately, because CAR s and BHAR s answer two

23
In this sample, there are more than 75 industries with no significant clustering of M&A activity, as well as
no significant calendar-date clustering.

29
different questions (Barber and Lyon, 1997). For example, a test of null hypothesis that

the 12 -month CAR is zero is equivalent to a test of the null hypothesis that the mean

monthly abnormal return of sample firms during the 1 -year post-event period is equal to

zero. On the other hand, the null hypothesis that 1 -year BHAR is equal to zero would

test whether the mean annual abnormal return is equal to zero. Of course, for

detecting/testing long-run abnormal returns the second null hypothesis is relevant.

BHARit are calculated as the difference between the return on buy-and-hold investment

in the sample firm and the return on a buy-and-hold investment in an asset portfolio with

an appropriate expected return. As shown below the calculation of BHARit , unlike

CAR, takes into account the monthly compounding (Barber and Lyon, 1997; Lyon et al.,

1999) .

τ τ
BHARit = ∏[1 + Rit ] − ∏[1 + E ( Rit )]
t =1 t =1

This method eliminates the measurement bias due to the realistic compounding. It

is also imperative to state that this difference in compounding makes CAR a biased
24
estimator of BHARit .

24
Let's compare 1-year CAR and 1-year BHAR for a random sample of 10,000 observations (Barber
and Lyon, 1997). Assume that both CAR and BHAR are calculated using equally weighted market
index. The annual CAR and BHAR per portfolio are calculated for 100 portfolios, each of which has
100 stocks. Since, on average, the returns on individual securities are more volatile than the return on the
market index, CAR is understated when BHAR is above zero and overstated when BHAR is below
zero (Barber and Lyon, 1997).
30
 2.3.5 Calculating Reference Portfolios

Expected returns are proxied by forming size/book-to-market reference

portfolios25. Fifteen reference portfolios are formed based on acquirer firm size and book-

to-market ratios in the sixth event month of each sample-year (1988-1991) to eliminate

new listings and rebalancing biases (Lyon et al., 1999). First, we calculate firm size

(market value of equity calculated as price per share multiplied by shares outstanding) in

the sixth event month of each year (for the entire event period of 1988-1992 for the

acquirers in 1988, and 1989-1993 for the acquirers in 1989, etc.) Second, in the sixth

month of year t , we rank all the sample firms that engaged in M&A in each sample

year, for example, 1988, on the basis of firm size and form 5 size portfolios based on

these rankings. Third, in each size group we rank the firms based on their book-to-market

ratio (book value of common equity (COMPUSTAT data item 60) reported on the firm's

balance sheet in year t divided by the market value of common equity in the end of year

t ) and further partition each size group into 3 book-to-market subgroups. Finally, the

returns to the 15 size/book-to-market portfolios are tracked for the period of τ = 60

months.

25
Reference portfolios based in industry membership could also be considered to proxy expected returns to
the buyer firms (e.g. Dess et al., 1990). This assumes that the expected returns vary systematically across
industries. However industry membership has no power in explaining stock return, whereas market value of
equity and book-to-market ratio of equity do have explanatory power (Fama and French, 1993). In other
words industry membership is not priced while equity size and book-to-market ratio of equity are priced by
the market, which warrants for controlling those systematic effects. Also BHARs are biased (Lyon et al.,
1999) only if there is an industry clustering which is not relevant for this sample.

31
 Long-run returns on each reference portfolio are calculated by first compounding

the returns on securities constituting the portfolio and then summing across securities:

 s +τ 
ns  ∏ (1 + Rit )  − 1
R =∑ 
bh
t = s
psτ
i =1 ns

where n s is the number of sampled securities traded in month s , the beginning

period for the return calculation. The return on this portfolio represents a passive equally

weighted investment in all securities constituting the reference portfolio in that period s

. With this method there are no new listings and rebalancing biases because there are no

out-of-sample new firms added subsequent to period s .

BHARit is calculated using (), and the E ( Rit ) is proxied by () which were in

essence formed by matched control firm technique. The use of reference portfolios based

on a control firm approach yields well-specified test statistics in both random and size

samples (Lyon et. al., 1999). Also if size/book-to-market portfolios are formed by an

increased number of groupings (thus with a lower number of firms in each group) the

precision of the reference portfolios increases; in fact, this technique can approach the

rule of matching a control firm with 70-130% of its size and/or book-to-market ratio26.

2.4 Data

26
There are 15 size/book-to-market portfolios in this study. The range of number of firms in each portfolio
is between 5 and 7 and the firms in each portfolio are within 70-130% range of their size and book-to-
market ratios.

32
 For the analysis, recapitalizations, self-tender offers, and repurchasing of common

shares, are excluded from the sample. Buyers should have stock returns for the preceding

60-months after the announcement date and target firms should have available

information to calculate q′ . A total of 413 M&As during 1988-1991 were identified

from the Thompson Financial Securities Data (SDC Mergers and Acquisitions Database)

that fit the selection criteria27. Financial and accounting data are obtained from

COMPUSTAT and the stock returns data is extracted from CRSP tapes using WRDS

database. Missing returns of acquirers are replaced with a mean monthly reference

portfolio return that the company belonged to based on its last reported return. It is, in a

sense, reinvesting the returns from the delisted stock, for that month, on the reference

portfolio that the stock belongs to.

After excluding the acquirers of target firms for which q′ could not be

calculated due to nonreported balance sheet item, there were 109 acquirers in y = 1988

. After calculating BHARit using (), the acquirers were divided into two groups based

on the type (high or low q′ ) of targets they bought. Of the 109 acquirers, there are,

n g1 , 75 acquirers that bought target firms with q′ ≤ 1 (group j = 1 ), and, n g 2 , 34

27
This might potentially limit us to draw inferences conditional on the survival of the acquirers. However
because the abnormal returns are not calculated by using a regression model, the tests of equality as well as
test to detect abnormal returns are not affected. Moreover the benchmark performance for each firm in the
sample is also formed within the sample, eliminating any survivorship bias in the calculation of abnormal
returns.

33
acquirers that bought target firms with q′ > 1 (group j = 2 ). For each group j , the

average monthly BHAR jt is calculated for 60 post-event months as:

n gj
∑ BHARit
BHAR jt = i =1
for t = 1L 60 and j = 1, 2
n gj

The calculation of BHARit for the other sample-years is carried out in the same

manner. The resulting pooled dataset has 24, 780 firm ∗ month observations. The

frequency statistics per-sample year is as follows:

y = 1988 n s = 109, n g1 = 75, n g 2 = 34

y = 1989 n s = 110, n g1 = 64, n g 2 = 46
y = 1990 n s = 95, n g1 = 47, n g 2 = 48
y = 1991 n s = 99, n g1 = 70, n g 2 = 29
y = pooled n s = 413, n g1 = 256, n g 2 = 157

In Tables 3-5 various additional descriptive statistics are presented for the

variables used in the analysis as well as some representative variables such as

advertisement capital as a percent of sales ( advstsls ) ; R&D capital as a percent of sales

( rdstsls ) ; plant, property, and equipment capital as a percent of sales ( ppesales) ;

and plant, property, and equipment capital as a percent of total assets ( ppeasset ) . The

descriptions of the variables are provided in Table-2. Descriptive statistics for the

variables are presented in Table-3. If we look at the correlation matrix in Table-4, we

observe that the advertisement capital as a percent of sales is positively correlated

34
(0.130, p = 0.008) with the group membership, q′ rank . We can conclude that it is

more likely to have a highly intangible target when that target has a higher ratio of

advertisement expenditure accounting for the net sales. It is reasonable to assume that

much of advertisement expenditure directly affects brand equity. Moreover, plant,

property, and equipment capital as a percent of total assets is equally and negatively

correlated with advertisement capital as a percent of sales (−0.242, p = 0.002) and

R&D capital as a percent of sales (−0.241, p = 0.002) . This is also in line with the

argument that firms that have higher advertisement and R&D capital as a percent of sales,

such as consulting firms or high-technology firms, would be less likely to have highly

tangible assets such as plant, property, and equipment.

In the theoretical setup, we argued that the type of asset-base of the target would

have a differential effect on the abnormal returns to the acquirers in the long-run. It is

important to stress the need to look at the long-run performance to gauge for performance

differences between acquirers of highly intangible versus highly tangible targets, because

even if we have similar synergies between the two types, the processes which firms need

to go through to realize those synergies would be different across these two types of

M&A. In the case of highly tangible targets there is very little that is unknown. However,

in the case for highly intangible targets, such as high-technology firms, it is a matter of an

acquirer's firm-specific capability even to pinpoint the source of economic value because

it would not necessarily be in the accounting statements.

The most important result in Table-5 is the relationship between q′ of the target

and the BHARit of the acquirer. There is a negative and significant relationship between

35
the level of intangibles of the target before the acquisition and the buy-and-hold long-run

abnormal returns, BHARit , to the acquirer of that target ( − 0.065, p < 0.0001 ). Other

variables of the target firms that are used commonly to proxy intangible assets are also

significantly correlated with the BHARit . These findings support the need to understand

the performance implications of acquiring intangible assets through M&A.

As a more conservative setup the reference portfolios are formed after acquirers

are separated into two groups based on whether the targets were high or low on intangible

assets. In each group the method described in the previous section for reference portfolio

construction is performed. The buy-and-hold abnormal returns calculated in this fashion

is denoted as BHARitq . If the target's intangible assets have any effect on the buyer's

post-event long-run performance, then constructing portfolios for the buyers of highly

intangible and tangible targets should decrease the correlation between BHARit and q′

. Indeed, the results show that the correlation between BHARitq and q′ is − 0.042

( p < 0.0001) , which is less than the correlation between BHARit and q′ ( − 0.065).

2.5. Results

Although the emphasis of this study is on the long-run performance, short term

market reaction and the associated CARs provide useful tests of several hypotheses (1a,

1b, 4a, 4b, and 6). These hypotheses investigate the effects of the information content,

agency motives, and information asymmetry on performance. As shown in Figure-1, the

CARs to highly tangible targets in the runup period ( t = −42,...,−1 ), is higher than the

CARs to highly intangible targets, providing support for Hypothesis 1a . The related
36
significance tests reject the null hypothesis that there is no significant difference between

the pre-event CARs to highly tangible versus intangible targets (test-statistic = −3.36 ,

p − value = 0.001 , and the median target CARs for both groups is negative) with

α = 0.001 significance level. This finding supports the expectation that the bids for

highly intangible targets constitute more of an unexpected event than the bids for highly

tangible targets.

In the same line of argument, announcement-day returns to highly intangible

targets are expected to be higher than the returns to highly tangible targets (Hypothesis

1b ). The null hypothesis of no significant differences between the announcement-day

returns to the buyers or highly intangible versus tangible targets is rejected (test-statistic=

-2.49, p − value = 0.01 ), providing evidence that announcement median CARs to

buyers of highly intangible targets (median CAR = −0.01 ) is statistically higher than

median CARs to buyers of highly tangible targets (median CAR = −0.0018 ).

The BHAR methodology provides the abnormal returns to an acquiring firm

above and beyond the expected returns that would be generated by firms with same

size/book-to-market ranking that employ the same strategy of M&A. Figures 2-6 show

striking differences between the monthly average abnormal returns for each group of

acquirers (buyers of highly intangible versus tangible targets). In each figure, there is a

significant downward trend in the average buy-and-hold abnormal returns to the acquirers

of highly intangible targets in the 60-month period after the merger announcement28. In

28
However in Figure-4 there seems to be an outlier month that corresponds to 1996. When the t -statistics
are recalculated for 1991 to test the equality between Med1t and Med 2t with a restricted sample of
37
Table-6, the following null Hypothesis 2 , regarding the equality of medians across two

time series in each year is tested:

H 20 : BHAR1 y = BHAR2 y for y = 1988 L1991, pooled

H 2 a : BHAR1 y ≠ BHAR2 y for y = 1988 L1991, pooled

where BHAR1 y is the median of the 60-month time series of average buy-and-

hold abnormal returns to the firms that acquired highly tangible targets (q′ ≤ 1) in the

year y . Similarly, BHAR2 y is the median of the 60-month time series of average buy-

and-hold abnormal returns to the firms that acquired highly intangible targets (q′ > 1) in

the year y .

Buy-and-hold long-run abnormal returns, generally, have positively skewed

distributions that would violate the normality assumptions. This violation introduces a

downward bias in the t-statistics (Barber and Lyon, 1997). Therefore nonparametric tests

of equality are carried out for the median value rather than the mean value for the

series29. The key test-statistic reported is one of Wilcoxon signed-ranks nonparametric

50-months the null hypothesis is still rejected at the α = 0.01 significance level. Similar results are also
obtained when the rest of the t-tests are run based on 50-month samples.

29
Overall nonparametric tests are more powerful for detecting abnormal performance when compared to the
parametric test (Barber and Lyon, 1996).

38
test30, although other equality tests31 are also reported in Table-6. Based on the t-statistics

and the associated probabilities, we can reject the null hypothesis at the α = 0.05

significance level, for each sample year as well as the pooled series, that the abnormal

returns, on average, would be the same for both strategies of buying highly tangible and

intangible targets. This result fails to support the theoretical argument that there are no

systematic differences between the acquisition strategies of buying highly tangible versus

intangible targets.

According to Hypothesis 3 , we expect that the abnormal returns, on average,

would be equal to zero for both of sets of acquirers. The related test is as follows:

H 30 : BHAR jy = 0 for y = 1988 L1991, pooled and j = 1, 2

H 3a : BHAR jy ≠ 0 for y = 1988 L1991, pooled and j = 1, 2

30
Suppose that we compute the absolute value of the difference between each observation and the mean,
and then rank these observations from high to low. The Wilcoxon test is based on the idea that the sum of
the ranks for the samples above and below the median should be similar. P-value for the normal
approximation to the Wilcoxon T-statistic is reported after being corrected for both continuity and ties.

31
``Kruskal-Wallis one-way ANOVA by ranks'' is a generalization of the Mann-Whitney test to more than
two subgroups. The test is based on a one-way analysis of variance using only ranks of the data. Kruskal-
Wallis test statistic is calculated by the chi-square approximation (with tie correction). Under the null
hypothesis, this statistic is approximately distributed with [(Number of Groups)-1] degrees of freedom.
``Van der Waerden'' (normal scores test) is analogous to the Kruskal-Wallis test, except the ranks are
smoothed by converting them into normal quantiles. The reported statistic is approximately distributed with
[(Number of Groups)-1] degrees of freedom under the null hypothesis. ``Chi-square'' test for the median is
a rank-based ANOVA test based on the comparison of the number of observations above and below the
overall median in each subgroup. This test is also known as the median test. Under the null hypothesis, the
median chi-square statistic is asymptotically distributed with [(Number of Groups)-1] degrees of freedom.

39
 In Table-6, medians for BHAR1 y and BHAR2 y over 60-months is presented in

the third and fourth rows. The null Hypothesis 3 is rejected for the BHAR1 y , where

y = 1989, 1991 . However, we fail to reject the null for y = 1988,1990, pooled .

Although there is the existence of idiosyncratic abnormal returns to buyers of highly

tangible targets in a specific calendar year, overall such acquisition strategies fail to yield

abnormal long-run returns. However, the test statistics for BHAR2 y are significant at the

α = 0.0001 level across all series, which rejects the null Hypothesis 3 . The acquirers

of highly intangible targets systematically suffer negative abnormal returns. For the

whole sample of buyers of highly intangible targets, the magnitude of the economic loss

is around 12% .

Results fail to support Hypothesis 4a . In each of the pre-event years, there are

no statistically significant differences between the free-cash-flows (adjusted for 4-digit

SIC industry median) to the buyers of highly intangible and tangible targets. Therefore

agency motives do not play a role in this context. If the market does not expect agency

motives to systematically drive the acquisition of targets with highly intangible versus

tangible assets then there should be no significant differences between the market

reactions to the two types of M&A announcements (Hypothesis 4b ). Results fail to

reject the null hypothesis of no difference between the CARs to buyers of highly

intangible versus tangible targets (test-statistic = 1.47, p − value = 0.14 ). Therefore

there seems to be no evidence of agency motives having differential impact of the M&A

of intangibles versus tangibles.

40
 As discussed in the section on financing of investments in intangible assets, the

related Hypothesis 5 states that in the post-event period buyers of highly intangible

targets are expected to decrease their debt ratios (adjusted for 4-digit SIC industry

median) significantly when compared to the buyers of highly tangible targets. The null

hypothesis of no difference is rejected (lowest test-statistic = 2.35 ) for each post-event

year for the next 5 years at least with a significance level of α = 0.05. To control for

pre-announcement differences between the two sets of acquirers, the same difference test

revealed no statistically significant differences between the debt ratios calculated in the

same fashion.

Buyers of highly intangible targets will pay a lower premium in comparison to

buyers of highly tangible targets, due to a financing and information asymmetry

difference between the two cases (Hypothesis 6 ). The findings reject the associated null

hypothesis of no statistically significant differences with test-statistic= − 2.49 (

p − value = 0.006 ) at the significance level α = 0.01. As expected, buyers of highly

intangible assets foresee the potential problems, and expect higher rates of return, thus

lowering the premium to such targets. The median premiums for highly tangible and

intangible assets are 16.3% , and 8% respectively.

To test for market over- or under-reaction the following regression is used for

each group in each post-event year:

BHARit = β it + γ it CARi (t = −5,..., +5)

41
 For the buyers of highly tangible targets, regression results yield statistically

insignificant intercepts ( β ). The only significant coefficient of CAR is observed for the

1-year after the event (t-statistic= 2.16, p − value = 0.03 ). These results show that the

market appropriately evaluates the announcements regarding tangible targets. Therefore

Hypothesis 7 is supported.

On the other hand, for the buyers of highly intangible targets, regression results

yield statistically significant intercepts ( β ) for each year, starting with the second year,

following the event. Therefore results support Hypothesis 8 . The coefficients of CARs (

γ ) are statistically insignificant for each post-event year. These results show that the

market corrects its initial response to the announcements regarding intangible targets over

time.

As discussed above, normality of the distribution of long-run buy-and-hold

abnormal returns degenerates as we further increase the number of months. Therefore the

sample is restricted to a 36-month period to test for abnormal returns. In Table-7, results

of the test for normality32 lead one to fail to reject the null hypothesis of normality. Thus,

it is appropriate to carry out the equality of mean tests. In the lower section of Table-6,

test results regarding Hypotheses 8a and 8b are presented. The null hypothesis, that

acquirers of highly intangible targets, on average, would earn zero abnormal returns, is

32
Jarque-Bera is a test statistic for testing whether the series is normally distributed. The test statistic
measures the difference of the skewness and kurtosis of the series with those from the normal distribution.

42
tested against the alternative hypotheses that are stated in the Hypotheses 8a and 8b .

Test statistics for this test are calculated for a 36 -month series of BHAR2 y , where

y = {1988, 1989, 1990, 1991, pooled}. As presented in Table-7, the null hypothesis is

rejected with at least α = 0.001 significance level for each sample-year as well as for

the pooled series. Overall, we can reject the null hypothesis that the mean abnormal

return is zero for the acquirers of targets with q′ > 1 . Moreover, Hypothesis 3a is

supported: Acquirers of highly intangible targets, on average, earn negative abnormal

returns (for our sample the range is between − 0.031 and − 0.118 ).

Hypothesis 7 , tests whether the average monthly returns for acquirers of low

intangibles, q′ ≤ 1 , is equal to zero against the alternative hypothesis that the average

monthly return for acquirers of low intangibles, q′ , is not equal to zero. Although this

hypothesis is similar to the Hypothesis 2 , the theoretical arguments that lead to each are

quite different. In Table-7, the upper section reports the test-statistics that were calculated

for 36 -month series of BHAR1 y , where y = {1988, 1989, 1990, 1991, pooled } . The

null hypothesis is rejected for each sample year with at least α = 0.01 significance level.

It appears that the buy-and-hold abnormal returns to the acquirers of highly tangible

targets are dependent upon the event year.

Like the stock market, trading assets in markets for M&A has a time specific

component that has to be taken into account when making comparisons across time

periods. In this paper, due to the method used in the construction of the reference

portfolios, in a particular year y , the time-fixed effects on the abnormal returns

43
calculated in that sample-year would be purged 33. If we look at the pooled sample and

test to see what is happening on average (for the whole sample) we see that the mean of

BHAR1, pooled is equal to 0.001 ( t − stat = 0.31 ), which fails to reject the null

hypothesis34. Therefore, Hypothesis 4 is supported: Acquirers of low intangible targets,

on average, breakeven (zero abnormal returns). As a robustness check when the same test

is carried out with the complete dataset, lumping both sets of acquirers together, both the

mean and the median of the time series of monthly long-run buy-and-hold abnormal

returns is not statistically significant than zero, which confirms the stylized fact that

acquirers break-even at best.

2.6 Discussion and Conclusion

Intangible assets are more likely to be valuable, rare, and hard-to-imitate, which

makes such firm-specific assets potential sources of sustainable competitive advantage.

Firms that have valuable future growth opportunities are also more likely to have high

concentration of intangible assets. How do firms come to have intangible assets, thus

growth opportunities? One method of accumulating intangible assets is through M&A

activity. Given the stylized fact that acquirers, on average, break-even at best, what

33
However, there are macroeconomic business cycles, spanning over multiple years, that were not
accounted for. Whatever is left that presents itself as statistically significant differences across sample-
years would be generated by the random effects of the sample-year, y . An alternative method would be
to construct portfolios by taking into account the business cycles and first grouping acquirers based on the
period in which they announced the M&A activity.

34
Although there seem to be idiosyncratic time-effects in terms of calendar year, across a time period such
effect should be smoothed out. The result for the pooled series of BHAR1, pooled is in accordance with
this expectation.

44
would be the performance implications of the acquisition strategy of buying highly

intangible targets? Both management and financial economics literature are not explicit

about the predicted performance of engaging in M&A activity to accumulate intangible

assets.

Theoretically, intangible assets are more likely to create the potential for growth

opportunities. Thus firms that acquire highly intangible targets actually buy a bundle of

growth potentials. However, because, on average, intangible assets are more likely to be

nonredeployable without losing significant value of their first-best use, acquirers' post-

M&A values are discounted. The results of this study reveal a significant performance

difference between the two types of acquisition strategies. Firms that buy highly

intangible targets lose, on average, 8% of their economic value over the 36 months and

12% over the 60 months following the M&A activity. On the other hand, firms that buy

highly tangible targets, on average break-even in the long-run. Overall, the market for

intangible assets seems to be less efficient than the market for tangible assets, in the sense

that long-run performance of acquirers will be a result of either a correction of initial

expectations of investors35 or unexpected revelations of unrealized but ex-ante expected

synergies. One of the limitations of the current study is that these two effects have not

been differentiated.

This study empirically shows that engaging in M&A that results in acquiring

intangible assets destroys economic value. This is a surprising result with respect to the

35
Buyers of highly intangible targets are overvalued at the time of the announcement because investors are
overconfident in their ability to evaluate the expected synergies of the M&A activity when the target firm is
highly intangible.

45
resource-based view. Resource-based view predicts that an acquisition strategy of buying

intangible assets versus tangible assets should not produce any systematic abnormal

returns. The findings of this study finds that in fact an acquisition strategy of buying

highly intangible targets generates systematically negative abnormal returns. First, one

can conclude that firms are better off using M&A activity to utilize their current asset

bases (by buying highly tangible targets), and realize already known growth

opportunities, rather than buying intangible assets that are more likely to provide valuable

future growth opportunities36.

Clearly we need to look at the types of intangible assets in this context and their

differential effects on acquirer performance. Second, firms that develop a capability of

extracting the economic value embedded in the intangible targets would create a

sustainable competitive advantage. It seems to be the case that the capabilities that are

unique, valuable, and inimitable with respect to M&A corporate strategies are the ones

associated with managing intangible assets of the targets. This finding represents a clear

link between the corporate strategies and managing resources and capabilities to create

sustainable competitive advantage.

Some firms are better at creating value by buying highly intangible targets,

because there is a wide variation among this negative mean of long-run performance.

36
Does this mean, firms that choose to internally develop intangible assets for future growth opportunities
are, on average, more likely to generate positive abnormal returns? If so, highly intangible firms `cash in'
when they become targets because the true market value of the intangible assets cannot be determined
through secondary markets such as the stock markets. When such targets are acquired, because the process
requires a period of information disclosure and negotiations the market value of the target is appreciated,
thus leading to the only-too-well known premiums to the targets shareholders. We would also expect to see
higher control premiums paid to the shareholders of highly intangible targets when compared to the control
premiums paid to the shareholders to the low intangible targets.

46
Conversely some firms are worse at doing the same transaction. This heterogeneity in

post-event long-run performance of the buyers allows us to develop and further research

a firm-specific governance capability that would be a source of competitive advantage.

The next step is to identify the components of such a capability and research the possible

differences among governance capabilities such as forming alliances and spot market

transacting. Can a firm be good at executing multiple governance forms simultaneously

or is specializing better?

The findings of the study have contributions to the research stream on the firm

growth: Firms that choose to grow through buying highly intangible targets, on average,

lose economic value. In the evolutionary perspective, firms grow by replacing the `profit

maximizing' assumption with `profit seeking' behavior (Nelson and Winter, 1982).

Therefore, growth is generated by either internal development of the firm's asset base or

by engaging in corporate activity of mergers, acquisitions and alliances. Firms ``satisfice;

(because) a firm is unlikely to possess a well-articulated global objective function in part

because individuals have not thought through all of their utility trade-offs (due to

bounded rationality) and in part because firms are coalitions of decision makers with

different interests that are unlikely to be fully accommodated in an intrafirm social

welfare function'' (Nelson and Winter, 1982: 35; Cyert and March, 1963; Simon, 1957).

Attempts of firms to do well are conditioned by the managers' subjective models

or interpretations of the reality of the economic world. Moreover managers of acquiring

firms like investors can have biases and simultaneously can misprice target firms with

highly intangible assets. These interpretations lead to firm strategies. Of course, these

strategies are different across firms because 1) different firms are good at different things,

47
and because 2) firms can have different interpretations of the economic opportunities and

constraints (Nelson and Winter, 1982). Firms have three general characteristic that are

important for understanding and developing firm-specific dynamic capabilities: strategy,

structure and core capabilities (Nelson, 1994).

Capabilities are considered core if they differentiate a company strategically.

Effective competition is based less on strategic leaps than on incremental innovation that

exploits carefully developed capabilities (Prahalad and Hamel, 1990). On the other hand

institutionalized capabilities can lead to incumbent inertia in the face of environmental

changes. For example, managers of new product development face a paradox: capabilities

simultaneously enhance and inhibit development (Leonard-Barton, 1992). While changes

in each of these attributes will affect each other strongly, changes in the core capabilities

and therefore the structure would be harder and more costly to implement. Moreover it

would take a longer time to observe the intended changes if it is at all possible.

M&A activity, as a method of growth, due to the complexity and size of the

investment that the bidder firm undertakes, is more likely to enhance/change the firm-

specific core capabilities and the structure. Alternatively, internal development is more

likely to be an artifact of the current structure and asset base. Penrose (1959) developed a

theory of firm growth based on both the internal resources of the firm and as well as

external sources of growth thought M&A activity. However we do not have a clear

understanding of why some firms choose to specialize in a particular method of growth

(M&A, alliances, and de novo) whereas other firms follow a mixed corporate strategy.

Consequently, we do not clearly know the performance implications of firm-specific

growth patterns over longer periods of time. Do firms that specialize in M&A and have

48
had large numbers of these investments in their history develop a capability to grow

through this certain method? Does the market reward such expertise?

49
 CHAPTER 3

HOW LONG DOES IT TAKE TO BUILD CORPORATE CAPABILITIES FOR

CONDUCTING ALLIANCES AND ACQUISITIONS?

Researchers in the fields of strategic management, industrial organization and

finance have long been interested in the relationships between corporate diversification

and firm performance. Extensive studies have documented the presence of corporate

capabilities in many companies, which are distinguished from business-specific

capabilities by their influence on multiple divisions of the organization (Collis and

Montgomery, 1998; Porter, 1987). Corporate capabilities are particularly important to

decisions by firms to expand into new industries (McGahan, 1999; McGahan and Porter,

2002). Yet despite their importance, corporate capabilities are difficult to measure

because they are designed to be fluid, fungible, and adaptable (Penrose, 1959). As a

consequence, much of the empirical research that documents the importance of corporate

capabilities focuses on variation across firms in their abilities to conduct expansion

decisions (Helfat, 1988). Relatively little research has focused on the processes by which

firms accumulate corporate capabilities in the first place (exceptions are Dyer, Kale, and

Singh, 2003; Kale, dyer, and Singh, 2002; Oxley and Sampson, 2003; Argyres and

Silverman; 2004).
50
 In this paper, we investigate the development of corporate capabilities for

conducting alliances and acquisitions among the 3, 595 firms that became publicly traded

in the United States through an initial public offering of stock (IPO) between 1988 and

1999. This allows us to track the evolution of corporate capabilities as a group of first

that became publicly traded for the first time. Nearly three-quarters of these firms

engaged in alliance and/or acquisition activity after their IPOs and before 1999. We

investigate investor responses to deals of each type, and find that the average abnormal

return for each subsequent deal of any kind generates a decreasingly negative market

reaction reaching around negative 10% after the 6th deal of any kind. The average

abnormal returns increases to negative 10% after the subsequent same-type 6th deal for

M&As, but firms reach negative 10% after their 11th subsequent alliance deals.

The average decrease in the magnitude of market reactions to the subsequent

same-type deals for each firm is consistent with the hypothesis that the stock prices of the

firms had adjusted to incorporate the expectation that the firms had developed corporate

capabilities and would continue to pursue deals of each type.

In a broad sense, these results suggest that, on average, firms establish their

corporate capabilities for conducting M&A relatively quickly after IPO. On average,

firms conducted their first two acquisitions in the first 18 months after going public, and

their first four acquisitions in the first 36 months after going public. Thus, in the first

three years after an IPO, investor expectations about corporate capabilities for conducting

acquisitions and alliances had normalized.

3.1 Antecedents

51
 This study has antecedents in a number of different streams. One group of studies

emphasizes the direct influence of alliances on firm performance. Recent empirical

evidence suggests that alliances, on average, create positive economic value (Chan et.al.,

1997; Anad and Khanna, 2000; Dyer et. al., 2003). Firms that emphasize alliances in their

corporate strategies benefit from flexibility (Kogut, 1989), inter-firm learning (Sampson,

2002), complementary capabilities (Sampson, 2002), and risk management (Villalonga,

2002).

A second stream of research shows that experience with a particular corporate

strategy, such as forming strategic alliances, contributes to the success of such strategies.

Previous alliance experience has been determined as one of the most important factors in

alliance success (McGahan and Villalonga, 2003b; Kale et. al. 2002; Anand and Khanna,

2000; Child and Yan, 1999; Simonin, 1997; Fiol and Lyles, 1985). The learning effects

associated with alliance experience enable firms to develop ‘relational capital’ (Kale et.

el. 2002; Dyer and Singh, 1998).

A third stream deals with the effects of acquisition experience on corporate

performance. In recent studies, McGahan and Villalonga (2003a, 2003b) find evidence

of acquisition capabilities in Fortune 100 firms, and Hayward (2002) tests the effect of

past acquisition experience on firm performance for Fortune 100 companies. In general,

the results suggest that the effects of learning across acquisitions are not as powerful as

the effects across alliances (McGahan and Villalonga 2003b). Hayward (2002) finds that

a firm performance in an acquisition depends on the level of similarity, the recency, and

the success of prior acquisitions.

52
 A fourth set of precedents covers the effect of pursuing corporate strategy

programs, such as a series of alliances or of acquisitions or of both, rather than individual

deals. Schipper and Thomson (1985) find that programs of boundary-spanning

transactions such as acquisitions can enhance the performance of firms in executing

particular transactions. McGahan and Villalonga (2003a) find evidence that “governance

effects,” i.e., the effects of pursuing particular types of deals such as divestitures,

alliances or acquisitions, influences the ability of firms to pursue particular types of deals.

This study builds on this literature by investigating the effects of heterogeneity in

boundary-spanning transactions from firm inception. The empirical design eliminates

common sample selection biases in corporate strategy studies while providing a large

panel dataset for analysis of how corporate strategy programs evolve over time and differ

within and across-industries.

3.2 Theory And Hypothesis

Firms pursue alliances and acquisitions to expand firm boundaries when another

firm has unique resources or superior access to resources, when the costs of executing the

transaction do not outweigh the benefits of the combination, and when the costs of

expected post-transaction integration are not too high. Corporate capabilities37 emerge

over time as firms experience with acquisitions and/or alliances. They can be defined as

valuable combinations of organizational ‘routines’, which refer to the repetitive patterns

37
Capabilities are a combination several routines involving resources such as stocks of knowledge,
financial human and relational capital stocks, processes and skills (Wernerfelt, 1984; Amit and Shoemaker,
1993).

53
of organizational boundary spanning activities that allow firms to devise, implement, and

govern corporate strategies (Nelson and Winter, 1982).

The rest of this sections focuses on how corporate capabilities can make

acquisitions and alliances more attractive by (a) lowering the costs of executing a

transaction (TCE), (b) enhancing the benefits of integration (RBV and CAPABILITIES

VIEW), and/or (c) lowering the costs of integration (TCE AND RBV).

Transaction-cost theory has established that acquisitions and alliances are

alternative mechanism for organizing (Williamson, 1991). Firm’s task is to devise a

governance mechanism that is concerned with the identification, explication, and

mitigation of all forms of contractual hazards38 (Williamson, 1996: 5). Also incomplete

contracts perspective, a recent development of earlier TCE literature, also suggests that

conditional on the optimal contracting choice being at least partially incomplete, ‘the

degree of incompleteness depends on the parties’ ability to describe the nature of the

trade’ (Hart and Moore 1998:3). In this context, gaining experience with a particular

governance form would be useful to firms in devising better and less costly to execute

contracts to mitigate contractual hazards.

For instance, although not intended to test the predictions of TCE, research on

alliance formation has shown that the choice of partner selection is determined by the

prior interactions as well as other interactions between combined resources and product

market opportunities (Gulati, 1995). This finding is consistent with the notion that

38
Emphasis is in the original.

54
governance experience in the form of repeated interactions would allow firms to devise

better contracts to govern future transactions with the same party as opposed to a new

partner.

Resource based view suggests that firms develop their productive yet socially

complex, and causally ambiguous resources and capabilities in a path dependent manner

(Barney 1991; Dierickx and Cool, 1989; Lippman and Rumelt, 1982). Such resources and

capabilities can be source of competitive advantage because they are more likely to be

unique, hard to imitate and substitute (Barney 1991, Peteraf 1993, Wernerfelt 1984,

Demsetz, 1973). Along the same lines, evolutionary economics and dynamic capabilities

perspectives suggest that ‘experiential learning’ is the necessary condition of developing

organizational routines that lead to capabilities (Nelson and Winter, 1982; Teece, et al.,

1997; Zollo and Winter, 2002). These paradigms suggest that the necessary condition of

developing corporate capabilities in a particular boundary spanning governance form is to

engage in repeated transactions in a path dependent manner.

Mitchell and Capron propose that firms seek the best available value of current

and future routines which leads to the protection, coordination, and creation of

capabilities (2003: 2). This valuation will have internal and external inputs. Internal

evaluation of expected value associated with capabilities (i.e. bundle of routines) will

increase as the firm gains valuable experience, such as engaging in same-type corporate

deal transactions. In addition to the relevant antecedents discussed earlier, empirical

evidence that focuses on the effects of prior experience of the focal firm with same-type

deals on the success of the subsequent same-type corporate transactions would provide

motivation for this study. For example, firms are found to benefit from prior acquisition

55
experience that can be represented as a U-shaped learning curve (Haleblian and

Finkelstein, 1999). Finkelstein and Haleblian (2002) look at the ‘transfer effects’ of

experience in acquisitions between the first and the second transactions of 96 acquirers.

They findings suggest that although the routines developed in previous acquisitions

transfer to the following same-type corporate transactions, the effectiveness of this

transfer depends on the similarity of industrial context. Hence we expect to see the

following relationship:

Hypothesis 1a: The likelihood of engaging in Alliances increases as the number of

past deals of the same-type increases for the focal firm

Hypothesis 1b: The likelihood of engaging in M&As increases as the number of

past deals of the same-type increases for the focal firm

External evaluation of a firm’s productive corporate capabilities is provided by

the stock market reactions of the market in general to the focal firm’s announcements of

corporate transactions. Consequently, at the time of the announcement, the focal firm

experiences changes in its equity value as a reflection of the market’s expectations

regarding the firm’s corporate level capabilities (i.e. ability to realize expected synergies

from an acquisition transaction). The empirical evidence regarding the effects of past

acquisition experience on the subsequent acquisition performance has been mixed (see

Hayward, 2002 for a detailed discussion). For instance, Capron (1999) shows that

acquirers with experience are more likely to be effective in re-deploying the firm assets.

56
On the other hand, as mentioned above Haleblian and Finkelstein (1999) show that only

certain kind of acquisition experiences are useful in the subsequent deals’ success. The

body of mixed evidence can be partially an artifact of differences in the modeling and

sampling approaches used in those studies. However it can also be due to the unobserved

heterogeneity in the temporal effects of experience, which we take into account with our

modeling approach by looking at the effects of cumulative same-type deals on the

subsequent same-type deal.

Hypothesis 2a: The likelihood of engaging in same-type subsequent deals is

related to the magnitude of the market reaction to prior same-type deals.

Hypothesis 2b: The magnitude of the market reaction to prior same-type deals has

a non-uniform pattern of influence on likelihood of engaging in same-type subsequent

deals.

On the other hand a Hayward discuss the temporal effects of past acquisition

experience on the subsequent same-type deal performance, and find that acquisitions that

are not too temporarily close or distant from the focal acquisition favorable affect the

focal acquisition (2002). Although the specification of this positive relationship is vague,

nonetheless it motivates the current study to take a stratified modeling approach. We test

the proposed relationships for each identifiable temporal stage to take into account the

possible heterogeneity in the order-specific characteristics. For instance is the effect of

same-type deal on the probability of engaging in the nth same-type deal same as the effect

57
on engaging in the n+1th same-type deal.

Furthermore prior same-type deal effects can vary with each subsequent same-

type deal. For instance, recency of the same-type deals might influence the effect of that

particular deal on the probability of engaging in the subsequent nth same-type deal.

Hayward’s results on the temporal effects of acquisition experience, as well as the series

of studies done by Finkelstein and his colleagues (e.g. 1999, 2002) show a nonlinear

relationship between acquisition experience and subsequent acquisition performance.

Therefore we also explore the existence of regimes in modeling to test the hypotheses to

look at whether there is a particular pattern of cumulated same-deal experience affecting

each subsequent deal uniformly or in a decaying manner.

Hypothesis 3a: Firm experience in alliance deals exhibit a non-uniform pattern of

influence over the subsequent same-type deals.

Hypothesis 3a: Firm experience in M&A deals exhibit a non-uniform pattern of

influence over the subsequent same-type deals.

3.2.1 Industry and Time effects

The variance decomposition of the explanatory power of firm versus industry

effects on performance largely show that firm effects dominate over business and

industry effects (e.g. Khanna and Rivkin, 2001, see Bowman and Helfat (1997) for an

excellent review of this literature). However industry effects play an important role in

capturing the industry context that affect of firm’s investment decisions as well as the

58
success of those investments (McGahan, 1999; McGahan and Porter, 2002).

For instance, industry effects is the main source of variance 1) in the

decomposition of profitability for the firms in the service sector (McGahan & Porter,

1997); 2) the level of advertisement and R&D intensity for nondiversified firms (Mauri

and Michaels, 1998); 3) the level of market share for small to medium firms in the

manufacturing sector (Chang and Singh, 2000); and in the decomposition of economic

profit as well as market to book ratio of equity of firms that are neither industry ‘leaders’

nor ‘losers’ (Gabriela, Subramanian and Verdin, 2003). Based on this literature and the

related empirical findings we control for industry effects in our empirical models and

expect to find significant explanatory power associated with the firm membership in the

Manufacturing and service sectors. We also control for announcement year of each deal

to account for any time-effects that are not controlled by industry or firm effects (e.g.

Helfat and Adner, 2003).

3.3 Data

The sample is restricted to the years 1988 through 1999 for two reasons. First,

comprehensive data on alliances is not available for years prior to 1988.

Comprehensiveness is important to identify all of a firm’s relevant experience. Second,

for years subsequent to 1999, we cannot identify deals that were announced but not

consummated.

We identified the sample from the group of privately held companies that went

through an initial public offering for the first time in their history during the years 1988

through 1999. The filtered sample of firms are represent the population of firms that
59
IPOed during 1988-1999 and have no public record of corporate deals prior to their IPO

year. The main motivation behind this specific filter is to allow us to track the cumulative

deal experience and the associated performance effects for each subsequent deal starting

with the very first deal.

IPO data is gathered from SDC Thompson Financials, Global New Issues

database. The universe of IPOs (Original IPOs in the US, excluding secondary offerings)

in 1988-1999 has 3595 companies. As detailed in Table 1- Panel A, we further filter the

IPO sample of 3595 firms based on whether the firms engaged in a corporate deal during

1988 to 1999 (949 firms did not have any deals) and whether the firms’ stock return data

can be verified in the COMPUSTAT/CRSP merged database provided by Wharton

Research Data Services (stock return data for 527 firms could not be verified). Finally we

eliminate firms that have IPOed during 1988 to 1999 but engaged in corporate deals prior

to their initial public offering (70 firms had pre-IPO corporate deals). The final sample

has 1949 firms that IPOed during 1988 to 1999, which we will refer to as the sample of

qualified IPOs.

Alliance data is gathered from SDC Thompson Financials, Joint Ventures &

Strategic Alliances database. The total number of alliance transactions in 1988-1999 is

47,831. The number of alliance participants per transaction range between 2-16 firms,

with 90.55% having only two participants. The population of qualified IPOs engaged in a

total of 3,107 alliance transactions, which constitutes 6.5% of all existing deals in the

same period.

Mergers and acquisition (M&A) data is gathered from SDC Thompson

Financials, Mergers & Acquisitions database. The number of total M&A transactions that

60
involve public acquirers in 1988-1999 is 67,652. More than half of these transactions

involve targets and acquirers within the same industry sector. The population of qualified

IPOs engaged in a total of 7,574 M&A transactions, which constitutes 11.20% of all

existing deals in the same period. This percentage is almost twice the amount of alliance

transactions that the same set of qualified IPO firms engaged in the same time period.

COMPUSTAT/CRSP merged database provided by Wharton Research Data

Services is utilized to get the information on the stock prices and returns for each focal

firm. We also obtained data on market returns (e.g. S&P, value and equal-weighted

market returns) from CRSP database. Finally, the accuracy of the announcement dates of

corporate deals is important to consider (Anand and Khanna, 2000). We verified the

accuracy of announcement dates reported by the SDC database by doing random checks

by searching Lexis Nexus Database, and other business news sources such as Wall Street

Journal Online. In addition we verified the absence of abnormal returns during the pre-

announcement period that spans -126 days up to -5 days of the reported announcement

date.

3.4 Descriptive Statistics

The 1949 qualified IPOs engaged in a total of 10,681 corporate deals in 1988-

1999 (Table 1-Panel B). The industry composition of the qualified IPOs is also very

instructive. During this period, the highest percentage of IPO activity occurred in the

service sector (32.94%) closely followed by the manufacturing sector (30.19%). The sub-

period of 1992-1997 account for the 73.33% of IPO activity, suggesting that this period

61
was a ‘hot’ IPO market and correspond to the favorable economic conditions of the

1990s.

The average number of M&A deals per each IPO year is higher than the average

number of alliances, with the exception of the firms that IPOed in 1991. The firms that

IPOed in 1997 and 1998 engaged in significantly higher average number of M&A deals

compared to the other years, especially when we consider the fact that the available deals

for the firms that IPOed in 1997 or 1998 is tracked until 2000, which would suggest that

the average number of deals should have been lower than the prior years (Table-PanelA).

Interestingly firms engage in alliance activity in their IPO year and do not wait to

become a newly established public firm (Table 2-Panel A). Moreover by, the qualified

IPOs reach the peak of their alliance activity, measured as the average number of alliance

deals per deal-year, in the second year following the IPO event (Table 2-Panel A). The

total number of alliance deals executed by the qualified firms that IPOed 1991 through

1996 constitute for the 74.16% of all alliance deals, which suggests that booming activity

might have the same effect on firms to increase the intensity of their corporate activities,

however alliance activity presents a more stable trend over 1988-1999 when compared to

the M&A activity (Table 2-Panel A).

As in the case for alliance deals, the qualified IPOs reach the peak of their M&A

activity, measured as the average number of M&A deals per deal-year, in the second year

following their IPO (Table 2-Panel B). Although the total number of M&A deals

executed by the qualified firms that IPOed 1992 through 1997 constitute for the 76.26%

of all M&A deals; 1995 seems to be low point in this sub-period. Hence, when compared

to the time trend in alliance transactions, M&A activity is more cyclical. Again, qualified

62
IPO firms engage in M&A activity in their IPO year and do not wait to become a newly

established public firm (Table 2-Panel B).

We also track the population of qualified IPO companies that end up delisting due

to poor performance and/or becoming targets themselves in subsequent years (Table 3-

Panel A). The population of qualified firms managed to survive with 0.05% of mortality

rate until the 3rd year following their IPO. The mortality rate for the whole sample across

all years is 12% (232 firms). The highest mortality rate occurred for the set of qualified

firms that IPOed in 1991.

The mortality rates peak on the fourth and fifth years following the IPO. Although

the highest percentage of survivors IPOed in 1989, on average we observe around 10% of

mortality among the qualified firm that IPO in 1988 through 1999 (excluding 1989). This

is very interesting since the corporate activity for these newly public firms peaks in their

second year prior to the onset of increased mortality39.

The qualified IPO firms executed, on average, 5.48 deals (Table 3-Panel D), but

experienced the highest number of corporate deals in their 1st year. If we look at the

M&A and Alliance deals separately, we notice that the average number of M&A deals in

the IPO-year as well as the first subsequent year is higher than the average alliance deals

in the same comparable time-period (Table 3-Panels B and C). Over the course of each

subsequent year following the IPO, the average of total M&A deals show a decreasing

39
Although the relationship between the peak level of corporate activity after the IPO and the following
peak of mortality rate with one-two years of grace period in between is very interesting, we chose not to
focus on this for the purposes of the current study.

63
trend with the peak happening in the 1st year and steadily declining afterwards (Table 3-

Panel B).

On the other hand, we fail to observe a similar trend in alliance deals. There

seems to be spells where alliance activity peaks, the first spanning over the 2nd and 3rd

years after the IPO. This is another distinction between the evolution of the M&A and

Alliance capabilities for these newly IPOed firms. The firms exhibit a less enthusiastic

tendency to form alliances in the first IPO year followed by the first year whereas these

firms seem to execute M&A deals right away in higher numbers. This is a challenging

observation to link to the theories that inform the boundary spanning activities of firms.

For instance, TCE would predict that M&A deals would be much more costly for these

newly public firms when compared to forming alliances. Moreover, alliances are more

likely to provide firms with flexibility in investment by providing options to expand with

relatively less upfront investment when compared to M&A deals.

3.5 Methods

We employed a logit model to test Hypotheses 1a and 1b. The intuition of this

model is straight forward. We estimate the probability of engaging in the same-type deal

(Alliance or M&As) subsequently by taking into account the absolute and temporal

effects of experience with specific corporate capabilities that evolve over time following

the firm’s IPO. By way of using multiple filters discussed earlier in our data selection

step we 1) control for the pre-IPO corporate deal experience, 2) capture the evolution and

path dependent nature of corporate level capabilities related to M&As and Alliances by

focusing on the population of newly IPOed firms, and 3) eliminate a potential source of

64
bias generated by the different dates for the M&A (1979) and Alliance (1988) datasets

provided by SDC, Thompson Financial Services. This step is particularly crucial for our

analysis since the main explanatory variables proxy corporate level deal experience.

Our dependent variable is a nominal variable that takes on the value of one if the

firm chooses to ally and zero if the firm chooses to acquire. The independent variables of

interest are constructed to capture the multiple facets of deal experience which is

essentially the building block of corporate capabilities. We construct two independent

variables. The first one is the Lagged alliance experience as a % of lagged total

experience (LAGEXPALL). This variable is constructed to test for H1a and measured as

the ratio of lagged total alliance experience in time t, over the lagged total deal

experience in time t. The hypothesized relationship outlined in Hypothesis 1a is that the

higher this ratio the higher the likelihood of forming an alliance as the subsequent deal.

The second set of independent variables is comprised of cumulative abnormal returns

over t={-5,…,+5} days around the announcement date of a corporate deal (M&A or

Alliance) by the qualified IPO firm. Accordingly we calculated the CARs for t={-

5,…,+5} days around the announcement date for each deal and constructed lagged

variables for each firm*deal observation such that for the nth deal has the CARs

associated with its first same-type deal, second same-type deal,…, and n-1th same-type

deal. We track the CARs up to the 10th lagged same-type deal

(1stSAMEDEAL,…,10thSAMEDEAL) per qualified IPO firm.

We carry the same analysis outlined above for the dependent variable, constructed

to test Hypothesis 1b, which is also a nominal variable that takes on the value of one if

the firm chooses to acquire, and zero if the firm chooses to ally. In the same fashion, we

65
construct the Lagged M&A experience as a % of lagged total experience (LAGEXPMA).

The logit analysis is carried out for each subsequent same-type deal to test for

Hypothesis 1b and 2b. By comparing the coefficients of LAGEXPALL (and

1stSAMEDEAL,…,10thSAMEDEAL), we are able to identify the temporal effects of

engaging in same-type deals if there are any. For instance, the lack of any difference in

the explanatory power of LAGEXPALL (and 1stSAMEDEAL,…,10thSAMEDEAL) for

engaging in the n th subsequent same-type deal would suggest that the probability of

engaging in the same-type deal does not vary across n th versus n+1th same-type deal.

As mentioned before, we include industry sectors based on 1-digit SIC codes

assigned to the qualified firm by constructing eight sector dummies, as well as time fixed

effects based on the deal year dummies as control variables.

3.6 Results

The average CARs for all deals, only alliances, and only M&As are negative and

significantlt different than zero for all level of subsequent (same-type or not) deal (Table

4). First deals after the IPO reulst in an average of negative 37% abnormal losses for the

focal firm when all deals are considered (Table 4-Panel A). This rate is also

representative of the losses incurred by the firms that announce their first M&A deal as

well (Table 4-Panel B). In all three panels, with each subsequent (same-type or not) deal,

the magnitude of the market reactions decrease approaching to less than -10% by the 6th

deal for M&A deals, and 11th for the Alliance deals (Table 4- Panel B and C). This

decline in the magnitude of negative market reaction with each subsequent deal is

consistent with the arguments made in this paper that same-type deal experience will

66
result in the recognition of the corporate strategy program by the market thus lowering

the magnitude of the reaction to each subsequent announcement. However, one very

strong finding puzzles us: Why do newly public firms experience consistent and very

persistent negative market reactions to their corporate deals? We leave this issue for now

and will come back to it in our discussion and.

The mean CARs for each subsequent deal year following the IPO reveals a

different dynamic than the one we described above. When the focal qualified IPO firm

engages in deals during the IPO year, the market responds by an extremely negative

reaction of 75% for all deals, as well as for only Alliances, and only M&As. It is

interesting to note that the M&A deals that are announced in the second post-IPO year

shows tremendous improvement over the initial extremely negative reaction and ranges

around 14% for all deals, and alliances. However M&A deals recover to negative 12% if

the same-type deal is announced in the second post-IPO year (Table 5. Panel B). This is

another corroborating evidence that the M&A and Alliance have underlying mechanisms

that are quite different in terms of building corporate capabilities by accumulating same-

type deal experience in the post-IPO period. Also the CARs for each subsequent post-IPO

year start to increase after the second ipo-year and in fact stay well under -7% average for

deals that are announced within 7 post-ipo years for both sets of deals (Table 5).

The results of the logit estimation to determine the explanatory power of lagged

cumulative M&A experience as a percentage of lagged cumulative total experience

(LAGEXPMA) yield several findings regarding Hypothesis 1a and 1b (Table 6A). First,

for all subsequent deals, regardless of the particular experience level, LAGEXPALL is

both economically and statistically significant at 1% confidence level, which provides

67
support for Hypothesis 1a. The probability of choosing to ally increase as the percentage

of prior alliance experience increases. On average, one unit increase in the lagged percent

of alliance experience increases the odds of observing an alliance for the subsequent deal

by 8 times ( e β = e 2.083 = 8.03 ) for the whole sample; and 10 times for the sub-sample of

firms that engaged in more than ten alliance deals (Table 6A). This finding is also

consistent with theoretical predictions by organizational theories such as the capabilities

view and evolutionary economics regarding capability building and the role of

experience.

Second, the findings also suggest that the effect of cumulative lagged alliance

deal experience is non-uniform in its magnitude across each subsequent nth alliance deal.

For instance, the largest effect of prior alliance experience is on the decision to whether

or not to ally for the second time (--a reminder that this is not necessarily with the same

prior partner, more often than not the subsequent deals have different partners). The

coefficient estimate for the LAGEXPALL is the highest for the 2nd deal and decreases in

magnitude until the 6th deal. This finding supports Hypothesis 3a which suggests that the

alliance experience has a temporal component. The cumulative past experience with

allying increases the marginal probability of choosing alliances over M&A at a

decreasing rate for each subsequent nth deal, especially for the first 6 deals (Table 6A).

Third, consistent with the empirical finding regarding industry effects, we also

find that if the focal firm is in the manufacturing sector, on average, the probability of

engaging in alliances as opposed to M&As increases. Also this effect is more pronounced

for the first 6 deals suggested by the decrease in coefficients for the independent dummy

variable that takes on the value of 1 if the focal firm is in the manufacturing sector.

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Membership of the focal firm in the services, retail trade and, transportation and public

utilities sectors have statistically significant explanatory power for the pooled sample

such that in those sectors the probability of forming alliances is higher when other

exogenous factors are controlled for. However the lack any significant explanatory power

of the same industry dummies in the deal-specific non-linear regressions suggest that

industry membership does not, on average, explain the probability of forming an alliance

as opposed to an M&A for the nth deal.

The results of the logit estimation to determine the explanatory power of lagged

cumulative M&A experience as a percent of lagged cumulative total experience

(LAGEXPMA) yield several findings regarding Hypothesis 1b and 3b (Table 6B). First,

like in the case of alliance experience, for all subsequent deals regardless of the particular

experience level, LAGEXPMA is both economically and statistically significant at 1%

confidence level, which provides support for Hypothesis 1b. The likelihood of engaging

in M&A activity increases as the prior M&A experience as a percent of total deal

experience increases.

The magnitude of this effect is higher when compared to the effect of alliance

experience on the probability to ally. This is strong evidence that suggests the existence

of significant differences in the development and the performance effects of alliance

versus M&A capabilities. On average, one unit increase in the lagged percent of alliance

experience increases the odds of observing an M&A for the subsequent deal by 12 times

( e β = e 2.498 = 12.15 ) for the whole sample; and 31 times for the sub-sample of firms that

engaged in more than ten M&A deals after they IPOed (Table 6B). This effect of M&A

experience is almost 3 times stronger than the effect of alliance experience in determining

69
the likelihood of the subsequent same-type deal for firms that have experience more than

10 same-type deals after their IPO. It is an interesting finding that might shed light into

the unanswered yet extremely important question that puzzles the corporate strategy

researchers: Why do firms continue to do M&As even after they experience negative

market reaction and end up losing economic value?

Second, the findings also suggest that the effect of cumulative lagged M&A deal

experience is non-uniform in its magnitude across each subsequent nth M&A deal. As

was the case for the alliance experience, the largest effect of prior M&A experience is on

the decision to whether or not to acquire for the second time. The coefficient estimate for

the LAGEXPMA is the highest for the 2nd deal and decreases in magnitude starting with

the 3rd deal but stays relatively stable for 5th through 9th deals. This finding supports the

Hypothesis 3b which suggests that the M&A deal experience has a temporal component.

The cumulative past experience with acquiring increases the marginal probability of

choosing M&A over alliance at a decreasing rate for each subsequent nth deal, especially

for the first 4 deals (Table 6B).

Third, contrary to the findings regarding the alliance activity, we find that if the

focal firm is in the manufacturing sector, on average, the odds of engaging in M&A as

opposed to alliances decreases by 0.22 for the pooled sample and by 0.17 for firms with

more than ten M&A deals. Also this effect is more less pronounced after for the 8th deals

suggested by the decrease in coefficients for the independent dummy variable that takes

on the value of 1 if the focal firm is in the manufacturing sector. Membership of the focal

firm in the services and retail trade sectors have statistically significant explanatory

power for the pooled sample such that in those sectors the probability of engaging in

70
M&As is lower when other exogenous factors are controlled for. However the lack any

significant explanatory power of the same industry dummies in the deal-specific non-

linear regressions suggest that industry membership does not, on average, explain the

probability of engaging in an acquisition as opposed to an alliance for the nth deal.

The results related to the test Hypothesis 2a and 2b are as follows. The market

reaction to each same-type deal is expected to explain the decision to whether or not

firms engage in the same-type deals subsequently. Therefore the set of explanatory

variables would increase as the number of same-type deals increases since we are

interested in isolating the effects for each prior deal by taking into account the order with

which we observe the related market reaction. For instance, first same-type deal’s market

reaction measured as the CARs over t={-5,…,+5} days around the announcement, has a

negative and statistically significant for the first 5 deals in a decreasing rate. As the

magnitude of the market reaction to the first same-type deal increase, the odds of

engaging in the subsequent same-type deal decreases by 0.60 times for the 2nd same-type

deal, and by 0.28 times for the 5th same-type deal. After the 5th deal the market reaction to

the first same-type deal has no statistically significant explanatory power which suggests

that the effect of the first-same time deal dissipates over the next 4 deals (Table 7). The

results suggest that the market reactions to the prior same-type deals have a conditional

effect of the subsequent same-type deals based on the order. We interpret these finding as

a partial support for Hypothesis 2a.

We see the same effect of the magnitude of market reaction to the immediate prior

same-deal type: the importance of the immediate prior same-type CARs decreases over

the 5 subsequent same-type deals. For instance, one unit increase in the magnitude of the

71
CARs to the second same-type deal increase the odds of choosing the same-type

corporate strategy as the third deal by 0.48. On the other hand, one unit increase in the

magnitude of the CARs to the third same-type deal increase the odds of choosing the

same-type corporate strategy as the fourth deal by 0.35. This illustrates the decaying

importance of experience associated with the prior same-type corporate deal over the first

5 deals.

The finding regarding industry fixed effects are consistent with the prior

discussion regarding Hypothesis 1a and 1b. The effect of the magnitude of same-type

prior deals on the probability of choosing the subsequent same-type deal increases if the

focal firm is in either the manufacturing or the services sector. From the results reported

in Table 7, we observe that the industry effects for manufacturing is higher than services

and have longer temporal effect for each subsequent same-type deal. On the other hand,

the industry effect of service sector is most important up until the 7th deal.

3.7 Conclusion

As a whole the results of this study highlighted some of the unanswered questions

regarding the nature and consequence of corporate level capabilities, namely alliance and

M&A capabilities. The frequency as well as order of same-type deal differs for alliance

versus M&A capabilities. Moreover we show that these capabilities have a finite self-life

in terms of generating higher success levels for the subsequent same-type deals; as well

as just impacting the probability of engaging in the same-type deals in the future

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 CHAPTER 4

WHY DO WE OBSERVE HETEROGENEOUS GOVERNANCE CHOICES FOR

SIMILAR TRANSACTIONS? THEORETICAL ISSUES IN CORPORATE
STRATEGY

Transaction cost theory suggests that the efficiency of organizing transactions is

determined by a particular transaction's characteristics. Given the same transaction

characteristics, the theory would predict that two firms, faced with the choice to use

markets, hybrid governance forms (e.g. alliances), or acquisitions, would follow the same

strategy. This paper argues that two additional factors are also important: (i) Firm

characteristics can intervene to create heterogeneous transaction choices and

(ii)Underlying Asset characteristics intervene to create heterogenous transaction choices.

I demonstrate via a formal model that these factors critically effect the firm's system of

optimal incentive mechanisms required to realize its expected return from alternative

governance choices. More generally, governance structure is formalized as a system of

complementary and/or substitutable incentive mechanisms. First, I demonstrate that

alliances are not a `transitory state' on the road to equilibrium, but an optimal form of

organizing when a party who contributes the most to the residual income of the combined

entity, also has valuable, yet intangible resources (capabilities), in addition to tangible

assets. Second, given a particular ownership structure, parties can improve their payoffs
73
 by devising and implementing supplementary incentive mechanisms such as

monitoring or profit sharing, thereby improving the second best solution to the

contracting problem described in the seminal paper by Grossman and Hart (1986) and

Hart and Moore (1991). Third, the model's implications for corporate strategy are as

follows: The source of heterogeneity in governance stems from the firm-specific ability

to bundle these incentive mechanisms appropriately. In other words, firms maximize the

expected surplus conditional on inducing agents efforts via the optimal bundle of

incentive mechanisms--namely, corporate strategy. Finally, the firm-specific ability to

monitor (as an incentive mechanism) plays an especially important role in the case of

related acquisitions precisely because it complements the ownership structure that would

have misaligned incentives.

4.1 Overview

Firms change their boundaries via corporate strategy. Corporate strategies

incorporate inter-firm transactions such as outsourcing deals, alliances, and mergers and

acquisitions, as well as corporate governance decisions that help implement such

transactions. This paper argues that a firm's boundary choices arise from a process of

matching optimal incentive mechanisms which minimize agency concerns. In addition to

ownership, 2 other incentive mechanisms are considered which may effect the firm's

boundary decisions, monitoring and control. It is important to consider these alternative

incentive mechanisms because they introduce additional agency costs that may emerge in

hybrid and hierarchical forms.

74
 Generally, the organizational economics and management literature has argued

that several factors determine a firm's boundary choices40: transaction characteristics

(transaction cost theory), that would cause the ex-post transacting inefficiencies; the

accumulation and utilization of firm-specific capabilities (the Q theory of investment and

more recently, the capabilities view); the trade-off between flexibility and riskiness of

investment opportunities (the real options perspective); and the allocation of ownership

rights over the parties' combined assets, which decrease ex-ante contracting inefficiencies

due to contract incompleteness (property rights and incomplete contracting literature)

(Veblen, 1908; Coase, 1937; Tobin, 1969; Lindenberg and Ross, 1981; Myers, 1987;

Trigeorgis 1993; Dixit and Pindyck, 1994). Other contextual conditions have been

identified to moderate the boundary spanning decisions. For instance, relational

contracting eliminates potential ex-ante contracting inefficiencies when the parties are in

a competitive setting where repeated interactions are of value (Macaulay and Stewart,

1963; Robinson and Stuart, 2001; Baker, Gibbons, and Murphy, 2002).

This paper seeks to shed light on the simultaneous existence and comparative

characteristics of different corporate strategies that affect firm boundaries. Transaction

cost theory, the most dominant theory of the firm, has salient predictions about the

governance choices among markets, hybrids forms, and hierarchies conditional on

40
Although, it should be noted that the applicability of these parameter to the within- as well as between-
firm incentive alignment decisions varies, this discussion is beyond the scope of this paper and left for
future work.

75
efficiency. This theory is most effective in prescribing `make-or-buy' decisions with

efficiency concerns (when the transaction characteristics are in extremes). It treats hybrid

forms, such as alliances, as transitionary states that allow parties to gather information on

transaction specific characteristics (e.g. asset specificity or uncertainty) (Williamson,

1991).

The treatment of alliances41 as transitory states, however, does not appear to be

consistent with recent empirical data. Alliances, defined42 as voluntary arrangements

between firms involving exchange, sharing, or co-development of products, technologies,

or services (Gulati, 1998), have in fact become one of the dominant methods of managing

firm growth and scope and appear to be persistent. More than 53,000 alliance transactions

are reported in the Thompson Financial Database between 1988-200143. Especially in

high-technology industries such as biotechnology the number and the variety of interfirm

collaborative agreements have been on the rise (Lerner and Merges, 1998). It is almost

natural to ask, "Are alliances simply a transitory state on the road to other stable

41
Alliances are discussed mostly in light of being efficient solutions to minimizing transaction costs (e.g.
Hennart, 1988, 1991); subject to allocation of control rights (e.g. Lerner and Tsai, 2000; Lerner and
Merges, 1998; Aghion and Tirole, 1994) or real options for flexibility (e.g. Kogut, 1991) and/or future
growth (e.g. Stuart, 2000; McGrath, 1997).

42
There are other classifications of interorganizational relationships such as: strategic alliances,
partnerships, coalitions, joint ventures, franchises, research consortia, and various forms of network
consortia (Ring and Van de Van, 1994; Zaheer and Venkatraman, 1995).

43
The categories reported in the Joint Venture Agreements database comprise of all types of alliances
including: equity joint ventures, strategic alliances, research and development agreements, sales and
marketing agreements, manufacturing agreements, supply agreements, licensing and distribution pacts.

76
(equilibrium) governance modes?" or "Do alliances reflect a stable governance form?"

More generally, "Why do we observe heterogeneous governance choices for similar

transactions?"

This paper builds on the recently developed literature on property rights and

incomplete contracts, as well as the capabilities view, to provide a more coherent theory

of corporate strategy. It is argued that in addition to transaction characteristics, two other

factors are also important in a firm's decision among governance modes. Firm

characteristics can intervene to create heterogeneous transaction choices and

(ii)Underlying Asset characteristics intervene to create heterogeneous transaction

choices. In the context of a formal model, I demonstrate that these factors critically affect

the firm's system of optimal incentive mechanisms required to realize its expected return

from alternative governance choices. More generally, governance structure is formalized

as a system of complementary and/or substitutable incentive mechanisms. First, I

demonstrate that alliances are not a `transitory state' on the road to equilibrium, but an

optimal form of organizing when a party who contributes the most to the residual income

of the combined entity, also has valuable, yet intangible resources (capabilities), in

addition to tangible assets. Second, given a particular ownership structure, parties can

improve their payoffs by devising and implementing supplementary incentive

mechanisms such as monitoring or profit sharing, thereby improving the second best

solution to the contracting problem described in the seminal paper by Grossman and Hart

(1986) and Hart and Moore (1991). Third, the model's implications for corporate strategy

are as follows: The source of heterogeneity in governance stems from the firm-specific

ability to bundle these incentive mechanisms appropriately. In other words, firms

77
maximize the expected surplus conditional on inducing agents efforts via the optimal

bundle of incentive mechanisms--namely, corporate strategy. Finally, the firm-specific

ability to monitor (as an incentive mechanism) plays an especially important role in the

case of related acquisitions precisely because it complements the ownership structure that

would have misaligned incentives.

4.2 Theoretical Background

4.2.1 Transaction Cost Economics

Transaction cost economics (TCE) suggest that the efficiency of organizing

transactions is based largely on the transaction characteristics of frequency, uncertainty,

and asset specificity (Williamson, 1985). An increase in any of these three dimensions

increases the likelihood of governing through an hierarchy rather than the market.

However, TCE also recognizes that strategic alliances are hybrid forms of governance,

which will give way to either market based contracting or internal organization

(hierarchy), as soon as enough information is gathered regarding contractual hazards

(Williamson, 1991). In other words, alliances are intertemporal solutions to concerns of

timely responses to exogenous market opportunities. The temporary nature of these

hybrid forms of governance is discussed by Williamson (1991: 293) as follows:

``For example, joint ventures are sometimes described as hybrids. If, however,

joint ventures are temporary forms of organization that support quick responsiveness, and

if that is their primary purpose, then both successful and unsuccessful joint ventures will

commonly be terminated when contracts expire. Successful joint ventures will be

78
terminated because success will often mean that each of the parties, who chose not to

merge but, instead, decided to combine their respective strengths in a selective and timely

way, will have learned enough to go it alone. Unsuccessful joint ventures will be

terminated because the opportunity to participate will have passed them by. Joint

ventures that are designed to give a respite should be distinguished from the types of

hybrid modes analyzed here, which are of an equilibrium type.''

Thus, hybrid forms of governance (such as alliances) emerge as efficient ways of

organizing when the asset specificity is neither high nor low, and the related uncertainty

is low (Williamson, 1991). Hybrid forms of governance become less advantageous when

firms need to respond to changes in the external conditions. When there is high

uncertainty (either in variance or frequency) (h)ybrid adaptations cannot be made

unilaterally (as with market governance) or by fiat (as with hierarchy) but require mutual

consent which takes time (Williamson 1991: 291). Therefore, firms that pursue alliances

under the external conditions of high uncertainty (e.g. high growth and/or fast-paced

changes) would be aligned inefficiently and should underperform when compared to

firms that pursue mergers and acquisitions (M&A). Thus, for example, firms that

historically diversify through both alliances and M&A would be responding to the timing

as well as cost minimizing concerns in a more efficient manner, and thus would create

more economic value than the firms that have diversified solely through M&As or

alliances.

79
 4.2.2 Property Rights Theory

The predictions of transaction cost economics regarding hybrid forms are not

consistent with empirical data. We observe relatively longer-lasting, as well as large

number of alliances, as a mechanism to allocate resources, formed especially in high-

technology industries (e.g. Mowery et. al, 1998), for various reasons other than to address

timing issues such as technology transferring among firms (Elfenbein and Lerner, 2001),

and learning (e.g. Larsson et. al., 1998, Khanna, 1998, Hamel, 1991). In some cases,

alliances provide the firm with resources and opportunities that would have been highly

costly or less probable to replicate through other forms of organizing. For example,

within the internet search engine market, portals with alliances receive direct

compensation for advertisements, promotions, and other services (Elfenbein and Lerner,

2001). Also these portals increase their appeal by extending their features and deepening

their contents through such collaborative agreements.

Property rights theory (PRT) offers more insight into the wide range of

governance forms that we observe. Ownership over physical assets assigns rights to the

ex-ante non-contractable residual income that is generated by employing those assets

(Grossman and Hart, 1986). The incentive to commit effort (invest) is affected by the

distribution of ownership rights over the physical assets, such that strengthening the

incentives of one part by increasing her ownership claim over the physical assets causes a

weakening of the incentives for the other party (Holmström and Roberts, 1998). Thus, the

theory predicts that joint ownership-meaning that both parties have the right to veto the

80
use of the asset- over assets is never optimal44 for perfectly complementary physical

assets (Holmström and Roberts, 1998: 78). However, joint ownership might be desirable

when investments improve non-human assets (Holmström and Roberts, 1998: 78), with

the necessary assumption that both parties would strictly be worse of if one of them veto

the use of the asset. For example, European banks formed consortia, such as European

American Banks, to enter the US market. Other examples would be the oil-drilling

consortia, and the iron-ore consortia formed by steel companies45. In these examples,

although the costs associated with hold-up is very high, the likelihood is very low

because each party increases its own non-human assets through providing effort.

Governance choices that are broadly defined as alliances encompass a spectrum

of ownership patterns licensing agreements (low integration) to equity joint ventures

(high integration). The main commonality of all types of alliances is that there is a `lock-

in' effect, with hindered option to nonmutually walking-away from the agreement. Main

difference between the TCE and the PRT is that the latter offers particular predictions

regarding the types of specificity that determine the level and direction of the likelihood

of integration (Whinston, 2002). PRT suggests that ownership payoffs to each party, who

own non-human assets and make non-contractible investments in human capital that are

complementary, would incorporate two components: share of the capitalized value of

cooperation (V), and separation payoffs (what could have been obtained on its own-V i )

(Hart and Moore, 1990).

44
Emphasis added.

45
These examples are discussed in Hennart (1991) in the context of TCE and joint ventures.

81
 The ownership of non-human assets affects V i , but not V. Therefore, as

investments by the buyer becomes more important for generating surplus, the buyer

should increase its ownership over the assets that affect its separation payoffs, V buyer .

Non-human assets can be classified as being tangible and intangible. Intangible assets

that are owned by the firm (e.g. R&D or Advertisement stock) would potentially have

different effects than tangible assets (e.g. plant, property, and equipment) on the

emergence of ownership patterns as the sole mechanisms to provide investment

incentives. Intangible assets are highly context and owner specific. Transactions between

parties regarding intangible assets, such as an R&D alliance, can be regarded as

incomplete, and high in both uncertainty, `lock-in' and asset specificity. Although TCE

would suggest integration, PRT would caution against it. Because the integration of a

highly intangible target suggests that the seller, although has diluted ownership claims to

the residual income generated to the combined firm, is still expected to provide at least

the same ex-ante level of effort. Therefore, the integration of such sellers would result in

ex-post incentive misalignments which lead to efficiencies.

4.2.3 Capabilities View of the Firm and Agency Costs

Residual income is what is generated above and beyond expected returns which

are used to payoff the factors of production. A firm's tangible assets generally have

secondary markets which defines the deviation between the realized and expected returns

to employing such assets in productive use. However, intangible assets are more likely to

have deviations between the expected and actual residual income generated by employing

such assets into productive use. Moreover, most intangible assets are
82
generated/maintained by experts, which makes the monitoring of effort very hard for

owners. Also in that context, residual control rights are by default assigned to the experts

rather than the owners (who are assumed to lack the required specialization). This would

constitute a classic application of agency theory (Jensen and Meckling, 1976), such that

the decrease in the threat of hold-up (due to lock-in effects, and assets specificity) in

regards to the internalization of highly intangible firms would also lead to an increase in

agency costs (e.g. suboptimal investing or expropriation of owner's economic wealth).

The capabilities view of the firm emphasizes the effects of expertise, due to firm

resources, on rent generation. Firms that develop valuable expertise might deter the

expected agency costs discussed above because such firms would be better at monitoring

the seller in an alliance setting. The existence of firm capabilities also acts as a

complementary incentive mechanism to asset ownership and curtails agency costs. Thus,

alliances become a viable option, when the buyer possesses firm-specific capabilities

(rather than the hierarchy's forbearance or the market's contract law) to provide the

necessary expertise to monitor the seller in alliance.

4.2.4 Hybrid Forms as Real Options

In recent years, real options logic has been employed to explain the multiple

number of varying alliances (e.g., Kogut, 1991), especially in the context of high-tech

firms engage in (e.g. McGrath, 1997). The option-based techniques are used to evaluate

the value of managerial flexibility regarding portfolio selection models (e.g. Trigeorgis

1993; Myers, 1987; Dixit and Pindyck, 1994; Mason and Merton, 1985; Kester, 1984).

The convenient application of financial options logic to firms' investment behavior has

83
suggested that firms, like investors, should invest in multiple projects and/or other firms

to hedge against risk. This risk is generally associated with the expected flexibility of

having multiple growth options and the uncertainty associated with how much and when

the expected gains from which of the options would materialize.

A direct application of real options logic is that firms forming alliances would

have an upside potential positively correlated with the expected returns (which is highly

uncertain at the time of the investment) to the venture, yet limiting the total losses

(because the firm shares the costs with its partner) in case the venture turned out to be

fruitless. This approach is commonly seen in high-technology industries that is

characterized in general by high research and development expenditures (Huchzermeier

and Loch, 2001; Amram and Kulatilaka, 1999). According to this perspective, the more a

firm has real options (alliances) the more it hedges away the diversifiable risks associated

with the flexibility gained by having multiple alliances. In this sense it is equivalent to a

portfolio of growth options. It is also important to note that real options logic can only be

used to rationalize alliances when the focal firm faces high uncertainty (variance) in the

expected returns to an investment opportunity. Therefore real options logic as a fruitful

theory of the firm-and firm boundary decisions is highly restrictive.

4.3 Model Setup and Intuition

This paper mainly uses the contracting model presented in Grossman and Hart

(1990) and expanded by Baker, Gibbons, and Murphy (2002) with a simple modification

to accommodate the firm-specific vector of firm-specific capabilities to govern a

particular type of governance structure that is a system of multiple mechanisms to create

84
the right incentives for the desired outcome by the focal firm.

Let set B  1, , I of firms. Each firm has a bundle of resources and

capabilities (e.g. ability to monitor third parties' R&D effort due its existing R&D efforts)

to i stock of governance experience and related competencies that would provide

advantages in a certain contracting situation. Hence we represent firm i as a capability

(for simplicity we only concentrate on firm-specific capabilities related to governance)

g g g
function such that Bi  fzi , zi , , zi , where zi is a random variable that
1 2 K

represents firm-specific capability in the particular incentive mechanism, gk , which is

in the available set of incentive mechanisms G, and create ex-ante incentives to invest

such that gk  G and k  1, , K. If the firm has a valuable capability in a

particular governance mechanism, such as monitoring, then the associated variable gk

will have a higher value when compared to the case where the firm has limited capability

in monitoring which would lead to a lower value for gk . Figure 1 illustrates the

relationship between incentive mechanisms and firm capabilities represented in Bi .

Of course, the level of complementarity of different incentive mechanisms depend

on the business context in which they are implemented. Corts and Singh (2004) show that

under different conditions repeated interactions and high-powered contracts can either be

substitutes or complements. Their results show that in the offshore drilling industry, oil

and gas companies' likelihood of choosing fixed-price contracts (high-powered) will

decrease with the increased frequency of interaction with a driller.

The interrelatedness between different incentive mechanisms of gk and gl (e.g.

repeated interactions, ability to effectively monitoring effort due to related expertise,

85
well-specified fixed-price contracting as in the case for oil and gas companies, etc.) is

reflected as follows:

Let gk  gl and gk , gl   G. We allow for the fact that these two capabilities

can be substitutes or complements such that Corrgk , gl   0 if gk and gl are

substitutes, and Corrgk , gl   0 if gk and gl are complementary.

c p
Let set A  a1 , , aN  represent the assets in place, where ai  ai , ai .

Firm's asset base has two main components: assets that are dedicated to the core business,

aci and assets that are peripheral to the core business and yet can be complementary and

p
of value only in combination with another firm's assets, ai (e.g. patents that are by-

products of R&D effort that is geared toward the core business---Xerox's Palo Alto

Research Center innovated in personal computing such as drop-down menus as well as

the core business of photocopying), which creates the economic motivation to contract in

the first place. It is also important to note that capabilities Bi are non-tradable (non-

contractible), whereas assets (i.e. resources) in place ai are.

At time, t  0 , relationship-specific investments in human-capital, x i  0, x i 

, where x i  0, are made. These investments need to be irreversible, sunk, and

nonverifiable vis-a-vis courts. Otherwise the contracting issue would be one of complete

contracting which makes the choice of governance mechanism irrelevant. As Baker, et al.

(2002) suggested, the traditional approach in Grossman and Hart (1990) is to assume that

the utilization level of an asset by its owner is enforceable ex post. Baker et al (2002)

modify the traditional approach and draw attention to the following intuitive caveat.

"...by imposing the following assumption: the right to determine the utilization of an asset
86
is inalienably attached to the asset's owner, and is, therefore non-contractible even ex

post." Two firms might contract to use their peripheral and complementary assets, (e.g.
p p
ai and aj ), jointly, but firm i although acts in accordance with the letter chooses to

violate the spirit by holding back the full effort which is non-verfiable and non-

contractible both ex ante and ex post. This assumption also eliminates the ex post

bargaining (except for the case where it is more feasible to see the asset to a third party).
p p
Moreover the coordinated use of ai and aj could either complement or compete with
c
the core activities (that utilize independently ai and aj ) of one or both firms.
c

As the level of initial investment increases the cost, Ci x i   0, also increases,

lim Ci ·  0

where Ci · is also strictly convex, and twice differentiable with x i0 and

lim Ci ·  

x ix i . All parties involved observe t  0 investment x i , hence the

information asymmetry is no the source of any inefficiency both ex ante and ex post. At

time, t  0 , parties can specify and (contractually commit to) a governance structure

B that specifies the subset of assets A  A controlled by the coalition (terminology

used to refer to the new entity that is formed by one or more existing firms) B  B . The

governance structure allows at most one coalition (if jointly owned, the control of the use

of the asset is assigned to the majority owner) to be in control of the asset.

It is also useful to note that the governance structure represents a system of

incentive mechanisms (Gibbons, 1998; Holmstrom and Milgrom, 1994). For instance,

Ichniowski, Shaw, and Prennushi (1997) showed that steel firms that used bundles of

incentive structures including flexible job assignment, teamwork, employment security,

87
skill training had higher productivity. This has been taken into account with the

specification of Bi as explained above.

At time, t  1 , firms for coalitions and trade to maximize firm-value (e.g.

surplus, Ricardian rents), V B, A  x  0 of coalition B with N firms if it

controls assets A and have made investments x  x 1 , , x N  at t  0 . Let V 

be twice differentiable and concave in x with V0, A  x  0, which ensures that

assets on their own do not generate value. Also, investments made by firm i will only

contribute to the value of the coalition V  if and only if that firm is part of the

VB,Ax
coalition. Hence, xi  Vi B, A  x  0 if firm i  B and Vi B, A  x  0 if

i  B. Additional investment by firm i increases marginal productivity of investments

p
by other firms in the coalition B , precisely because of the complementarity between ai
p
and aj where i  j and i, j  B. This argument translates into the following

condition: xj Vi B, A  x  0  i  j.

For any coalition B to exist it should be such that no other sub-group of firms

within that coalition B can create greater value by splitting up. This is in fact the

   
superadditivity condition of VB, A  x  V B , A  x  V B\B , A\A  x

B  B and A  A. This also implies that the combination of all firms to form grand

coalition B will have the maximum surplus. Obviously, this is not a realistic

assumption since merged firms more often than not experience negative side effects of

merging (e.g. value loss due to clashing organizational cultures of the acquirer and the

target). However this simplification is not expected to have a significant impact on the
88
model's implications.

We also add the following condition to eliminate overinvestment by any firm

i i   
within the coalition, B such that V B, A  x  V B , A  x B  B and

A  A. The implication is that the addition of new firms (and/or assets) into the

coalition will not decrease the marginal productivity of firm i . Consistent with the prior

discussion on superadditivity, the addition of new firm (and/or assets) to the coalition

increases the total value and the marginal productivity of firms within that coalition.

Firm i maximizes the expected return from date t  1 bargaining for given

governance structure  and given vector of investments x will be computed as the

firm's Shapley value46 and denoted by

Hi   x   pBVB, B  x  VB\i, B\i  x

BiB where

|B|1! I|B|!
pB  I! and |B| is the number of agents in coalition B . The Shapley value

is associated with the firm i 's average contribution (based on its assets and investment)

to a coalition given all possible combinations of firms in the set. The computation of the

Shapley value is such that firms i 's (marginal) contribution to a coalition B , weighted

by the probability pB that coalition B will form, summed over all coalitions where

46
Simple way of calculating Shapley value is as follows. Specify all the permutations in B. For each
permutation, B\i is the group of firm that firm i enters into. For each specified permutation, we
compute the net value of VB, B  x  VB\i, B\i  x. Then we multiply the net
1
value with the probability of permutation I! and sum over all permutation.

89
firm i is a part of.

As mentioned before, the maximum net value (surplus) for any given investment

level x , is created when the coalition encompasses all firms, B with all assets A ;

which is also equivalent to the first-best solution to the following maximization:

I
max Vx  Ci x i 
x
i1

The first order condition (FOC) of 1 for all i is as follows:

Vi B, A  x FB   Ci x iFB 

The intuition of the FOC is that it equates the marginal return (increase in total

surplus since they are positively correlated) to the marginal cost of firm i 's investment

of x FB (unique and maximum level of first-best investment level).

Since at t  0 , firms choose investment levels x i non-cooperatively with the

anticipation of Hi   x at t  1 , we expect that each firm underinvests when

compared to the first-best solution such that for any governance structure  , unique

 
Nash equilibrium is x i   x iFB for all firm i .

90
 
Proof: Assume that the investments by other firms, x iFB  under the

governance structure  are given. Firm i chooses x i to maximize the expected

profits i given below:

max i  Hi   x  Ci x i 
x

  pBVB, B  x  VB\i, B\i  x  Ci x i 

BiB

FOC is

Hi   x  
  pBVi B, B  x    Ci x i 
x i
BiB

Recall that the condition that the first best involved all the assets A utilized y the

grand coalition B that is formed by all the firms. Hence

Vi B, B  x    Vi B, A  x  . The implication is as follows:

 pBVi B, B  x     pBVi B, A  x  

BiB BiB

 Vi B, A  x  
Vx  

x i

91
 The intuition of the theorem is such that at Nash equilibrium, firm i's marginal

Hix 
return on investment x i is less than or equal to the efficient marginal return
Vx 
x i , which suggests that firm i underinvests.

The goal is to determine the optimal governance structure than minimizes this

inefficiency (or maximizes the second-best optimal incentives to invest).

4.4 A Real World Example

I will illustrate the implications of this model below with the following example

drawn from the pharmaceutical industry:47: ArQule-Pfizer versus Pharmacopeia and

Schering-Plough.

ArQule maps arrays of 200,000 compounds and provides exclusive access

projects to big pharma partners. The pharma firms pay upfront fees with potential for

downstream milestones and royalties. The subscription model works as long as the

premium value of a company's service or technology is clear. There are a number of

competitors to the firm, providing similar services.

Pfizer signs an agreement with ArQule, where ArQule will not only produce a

microarray library exclusively for Pfizer but will also will transfer the ability to make

such libraries to Pfizer over 4.5 years on nonexclusive basis. For ArQule, the amount of

47
Dorey, Emma. 1999. ArQule-Pfizer deal breaks mold. Nature Biotechnology, Vol. 17, SEPTEMBER, pp.
843-844. http://biotech.nature.com.

92
money Pfizer pays is guaranteed and is not dependent on the progress of particular hit,

leads or clinical candidate molecules.

In the state of capital markets means that even the most well-established

companies are losing faith in their ability to leverage investment on the basis of possible

milestone and royalty payments in the future. For ArQule the deal means that the

company can claim- for the time being at least- to be bucking the trend toward

commodisation in combinatorial chemistry.

The deal ArQule signed will transfer automated machinery, software, hardware

and dedicate 20 to 40 of its 200 staff to its Medford site to teach Pfizer how to produce

libraries. Bur after 4.5 years the resources will be reassigned to other ArQule business.

ArQule will receive an upfront fee, and will receive a fee every year half of it guaranteed.

The variable portion is dependent on ArQule putting in place a functioning system that

delivers agreed number of molecules.

One of ArQule's main rivals in combinatorial chemistry, Pharmacopeia has a

different structure in place. Pharmacopeia offers lead discovery services for upfront fees

and milestones, and optimization services paid for on a per person year on the project.

Pharmacopeia assigned a team of chemists and biologists to provide a range of discovery

services to Schering Plough. The deal differs from the ArQule/Pfizer deal in that rights to

compounds not developed by Schering revert back to Pharmacopeia, and there is the

potential for milestones and royalties on drugs developed by Schering-Plough based on

the work.

There are many competitors in commodisation of combinatorial chemistry

business. The major difference in their capabilities is whether the firms can differ in their

93
ability to deliver molecules to the client.

In essence, although combinatorial chemistry firms have been poor performers, as

far as their technologies are concerned on new product delivery, Pfizer is in a position to

benefit by choosing the central core upon which to build libraries, rather than having to

rely on ArQule's choices.

4.4.1 Who should own What?

Let firm B1 , be the parent firm that has two divisions ( i and j ), B1i and B1j
p c p
with the following assets A1i  a1i , a1i  and A1j  a1j , a1j  . In terms of each
c

division and the governance capabilities that each division has accumulated over time we
g1 g2 gK g g g
assume that B1i  fz1i , z1i , , z1i  and B1j  fz1j , z1j , , z1j . Let B2 be the
1 2 K

c p
target firm with the following assets A2  a2 , a2  .

There are four agents: B1 , B1i , B1j , and A2 . For example, B2 could be multi-

divisional firm like Pfizer, with two main businesses of Drug Research and Development

( B1i ) and Drug Manufacturing ( B1j ). The service is for B2 (e.g. ArQule) to provide

non-tradable (hence non-contractable), relationship-specific capability; such as teaching

Pfizer ( B2 ) the capability to build its own combinatorial chemistry library. The cost of

B2 's relationship investment x 2 (including the opportunity cost of giving up business

from other pharmaceutical firms due to limited capacity) is C2 x 2   0. The value of

this investment to B1 , Pfizer, or more specifically to the Drug Research and

Development division, B1i , is V1 B, A  x 2   C2 x 2  , such that it is higher than

94
the cost of the investment required to realize the expected value, making the investment

efficient.

In other words, at date t  0 , ArQule ( B2 ) can invest of x 2 , in providing

Pfizer ( B1 ) with the capability to make its own combinatorial chemistry library with

bearing the cost of C2 x 2   0 to create the value of V1 B, A  x 2   C2 x 2 .

Only Pfizer, or more specifically the Drug Research and Development division ( B1i ) of

Pfizer ( B1 ) values the service provided by ArQule that is relationship-specific so both

B1i and B2 are indispensable.

...so Who Should Own A2 ? Conversely, who should own the assets of ArQule?

4.4.2 Case 1: Agent B1 j (Manufacturing Division of Pfizer) owns target B2

's (ArQule's) assets

Let's consider the case where the division B1j is assigned ownership rights (or

control) over the assets of B2 . In the payoff Table  1 , each row represents the

marginal contributions of agents in the coalition represented by permutation in the same

row. Notice that agents can only enter coalitions from the right.

For instance for the first row, B1 by itself does not generate the expected value

of V1 , therefore the marginal contribution of B1 is 0 . Then B2 enter the coalition

and with or without B1 the coalition does not generate V1 as well. Therefore the

marginal contribution of B2 is again 0. Given this ownership structure, all agents are

required to generate the expected value since B1j owns the assets, B2 provides effort,

95
and B1i is the recipient that will benefit from B2 's effort and B1 will pay for B2 's

effort since it owns both B1j and B1j . The surplus will need to be divided among all
V 1 B,Ax2 
agents and each will end up receiving 4 . Hence B2 will provide effort if and
V 1 B,Ax2 
only if the gain is more than the cost of its investment; 4
 C2 x 2 .

If the parent firm, or one of its divisions have developed capabilities in

monitoring the same type of effort that B2 would be expected to provide it would create

additional incentive for B2 to provide effort and supplement the incentive mechanism

based on asset ownership. In that case, the surplus would be divided among B2 , B1i and

B1 or B1j depending on which one of the two provides the monitoring.

4.4.3 Case 2: Target B2 (ArQule) continues to own its assets

Let's now consider the case where the target B2 keeps its ownership rights (or

control) over the assets of B2 . In this case the marginal contribution of B2 positive and

for the expected to be realized B2 and B1 are required in the coalition and B1j and

B1i have no bargaining power with respect to B2 . Therefore the payoff to the agents

involved are as follows:

V 1 B,Ax2 
VB 2  2 for the target firm since it owns the assets and is required to

provide the effort;

V 1 B,Ax2 
VB 1  2 for the parent firm since the effort provided by B2 is valuable

to the parent firm;

96
 VB 1j  0 for the division because it is dispensable for both B1 and B2 at time

t  1 . Even if this division do not cooperate with the parent, it is replaceable for B1 ;

VB 1i  0 for the division that will be the eventual recipient of the effort

provided by B2 because it does not have the ability to veto the right to use the assets of

B2 at time t  1 . However, if this division does not cooperate, it can decrease the

parent's surplus effectively. Moreover, this result can be instructive in explaining the

performance differences between single business and multi-business firms. Therefore the

parent would be able to realize its surplus if that division shares in the parent's surplus.

4.5 Discussion

Transaction cost theory suggests that the efficiency of organizing transactions is

determined by a particular transaction's characteristics. Given the same transaction

characteristics, the theory would predict that two firms, faced with the choice to use

markets, hybrid governance forms (e.g. alliances), or acquisitions, would follow the same

strategy. This paper argues that two additional factors are also important: (i) Firm

characteristics can intervene to create heterogeneous transaction choices and

(ii)Underlying Asset characteristics intervene to create heterogenous transaction choices.

I demonstrate via a formal model that these factors critically effect the firm's system of

optimal incentive mechanisms required to realize its expected return from alternative

governance choices. More generally, governance structure is formalized as a system of

complementary and/or substitutable incentive mechanisms. First, I demonstrate that

alliances are not a `transitory state' on the road to equilibrium, but an optimal form of

organizing when a party who contributes the most to the residual income of the combined
97
entity, also has valuable, yet intangible resources (capabilities), in addition to tangible

assets. Second, given a particular ownership structure, parties can improve their payoffs

by devising and implementing supplementary incentive mechanisms such as monitoring

or profit sharing, thereby improving the second best solution to the contracting problem

described in the seminal paper by Grossman and Hart (1986) and Hart and Moore (1991).

Third, the model's implications for corporate strategy are as follows: The source of

heterogeneity in governance stems from the firm-specific ability to bundle these incentive

mechanisms appropriately. In other words, firms maximize the expected surplus

conditional on inducing agents efforts via the optimal bundle of incentive mechanisms--

namely, corporate strategy. Finally, the firm-specific ability to monitor (as an incentive

mechanism) plays an especially important role in the case of related acquisitions

precisely because it complements the ownership structure that would have misaligned

incentives.

There is a limit to the size of firms and growth through hierarchies (e.g. Coase,

1937; Penrose, 1959). One of the implications of this paper is that limits to firm growth is

endogenized since a portfolio of corporate strategies are bounded by the capabilities of

the firm which makes acquisitions in increasingly unrelated businesses less efficient.

Forming alliances in increasingly unrelated businesses also incorporates increasing

opportunity and agency costs due to increasing inefficiency. Moreover, the cost of

corporate control increases as the firm's level of diversification increases mainly because

the marginal rate of returns from the firm's resources such as managerial talent would be

decreasing while the effectiveness of incentive mechanism to curtail all agency costs

decreases

98
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114
 APPENDIX A

TABLES AND FIGURES

115
 Target firms with
Panel A: Tobin's q’ <=1 Panel B: Tobin's q’ >1
In the event year t = -1 In the event year t = -1
N=253 N=157
Event year -5 -4 -3 -2 -1 0 -5 -4 -3 -2 -1 0

Estimated R&D
expense as a percent 1.12 25.24 0.62 0.15 0.16 0.30 2.19 0.93 0.38 0.35 0.81 0.98
of Sales

Estimated R&D
expense as a percent 1.79 0.51 0.88 0.27 0.27 1.74 1.74 1.62 0.84 0.41 0.39 0.41
of Cost of Goods Sold

Estimated
advertisement expense 0.52 0.30 0.20 0.10 0.08 0.09 4.64 12.76 0.79 0.46 0.06 0.15
as a percent of Sales

Estimated
advertisement expense
3.45 0.53 0.26 0.13 0.17 0.22 25.56 0.69 1.11 0.67 0.17 0.25
as a percent of Cost of
Goods Sold

R&D capital as a
0.13 0.22 0.17 0.19 0.23 0.47 0.33 1.04 0.44 0.49 1.05 1.33
percent of Sales

R&D capital as a
percent of Cost of 0.21 0.29 0.37 0.39 0.39 1.40 0.70 0.46 0.85 0.53 0.51 0.55
Goods Sold

Advertisement capital
0.11 0.10 0.08 0.07 0.08 0.10 0.12 0.10 0.10 0.09 0.10 0.36
as a percent of Sales

Advertisement capital
as a percent of Cost of 0.20 0.16 0.17 0.17 0.19 0.26 0.25 0.24 0.27 0.24 0.25 0.47
Goods Sold

Tobin's q 1.21 0.90 0.85 0.77 0.66 0.80 2.13 1.87 2.15 2.15 2.26 2.47

4-Digit industry
0.03 0.05 0.08 0.08 0.17 0.05 0.02 0.04 0.05 0.04 0.00 0.02
adjusted Leverage

Intangibles as a
percent of Cost of 0.75 0.83 0.92 0.84 0.85 1.23 1.17 0.92 1.11 1.03 0.88 1.11
Goods Sold

Cash as a percent of
0.27 0.55 0.25 0.67 0.75 0.31 0.60 2.58 3.11 0.79 0.45 0.83
Sales

Panel A and B presents the mean values for each variable.

Table 1. Measures of Intangibility – Part 1

116
 Panel C: Wilcoxon Equality Test between Target firms with Tobin’s q’ <=1 (Panel A) and
Tobin’s q’ > 1 (Panel B) in the event year t = -1
H0: [Panel A]- [Panel B] =0

Event year -5 -4 -3 -2 -1 0

Estimated R&D expense as -1.369 -0.774 -0.727 -0.932 -0.617 -0.144

a percent of Sales (0.171) (0.439) (0.467) (0.351) (0.537) (0.886)

Estimated R&D expense as

-1.730 -1.025 -0.990 -0.987 -0.767 -0.074
a percent of Cost of Goods
(0.084)^ (0.306) (0.322) (0.324) (0.443) (0.941)
Sold

Estimated advertisement
-2.045 -0.605 -1.926 -1.306 -0.274 -0.830
expense as a percent of
(0.041)* (0.545) (0.054)^ (0.191) (0.784) (0.406)
Sales

Estimated advertisement
-1.866 -0.087 -1.783 -0.778 0.496 -0.148
expense as a percent of
(0.062)^ (0.931) (0.075)^ (0.437) (0.620) (0.882)
Cost of Goods Sold

R&D capital as a percent of -1.534 -1.439 -1.591 -1.167 -0.622 -0.592

Sales (0.125) (0.150) (0.112) (0.243) (0.534) (0.554)

R&D capital as a percent of -1.730 -1.025 -0.990 -0.987 -0.767 -0.074

Cost of Goods Sold (0.084)^ (0.306) (0.322) (0.324) (0.443) (0.941)

Advertisement capital as a -2.031 -1.956 -1.981 -0.817 -1.528 -0.879

percent of Sales (0.042)* (0.050)* (0.048)* (0.414) (0.127) (0.379)

Advertisement capital as a
-1.933 -0.975 -1.523 -0.278 -0.653 -0.050
percent of Cost of Goods
(0.053)^ (0.330) (0.128) (0.781) (0.514) (0.960)
Sold

Tobin's q’ (Chung-Pruitt -6.717 -7.920 -10.892 -13.047 -19.368 -12.026

approximation) (0.000) ^^ (0.000)^^ (0.000)^^ (0.000)^^ (0.000)^^ (0.000)^^

4-Digit industry adjusted 0.921 1.528 1.589 1.852 2.826 1.717

Leverage (0.357) (0.127) (0.112) (0.064)^ (0.005)** (0.086)^

Intangibles (advertisement
-3.025 -2.076 -1.817 -1.968 -2.000 -2.171
and R&D) as a percent of
(0.002)** (0.038)* (0.069)^ (0.049)* (0.046)* (0.030)*
Cost of Goods Sold
-3.156 -3.416 -4.240 -3.174 -4.087 -2.763
Cash as a percent of Sales
(0.002)** (0.001)*** (0.000)^^ (0.002)** (0.000)^^ (0.006)**

^^Significant at the p=0.0001 level. ***Significant at the p=0.001 level. **Significant at the p=0.01 level.
*Significant at the p=0.05 level. ^Significant at the p=0.1 level.

Table 2. Measures of Intangibility – Part 2

117
 Variable Name (Code)
Advertisement capital as a
percent of Sales (advstsls)
R&D capital as a percent of
Sales (rdstsls)
Plant, property, and equipment
as a percent of Sales (ppesales)
Plant, property, and equipment
as a percent of Total Assets
(ppeasset)
Market value of equity-$mil
(C)
Book value of equity-$mil
(bookvl)
Book-to-market ratio of equity
(btm)
Log of market value of equity
(lnmkt)
Tobin's q’
Dichotomy of High vs. Low
Tobin's q’ (q’rank)
Variable Description
Target's advertisement capital ($) over the past five-year period before
the announcement (depreciation rate is assumed to be 20%) is scaled by
the target's average net sales ($) over the past five-year period before the
announcement
Target's R&D capital ($) over the past five-year period before the
announcement (depreciation rate is assumed to be 20%) is scaled by the
target's average net sales ($) over the past five-year period before the
announcement
Target's book-value of Plant, Property, and Equipment ($) is scaled by
the net sales ($) for the last fiscal-year end before the announcement date
Target's book-value of Plant, Property, and Equipment ($) is scaled by
the book-value of total assets ($) for the last fiscal-year end before the
announcement date
Acquirer's monthly market value of equity ($) is calculated by
multiplying the common shares outstanding (#mil) and the stock price
per share, for the 60-month period after the announcement date
Acquirer's quarterly book-value of common equity ($) for the 15-
quarters (60-months) period after the announcement date. It is assumed
that the book-value of common equity stays constant during a given
quarter.
Acquirer's book value of common equity ($) is scaled by the market
value of common equity ($) for the 60-month period after the
announcement date.
Natural logarithm of C, used for scaling.
Modified Tobin's q is calculated based on Chung-Pruitt approximation
If Tobin's q’< 1 then q’rank =1, indicating target firms with low
intangible.
If Tobin's q’ > 1 then q’rank =2, indicating target firms with high
intangibles.
Table 3. Variable Descriptions
118
Firm Type Variable N Mean Std. Dev Minimum Maximum

Tobin's q’ (Chung-Pruitt approximation) 413 1.22 1.41 -0.49 13.07

Advertisement capital as a percent of Sales 413 0.01 0.03 -0.02 0.17

R&D capital as a percent of Sales 410 0.07 0.45 -0.01 8.43

Target
Plant, Property, and Equipment capital as a
162 0.67 0.92 0.01 5.16
percent of Sales

Plant, Property, and Equipment capital as a

162 0.41 0.24 0.01 1.32
percent of Total Assets

Book-to-market ratio of equity 24,699 1.46 13.43 0.00 385.62

Book value of equity ($mil) 24,780 1,503 3,359 0.00 42,832

Log of market value of equity 24,699 7.23 2.85 -1.98 16.24

Acquirer Buy-and-hold return 24,780 0.42 0.66 -0.67 5.82

Buy-and-hold abnormal return based on

24,780 -0.05 0.96 -6.24 24.62
size/book-to-market of equity portfolios

Buy-and-hold abnormal return based on

q’rank/size/book-to-market of equity 24,780 0.00 0.89 -6.66 24.34
portfolios*

Acquirer firm's variables are calculated monthly using Compustat/CRSP merged database maintained by Wharton
Research Database Services, for the entire 60-month period after the announcement date. Target firms' variables are
calculated annually using Compustat/CRSP merged database maintained by Wharton Research Database Services,
for the last fiscal year-end date before the announcement year.
*For a more conservative test, buy-and-hold abnormal returns are calculated by using reference portfolios that are
formed by a three-tier ranking in the order of target’s q’rank/size/book-to-market.

Table 4. Descriptive Statistics

119
 Target Firms

Variables 1 2 3 4 5

1. Tobin's q’ (Chung-Pruitt approximation) 1

2. Advertisement capital as a percent of Sales 0.570^^ 1

3. R&D capital as a percent of Sales 0.04 0.130** 1

4. Plant, Property, and Equipment capital as a percent

0.018 0.014 -0.032 1
of Sales
5. Plant, Property, and Equipment capital as a percent
-0.015 -0.017 -0.171* 0.101 1
of Total Assets

^^Significant at the p=0.0001 level. ***Significant at the p=0.001 level. **Significant at the p=0.01 level.
*Significant at the p=0.05 level

Table 5. Correlation Matrix for Target Variables

120
 Panel A

Acquirer’s Variables 1 2 3 4 5 6 7

1. Market value of Equity 1.000

2. Book-to-market ratio of equity -0.020** 1.000

3. Book value of equity 0.153^^ 0.209^^ 1.000

4. Log of market value of equity 0.400^^ -0.112^^ 0.376^^ 1.000

5. Buy-and-hold return 0.158^^ -0.040^^ 0.058^^ 0.245^^ 1.000

6. Buy-and-hold abnormal return based on

0.037^^ -0.005 0.010 0.034^^ 0.261^^ 1.000
size/book-to-market of equity portfolios

7. Buy-and-hold abnormal return based on

0.027^^ -0.005 -0.001 0.043^^ 0.000 0.819^^ 1.000
q’rank/size/book-to-market of equity portfolios

Panel B
Acquirer’s Variables
Target’s Variables
1 2 3 4 5 6 7

Tobin's q’ (Chung-Pruitt approximation) 0.038^^ -0.016* 0.033^^ 0.082^^ 0.013* -0.065^^ -0.042^^

Advertisement capital as a percent of Sales 0.088^^ 0.058^^ 0.175^^ 0.091^^ 0.01 0.050^^ -

R&D capital as a percent of Sales 0.012^ 0.009 -0.023*** -0.044^^ -0.013* -0.019** -

Plant, Property, and Equipment capital as a

-0.024* -0.020* 0.012 -0.034** -0.029** -0.030* -
percent of Sales
Plant, Property, and Equipment capital as a
-0.086^^ 0.000 0.030** -0.086^^ -0.037*** 0.031* -
percent of Total Assets

The target firm's variables are assumed to be constant during the 60-month period after the announcement.
^^ Significant at the p=0.0001 level. ***Significant at the p=0.001 level. **Significant at the p=0.01 level.
*Significant at the p=0.05 level. ^ Significant at the p=0.1 level.
N = Firm*Post-event months =24,780

Table 6. Correlation Matrix

121
 Event Year 1988 1989 1990 1991 All years

Number of post-event
months 60 60 60 60 60
Median Buy-and-Hold
abnormal returns for firms 0.018 0.021 -0.015 -0.046 -0.005
with Tobin’s q’ <=1

Median Buy-and-Hold
abnormal returns for firms -0.081 -0.121 -0.049 -0.135 -0.122
with Tobin’s q’ >1

Median Equality Test Name Median Equality Test-Statistic

Event Year 1988 1989 1990 1991 All years

Wilcoxon / Mann-Whitney 7.109^^ 9.067^^ 3.126** 3.315*** 7.041^^

Med. Chi-square 43.200^^ 83.333^^ 6.533* 4.800* 34.133^^

Adj. Med. Chi-square 40.833^^ 80.033^^ 5.633* 4.033* 32.033^^

Kruskal-Wallis 50.579^^ 82.259^^ 9.786** 11.003*** 49.613^^

Van der Waerden 48.222^^ 72.583^^ 11.402*** 11.106*** 47.643^^

^^Significant at the p=0.0001 level. ***Significant at the p=0.001 level. **Significant at the
p=0.01 level. *Significant at the p=0.05 level.

Table 7. Test of Median Equality for the 60-Month Average Buy-and-Hold Abnormal Returns

122
 Panel A: Target firms with Tobin's q’ <=1 Panel B: Target firms with Tobin's q’ >1
N=253 N=157

All All
Event Year 1988 1989 1990 1991 1988 1989 1990 1991
Years Years
Mean
0.040^^ 0.016*** 0.032** -0.060^^ 0.001 -0.097^^ -0.066^^ -0.031^^ -0.118^^ -0.071^^
(H0: Mean=0)

Median 0.024 0.013 0.041 -0.060 0.002 -0.091 -0.060 -0.034 -0.140 -0.085

Maximum 0.102 0.067 0.130 -0.001 0.023 -0.001 0.014 0.019 0.006 0.004

Minimum -0.016 -0.022 -0.074 -0.121 -0.032 -0.250 -0.183 -0.083 -0.307 -0.176

Std. Dev. 0.033 0.022 0.056 0.033 0.014 0.078 0.052 0.027 0.089 0.059

Skewness 0.515 0.515 -0.130 -0.239 -0.578 -0.665 -0.600 0.080 -0.397 -0.229

Kurtosis 1.850 2.889 1.919 2.477 2.613 2.229 2.699 1.908 2.197 1.693
Jarque-Bera t-
statistic
3.577 1.611 1.854 0.753 2.226 3.546 2.295 1.827 1.914 2.880
(H0: Normal
Dist.)

Probability 0.167 0.447 0.396 0.686 0.329 0.170 0.317 0.401 0.384 0.237

Number of
post-event 36 36 36 36 36 36 36 36 36 36
months

^^Significant at the p=0.0001 level. ***Significant at the p=0.001 level. **Significant at the p=0.01 level.
For the pooled sub-sample of firms with Tobin’s q’ <=1, the mean is 0.001, and we fail to reject H0: Mean=0 (t-
statistic = 0.31 and p-value = 0.76).
For the pooled sub-sample of firms with Tobin’s q’ >1, the mean is –0.071, and we reject H0: Mean=0 (t-statistic
= -7.25 and p-value = 0.0001).

Table 8. Descriptive Statistics for the Average Monthly Buy-and-Hold Abnormal Returns [BHAR jt ]

123
 CARs to acquirers of highly tangible targets (Tq1)
CARs to acquirers of highly intangible targets (Tq2)
CARs to highly tangible targets
0.35
CARs to highly intangible targets
Combined CARs (Tq1)
0.3 Combined CARs (Tq2)

0.25
Cumulative Abnormal Re turn (CAR)

0.2

0.15

0.1

0.05

0
-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100 110 120 130

-0.05

-0.1

-0.15 Event Days, t={-42,..,0,..,+126}

Runup window: t={-42,…,-1}
Markup window: t={0,…,126}

Figure 1. Cumulative Abnormal Returns Around the Announcement Day, t=0

124
 0.2

Post-merger Average
Average Abnorm al Return

0.1
Buy-and-Hold Monthly
Abnormal Returns for
0
bidders of Targets
1 10 19 28 37 46 55 w ith Low Intangibles
-0.1
Post-merger Average
Buy-and-Hold Monthly
-0.2
Abnormal Returns for
bidders of Targets
-0.3 w ith High Intangibles

-0.4
Post-Merger Month

Figure 2. Average Monthly Abnormal Returns to the Acquirers with announcement year of 1988

125
 0.2

0.1
Post-merger Average
Average Abnorm al Return

Buy-and-Hold Monthly
0 Abnormal Returns for
1 10 19 28 37 46 55 bidders of Targets
-0.1 w ith Low Intangibles

-0.2 Post-merger Average

Buy-and-Hold Monthly
-0.3 Abnormal Returns for
bidders of Targets
-0.4 w ith High Intangibles

-0.5
Post-Merger Month

Figure 3. Average Monthly Abnormal Returns to the Acquirers with announcement year of 1989

126
 0.15
0.1

Average Abnorm al Returns

Post-merger Average
0.05 Buy-and-Hold Monthly
Abnormal Returns for
0
bidders of Targets
-0.05 1 11 21 31 41 51 w ith Low Intangibles
-0.1 Post-merger Average
Buy-and-Hold Monthly
-0.15
Abnormal Returns for
-0.2 bidders of Targets
w ith High Intangibles
-0.25
-0.3
Post-Merger Month

Figure 4. Average Monthly Abnormal Returns to the Acquirers with announcement year of 1990

127
 0.4
Post-merger
0.3 Average Buy-and-

Average Abnorm al Return

0.2 Hold Monthly
Abnormal Returns
0.1 for bidders of
Targets with Low
0
Post-merger
-0.1 1 10 19 28 37 46 55
Average Buy-and-
Hold Monthly
-0.2
Abnormal Returns
-0.3 for bidders of
Targets with High
-0.4
Post-Merger Month

Figure 5. Average Monthly Abnormal Returns to the Acquirers with announcement year of 1991

128
 0.05

Average Abnorm al Returns

0 Post-merger Average
Buy-and-Hold Monthly
1 11 21 31 41 51
Abnormal Returns for
-0.05
bidders of Targets
w ith Low Intangibles
-0.1
Post-merger Average
Buy-and-Hold Monthly
-0.15
Abnormal Returns for
bidders of Targets
-0.2 w ith High Intangibles

-0.25
Post-Merger Month

Figure 6. Average Monthly Abnormal Returns to the Pooled Acquirers with announcement years in 1988-1991

129
 Panel A. IPOed firms over 1988-1999
Total #
Total IPOed firms that did M&As Qualified IPOs
IPO of IPOs Average # of Alliances for Average # of M&As for
and Alliances and merged to (no pre-IPO
Year from Qualified IPOs Qualified IPOs
COMPUSTAT/CRSP deals)
SDC
1988 192 60 60 2.75 4.14
1989 140 64 64 3.43 4.11
1990 130 54 54 4.53 5.07
1991 220 121 121 7.38 5.70
1992 345 190 187 3.85 5.97
1993 453 243 239 3.52 5.49
1994 347 215 209 2.99 6.70
1995 300 185 181 4.14 5.14
1996 485 300 290 3.03 6.46
1997 366 230 224 2.08 9.32
1998 234 137 128 2.76 7.20
1999 383 220 192 1.85 2.62
Total 3595 2019 1949 3.53 6.15
Panel B. Number of deals per 1-Digit SIC Industry Category
Agricul
Transport Finance,
ture,
IPO ation & Constru Insurance Retail Minin Servic Wholesa Unmatch
Forestr Manufacturing Total
Year Public ction , & Real Trade g es le Trade ed
y, &
Utilities Estate
Fishing
1988 0 33 0 81 86 6 0 76 15 0 297
1989 0 13 0 42 190 0 4 55 10 0 314
1990 0 34 5 65 102 39 13 55 10 0 323
1991 0 50 4 72 465 46 5 300 33 0 975
1992 0 205 25 106 492 41 19 305 69 0 1262
1993 0 32 20 326 505 95 37 361 39 0 1415
1994 2 78 9 384 376 46 40 306 38 0 1279
1995 1 33 0 104 273 22 31 448 126 2 1040
1996 0 229 43 175 435 64 22 559 43 0 1570
1997 11 96 32 238 206 56 12 508 103 5 1267
1998 11 58 34 62 71 27 0 302 21 0 586
1999 0 30 3 29 24 18 0 243 6 0 353
1068
Total 25 891 175 1684 3225 460 183 3518 513 7
1

Table 9. Sample Descriptio

130
 Panel A. Number of Alliance Deals Deals in Post-IPO Subsequent years

Announcement Year of the Alliance Deal

Issue Year of the
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Total
IPO
1988 1 0 2 15 16 6 5 6 3 1 3 5 63

1989 0 0 12 9 15 15 8 8 4 11 7 8 97

1990 0 0 5 18 9 6 15 3 5 3 6 5 75

1991 0 0 0 38 84 72 48 58 34 47 59 47 487

1992 0 0 0 0 32 76 50 49 29 35 26 30 327

1993 0 0 0 0 0 58 89 70 47 54 48 36 402

1994 0 0 0 0 0 0 32 62 39 57 42 33 265

1995 0 0 0 0 0 0 0 43 85 93 54 51 326

1996 0 0 0 0 0 0 0 0 58 139 138 162 497

1997 0 0 0 0 0 0 0 0 0 29 101 110 240

1998 0 0 0 0 0 0 0 0 0 0 28 104 132

1999 0 0 0 0 0 0 0 0 0 0 0 196 196

Total 1 0 19 80 156 233 247 299 304 469 512 787 3107

Table 10. Number of Alliance for each IPO year

131
 Panel B. Number of M&A Deals in Post-IPO Subsequent years

Announcement Year of the M&A deal

Issue Year of the IPO 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Total

1988 6 33 33 28 34 18 11 20 10 13 16 12 234

1989 0 11 33 25 23 22 17 23 18 12 17 16 217

1990 0 0 33 51 35 25 19 19 17 13 21 15 248

1991 0 0 0 30 84 79 72 51 42 49 44 37 488

1992 0 0 0 0 88 156 148 121 134 112 96 80 935

1993 0 0 0 0 0 66 219 141 148 159 161 119 1013

1994 0 0 0 0 0 0 108 195 203 186 233 89 1014

1995 0 0 0 0 0 0 0 67 210 173 193 71 714

1996 0 0 0 0 0 0 0 0 161 423 322 167 1073

1997 0 0 0 0 0 0 0 0 0 217 549 261 1027

1998 0 0 0 0 0 0 0 0 0 0 210 244 454

1999 0 0 0 0 0 0 0 0 0 0 0 157 157

Total 6 44 99 134 264 366 366 594 637 943 1357 1268 7574

Table 11. Number of M&A for each IPO year

132
 Panel A. Percent of firms that got delisted due to mergers or liquidation for each year following the IPO event

Number of years following the IPO event

Issue Year Qualified IPOs (no
of the IPO pre-IPO deals)
0 1 2 3 4 5 6 7 8 9 10 11 All years

1988 60 0.00 0.00 0.00 1.67 6.67 0.00 0.00 0.00 0.00 0.00 1.67 10.00 20.00
1989 64 0.00 0.00 0.00 0.00 0.00 0.00 4.69 0.00 0.00 0.00 0.00 0.00 4.69
1990 54 0.00 1.85 0.00 0.00 3.70 0.00 0.00 9.26 5.56 0.00 0.00 0.00 20.37
1991 121 0.00 0.00 0.00 4.96 2.48 0.83 0.00 4.13 5.79 3.31 0.00 1.65 23.14
1992 187 0.00 0.00 0.00 1.60 0.00 0.53 0.00 0.00 3.21 0.53 2.14 4.81 12.83
1993 239 0.00 0.00 0.00 0.00 1.67 0.42 0.84 1.67 0.00 5.44 4.60 0.00 14.64
1994 209 0.00 0.00 0.00 3.35 2.87 1.91 1.91 1.44 0.48 2.39 0.00 0.00 14.35
1995 181 0.00 0.00 0.55 1.66 1.10 3.31 0.00 2.21 0.55 0.00 0.00 0.00 9.39
1996 290 0.00 0.00 0.69 1.72 4.83 1.03 1.03 2.07 0.00 0.00 0.00 0.00 11.38
1997 224 0.00 0.00 0.00 0.89 4.02 0.45 1.79 0.00 0.00 0.00 0.00 0.00 7.14
1998 128 0.00 0.00 3.13 6.25 4.69 2.34 0.00 0.00 0.00 0.00 0.00 0.00 16.41
1999 192 0.00 0.00 0.00 0.52 0.52 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1.04
All years 1949 0.00 0.05 0.36 1.85 2.62 1.03 0.82 1.39 0.92 1.18 0.82 0.87 11.90

Table 12. Mortality Rates of Firms and Deal Frequency

133
 Panel B. Average number of M&A deals per firm for each year following the IPO event
Number of years following the IPO event
Issue Year of the IPO
0 1 2 3 4 5 6 7 8 9 10 11 All years
1988 1.33 1.61 6.03 2.64 3.53 2.22 1.55 2.50 1.60 1.77 1.50 1.33 2.74
1989 1.91 1.55 2.12 1.35 1.82 1.59 2.48 1.33 1.67 1.59 1.75 . 1.75
1990 1.76 4.10 3.29 2.20 3.21 2.37 2.06 2.69 3.95 1.93 . . 2.92
1991 2.73 2.26 2.95 2.72 2.10 2.38 4.84 3.41 2.84 . . . 2.87
1992 3.98 4.81 3.70 3.51 5.39 4.66 4.48 2.65 . . . . 4.23
1993 2.80 4.95 2.48 3.65 2.94 3.96 4.08 . . . . . 3.70
1994 3.68 3.81 4.51 4.74 6.84 2.44 . . . . . . 4.68
1995 3.76 5.68 7.36 7.47 2.07 . . . . . . . 6.03
1996 3.99 7.61 5.33 3.40 . . . . . . . . 5.73
1997 5.12 10.12 5.06 . . . . . . . . . 7.78
1998 7.98 7.79 . . . . . . . . . . 7.87
1999 3.20 . . . . . . . . . . . 3.20
All years 4.58 6.80 4.73 4.37 4.50 3.47 4.00 2.69 2.80 1.76 1.63 1.33 5.03

Continued

Table 13. Average number of M&A deals per firm for each year following the IPO event

134
Table 13 continued

Panel C. Average number of Alliance deals per firm for each year following the IPO event
Issue Year of the Number of years following the IPO event
IPO 0 1 2 3 4 5 6 7 8 9 10 11 All years
1988 1.00 . 1.00 2.87 3.38 1.33 3.40 1.00 1.67 1.00 1.00 1.40 2.33
1989 . 2.17 1.44 1.67 2.60 1.75 2.75 1.50 2.27 2.71 1.25 . 2.05
1990 1.40 3.33 2.11 1.00 3.93 1.00 1.40 1.00 2.33 2.20 . . 2.52
1991 2.68 2.88 2.58 3.04 5.07 2.65 6.15 17.10 9.13 . . . 5.72
1992 1.94 1.76 1.88 1.94 1.83 2.54 1.08 2.67 . . . . 1.94
1993 3.17 2.51 2.03 2.02 2.15 2.38 1.72 . . . . . 2.33
1994 1.88 2.42 1.82 2.23 1.52 2.58 . . . . . . 2.10
1995 4.51 13.14 10.42 5.48 3.04 . . . . . . . 8.38
1996 3.47 3.29 7.26 9.58 . . . . . . . . 6.46
1997 1.79 2.56 4.36 . . . . . . . . . 3.30
1998 1.93 3.83 . . . . . . . . . . 3.42
1999 4.18 . . . . . . . . . . . 4.18
All years 3.34 3.98 5.03 5.26 2.98 2.41 3.35 10.82 7.06 2.38 1.18 1.40 4.33
Panel D. Average number of deals per firm for each year following the IPO event
Issue Year of the Number of years following the IPO event
IPO 0 1 2 3 4 5 6 7 8 9 10 11 All years
1988 1.29 1.61 5.74 3.19 4.20 2.00 2.13 2.38 1.62 1.71 1.53 1.59 2.88
1989 1.91 1.71 2.00 1.89 2.84 2.04 2.61 1.64 2.22 2.00 2.25 . 2.11
1990 1.92 5.09 3.95 2.10 4.18 2.18 2.91 2.38 3.81 2.20 . . 3.41
1991 2.93 3.05 3.30 3.27 3.79 3.03 6.02 12.71 6.60 . . . 4.81
1992 3.65 4.24 3.65 3.36 4.93 4.61 4.00 3.07 . . . . 3.98
1993 3.13 4.59 2.56 3.51 3.18 4.25 3.70 . . . . . 3.65
1994 3.41 3.87 4.32 4.51 6.61 2.72 . . . . . . 4.51
1995 4.61 8.93 9.51 8.26 3.54 . . . . . . . 7.83
1996 4.22 7.19 7.16 9.01 . . . . . . . . 7.15
1997 4.98 9.52 5.93 . . . . . . . . . 7.59
1998 7.46 8.11 . . . . . . . . . . 7.84
1999 4.89 . . . . . . . . . . . 4.89
All years 4.64 6.77 5.60 5.67 4.59 3.64 4.11 6.44 4.96 2.00 1.93 1.59 5.48

135
 Panel A. Average CARs for each consecutive deal after IPO
Issue Year of the IPO
1st 2nd 3rd 4th 5th 6-10th 11-30th 31-60th 61-127th All years
1988 -0.176*** -0.119* -0.146** -0.097 -0.209** -0.005 -0.027 0.047 . -0.098
59 40 36 28 20 58 55 1 0 297
1989 -0.244** -0.088* -0.136** -0.032 -0.056 -0.143*** -0.150** . . -0.134
60 44 38 34 30 69 38 0 0 313
1990 -0.459*** -0.259*** -0.017 0.037* -0.040 0.003 -0.002 0.061* . -0.101
50 38 34 24 23 75 66 13 0 323
1991 -0.251*** -0.1718*** -0.139*** -0.084* -0.052 -0.034** -0.027* 0.016 0.077*** -0.074
98 94 83 67 64 231 238 64 36 975
1992 -0.258*** -0.159*** -0.128*** -0.091*** -0.063** -0.055*** -0.055***' -0.041*** . -0.104
162 139 123 107 93 302 252 57 0 1235
1993 -0.264*** -0.138*** -0.127*** -0.107*** -0.069** -0.043*** -0.015* -0.007 . -0.097
196 172 151 129 109 354 251 32 0 1394
1994 -0.333*** -0.219*** -0.090*** -0.085** -0.037 -0.055*** -0.007 -0.026** . -0.107
182 152 128 106 87 292 301 27 0 1275
1995 -0.364*** -0.269*** -0.141*** -0.133*** -0.110** -0.057** -0.077*** -0.030 0.019 -0.143
143 120 97 86 68 180 188 73 45 1000
1996 -0.345*** -0.228*** -0.171*** -0.109*** -0.114*** -0.054*** -0.040*** -0.057*** -0.011 -0.134
224 182 154 129 105 314 324 69 34 1535
1997 -0.496*** -0.356*** -0.277*** -0.225*** -0.219*** -0.237*** -0.120*** -0.011 . -0.249
177 148 132 98 73 231 347 45 0 1251
1998 -0.504*** -0.432*** -0.394*** -0.443*** -0.545*** -0.312*** -0.150*** -0.221** . -0.352
89 76 52 41 38 140 121 20 0 577
1999 -0.898*** -0.868*** -0.713*** -0.792*** -0.700*** -0.668*** -0.879*** . . -0.805
88 75 57 41 24 44 19 0 0 348
All years -0.371 -0.264 -0.191 -0.156 -0.136 -0.097 -0.062 -0.031 0.029 -0.163
1528 1280 1085 890 734 2290 2200 401 115 10523

Table 14. Descriptive Statistics for CARs per deal over -5,…,+5 days around the deal announcements

136
 Panel B. Average CARs for each subsequent M&A deal after IPO
Issue Year of the IPO
1st 2nd 3rd 4th 5th 6-10th 11-30th 31-60th 61-127th All years
1988 -0.175 -0.116 -0.134 -0.071 -0.153 -0.010 -0.032 . . -0.099
55 34 31 22 14 37 41 0 0 234

1989 -0.223 -0.099 -0.106 -0.058 -0.154 -0.048 -0.019 . . -0.120

55 41 31 23 19 41 6 0 0 216

1990 -0.458 -0.224 -0.014 0.033 -0.051 0.022 -0.017 . . -0.120

48 35 29 20 19 59 38 0 0 248

1991 -0.204 -0.135 -0.076 -0.008 0.033 0.003 0.014 0.012 . -0.061
83 78 62 44 39 105 74 3 0 488

1992 -0.284 -0.169 -0.123 -0.078 -0.050 -0.059 -0.039 -0.041 . -0.112
149 114 98 82 63 196 161 56 0 919

1993 -0.251 -0.107 -0.095 -0.054 -0.029 0.001 -0.025 -0.007 . -0.083
183 142 114 87 68 207 164 29 0 994

1994 -0.325 -0.216 -0.072 -0.028 -0.020 -0.031 -0.014 -0.022 . -0.100
161 125 104 79 69 214 238 23 0 1013

1995 -0.374 -0.278 -0.132 -0.099 -0.076 -0.024 -0.020 -0.028 -0.098 -0.147
131 96 78 60 46 115 124 43 2 695

1996 -0.353 -0.230 -0.145 -0.087 -0.039 -0.053 -0.029 -0.157 . -0.144
195 147 121 94 75 205 192 26 0 1055

1997 -0.530 -0.394 -0.307 -0.234 -0.233 -0.258 -0.147 -0.016 . -0.280
159 127 108 78 56 182 269 40 0 1019

1998 -0.571 -0.538 -0.482 -0.453 -0.520 -0.355 -0.105 -0.307 . -0.390
76 57 42 32 28 105 95 15 0 450

1999 -0.888 -0.809 -0.854 -0.849 -0.523 -0.517 -1.000 . . -0.815

64 36 21 14 11 9 1 0 0 156

All years -0.371 -0.250 -0.169 -0.118 -0.101 -0.082 -0.052 -0.058 -0.098 -0.165
1359 1032 839 635 507 1475 1403 235 2 7487

Table 15. Descriptive Statistics for CARs per M&A deal over -5,…,+5 days around the deal
announcements

137
 Panel C. Average CARs for each subsequent Alliance deals after IPO
Issue Year of the
IPO 61- All
1st 2nd 3rd 4th 5th 6-10th 11-30th 31-60th
127th years
1988 -0.197 -0.136 -0.222 -0.189 -0.341 0.005 -0.012 0.047 . -0.094
4 6 5 6 6 21 14 1 0 63
1989 -0.469 0.063 -0.266 0.021 0.112 -0.283 -0.175 . . -0.166
5 3 7 11 11 28 32 0 0 97
1990 -0.501 -0.665 -0.039 0.054 0.013 -0.071 0.018 0.061 . -0.037
2 3 5 4 4 16 28 13 0 75
1991 -0.509 -0.354 -0.328 -0.230 -0.186 -0.065 -0.046 0.016 0.077 -0.086
15 16 21 23 25 126 164 61 36 487
1992 0.038 -0.116 -0.148 -0.133 -0.090 -0.048 -0.083 -0.028 . -0.079
13 25 25 25 30 106 91 1 0 316
1993 -0.438 -0.287 -0.226 -0.216 -0.136 -0.106 0.004 0.001 . -0.132
13 30 37 42 41 147 87 3 0 400
1994 -0.400 -0.231 -0.168 -0.250 -0.101 -0.121 0.017 -0.048 . -0.137
21 27 24 27 18 78 63 4 0 262
1995 -0.244 -0.235 -0.177 -0.211 -0.181 -0.116 -0.187 -0.034 0.025 -0.134
12 24 19 26 22 65 64 30 43 305
1996 -0.290 -0.216 -0.269 -0.166 -0.301 -0.057 -0.055 0.003 -0.011 -0.111
29 35 33 35 30 109 132 43 34 480
1997 -0.196 -0.124 -0.140 -0.188 -0.175 -0.162 -0.028 0.029 . -0.113
18 21 24 20 17 49 78 5 0 232
1998 -0.108 -0.113 -0.024 -0.406 -0.614 -0.184 -0.313 0.040 . -0.220
13 19 10 9 10 35 26 5 0 127
1999 -0.925 -0.922 -0.630 -0.763 -0.849 -0.706 -0.872 . . -0.796
24 39 36 27 13 35 18 0 0 192
All years -0.378 -0.322 -0.263 -0.253 -0.214 -0.123 -0.081 0.006 0.031 -0.159
169 248 246 255 227 815 797 166 113 3036

Table 16. Descriptive Statistics for CARs per Alliance deal over -5,…,+5 days around the deal
announcements

138
 Panel A. Average CARs per deal for each year following the IPO event
Issue Year of the Number of years following the IPO event
IPO 0 1 2 3 4 5 6 7 8 9 10 11 All years
1988 -0.41-0.18-0.04 0.03 -0.03-0.11-0.06-0.20-0.08-0.12-0.16-0.24 -0.10
1989 -0.66-0.22-0.02-0.04-0.28-0.20-0.09-0.08-0.04-0.12 0.03 . -0.13
1990 -0.73-0.04 0.00 0.03 -0.01-0.03-0.07-0.07 0.05 -0.01 . . -0.10
1991 -0.76-0.16 0.00 0.02 0.01 0.01 -0.01 0.01 0.02 . . . -0.07
1992 -0.66-0.14 0.01 -0.01-0.02 0.00 -0.05-0.09 . . . . -0.10
1993 -0.77-0.11 0.00 0.02 -0.01-0.02-0.04 . . . . . -0.10
1994 -0.71-0.12 0.01 0.01 -0.03-0.04 . . . . . . -0.11
1995 -0.79-0.19-0.01-0.01 0.03 . . . . . . . -0.14
1996 -0.70-0.12 0.01 0.01 . . . . . . . . -0.13
1997 -0.78-0.19 0.00 . . . . . . . . . -0.25
1998 -0.76-0.07 . . . . . . . . . . -0.35
1999 -0.80 . . . . . . . . . . . -0.80
All years -0.75-0.14 0.00 0.01 -0.02-0.03-0.04-0.06 0.01 -0.08-0.05-0.24 -0.16
Panel B. Average CARs per M&A deal for each year following the IPO event
Issue Year of the Number of years following the IPO event
IPO 0 1 2 3 4 5 6 7 8 9 10 11 All years
1988 -0.05 . 0.10 0.03 -0.06-0.04 0.10 -0.22 0.01 -1.00-0.21-0.57 -0.09
1989 . -0.33-0.16 0.02 -0.40-0.55-0.38 0.06 0.07 0.02 0.16 . -0.17
1990 -0.41-0.06-0.05 0.17 -0.01 0.10 -0.04 0.03 0.08 -0.14 . . -0.04
1991 -0.76-0.19-0.03 0.02 0.02 -0.01-0.04 0.02 0.09 . . . -0.09
1992 -0.57-0.08 0.05 0.03 0.03 0.02 -0.09-0.16 . . . . -0.08
1993 -0.78-0.07 0.02 0.03 -0.05-0.02-0.02 . . . . . -0.13
1994 -0.72-0.15-0.02 0.03 -0.05-0.09 . . . . . . -0.14
1995 -0.72-0.17 0.01 0.01 0.06 . . . . . . . -0.13
1996 -0.74-0.16 0.01 0.02 . . . . . . . . -0.11
1997 -0.65-0.11 0.02 . . . . . . . . . -0.11
1998 -0.72-0.09 . . . . . . . . . . -0.22
1999 -0.80 . . . . . . . . . . . -0.80
All years -0.74-0.13 0.01 0.03 -0.03-0.05-0.06-0.04 0.08 -0.12 0.06 -0.57 -0.16
Panel C. Average CARs per Alliance deal for each year following the IPO event
Issue Year of the Number of years following the IPO event
IPO 0 1 2 3 4 5 6 7 8 9 10 11 All years
1988 -0.47-0.18-0.05 0.03 -0.02-0.14-0.13-0.19-0.10-0.05-0.15-0.11 -0.10
1989 -0.66-0.18 0.03 -0.08-0.20-0.04 0.01 -0.11-0.14-0.17-0.04 . -0.12
1990 -0.78-0.04 0.01 0.00 -0.01-0.05-0.08-0.09 0.04 0.03 . . -0.12
1991 -0.76-0.12 0.04 0.02 0.00 0.02 0.02 -0.02-0.06 . . . -0.06
1992 -0.69-0.17 0.00 -0.02-0.03 0.00 -0.05-0.07 . . . . -0.11
1993 -0.77-0.13-0.01 0.01 0.00 -0.02-0.04 . . . . . -0.08
1994 -0.70-0.11 0.02 0.00 -0.03-0.02 . . . . . . -0.10
1995 -0.84-0.20-0.02-0.01 0.01 . . . . . . . -0.15
1996 -0.69-0.11 0.01 -0.01 . . . . . . . . -0.14
1997 -0.80-0.21-0.01 . . . . . . . . . -0.28
1998 -0.76-0.07 . . . . . . . . . . -0.39
1999 -0.82 . . . . . . . . . . . -0.82
All years -0.76-0.14 0.00 0.00 -0.02-0.02-0.04-0.08-0.05-0.07-0.10-0.11 -0.17

Table 17. Descriptive Statistics for CARs-5,…,+5 following the IPO year

139
 Panel A. Logit Analysis for Choice of Alliance Deala
Pooled 2nd 3rd 10th After the
4th deals 5th deals 6th deals 7th deals 8th deals 9th deals
Sample deals deals deals 10th deal
Lagged alliance experience as a %
2.083*** 9.695*** 2.164*** 1.008*** 1.201*** 1.850*** 1.653*** 2.002*** 2.443*** 2.084*** 2.323***
of lagged total experienceb
-0.265 -2.449 -0.378 -0.38 -0.425 -0.463 -0.487 -0.58 -0.635 -0.664 -0.457
Agriculture, Forestry, & Fishing 1.804
-1.979
Construction 1.172 0.368 -0.086 0.899 1.486 -0.214 0.355
-0.844 -1.717 -1.159 -1.302 -1.515 -1.236 -1.462
Finance, Insurance, & Real Estate 0.204 -1.621 -1.288 -0.208 0.221 -0.834 -0.884 -0.924 -0.191 -1.204 -1.232*
-0.579 -1.005 -0.86 -0.95 -1.28 -0.702 -0.724 -0.971 -1.058 -1.058 -0.707
Manufacturing 2.949*** 2.124*** 1.850*** 2.380*** 2.994*** 1.415*** 0.949** 1.279** 1.463** 1.512** 1.776***
-0.456 -0.709 -0.624 -0.785 -1.092 -0.417 -0.432 -0.515 -0.704 -0.614 -0.418
Mining 1.192 0.726 1.851 2.088 1.598 -0.187
-0.784 -1.439 -1.746 -1.277 -1.443 -0.979
Retail Trade 1.714*** 0.616 0.449 1.729* 0.023
-0.585 -0.891 -0.887 -0.931 -1.465
Services 2.207*** 1.087 0.855 1.398* 2.236** 0.585 0.007 0.512 1.545** 0.919 0.960**
-0.476 -0.717 -0.622 -0.792 -1.096 -0.421 -0.444 -0.535 -0.725 -0.64 -0.44
Transportation & Public Utilities 1.671*** 0.144 0.586 0.385 1.684
-0.532 -0.96 -0.77 -0.928 -1.16
1990 -1.766*
-1.045
1991 1.283 0.182
-0.905 -0.746
1992 1.119 -0.954 -0.585 0.979 1.01 1.094 0.609 2.147** -0.997
-0.889 -0.895 -0.674 -0.618 -0.626 -0.997 -0.946 -1.095 -1.701
1993 1.411 -0.102 -0.292 0.68 0.706 0.878 0.419 0.119 -0.283 0.272
-0.885 -0.922 -0.673 -0.626 -0.658 -1.012 -0.911 -0.867 -1.415 -0.484
1994 1.223 -1.174 -0.475 -0.096 1.324* 1.122 0.324 0.269 1.026 -0.179 0.025
-0.888 -0.905 -0.669 -0.55 -0.719 -1.007 -0.909 -0.8 -1.021 -1.396 -0.511
1995 1.476* -0.987 -0.001 -0.179 0.834 1.383 -0.156 0.331 2.001* 0.13 0.392
-0.876 -0.925 -0.656 -0.542 -0.61 -0.939 -0.938 -0.735 -1.035 -1.426 -0.482
1996 1.083 -1.06 -1.011 -0.233 0.169 1.41 0.081 -0.122 1.389 -0.959 0.029
-0.891 -0.912 -0.642 -0.552 -0.599 -0.945 -0.905 -0.748 -1 -1.363 -0.537
1997 1.548* -0.81 -0.192 0.661 0.571 1.253 -0.102 0.437 1.394 0.785 0.355
-0.877 -0.907 -0.635 -0.546 -0.576 -0.93 -0.832 -0.717 -0.882 -1.387 -0.445
1998 1.407 -0.719 -0.9 -0.479 0.291 1.189 0.239 -0.224 1.001 -0.927 0.231
-0.88 -0.903 -0.641 -0.539 -0.589 -0.923 -0.837 -0.688 -0.872 -1.371 -0.463
1999 1.919** 0.08 -0.278 0.471 0.228 1.645* 0.104 0.06 1.610* -0.102 0.959**
-0.875 -0.929 -0.645 -0.559 -0.567 -0.935 -0.825 -0.685 -0.865 -1.37 -0.457
Constant -5.485***-9.866***-2.416***-2.692***-3.776***-3.431***-1.786**-2.625***-4.707*** -1.911 -2.964***
-1.002 -2.586 -0.869 -0.961 -1.272 -0.957 -0.853 -0.867 -1.156 -1.377 -0.565
Observations 5008 400 435 411 364 309 265 220 185 156 2028
Log-likelihood -2804.5 -152.21 -244.18 -242.89 -211 -184.55 -162.41 -127.21 -103.59 -86.59 -1102.07
Prob>Chi2 0 0 0 0 0 0 0.001 0.004 0 0.007 0
Pseudo R-squared 0.18 0.42 0.19 0.14 0.16 0.14 0.11 0.14 0.18 0.2 0.21
a The dependent variable is a dummy variable that takes the value of 1 if the focal deal is an Alliance, and 0 if the focal deal is an M&A. The
dataset is a panel dataset with multiple deals per firm. Therefore to account for the potential bias from clustering within groups (firms) we report
the robust standard errors below each p[arameter estimate. *** p <0.01, ** p < 0.05, * p < 0.10.
b This variable is constructed to test for H1. The variable is a ratio of lagged total alliance experience over the lagged total deal experience. The
hypothesized relationship is that the higher this ratio the higher the likelihood of having an alliance deal as the next deal.

Table 18. Logit Analysis of Deal Type Choice (Alliance=1, M&A=0) and Past experience in the same-type
deals

140
 Panel B. Logit Analysis for Choice of M&A Deala
Pooled 2nd 3rd 4th 5th 6th 7th 8th 9th 10th After the
Sample deals deals deals deals deals deals deals deals deals 10th deal
Lagged M&A
experience as a % of
2.498***9.024***1.538*** 0.593 1.807***1.418***1.615***1.785***1.933***2.562*** 3.455***
lagged total
experienceb
-0.264 -2.329 -0.479 -0.47 -0.459 -0.508 -0.538 -0.618 -0.693 -0.657 -0.374
Agriculture, Forestry,
-2.039** -2.621*
& Fishing
-0.846 -1.41
Construction 0.155 0.187 0.171 -1.279 -0.126
-0.511 -1.13 -1.17 -1.468 -0.86
Finance, Insurance, &
0.285 0.858 1.3 -0.644 0.162 0.424 -0.218 -0.65 -0.514
Real Estate
-0.335 -0.708 -1.433 -1.133 -0.964 -0.87 -1.168 -0.909 -0.456
Manufacturing -1.528*** -0.819 -1.258** -2.361** -2.367** -1.630* -1.365* -1.394 -1.693** -1.987** -1.772***
-0.302 -0.615 -0.554 -1.026 -1.051 -0.84 -0.759 -1.059 -0.856 -0.799 -0.478
Mining -0.469 0.458 0.811 -1.952 -1.298 -2.140* -1.517 -0.403
-0.468 -1.265 -1.249 -1.272 -1.145 -1.187 -1.334 -0.861
Retail Trade -0.948** 0.075 0.721 -1.227 -1.667 -1.224 -1.603* -0.916 -2.046** -1.607***
-0.391 -0.867 -0.927 -1.149 -1.183 -1 -0.863 -1.307 -0.958 -0.584
Services -1.028*** -0.457 -0.668 -2.091** -1.735 -0.688 -0.279 -0.796 -1.384* -1.232 -1.340***
-0.303 -0.627 -0.574 -1.029 -1.058 -0.844 -0.768 -1.043 -0.81 -0.809 -0.446
Transportation &
-0.305 0.53 0.701 -0.981 -1.401 -0.537 -0.156 -0.273 -0.632 -0.748
Public Utilities
-0.347 -0.875 -0.791 -1.118 -1.107 -0.895 -0.846 -1.156 -1.027 -0.48
1990 1.574 -0.252
-0.987 -1.152
1991 0.142 0.001 1.831 0.943 0.739 -1.049
-0.677 -0.688 -1.204 -1.221 -1.84 -1.382
1992 -0.341 -0.149 -0.06 0.49 -0.777 0.441 -1.037
-0.617 -0.645 -0.646 -1.127 -0.778 -1.126 -1.295
1993 -0.036 0.393 1.306 0.21 0.059 0.641 -0.749 2.007 0.337 -0.822
-0.646 -0.629 -1.107 -0.776 -1.089 -0.893 -1.105 -1.634 -1.238 -1.355
1994 0.222 0.908 0.503 1.484 -0.186 1.093 0.763 0.5 2.372 -0.358 -0.573
-0.643 -0.637 -0.616 -1.103 -0.744 -1.07 -0.846 -1.249 -1.566 -1.134 -1.356
1995 0.196 0.57 0.55 1.516 -0.083 0.326 1.422 -0.297 0.336 -0.639 -0.781
-0.647 -0.573 -0.595 -1.087 -0.712 -1.019 -0.899 -1.004 -1.276 -1.164 -1.369
1996 0.686 0.852 0.848 1.968* 1.031 1.034 0.763 -0.269 1.457 1.208 -0.021
-0.647 -0.575 -0.589 -1.091 -0.778 -1.023 -0.79 -1.018 -1.279 -1.347 -1.363
1997 0.673 1.232** 1.078* 1.697 0.716 1.234 1.371* -0.142 1.254 -0.537 -0.313
-0.643 -0.612 -0.596 -1.071 -0.703 -1.016 -0.772 -0.966 -1.227 -1.085 -1.364
1998 0.987 1.448** 1.450** 1.971* 0.518 1.669 1.434* 1.028 2.006 0.858 0.084
-0.636 -0.595 -0.612 -1.071 -0.699 -1.029 -0.767 -0.992 -1.227 -1.127 -1.339
1999 0.408 0.799 1.803*** 1.274 0.734 0.175 1.074 0.151 1.635 0.105 -0.642
-0.641 -0.592 -0.663 -1.07 -0.7 -0.997 -0.767 -0.947 -1.202 -1.058 -1.336
Constant -0.406 -7.806*** -0.181 1.198 1.249 0.332 -0.4 1.026 -0.149 0.222 0.133
-0.733 -2.393 -0.839 -1.479 -1.32 -1.305 -1.129 -1.407 -1.641 -1.475 -1.469
Observations 6716 429 646 591 523 434 367 307 247 201 2829
Log-likelihood -2980.4 -186.22 -261.45 -243.89 -229.94 -190.46 -162.84 -121.21 -97.56 -92.07 -1118.19
Prob > Chi2 0 0 0 0 0 0 0 0 0 0 0
Pseudo R-squared 0.19 0.21 0.14 0.13 0.13 0.15 0.14 0.12 0.17 0.21 0.3
a The dependent variable is a dummy variable that takes the value of 1 if the focal deal is an M&A and 0 if the focal deal is an
Alliance. The dataset is a panel dataset with multiple deals per firm. Therefore to account for the potential bias from clustering
within groups (firms) we report the robust standard errors below each parameter estimate. *** p <0.01, ** p < 0.05, * p < 0.10.
b This variable is constructed to test for H1. The variable is a ratio of lagged total M&A experience over the lagged total deal
experience. The hypothesized relationship is that the higher this ratio the higher the likelihood of having an M&A deal as the
next deal.

Table 19. Logit Analysis of Deal Type Choice (M&A=1, Alliance =0) and Past experience in the same-type
deals

141
 g y yp yp
Panel A. Logit Analysis for Choice of Alliance Deala
Pooled Pooled 1st-2nd 1st-3rd 1st-4th 1st-5th 1st-6th 1st-7th 1st-8th 1st-9th 1st-10th After the 11th
Sample Sample deals deals deals deals deals deals deals deals deals deal
Dummy=1 if lagged CAR-5,..,+5 >=0 0.033 0.148*
-0.059 -0.077
Agriculture, Forestry, & Fishing 0.568 1.782
-1.096 -1.983
Construction -0.279 1.152 0.091 0.734
-0.558 -0.84 -1.147 -1.258
Finance, Insurance, & Real Estate -0.501* 0.186 -1.969** -1.826
-0.284 -0.58 -0.88 -1.269
Manufacturing 1.995*** 2.926*** 2.040*** 2.817*** 4.186*** 5.106*** 5.107*** 4.540*** 4.475*** 4.387*** 4.004*** 6.470***
-0.249 -0.454 -0.53 -0.776 -0.749 -1.213 -1.292 -1.228 -1.535 -1.659 -1.485 -1.118
Mining 0.092 1.183 -0.273
-0.417 -0.783 -1.18
Retail Trade 0.771** 1.697*** 0.322 -0.49
-0.318 -0.584 -0.698 -1.298
Services 1.399*** 2.185*** 1.247** 1.571** 2.640*** 3.303*** 2.877** 2.642** 2.232 1.151 0.888 5.266***
-0.266 -0.474 -0.532 -0.772 -0.757 -1.161 -1.161 -1.163 -1.361 -1.445 -1.333 -1.138
Transportation & Public Utilities 0.419 1.649*** 0.179 0.253 0.867 0.897 0.781 1.14
-0.31 -0.531 -0.69 -0.932 -1.065 -1.556 -1.637 -1.681
1990 0.414 -1.26 -1.835 1.411 1.87 3.137**
-1.14 -0.907 -1.155 -0.986 -1.154 -1.363
1991 1.353 1.805 -2.297*
-1.119 -1.13 -1.177
1992 1.325 -0.128 1.81 -0.06 1.400** 0.44 2.434* 0.827 4.116** -1.261
-1.108 -0.326 -1.108 -0.601 -0.702 -0.948 -1.332 -1.398 -1.948 -0.901
1993 1.46 0.151 2.534** 0.465 0.885 0.949 1.783 -1.25 -0.281
-1.101 -0.325 -1.104 -0.616 -0.684 -0.839 -1.154 -1.309 -1.01
1994 1.105 -0.045 1.506 -0.014 0.868 1.372 1.81 -0.437 0.107 -1.21 -1.345 -0.352
-1.1 -0.347 -1.093 -0.563 -0.673 -0.899 -1.203 -0.992 -1.413 -1.507 -1.48 -0.971
1995 1.199 0.206 1.303 0.097 0.913 0.222 2.804** -1.26 1.193 0.367 -0.528 0.529
-1.1 -0.345 -1.098 -0.561 -0.671 -0.82 -1.169 -1.096 -1.181 -1.562 -1.298 -1.02
1996 0.877 -0.183 1.283 -0.443 -0.641 -0.368 0.632 -0.246 0.759 -0.952 -2.576* -0.022
-1.102 -0.37 -1.095 -0.537 -0.77 -0.913 -1.149 -0.923 -1.396 -1.639 -1.355 -1.018
1997 1.016 0.278 1.376 -0.301 0.665 0.372 1.79 -0.67 -0.921 -0.763 -1.911 -0.201
-1.099 -0.341 -1.094 -0.539 -0.635 -0.825 -1.14 -0.938 -1.458 -1.703 -1.394 -0.976
1998 0.812 0.135 1.009 -1.024* -0.383 -0.653 1.123 -1.183 0.132 -1.341 -3.154** -0.574
-1.1 -0.341 -1.096 -0.574 -0.663 -0.814 -1.12 -0.862 -1.295 -1.593 -1.3 -0.989
1999 1.558 0.652* 2.507** 0.046 1.012 0.469 1.811 -1.101 -0.724 0.008 -1.724 -0.202
-1.099 -0.345 -1.09 -0.537 -0.66 -0.829 -1.124 -0.863 -1.491 -1.446 -1.083 -0.92
Lagged Alliance experience as a % of
2.086***
lagged total experienceb
-0.265
First same-type deal's CAR-5,..+5 -0.501*** -0.593** -0.767** -1.275*** -0.736 -0.666 -1.2 5.164** -0.972 0.269
-0.19 -0.234 -0.326 -0.461 -0.671 -0.803 -1.16 -2.155 -1.372 -0.319
Second same-type deal's CAR-5,..+5 -0.741*** -0.358 -0.349 -1.016 -0.463 1.208 0.325 2.247 0.612*
-0.276 -0.347 -0.438 -0.65 -0.878 -1.448 -1.498 -1.498 -0.326
Third same-type deal's CAR-5,..+5 -1.041*** -0.44 -0.344 -0.918 -1.004 -0.099 1.316 0.459
-0.387 -0.436 -0.542 -0.829 -1.217 -1.731 -1.704 -0.285
Fourth same-type deal's CAR-5,..+5 -1.482*** -1.013* -0.601 -1.021 -0.744 -1.627 0.421*
-0.56 -0.572 -0.723 -1.237 -1.219 -1.913 -0.224
Fifth same-type deal's CAR-5,..+5 -0.62 -0.639 -0.522 -1.266 -1.239 0.153
-0.599 -0.688 -0.881 -1.043 -1.303 -0.181
Sixth same-type deal's CAR-5,..+5 -0.4 -1.582 -0.758 0.237 -0.098
-0.697 -0.986 -1.144 -0.911 -0.139
Seventh same-type deal's CAR-5,..+5 -0.491 -1.237 -0.643 -0.172
-1.241 -1.3 -1.079 -0.151
Eighth same-type deal's CAR-5,..+5 -0.359 -1.735 -0.575***
-1.432 -1.354 -0.126
Nineth same-type deal CAR-5,..+5 0.175 -0.245*
-1.456 -0.134
Tenth same-type deal CAR-5,..+5 0.152
-0.227
Constant -3.271*** -4.268*** -4.350*** -3.531*** -5.936*** -7.007*** -7.941*** -4.853** -6.743** -5.380* -3.356 -5.740***
-1.12 -0.581 -1.205 -0.953 -1.036 -1.719 -2.026 -1.91 -3.138 -3.171 -2.638 -1.359
Observations 10637 5008 966 727 505 392 303 233 157 128 100 1950
Log-likelihood -5688.3 -2801.88 -423.28 -297.67 -189.01 -131.35 -96.08 -71.81 -40.64 -32.69 -28.64 -715.99
Prob>Chi2 0 0 0 0 0 0 0 0 0 0 0 0
Pseudo R-squared 0.11 0.18 0.18 0.24 0.31 0.39 0.42 0.39 0.48 0.51 0.47 0.34
a The dependent variable is a dummy variable that takes the value of 1 if the focal deal is an Alliance, and 0 if the focal deal is an M&A. The dataset is a panel dataset with multiple deals per firm. Therefore
to account for the potential bias from clustering within groups (firms) we report the robust standard errors below each p[arameter estimate. *** p <0.01, ** p < 0.05, * p < 0.10.
b This variable is constructed to test for H1. The variable is a ratio of lagged total alliance experience over the lagged total deal experience. The hypothesized relationship is that the higher this ratio the higher
the likelihood of having an alliance deal as the next deal.
This series of same-deal lagged CAR{-5,..+5} variables is constructed to test for H2 and take into account the possible heterogenity due to particular stage of the decision tree that would represent the series
of corpotrate deals. The variable is a ratio of lagged total alliance experience over the lagged total deal experience. The hypothesized relationship is that the likelihood of having an alliance deal is related to
the magnitude of the market reaction measured as CARS in +5 and -5 days around the announcement day of the focal firm's prior same-type deals.

Table 20. Logit Analysis of Deal Type Choice and Market Reaction to the same-type deals

142
Figure 7. Model Payoffs

143
G: Set of Incentive Mechanisms (i.e. monitoring,
job design, compensation schemes, flat
organizational structure, etc.) available to the firm
g1, g2,…,gk

Z: Unobservable function that

Z converts related firm-specific routines
underlying g1,…,gk into related
capabilities for firm i

Firm-specific capabilities
z ig k , where k= {1,…,K}

f: Unobservable function that links the

unobserved ‘true’ capabilities of z ig tok

f observable bundle of firm capabilities

Bi

Figure 8. Corporate Capability as a System of Governance Mechanisms

144