Product Market Synergies and Competition in Mergers and Acquisitions

We examine how product similarity and competition influences mergers and acquisitions and the ability of firms to exploit product market synergies. Using novel text-based analysis of firm 10K product descriptions, we find three key results. (1) Firms are more likely to enter restructuring transactions when the language describing their assets is similar to all other firms, consistent with their assets being more redeployable. (2) Targets earn lower announcement returns when similar alternative target firms exist. (3) Acquiring firms in competitive product markets experience increased profitability, higher sales growth, and increased changes in their product descriptions when they buy target firms that are similar to them and different from rival firms. Our findings are consistent with similar merging firms exploiting synergies to create new products and increase their product differentiation relative to ex-ante rivals. ∗University of Maryland and University of Maryland and National Bureau of Economic Research respectively. Hoberg can be reached at [email protected] and Phillips can be reached at [email protected]. We thank Michael Faulkender, Kathleen Hanley, Nagpurnanand Prabhala, David Robinson and seminar participants at Duke University, Hong Kong University of Science and Technology, National University of Singapore, Ohio State University, the Securities Exchange Commission, and the University of Maryland for helpful comments. All errors are the authors alone. Copyright c ©2008 by Gerard Hoberg and Gordon Phillips. All rights reserved. It has long been viewed that product market synergies and competition are key drivers of mergers. However, papers examining mergers have been unable to identify if asset complementarities and new product introductions are important for mergers. We examine whether product market measures of similarity and competition affect firms’ propensity to merge and whether firms use mergers and acquisitions to create product differentiation using synergies, thereby reducing product market competition between merging firms and their rivals. In competitive markets, mergers are a quick way to potentially increase product offerings to increase product differentiation if synergies are important. Thus, firms may have incentives to merge with firms that have different skills or technologies that increase the ability to introduce new products through synergies. However, because acquirers may be better at managing similar products due to managerial expertise and familiarity, mergers offering greater product similarity can also add value. There is thus a tension between merging with a firm whose product is very similar, and a firm whose skills or technologies are different enough from rivals to help differentiate the acquirer. We explore this “similar but different” tension in examining the likelihood of mergers and ex post merger outcomes. Our paper attempts to identify the importance of synergies as a source of gains from merging. ? model asset complementarity and synergies as a motive for mergers and provide evidence that merging firms have similar market-to-book valuations. However, given they do not have product data or descriptions, they are unable to provide direct evidence that firms with complementarities combine to exploit potential synergies. Our paper provides direct evidence on synergies and asset complementarity as we provide measures of new product creation and we provide evidence on how similar firms are with respect to their existing prodSee ? and ? for two surveys on different motives for mergers. ? and ? have documented increased industry-adjusted cash flows following mergers. However, the literature has not been able to identify if changes in cash flows are due to merger synergies in the form of new products, cost reductions, or due to higher prices arising from increased market power. ? and ? famously show that the notion of product differentiation is fundamental to theories of industrial organization, with product differentiation increasing the profitability of firms. The Hotelling model allows for a concept of distance and makes a distinction between “close” rivals versus “distant” rivals, a concept that we exploit. In Chamberlain, product differentiation exists but all rivals are equally close. See also the survey by ?. ucts. We also measure the extent that firms merge to create product differentiation