The Market for Mergers and the Boundaries of the Firm∗

Mergers redraw the boundaries of the firm. In this paper, we relate incomplete contracts to empirical regularities in the market for mergers and acquisitions. We begin by empirically challenging conventional wisdom about mergers and acquisitions: high M/B acquirers typically do not purchase low M/B targets. Instead, mergers typically pair together firms with similar M/B ratios. To show why this occurs, we build a continuous time model of investment and merger activity that combines search, relative scarcity, and asset complementarity. Our model shows that the ‘like buys like’ empirical finding is a natural consequence of a prediction from the property rights theory of the firm; namely, that complementary assets should be placed under common control. A number of new empirical predictions emerge from our analysis. First, if asset complementarity is important, then we should see small differences in the M/B of targets and acquirers. It also predicts that the difference in M/B ratios should increase when discount rates are high and valuations are low. In additional tests, we show that both of these predictions are borne out by the data. Our findings suggest that the incomplete contracts theory of the firm is central to understanding the empirical regularities of the market for mergers and acquisitions. ∗We would like to thank Boyan Jovanavic, Charles Jones, Denis Gromb, Gordon Philips, Stefano Rossi, Tano Santos and S. Viswanathan for useful discussions, and workshop participants at Columbia, Duke, the 2004 EFA meetings, the National Bureau of Economic Research Summer Institute, the Federal Reserve Board New York, the Stockholm School of Economics, 2005 AFA meetings, University of Maryland, SUNY Buffalo, SUNY Binghamton, Tuck School of Business, 2005 Econometric Society World Congress, William & Mary, Utrecht School of Economics and Texas Christian, University of Virginia. Any errors are our own. The Market for Mergers and the Boundaries of the Firm