Mergers & Acquisitions and Innovation Performance in the Telecommunications Equipment Industry

Transcription

1 Mergers & Acqustons and Innovaton Performance n the Telecommuncatons Equpment Industry Tseveen European Unversty Vadrna Andreas Stephan European Unversty Vadrna and DIW Berln ABSTRACT In response to global market forces such as deregulaton and globalzaton, technologcal change and dgtal convergence, the telecommuncatons n the 1990s wtnessed an enormous worldwde round of Mergers & Acqustons (M&A). Gven both M&A and Innovaton a major means of today s compettve strategy development, ths paper examnes the nnovaton determnants of M&A actvty and the consequences of M&A transactons on the technologcal potental and the nnovaton performance. We examne the telecommuncatons equpment ndustry over the perod usng a newly constructed data set wth frm-level data on M&A and nnovaton actvty as well as fnancal characterstcs. By mplementng a counterfactual technque based on a matchng propensty score procedure, the analyss controls for merger endogenety and ex-ante observable frms characterstcs. The study provdes evdence that M&A realze sgnfcantly postve changes to the frm s post-merger nnovaton performance. The effects of M&A on nnovaton performance are n turn drven by both the success n Research and Development (R&D) actvty and the deteroraton n nternal technologcal capabltes at acqurng frms pror to a merger. Keywords: Mergers & Acqustons, Innovaton Performance, Telecommuncatons Equpment Industry JEL Classfcatons: L63, O30, Correspondng author: European Unversty Vadrna, Faculty of Economcs and Management Studes, Grosse Scharrnstrasse 59, D Frankfurt (Oder), E-mal: gantumur@euv-ffo.de

2 1 Introducton The telecommuncatons ndustry s movng fast both on the technology front and n terms of structure. A recent surge of Mergers and Acqustons (M&A) n the telecommuncatons ndustry s a reflecton of the drastcally changng envronment of the market. 1 Deregulaton and lberalzaton, technologcal nnovaton and dgtal convergence and the evolvng requrements of the captal markets have drven dramatc changes n the telecommuncatons ndustry as a whole. The ndustry n turn has sparked fundamental changes n the economc landscape worldwde. As the telecommuncatons frms face ncreasng exposure to nternatonal competton, the ndustry has undergone a radcal transformaton creatng exctng new opportuntes and new challenges for nfrastructure and servce provders (L and Whalley, 2002). Market wnners are n most cases also technology leaders or hghly capable of turnng a base technology nto a superor product that meets the customer needs (Brodt and Knoll, 2004). The rapd technologcal change, growng technologcal complexty and the shortenng of product lfe cycles add new dmensons to an already complex scenaro and ncreasngly force frms to source technologes externally. Frms wll often prefer M&A to other cooperatve approaches of R&D network buldng, e.g., R&D jont ventures, because M&A provde an mmedate controllng presence n the new, fast expandng market, rather than havng to gradually buld a new busness or negotate wth a partner about developng a cooperaton (Caves, 1982; Capron and Mtchell, 1997). Whle several analyses have stressed that the telecommuncatons ndustry has undergone major restructurng n the 1990s through ntense M&A actvty (e.g., Jamson, 1998; Km, 2005; Rosenberg, 1998, Warf, 2003), we are not aware of any study whch nvestgates the lnkage between recent rses both n M&A and nnovaton actvty. The goal of ths paper s to uncover the keen relance of the telecommuncatons frms on M&A as a technology sourcng strategy. We am at provdng an answer to the followng queston: Why do frms n the telecommuncatons ndustry ncreasngly use M&A as a technology source? Does M&A affect the nnovaton performance of frms nvolved as ther proponents expect? Before attemptng to determne ths task, however, a more basc queston needs to be addressed, namely: Does the nnovaton actvty of frms depct a sgnfcant predctor of enterng the M&A market? Admttedly, technologcal reasons do not motvate all M&A. M&A can be motvated, for nstance, by the desre to obtan fnancal synerges or market power, to obtan access to dstrbuton channels, and/or to gan entry nto new markets. 2 Such M&A may not be able to be 1 Between 1996 and 2001, more than twenty M&A deals worth over $20 bllon took place n the telecom sector, 14 of whch were n the US. Telecom mergers amount for seven of the largest operatons announced n 2000, and eght out of the ten largest of all tmes (Le Blanc and Shelansk, 2002) 2 For extensve revew, see Shmzu et al. (2004) 1

3 drectly expected to mprove the frms nnovaton performance. However, n hgh technology ndustres where nnovaton s key to a compettve advantage, frms wll ncorporate the mpact of M&A on technologcal performance even when the transacton s not nnovaton-drven, thus choosng the most approprate nnovaton and fnancal strateges. Moreover, to the extent that access to technology and know-how become ncreasngly mportant to succeed n the market, factors such as the frm s sze, hstory and equty become less and less crtcal requrements. Ths allows new challengers to realze tremendous growth rates. Furthermore, t spurs the quest for external knowledge sourcng both at the establshed and new frms n the market. As nnovaton s becomng ndspensable for strategc compettveness n the hgh technology ndustry, we ask: How do frms that choose M&A and frms that stay outsde of the M&A market dffer wth respect to ther nnovaton performance? The follow up queston s then, what are the effects of M&A on the nnovatve performance of frms f we control for the dfferences n nnovaton performance pror to M&A actvtes? Though occurrence of M&A has grown dramatcally n the last years, academc research on the relatonshp between nnovaton and M&A has not kept pace wth the changes. In spte of the vast and rapdly growng body of lterature on M&A, 3 emprcal evdence whch has explored ths relatonshp s rather lmted and often nconclusve. 4 The lterature on the technologcal effects of M&A shows contradctory mplcatons. On the one hand, M&A may buld up competences and foster nnovaton for a number of reasons. M&A can reduce hgh transacton costs related to the transmsson of knowledge between frms (Bresman et al., 1999). Furthermore, n fast movng markets wth abbrevated product lfe cycles, frms may perceve that they do not have the tme to develop the requred sklls and knowledge nternally, and therefore, turn outward to M&A. In ths sense, M&A may offer a quck access to knowledge assets (Warner et al., 2006). Moreover, M&A may extend the technologcal base of frms nvolved allowng them to acheve greater economes of scale and scope through more effcent deployment of knowledge resources. Also, M&A may enlarge the overall R&D budget of frms engaged, whch then enables them to tackle larger R&D projects and, thereby, ths spreads the rsk of nnovaton. In addton, the ntegraton of complementary knowledge may also ncrease nnovaton through M&A leadng to more advanced technologes beng developed (Gerpott, 1995). Fnally, by exchangng the best practces on nnovaton management wthn the combned entty, frms may employ effcent technology ntegraton. On the other hand, nnovaton-drven M&A encompass the dffcultes assocated wth nnovaton as well as the obstacles faced n mergers. Frst of all, dfferences n corporate culture, processes and knowledge base may mpede a smooth transton of knowledge (Lane and 3 For revew see Roeller et al. (2001) and Shmzu et al. (2004) 4 For revew see Veugelers (2005) 2

4 Lubatkn, 1998; Very, 1997). Furthermore, M&A ntegraton process s tme consumng and costly. Ths may dvert management attenton away from nnovaton (Htt et al., 1996). Also, trade off payment of debt and debt costs for nvestment n R&D can occur due to M&A (Htt et al., 1990). In addton, a dsadvantage of M&A s that t nvolves entre frms whereas the advantages for knowledge exchange may be lmted to only a small part of the frms nvolved. In M&A, knowledge beyond that requred s also acqured. Ths may cause ndgestblty: a frm may acqure more knowledge than t can use n a meanngful way (Hennart and Reddy, 1997). Fnally, as the lterature has shown, technologcally motvated and ntensve acqustons are hghly vulnerable to falure (Chakrabart et al., 1994). One of the man reasons for ths value destructon les n the mscarred and napproprate ntegraton of the technology-based frm after the acquston (Duysters and Hagedoorn, 2000). Even when the merger s successful n terms of the ntegraton of R&D departments, n other busness areas the merger may not be a success, thereby nfluencng a dsntegraton of the entre frm. One of the man reasons for the contradctons and nconclusveness of prevous studes mght be due to cross-ndustry nvestgatons. Consequently, we focus on the recent ncrease n M&A and nnovaton actvtes of frms n the telecommuncatons equpment ndustry as the exstence of ndustry clusterng n M&A actvty n the 1990s s evdent (Andrade et al., 2001). Lyng at the core of the telecommuncatons ndustry, the telecommuncatons equpment ndustry takes a central role n the technologcal transformaton of the entre ndustry. Also, the growng market concentraton observed for technology producers and the relevance of patentbased technologcal standards n recent years are motves for selectng ths well-defned ndustry. Ths study provdes emprcal evdence on our research questons by examnng the M&A that took place between telecommuncatons equpment frms durng the 1988 to 2002 perod. It uses a newly created data set from the followng four complementary data sources: NBER Patent, Thomson One Banker-Deals, Compustat and Global Vantage databases. We adopt a treatment effect estmaton approach wth endogenous selecton usng a matchng propensty score technque. In order to explore the nterrelatonshp between M&A and R&D of frms, we capture broad dmensons on both actvtes. We analyze R&D nput and output as well as the knowledge stock and research productvty of frms. Furthermore, we reveal the role that a frm plays n a transacton as an acqurer, a target and a poolng merger. We fnd evdence consstent wth the followng propostons. Frst, the telecommuncatons equpment frms undertake M&A n order to strengthen ther success n nnovaton, and thereby, ther market poston. Second, the equpment manufacturers n telecommuncatons, whch experenced low research productvty from ongong explotaton of R&D efforts n the past, are forced to explore potental future nnovaton trajectores n new busness unts by acqustons. Thrd, those telecommuncatons equpment frms wth a 3

5 declnng nventve portfolo, are nvolved n poolng mergers to offer comprehensve and ntegrated equpment solutons. Fnally, equpment frms n telecommuncatons can successfully outsource R&D through M&A as a means of revtalzng a frm by enhancng and supplementng ts knowledge base effectvely. The artcle proceeds as follows: Secton 2 draws a broad pcture on the developments n telecommuncatons equpment ndustry wth regard to ts M&A and R&D actvtes. Secton 3 presents the theoretcal underpnnngs of our research questons. Data descrpton s provded n Secton 4, whle Secton 5 dscusses measures of performance and emprcal methodology. We report emprcal results n Secton 6 and conclude wth a dscusson of fndngs n Secton 7. 2 Telecommuncatons Equpment Industry The telecommuncatons equpment ndustry provdes all equpment requred for the use or provson of telecommuncatons and data servces. The structure of the ndustry s presented n Fgure 4 and descrbed n the Appendx. Untl recently, wth ts regulated and very stable market structure, the telecommuncatons ndustry had correspondngly lttle, f any, opportuntes for mergers. 5 Most natonal telecommuncatons markets were characterzed by vertcally ntegrated natonal monopoles where telecommuncatons equpment producton and ts demand were largely n the hands of government agences. Ths pcture radcally changed n late 1980s wth the begnnng of the lberalzaton and deregulaton process whch culmnated n the standardzaton and subsequent rapd dffuson of the GSM. 6 Durng ths perod, the vertcally ntegrated monopoles had dssolved, whle R&D and nnovaton ncreasngly shfted towards the producers of telecommuncatons equpment. For the telecommuncatons equpment producers, regulatory lberalzaton has both mpled the openng of new markets abroad and a shft n competton from the natonal to the global level. In addton, the process of convergence between telecommuncatons, IT and broadcastng through ts technologcal, organzatonal, and market/servce aspects has a farreachng nfluence on the market structure of the telecommuncatons ndustry (Tadayon and Skouby, 1999; Km, 2005). The ICT convergence essentally has come about through two parallel technologcal changes. The frst ntal radcal nnovaton s the applcaton of ntegrate crcut technology to allow dgtal swtchng of telephone calls that change the core desgn concepts of telephone systems. The second development s the Internet. It s based on the 5 We employ, hereafter, the term merger to defne both merger and acquston f not otherwse ndcated. 6 Global System for Moble Communcaton 4

6 TCP/IP 7 protocol that standardzes the rules of packagng, transmttng and recevng data over the Internet, provdng more flexblty and fttng further between nformaton and telecommuncatons technologes (Mnn and Palmberg, 2006). As a result of nternatonal competton stemmng from the lberalzaton of ts market and pace of technologcal evoluton, telecommuncatons frms that tradtonally operated only n ther home markets have expanded throughout the world, often by undertakng mergers of foregn telecommuncatons frms. The 1990s wtnessed an enormous wave of mergers that dramatcally reconfgured the market structure of global telecommuncatons equpment (see Fgure 1). Mergers provded a means of rapdly overcomng the shortcomngs of exstng networks and servces as well as helpng address the nadequaces assocated wth the provson of such global servces under the exstng framework of correspondent relatonshps between telecommuncatons operators (Capron and Mtchell, 1997). M&A Fgure 1. M&A n the Telecommuncatons Equpment Industry, Year Source: Authors' calculatons from Thomson One Banker-Deals In the recent years, the exstng network operators have rebult ther telecommuncatons nfrastructure to accommodate ncreased voce and data traffc. Major nvestments were undertaken to mprove network capacty, to enable the transport of hgh-speed data and to enhance the ntellgence of the fxed network to enable customers to beneft from advanced servces. Investment n R&D plays a major role n the rse and fall of the telecommuncatons equpment ndustry. Whle the trade and regulatory lberalzaton prmarly has globalzed the demand for telecommuncatons equpment, technologcal change n the ndustry has had pervasve effects further upstream on R&D. One aspect of ths s the ongong convergence between varous technology sub-felds of ICT, whch requre technologcal dversfcaton 7 Transmsson Control Protocol/Internet Protocol 5

7 amongst the ncumbents and open up multple entry optons (Mnn and Palmberg, 2006) also for new players. Fgure 2 gves a broad overvew of the R&D expendtures for the equpment manufacturng frms of our sample over the last decade. Durng the monopoly era, hardly any vsble mportance to R&D was gven as the technology was domnated by analog systems. Dgtalzaton was the man technologcal achevement n communcatons: hence, new technologes were ntroduced nto the market n all areas of communcatons, e.g., voce, data networks, satellte, cellular, swtchng and routng network devces, etc. For the frst tme servce frms had choces n terms of selectng the equpment manufactures. R&D experenced ts peak durng those years. However, after the telecom crash, both the sales volume and retal prces dropped. That drectly affected the amount of R&D spendng n Research dd not make t through the product lfecycles and the launchng of new technologes was delayed, e.g., thrd generaton (3G) wreless networks. Fgure 2. Average R&D expendtures n the Telecommuncatons Equpment Industry, R&D (mo $) Year Source: Authors' calculatons from Compustat and Global Vantage databases In the dgtalzed markets, success s ncreasngly based on non-physcal or ntangble factors rather than merely on the telecommuncatons networks and other physcal assets that provded the prevous natonal telecom monopoles wth a prmary source of revenues (Quah, 2000). Recent ntensve competton has dramatcally changed the busness envronment of the telecommuncatons frms and forced them to seek new strateges. Not only technologcal nnovatons themselves but also related patent rght royaltes or lcense fees provde telecommuncatons frms wth an outstandng source of ncome. It may be ncreasngly costly not to be nnovatve because the lcense fees for patents relatng to the communcaton products become a major cost for communcaton product manufacturers and ther customers 6

8 (Kretschmer, 1997). The growth n the patentng of the worldwde telecommuncatons equpment ndustry has been tremendous (see Fgure 3). From 1988 to 1998 the number of communcaton equpment patents appled by the UPSTO ncreased by more than four tmes. The abrupt fall n the patent applcatons after 1998 n Fgure 3 s prmarly caused by the truncaton of the patent data sample. 8 Patent applcatons Fgure 3. Patentng n the Telecommuncatons Equpment Industry, Year Source: Authors' calculatons from NBER Patent Database To summarze the M&A and R&D trends, the telecommuncatons equpment ndustry n the 1990s has experenced the race of technologcal changes and a major restructurng, whch s characterzed by ntense merger actvty. 3 Theoretcal Background Technologcal change nfluences the ablty of frms to ntegrate, buld and reconfgure nternal and external competences n order to address alterng compettve and technologcal challenges. Dos (1988) descrbed the technologcal changes to be contnuous or ncremental because they reflect a path dependent and cumulatve development as a technologcal paradgm or pattern of nqury. Incremental change tends to renforce the market power of ncumbent frms because t utlzes exstng competences n development and can be deployed through an establshed set of sales and marketng resources (Teece, 1996). Accumulated pror knowledge and heurstcs consttute the related problem-solvng knowledge that permts ncumbents to acqure related 8 Whle consderng only patents that eventually granted, we date the patents n our sample by the date of applcaton. We have all patents whch were granted by 2002; thus, our patent numbers are not qute complete n the latter years. We end our analyss on patents n 2000 because, n the subsequent years, a truncaton due to the grant lag appears to be more vsble. 7

9 problem-solvng capabltes. Learnng capabltes nvolve the development of the capacty to assmlate exstng knowledge, whle problem-solvng sklls represent a capacty to create new knowledge; and they are mutually nclusve. To the extent that the nnovaton embodes new sklls or knowledge, ncumbents can be hndered n respondng as they may have lttle or no relevant development hstory to draw upon (Dos, 1988). Frms must absorb the envronmental nformaton on nnovaton and eventually be able to explot t through new products or processes n the market. Cohen and Levnthal (1989) elucdated the two faces of R&D actvty. That s, R&D actvty does not only stmulate nnovaton, but t also enhances the frms ablty to assmlate outsde knowledge. The second face of R&D s called the absorptve capacty, and t s consdered to be crucal partcularly for assessng the effectve contrbuton by spllovers from others. Defned as a set of knowledge and competences, the frm's knowledge base remans a prelmnary condton n the assmlaton of spllovers from R&D efforts of envronment. For Rosenberg (1990), fundamental research nsde the frm has strong complementartes wth external R&D. All n all, both Cohen & Levnthal and Rosenberg nsst on potental synerges between the frm's own knowledge base and external flows of scentfc and techncal knowledge. Thus, the responsveness of R&D actvty to explot external knowledge flows s an ndcaton of the mportance of absorptve capacty. In ndustres lke telecommuncatons, ths response must be quck due to hghly compettve condtons caused by short product lfecycles, new technologes, frequent entry by unexpected outsders, repostonng of ncumbents and radcal redefntons of market boundares as ICT ndustres converge. Hghly reactve frms wth hghly absorptve capactes wll not wat for falure to spur development. By contrbutng R&D to the frms absorptve capacty, however, one should bear n mnd the fact that technologcal performance does not necessarly depend on past or referental performance, but rather on absorptve capacty generated n the past. In other words, frms wth hgh absorptve capacty wll explot new deas regardless of ther past performance. Frms, especally those wth hgh technologcal content, strve to overcome constrants algned wth cost, appropraton, absorptve capacty and tme regardng R&D performance. Thus, frms are faced wth the assocated objectves of developng a response to an nnovaton and dong so n a tmely fashon. Therefore, there s a crucal strategc choce to be made for frms that decde to conduct R&D actvtes. Tradtonally, the economc lterature on the choce of strateges for performng R&D bascally consders two alternatves: ether R&D s performed nternally or t s acqured externally; these two alternatves could also be combned. The theoretcal lterature, drawng on transacton costs economcs (Coase, 1937; Wllamson, 1981) and property rghts theory (Hart and Moore, 1986), consders the choce between external sourcng and nternal development as substtutes,.e., the classcal make-or-buy decson. 8

10 Technologcal know-how s often tact and can, therefore, not be easly transmtted from one frm to another (Larsson et al., 1998). In order to avod hgh transacton costs, frms may be nduced to engage n a merger n order to solve problems related to the transmsson of tact knowledge (Bresman et al., 1999). At the same tme, nternal developments may be perceved by frms because of the hgh rsk due to the low probablty of the nnovaton success and the length of requred tme for the nnovatons to provde adequate returns (Hundley et al., 1996). Thus, frms prefer to nvest fewer resources n nternal R&D when faced wth resource constrants or attractve external nnovaton sources exst. It s argued that the acqustons of frms wth an nnovatve portfolo of nterest often represent more certanty and lower rsk of explotng knowledge assets than new ventures do (Chakrabart et al., 1994). Engagng n acqustons, frms, however, may trade off payment of debt and debt costs for nvestment n R&D. That s, as the nnovaton developments embed assets that are largely non-redeployable, frms are lkely to prefer the use of debt to fund acqustons rather than to support nnovaton actvtes (Htt et al., 1990). However, due to the fact that the fnancal and nnovaton strateges of future-orented frms are jontly decded, a lack fnancal resources may be mperatve for frms pursung a compettve strategy premsed on nnovaton. Hence, the mutually exclusve choce between these nnovaton strateges s too restrctve. Moreover, R&D strategy adopted by a frm depends on ts envronment and on dfferences n the abltes of the frms to conduct R&D actvtes. Whle the dffculty n beng a good buyer when one s not also a maker and vce versa occurs, most theores of economc organzaton whch rely on a comparson of costs or benefts per transacton to explan the organzaton of economc actvty have typcally gnored the possblty of multple nnovaton sources. The studes nspred by the resource- and knowledge-based approaches argue that a frm can rely on a combnaton of dfferent strateges to engage n nnovaton. Followng the absorptve capacty argument, the ablty to recognze the value of new nformaton and also to ntegrate and deploy t s enhanced when the new knowledge s related to what s already known (Cohen and Levnthal, 1990). The combnaton of smlar felds of technology are expected to enable frms to share technologcal expertse, to shorten the nnovaton lead tme and to engage n projects larger than what would be possble wthn the once separated frms (Kogut and Zander, 1992). Yet, the relatedness between the knowledge bases s lkely to have a nonmonotonc nfluence on subsequent ntegrated nnovaton performance (Lubatkn, 1983; Lane and Lubatkn, 1998). In other words, wth ncreasng relatedness, the nnovaton performance wll ntally ncrease reachng some optmum and then t wll decrease. Ahuja and Katla (2001) showed that, from one sde, when the knowledge bases of acqurng and acqured frms are very smlar, then the benefcal effects of such combnaton would be lmted, as there wll not be 9

11 much to learn from each other. On the other hand, when the knowledge bases are very dstnct, the absence of common sklls and smlar cogntve structures and the lack of an adequate absorptve capacty wll mpede communcaton and knowledge transfer. Nevertheless, dstnctve knowledge bases of nternal and external sources can be partcularly valuable under condtons of technologcal uncertanty (Sorenson and Sorensen, 2001) and mght be of use n creatng knowledge complementartes. It s theoretcally evdent that the frms who nvest n R&D have, n any case, a natural advantage n the explotaton of hgh technology, and f the results of ther own R&D have not been satsfactory, those frms are nclned to procure technology externally. In ths context, to justfy the desderatum of the external technology source, t s essental to attend to the ncreasng evdence that a frm s sze and poston wthn the ndustry affects the nature and the type of nnovaton n whch t s engaged (Hart and Ramanantsoa, 1992; Chrstensen, 1997). Frst, pursung to develop the knowledge and to create a new one nternally, frms mght be partcularly hndered by radcal or sgnfcant nnovatons rather than by mnor or ncremental nnovatons snce the latter are technologcal changes that are close to the current expertse. Ths s dstnctve to establshed frms n the market or market leaders - mostly large frms, whch tend to nnovate n order to renforce ther postons or to enhance ther core competences. The mprovements on ther R&D can be, ndeed, sgnfcant, but they are not lkely to change ther status quo. Second, pror success n developng competences may block frms from adjustng from envronment. The former competences may become rgdtes or barrers to performance for developments that dffer greatly from exstng knowledge. To fully utlze ts strengths, large frms need the path to nnovaton to be predctable. Havng less to gan from a radcally new desgn than a market challenger, they are less lkely to pursue dsruptve technologes or to embrace new nnovatons whch would threaten ther domnance. Fnally, large frms mght prefer explotatve nvestments rather than exploratve as the latter s uncertan n payoff and organzatonally challengng. However, the ongong explotaton of the exstng knowledge and capabltes, even those that make an organzaton successful for a certan tme, after a certan pont hnders the creaton of new knowledge and eventually leads to a technologcal exhauston (March, 1991; Vermeulen and Barkema, 2001). These selfrenforcng capactes can also create competency-destroyng technologcal change. On the other hand, new frms or market challengers, mostly small frms, are more entrepreneural and can respond more quckly to unexpected opportuntes. By creatng new felds of technology or new sklls where the market leader does not have an expertse or an establshed poston, they are lookng for opportuntes to upset the leader s poston and to radcally change the compettve stuaton, thus elmnatng or dmnshng the leader market 10

12 domnance. Whle they are more lkely to fal, they are more wllng or able to venture nto completely new drectons because they have less of a vested nterest n the current technology and are not ted to sunk nvestments n obsolete technologes. At the same tme, small challengers have fewer resources to spend on R&D and because there s a lack of strong enterprse channels, they are less lkely to have the resources to brng an nventon to the marketplace. Ths lack of manufacturng and dstrbutng actvty can be flled by large frms whch possess a greater ablty to fnance a large amount of R&D as well. In sum, we suppose that a dsrupton n productve effcency n the nnovaton actvty of frms forces them to turn outward to technologcal mergers. Next, we expect that a merger between accumulated absorptve capactes facltates the mergng frm s ablty to understand new knowledge held by ts acquston target or partner n a poolng merger. Furthermore, we presume that relatve absorptve capacty enhances the mergng frm s ablty to assmlate new knowledge from ts acquston target or partner n a poolng merger. In addton, we predct that the strengthenng of buldng absorptve capacty shapes the mergng frm s ablty to apply the assmlated knowledge. Fnally, we propose that a merger nfluences the mergng frm s ablty to strengthen and to buld up ts knowledge base. Consequently, the R&D functons of mergng frms have to be effectvely ntegrated and coordnated through the nteracton emergng n such crcumstances. 4 Data Descrpton In order to examne the nteracton between merger and nnovaton actvty, a new frm-level database s constructed whch covers all frms n the telecommuncatons equpment ndustry that operated n any year over the 18 years perod, 1987 to 2004 (ncludng lagged perods). Ths database s created by complex matchng process of nformaton from ntally four separate data sets. The frst two datasets nclude frms fnancal characterstcs and the addtonal two data sets descrbe the frms merger and nnovaton actvtes, respectvely. We defne the telecommuncatons equpment frms as those whch have prmary actvty n the communcatons equpment Standard Internatonal Codes (SIC) 3661, 3663, or The populaton of frms and ther fnancal nformaton ncludng R&D expendtures were drawn from Compustat and Global Vantage databases. After elmnatng frms wth mssng fnancal nformaton, we could dentfy a sample of 638 telecommuncatons equpment frms for those a data on R&D expendtures, total assets, market value, cash flow, long term debt were avalable. 11

13 Our patent statstcs for the telecommuncatons equpment ndustry are based on the database whch s compled by the Natonal Bureau of Economc Research (NBER, Hall et al., 2001). Ths database comprses detaled nformaton on all US patents granted between 1963 and 2002 and all patent ctatons made between 1975 and The patent and ctatons data were procured orgnally from the US Patent Offce and from Derwent Informaton Servces, respectvely. Although ths US data could mply a bas n favor of US frms and aganst non-us frms, the group of non-us frms n ths sample represents a group of nnovatve and rather large frms that are known to patent worldwde. Our database ncludes nformaton on the patent number, the applcaton and grant dates, the detaled technology feld(s) of the nnovaton, the name(s) of the nventors, the cty and state from whch the patent was fled and ctatons of pror patents on whch the current work bulds. Followng the classfcaton n Hall et al. (2001), we nclude the patents for whch frms appled n twelve man classes of the Internatonal Patent Classfcaton (IPC) 178, 333, 340, 342, 343, 358, 367, 370, 375, 379, 385 or n the category communcaton equpment. As the dstrbuton of the value of patented nnovatons s extremely skewed, we also consder the number of forward ctatons as an ndcator of the mportance or the value of nnovatons for each patent, thereby overcomng the lmtatons of smple counts (Brouwer and Klenknecht, 1999; Grlches, 1990). Durng the observed perod, 251 frms from our sample have appled for a total of 11,226 patents n communcaton equpment (ncludng multple applcatons by the same frm n the same year and for the whole perod); ths produces a total of 86,442 ctatons. 9 The most actve frms n the patent applcatons were Motorola, Semens, Nortels Network, Qualcomm, and Alcatel Bell Telephone wth 61.72% of the total patent applcatons. M&A transacton data were obtaned from the Thomson One Banker-Deals database. Updated daly, the database offers detaled nformaton on merger transactons ncludng target and acqurer profles, deal terms, fnancal and legal advsor assgnments, deal value and deal status. Ths database ncludes allances wth a deal value of more than 1 mllon USD, thus ensurng that the overwhelmng majorty of mergers are covered. Our ntal sample on merger transactons contans nformaton on 364 completed deals (ncludng multple deals by the same frm n the same year and durng the observed perod) carred out by 178 frms and announced durng the perod from 1988 to Usng nformaton from the data source, we dstngushed between the role that a frm played n a M&A transacton and classfed the frms n our sample n generally as an acqurer, the frm whch purchased the stock or other equty nterests of another entty or acqured all or a substantal porton of ts assets; a target, the frm whch sold a sgnfcant amount or all of tself to another frm; or a partner n a poolng merger, the frm whch pooled ts assets wth another frm or merged wth another frm of approxmately equal 9 The data set s truncated, whch mght cause a downward bas n the ctaton counts of recent patents. 12

14 sze. Out of 364 M&A transactons, we could dentfy 217 acqurer, 25 targets and 122 partners n poolng mergers. 10 Furthermore, 59.6% of all of the mergers nvolve nnovatve frms,.e., frms that appled for at least one patent durng the observed perod. Whle 84.8% of the merger frms took part up to three tmes n a merger, we can observe that the merger actvty of the telecommuncatons equpment ndustry s characterzed by the transactons of certan frms. For nstance, the large-scale frms such as Ercsson, Semens, ADC Telecommuncatons, Motorola and Alcatel carred out 17.86% of the total merger transactons. For our econometrc analyss, we restrct the multple transactons carred out by one frm n the same year to the largest transacton only. 11 Fnally, the estmaton sample conssts of total 300 M&A transactons, whch nvolve 186 acqurer, 22 targets and 94 partners n poolng mergers. The databases were matched on the bass of frm names, CUSIP numbers 12 and address nformaton provded by each database. The frms that are lackng nformaton or have nadequate data on the matchng procedure were cross-checked and completed wth nformaton reported n the Dun & Bradstreet s Who owns whom annual ssues. 5 Econometrc Methodology In ths secton we descrbe the econometrc approach. The am of the analyss s twofold: frst, to nvestgate the mpact of success n nnovaton actvty on the lkelhood that a frm engages n a merger, and second, to analyze the effect of a merger on a frm s nnovaton performance. The general perspectve on mergers and the technologcal-related reasons of merger actvty both stress the mportance of understandng the condtons under whch the change n ownershp mght have a sgnfcant effect on the nnovaton performance of frms. Hence, the effects of a merger must be related to the reasons and expectatons behnd the transacton. In order to explore the lnk between merger and nnovaton performance of frms, we estmate the nnovaton determnants that nfluence the merger and may alter followng the merger. 10 We lack fnancal data on the target frms for transactons that nvolve the acqustons mostly of a prvately held and/or a relatvely small frms that are not operated n the US and not lsted n Global Vantage. 11 The frequency of merger transactons carred out by one frm n the same year s as follows: 294 frms wth one deal, 44 frms wth two deals, sx frms wth three deals, and three frms wth four deals n a gven year durng the sample perod. 12 CUSIP stands for Commttee on Unform Securtes Identfcaton Procedures. A CUSIP number dentfes most securtes, ncludng stocks of all regstered US and Canadan companes and US government and muncpal bonds. The CUSIP system facltates the clearng and settlement process of securtes. A smlar system s used to dentfy foregn securtes (CUSIP Internatonal Numberng System). 13

15 5.1 Estmatng the Propensty to Merge We start our analyss by explorng the determnants of mergers and by nvestgatng the attractveness of telecommuncatons equpment frms as merger canddates. Employng a random utlty model, we consder the frm s decson of whether to acqure, to be acqured, to have nvolvement n a poolng merger or to stay outsde the merger market. The utltes assocated wth each of these choces k are modeled as a functon of the frm s characterstcs X whch affect the utltes dfferently: U = X β + e (1) k k k Whle the level of utlty s not observable, we can, however, nfer from the frms choces how they rank each of these alternatves. If we assume that the e j are dstrbuted Webull, the dfferences n the dsturbances are dstrbuted logstc and a multnomal logt can be used to estmate the dfferences n the parameters β. The propensty of engagng n a merger s modeled as a functon of the frm s characterstcs. We base the analyss on a panel that conssts of nnovaton-related and fnancal varables on both merged and non-merged frms for whch data were avalable durng the 1988 to 2002 perod. The probablty that frm chooses alternatve k s specfed ' ( βk ) ' ( β ) ( β β ) exp X 1 Pr( chooses k ) = = m m ' exp l l X exp l l k X (2) where β1,..., βm are m vectors of unknown regresson parameters. An mportant property of the multnomal logt model s that relatve probabltes are ndependent from each other, whch s the so-called ndependence of rrelevant alternatves (IIA) property. In order to obtan robust standard errors of estmated coeffcents, approprate tests were conducted, whch are dscussed n Secton 5.1. In the followng, we explan the determnants of a merger captured by our analyss and assess the approprateness and plausblty of the merger choce. Summary statstcs of the varables are shown n Table The nnovaton performance of a frm s examned wth respect to ts R&D nput, R&D output, the stock of accumulated knowledge generated by past R&D efforts, and the research productvty. R&D nput and R&D output of frms are measured by ther R&D expendture and the number of patent applcatons, respectvely. R&D expendtures nvolve both current and 13 We checked that there exsts no multcollnearty among selected varables. 14

16 captal expendtures, where the current expendtures are composed of labor costs and other current costs, and the captal expendtures are the annual gross expendtures on fxed assets used n the R&D projects of frms. We analyze the frms ntellectual property rghts regstered as patents that are actually granted. Each patent contans hghly detaled nformaton on the nnovaton tself (Hall, 2001). As a strong relatonshp exsts between the sze of the frm and ts R&D expendture and total number of patents, as suggested by common nnovaton studes, we took the ratos of the R&D expendtures and the patent counts to the total assets; we then defned them as R&D ntensty and patent ntensty, respectvely. INSERT TABLE 1 ABOUT HERE In order to account not only for the quantty but also the qualty of the patented nventons, we measured the patent-based characterstcs of a frm usng the number of forward ctatons of patents. As mentoned above, the number of ctatons receved by any gven patent s truncated n tme because we only know about the ctatons receved thus far. In other words, the number of forward ctatons a patent receved depends on the year of the applcaton. We, therefore, normalze the ctaton counts by ther average value calculated over all patents belongng to the same technologcal sub-class whose applcaton was fled n the same year. 14 We then weght each patent of a frm by the number of normalzed ctatons that t subsequently receved (Trajtenberg, 1990). The stock of accumulated knowledge of a frm s measured usng ctaton-based patents and calculated by applyng the perpetual nventory method by assumng a deprecaton rate of 15% per annum (Hall, 1990). Hence, the ndvdual patents n the frm s knowledge base provde the bass for comparng the frm s own knowledge base wth that of other frms. R&D productvty, defned as the rato of ctaton-weghted patent to R&D expendture, accounts for the frm s research productvty. Research productvty may be nterpreted as the effcency wth whch R&D brngs forth new and useful knowledge. Snce fnancal profles of frms are lkely to nfluence both ther nnovatve and merger actvty, we also nclude the frms fnancal characterstcs. To express all monetary values n real terms, we employ the US ndustry-based Producer Prce Index wth bass year All covarates n the regressons have been lagged by one year n order to avod potental endogenety problems as well as possble bases arsng from dfferent merger accountng methods and fnancal statement consoldaton Ths s the fxed-effects approach proposed n Hall et al. (2001) 15 Smlar methods have been wdely used n the lterature (Hall, 1999). We are aware, however, that laggng regressors do not control for all sources of endogenety (Wooldrdge, 2002). 15

17 Frm sze s proxed by the book value of the total assets. Some emprcal evdence has shown that the purchase of larger companes s postvely related to post-merger performance, as larger targets can beneft the buyer n terms of economes of scale, a larger resource base and a larger customer base (Seth, 1990; Loderer and Martn, 1992; Clark and Ofek, 1994; Ahuja and Katla, 2001). However, other studes have clamed that these potental benefts mght not be realzed f the ntegraton of larger acqured organzatons creates greater coordnaton problems and needs resources to be devoted to solve ths at the expense of busness operatons, thus leadng to a negatve mpact of a merger (Lubatkn 1983; Kusewtt 1985; Ahuja and Katla, 2001). The economc performance of a frm s proxed by frm growth and Tobn s q. Frm growth s measured by the annual growth rate of the market value. Frms wth growng market value may appear as lkely acquston targets for mature frms lookng to absorb growth opportuntes. We approxmate Tobn s q by calculatng the rato of the market value to the book value of a frm s assets, where the former s the sum of the book value of long-term debt and the market value of common equty (Danzon et al., 2004). Accordng to the q-theory of nvestment, captal should flow from low-q to hgh-q frms. Indeed, by knowledge flows, technology shocks cause a large varaton n the frms Tobn s q (Jovanovc and Rousseau, 2004). The nterpretaton of the effect of Tobn s q should be treated wth some cauton, because, apart from beng a forward lookng ndcator - a frm s growth opportuntes (Gugler et al., 2004), Tobn s q s also lkely to reflect stock undervaluaton (Mork et al., 1990), or manageral performance (Powell, 1997). The cash flow rato s defned as the rato of cash flow to the total assets, and t represents the fnancal capabltes of the frms. The cash-flow rato amounts for funds avalable to a frm for operatons, nvestments and acqustons. Gven the argument that R&D s prmarly fnanced by nternally generated resources, the cash-flow rato mght be an mportant determnant of the (nclusvely) choce between nternal R&D or external know-how of nnovatve frms. Followng the practce of prevous studes (e.g., Hall, 1999), a dummy varable s ncluded whch ndcates mssng R&D values and equals one when R&D s mssng and zero otherwse. For the frm-years observatons wth mssng R&D ntensty, we then set the R&D ntensty equal to zero. Moreover, to capture the dfference between frms wth no R&D output, we employ smlarly a dummy for frms wth zero (ctaton-weghted) patent ntensty. Table 2 depcts the t-statstcs of the dfferences n means of the frms characterstcs separately for merged and non-merged frms. Frms that actually merged are characterzed by a greater knowledge stock expressed n accumulated ntellectual property rghts than frms that 16

18 dd not merge. In terms of total assets, there s a sgnfcant sze dfference between merged and non-merged frms, thus showng that larger frms are more lkely to merge. INSERT TABLE 2 ABOUT HERE The merged frms had, on average, a larger Tobn s q and cash-flow rato, and they were less lkely to have mssng R&D values and zero (ctaton-weghted) patent ntensty. The frms n our sample do not dffer sgnfcantly n ther R&D and (ctaton-weghted) patent ntensty as well as research productvty pror to a merger. 5.1 Estmatng the Impact of M&A on Innovaton Our analyss of the effects of mergers controls for endogenety and ex-ante observable frm characterstcs usng a propensty score method (Deheja and Wahba, 2002). For each frm n the sample, let M be a merger ndcator that equals one when the frm engages n a merger and zero otherwse. We denote Y 1 as the nnovaton performance of mergng and Y 0 as the nnovaton performance of non-mergng frms and observe hence ( 1 ) M and Y = M Y 1 + M Y 0. Accordngly, let E Y 1 M = 1 and E Y 0 M = 0 denote average outcomes of the technologcal performances of merged and non-merged frms, respectvely. The effect we are nterested n s that of merger on the technologcal performance of the merged frms, or the dfference between the expected nnovatve performances of the merged frms and the frms that would have experenced f they dd not merge: τ M = = = = 1 E Y1 M 1 E Y0 M 1 (3) Ths denotes the expected treatment effect on the treated. Snce we do not have the counterfactual evdence of what would have happened f a frm had not engaged n a merger, E Y 0 M = 1 s unobservable. However, t can be estmated by E Y 0 M = 0 and the effect can be then gven by the dfference n the average outcome between the merged and nonmerged nnovatve performances: e τ = E Y1 M = 1 E Y0 M = 0 (4) 17

19 In fact, we have observatons on the frms whch dd not engage n a merger, but f the merged and the non-merged frms systematcally dffer n ther frm characterstcs, (4) wll be a based estmator of (3) (Hrano et al., 2002). 16 Rubn (1997), Rosenbaum and Rubn (1983, 1984) showed that a propensty score analyss of observatonal data can be used to create groups of treated and control unts that have smlar characterstcs, whereby comparsons can be made wthn these matched groups. In these groups, there are frms that have been merged and frms that have not been merged; hence, the allocaton of the merger can be consdered to be random nsde the groups of frms. The merger propensty score s defned as the condtonal probablty of engagng n a merger gven a set of observed covarates ( ) ( ) X : p M = Pr M = 1 X = E M X (5) The propensty score s a balancng score, meanng that condtonal on the propensty score the dstrbutons of the observed covarates are ndependent of the bnary treatment assgnment (Rosenbaum and Rubn, 1983; 1984). In other words, the propensty score matchng reles on the strong gnorablty assumpton, whch mples that for common values of covarates, the choce of treatment s not based on the benefts of alternatve treatments. The treatment effect of a merger s then estmated as the expectaton of the condtonal effects over the dstrbuton of the propensty score n the merged sample: { ( ) ( ) } τ = = ( ), =, = M = 1 Ep M E Y 1 p M M 1 E Y0 p M M 0 M 1 (6) We estmated the propensty scores by applyng a multnomal logt model from the frst stage of our analyss. Hereby, we nclude the determnants of technologcal performance as well as ther nteracton terms. Usng the computed propensty scores, we subclassfy the sample nto fve strata accordng to propensty score quntles. 17 As we are nterested n estmatng the effects of mergers and because there are fewer merged frms than frms whch dd not engage n mergers, we create strata based on the estmated propensty scores for merger events, so that each stratum contans an equal number of mergers. 18 Ths ensures an adequate number of mergers n each stratum. To check for the adequacy of the propensty score model, some 16 Descrptve data n Table 2 show that merged and non-merged frms n our sample suggest sgnfcant dfferences n the observed characterstcs. 17 Fve sub-classes (quntles) constructed from the propensty scores wll often suffce to remove over 90% of the selecton bas due to each of the covarates (Rosenbaum and Rubn, 1984). 18 In general, strata boundares can be based on the values of the propensty scores for both groups combned or for the treated or control group alone (D Agostno, 1998). 18

20 analyses were conducted to assess the covarate balance n the fve groups of matched merged and non-merged frms that wll be dscussed n the next secton. Usng the propensty score subclassfcaton, we can estmate the effects of a merger on nnovaton performance by takng the weghted average (by number of merged frms) of the wthn-strata average dfferences n performance outcomes between merged and non-merged frms. Ths s the average treatment effect on the treated referred to n the causal nference lterature. The varance of the average treatment effect estmate s calculated by dvdng the sample varances of the performance outcomes for merged and non-merged frms wthn each strata by the number of merged and non-merged frms wthn that strata, respectvely; and then by averagng these across all fve strata. Because the subclassfcaton s based on propensty scores estmated from the data and therefore depends on the sample, the outcomes wthn each strata and between the strata are not ndependent (Du, 1998). However, one can make the strong gnorablty assumpton less restrctve by ncorporatng a wder array of frm characterstcs n the analyss (Benjamn, 2003). 6 Emprcal Results 6.1 Technologcal Determnants of a Merger In ths secton, we examne the merger decson of the telecommuncatons equpment frms n a multvarate analyss. Gven that both mergng and non-mergng frms are ncluded n the sample, we can attempt to dstngush between the characterstcs of mergng frms n transacton events and the frms outsde of the merger market. We estmate equaton (2) usng a multnomal logt model wth four outcomes: to be an acqurer, to be acqured, to be a poolng merger, or to be not nvolved n a merger. There are substantal drawbacks assocated wth the use of the multnomal logt estmaton because t assumes that the dsturbances are ndependent across alternatves. Ths assumpton suggests that f a frm was choosng between the four alternatves, then there s no relatonshp between a frm's dsturbances for beng an acqurer, a target, a partner n a poolng merger or does not nvolvement n a merger. In the context of ths analyss, t s lkely that merger behavor wll not fulfll ths requrement. The test of the mantaned assumpton of ndependence of rrelevant alternatves (IIA) wll ndcate whether the rato of the choce probabltes of any two alternatves s entrely unaffected by the systematc utltes of any other alternatves. In order to examne how the estmaton results are affected by ths property, four Hausman tests were conducted. The results from multnomal logt are compared wth those from a bnomal logts between the non-merged frms sample and each of the samples of acqurng, acqured and poolng merged frms as well as between acqurer and 19