The Incentives for Vertical Mergers and Vertical Integration

We examine the incentives for firms to vertically integrate through vertical mergers 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 engage in vertical mergers, 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 stable product markets are more likely to vertically integrate consistent with control rights being obtained by firms to facilitate commercialization of already realized innovation. ∗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, Giacinta Cestone, Thomas Hellmann, Sébastien Michenaud and seminar participants at Arizona State University, Humboldt University, IFN Stockholm, Tsinghua University, UBC and the University of Maryland for helpful comments. All errors are the authors alone. Copyright c ©2013 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 a major topic in both finance and economics. 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. Our focus is on both vertical integration and vertical mergers. 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 a firm is vertically integrated and whether firms engage in vertical mergers. Our analysis of the incentives for relationship specific investment, ex-post holdup and vertical mergers is distinct from other motives for mergers including neoclassical theories, agency theories and horizontal theories of mergers. Part of our contribution is methodological. We analyze vertical integration and vertical mergers using new firm-specific measures of vertical integration and 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, how their vertical integration changes over time, and the extent to which mergers represent vertical transactions. Our study is thus able to analyze vertical integration beyond the single industry focus of most studies 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 mergers, and Phillips and Zhdanov (2013) for a recent horizontal theory of mergers. These early studies include Monteverde and Teece (1982) focusing on automobile manufacturing, Masten (1984) focusing on airplane manufacturing, and Joskow (1987) focusing on coal markets. An extensive review of the empirical literature on vertical integration can be found in Lafontaine and Slade (2007) and Bresnahan and Levin (2012).