The Incentives for Vertical Acquisitions and Integration

We examine the incentives for firms to vertically integrate through acquisitions and production. We develop a new firm-specific measure of vertical integration using 10-K text to identify the extent a firm’s products span vertically related product markets. We find that firms in high R&D industries are less likely to vertically integrate or become targets in vertical acquisitions, and are more likely to initiate customer or supplier relationships outside of the firm. These findings are consistent with firms with unrealized innovation avoiding integration to maintain ex ante incentives to make relationship specific investments and maintain residual rights of control as in Grossman and Hart (1986). In contrast, firms in high patenting industries with mature product markets are more likely to be vertically integrated consistent with control rights being obtained by firms to facilitate commercialization of already realized innovation and limit potential holdup. ∗University of Maryland, University of Maryland, and University of Southern California and National Bureau of Economic Research, respectively. Frésard can be reached at [email protected], Hoberg can be reached at [email protected] and Phillips can be reached at [email protected]. We thank Ken Ahern, Jean-Noel Barrot, Thomas Bates, Giacinta Cestone, Oliver Hart, Thomas Hellmann, Sébastien Michenaud and seminar participants at the 2014 American Finance Association Meeting, Arizona State University, Carnegie Mellon, Humboldt University, IFN Stockholm, MIT, Tsinghua University, UBC, the University of Alberta, and the University of Maryland for helpful comments. All errors are the authors alone. Copyright c ©2014 by Laurent Frésard, Gerard Hoberg and Gordon Phillips. All rights reserved. The scope of firm boundaries and whether to organize transactions within the firm (integration) or by using external purchasing is of major interest in understanding why firms exist. Williamson (1971), Williamson (1979) and Klein, Crawford, and Alchian (1978) pioneered this area through their theory of transaction cost economics and ex post holdup given contractual incompleteness. Firms choose the organizational form that minimizes transaction costs and ex post holdup. Grossman and Hart (1986) in their property rights theory of the firm show that control rights are key and influence ex ante investment. They show that ex ante incentives for a firm to invest in relationship-specific assets are reduced through vertical integration for the firm that gives up its residual rights of control to the other contracting firm. We examine how the distinction between incentives for ex ante investment in relationship-specific assets, and the potential for ex post holdup, influence the extent to which firms are vertically integrated and whether they engage in vertical acquisitions. Our analysis of the incentives for relationship-specific investment, ex post holdup and vertical transactions is distinct from other motives for acquisitions including neoclassical theories, agency theories and horizontal theories of acquisitions. We analyze vertical integration and vertical acquisitions using new firm-specific measures of integration and vertical relatedness constructed using text-based analysis of firm product descriptions filed with the Securities and Exchange Commission. We focus on how these firm product vocabularies relate to commodity descriptions from the BEA input-output tables. We then measure how vertically integrated firms are by looking at whether the products (and services) they offer span vertically related markets. Similarly, we identify the extent to which mergers and acquisitions represent vertical transactions by examining if participating firms’ products are vertically linked. Our study is thus able to analyze vertical integration dynamically and beyond the single industry focus of most studies on vertical integration in industrial organization. See Maksimovic and Phillips (2001), Jovanovic and Rousseau (2002), and Harford (2005) for neoclassical and q theories and Morck, Shleifer, and Vishny (1990) for an agency motivation for acquisitions, and Phillips and Zhdanov (2013) for a recent horizontal theory of acquisitions. These early studies include Monteverde and Teece (1982) focusing on automobile manufacturing, Masten (1984) focusing on airplane manufacturing, and Joskow (1987) focusing on coal