Advances in Mergers and Acquisitions, Volume 5

ADVANCES IN MERGERS AND ACQUISITIONS i ADVANCES IN MERGERS AND ACQUISITIONS Series Editors: Cary L. Cooper and Sydne...

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ADVANCES IN MERGERS AND ACQUISITIONS

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ADVANCES IN MERGERS AND ACQUISITIONS Series Editors: Cary L. Cooper and Sydney Finkelstein Recent Volumes: Volumes 1–2: Edited by Cary L. Cooper and Alan Gregory Volumes 3–4:

Edited by Cary L. Cooper and Sydney Finkelstein

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ADVANCES IN MERGERS AND ACQUISITIONS VOLUME 5

ADVANCES IN MERGERS AND ACQUISITIONS

EDITED BY

CARY L. COOPER Lancaster University Management School, Lancaster University, UK

SYDNEY FINKELSTEIN Tuck School of Business, Dartmouth College, USA

Amsterdam – Boston – Heidelberg – London – New York – Oxford Paris – San Diego – San Francisco – Singapore – Sydney – Tokyo JAI Press is an imprint of Elsevier

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JAI Press is an imprint of Elsevier The Boulevard, Langford Lane, Kidlington, Oxford OX5 1GB, UK Radarweg 29, PO Box 211, 1000 AE Amsterdam, The Netherlands 525 B Street, Suite 1900, San Diego, CA 92101-4495, USA First edition 2006 Copyright r 2006 Elsevier Ltd. All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher Permissions may be sought directly from Elsevier’s Science & Technology Rights Department in Oxford, UK: phone (+44) (0) 1865 843830; fax (+44) (0) 1865 853333; email: [email protected]. Alternatively you can submit your request online by visiting the Elsevier web site at http://elsevier.com/locate/permissions, and selecting Obtaining permission to use Elsevier material Notice No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. Because of rapid advances in the medical sciences, in particular, independent verification of diagnoses and drug dosages should be made British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN-13: 978-0-7623-1337-2 ISBN-10: 0-7623-1337-4 ISSN: 1479-361X (Series) For information on all JAI Press publications visit our website at books.elsevier.com Printed and bound in The Netherlands 06 07 08 09 10 10 9 8 7 6 5 4 3 2 1

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CONTENTS vii

LIST OF CONTRIBUTORS INTRODUCTION Cary L. Cooper and Sydney Finkelstein

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RELATEDNESS AND ACQUIRER PERFORMANCE Lasse B. Lien and Peter G. Klein

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RISK REDUCTION THROUGH ACQUISITIONS: THE ROLES OF FIRM-SPECIFIC INVESTMENTS AND AGENCY HAZARDS Heli Wang and Jeffrey J. Reuer

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KNOWLEDGE PRESERVATION AND TRANSFER DURING POST-ACQUISITION INTEGRATION Annette L. Ranft

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ANTECEDENTS OF TARGET FIRM MEMBERS’ TRUST IN THE ACQUIRING FIRM’S MANAGEMENT: A DECISION-MAKING SIMULATION Gu¨nter K. Stahl, Chei Hwee Chua and Amy L. Pablo

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CULTIVATING POSITIVE EMOTIONS IN MERGERS AND ACQUISITIONS Verena Kusstatscher

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CONTENTS

HOW TO AVOID RUINING YOUR COMPANY THROUGH INTERNATIONAL ACQUISITIONS? THE AHOLD CASE Harry G. Barkema

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INTERCONNECTED FIRMS AND THE VALUE OF NETWORK RESOURCES Dovev Lavie

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LIST OF CONTRIBUTORS Harry G. Barkema

Tilburg University, Netherlands

Chei Hwee Chua

Sonoco International Business Department, Moore School of Business, University of South Carolina, USA.

Peter G. Klein

Contracting and Organizations Research Institute, University of Missouri, USA.

Verena Kusstatscher

Countess Lene Thun Foundation, Italy, Manchester Business School, UK

Dovev Lavie

McComb’s School of Business, University of Texas at Austin, USA

Lasse B. Lien

Norwegian School of Economics and Business Administration, Norway

Amy L. Pablo

Haskayne School of Business, University of Calgary, Canada

Annette L. Ranft

College of Business, Florida State University, USA.

Jeffrey J. Reuer

Fisher College of Business, The Ohio State University, USA

Gu¨nter K. Stahl

INSEAD, France and Singapore

Heli Wang

School of Business and Management, Hong Kong University of Science and Technology, Hong Kong

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INTRODUCTION Cary L. Cooper and Sydney Finkelstein Each collection of articles that makes up a volume of Advances in Mergers and Acquisitions paints a picture of contemporary research on this topic, and provides insight to what scholars around the world see as the ‘‘hot buttons’’ worthy of attention. This volume of Advances is no different. We have seven contributions from scholars in North America, Europe, and Asia, and there is considerable diversity among specific research questions to be sure. These papers collectively address acquisition strategy and acquisition integration, successful deals and unsuccessful ones, ownership structure and managerial structure, risk and return, knowledge preservation and knowledge transfer, building trust and cultivating emotions, and alliances and networks. This breadth of attention across the spectrum of research possibilities on mergers and acquisitions (M&A) is remarkable in that it suggests both that this topic has morphed in recent years to encompass a broad array of issues that go far beyond what earlier generations of scholars concerned themselves with, and that there is still so much more to be learned about the processes and performance of M&A. Of the seven papers collected here, fully six are empirical. The methods vary dramatically among these articles, and include large-firm large-sample studies, small in-depth analyses, a simulation, and a case study. One of the benefits of an edited volume of articles on a core topic is the opportunity it presents to bring together not only the diversity of topics described above, but a diversity of methods as well. The insights that emerge from these multiple methods may well be more varied than might otherwise be the case, and offer an additional potential contribution. Advances in Mergers and Acquisitions, Volume 5, 1–7 Copyright r 2006 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1016/S1479-361X(06)05009-5

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CARY L. COOPER AND SYDNEY FINKELSTEIN

The first article in this volume is by Lien and Klein on relatedness and acquisition performance. Surely this has been one of the most well-studied topics in this research stream, yet as these authors point out the results from this work have not been nearly as supportive as one would expect. They pay particular attention to issues of measurement, and we would have to agree with their contention that most research on acquisition relatedness has not paid adequate attention to inherent problems in measurement. In truth, the most common measure of acquisition relatedness – a match of four-digit SIC codes – is not nuanced enough to capture the concept (Seth, 1990). Qualitative evidence and managerial experience suggest that what matters in acquisition success is the alignment of strategies and resources between merging firms, and not necessarily product or market similarity (Hitt, Harrison, & Ireland, 2001), yet relatedness measures are usually based on product or market indices that rely on SIC data or Federal Trade Commission (FTC) merger categories. Such measures have a limited ability to capture the complex and deal-specific nature of relatedness (Ramaswamy, 1997). So when Lien and Klein develop a new measure of relatedness that avoids these problems, it is worth taking note. In fact, we would not be surprised to see their measurement approach adopted by other researchers who are searching for a more effective way to capture one of the truly fundamental constructs in research on M&A. One more thing to note about Lien and Klein is their integration of the resource-based view (RBV) of the firm to the M&A literature. While they are not the first to do so, they are especially precise in explaining how the RBV logic plays out in the context of M&A. Moreover, they make the point that resource complementarity is a key element in defining relatedness, and we suspect others will pick up on this insight moving forward as well. In sum, Lien and Klein break new ground in their paper, pointing out once again that studies of apparently ‘‘old’’ research topics like acquisition relatedness have the potential for exciting new insights when approached in novel ways. The second article retains the focus on acquisition strategy, though in a very different way. In a study comparing 316 single-business firms engaging in their first diversification move to a control sample of non-diversifying firms, Wang and Reuer found that when firm-specific investments by stakeholders were important to a firm, these firms were more likely to engage in risk-reduction diversification. So, for example, when defined benefit pension plans were substantial in a firm – implying that employee stakeholders played a key role in that firm – they were more likely to seek to reduce their risk via acquisition. This is an intriguing idea for several reasons. First, it suggests one reason why firm-specific investments that carry inherent risk to the investor

Introduction

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(e.g., employees remaining in a firm over time and voluntarily reducing their alternative employment opportunities) might not be as risky as typically thought. These employees who have tied their futures to their employer are less vulnerable to firm risk when the firm diversifies into other businesses. Second, acquisition is typically seen as an ineffective means to reduce risk since shareholders can diversify their own risk much more easily (say, by investing in broad-based market funds). Wang and Reuer’s logic suggests that such risk reduction has benefits that could be value-enhancing by retaining stakeholder support for the firm’s operations. Finally, while these authors make no mention of resource dependence theory, it is interesting to note that their core hypothesis turns this wellknown theory (that has played a prominent role in past research explaining merger and acquisition activity; Pfeffer, 1992; Finkelstein, 1997) on its head. Wang and Reuer argue that firm-specific investments by stakeholders are a good thing because such investments can be sources of competitive advantage. Hence, to motivate and retain their support, firms have an incentive to reduce stakeholders’ risk, or in the terminology of resource dependence theory, reduce the dependence of stakeholders on the firm. In contrast, resource dependence would argue that firms wish to reduce their own dependence on stakeholders, a rather different outcome. We will leave it to others to connect the dots, but it seems there are interesting follow-up research questions that could be posed in considering these alternative theoretical approaches. All the more so when one considers that for years resource dependence theory figured prominently in the literature as an explanation for M&A, yet seems to be forgotten in recent years. In the third paper in this collection, attention turns to the acquisition integration process. As integration issues play a large role in several of the next articles, let us first make a few general comments about this topic. There are three basic requirements for mergers and acquisition success – the strategy has to be right, the price has to be manageable, and the integration process must be effective. It is this latter concern that has garnered more and more attention in recent years, though when you get right down to it the topic of ‘‘integration’’ is not much different than the topic of ‘‘management.’’ By this we mean that just as there are literally hundreds of key variables that need to be effectively managed in any firm, so too are there countless variables that need to be effectively managed during an acquisition integration process. This makes theory-building quite problematic because integration is not one ‘‘thing’’ but a long series of managerial activities. We need look no further than several of the articles here to see that issues like culture, trust, and knowledge are of central concern, each research streams in their own right.

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Despite this complexity, we should be careful not to suggest it is an impossible task. Each study adds another stepping-stone, as the present ones do as well. And is it really possible to fully understand the role of strategy in M&A if one totally disregards integration issues? Consider the challenge of realizing synergies from an acquisition. Strategic approaches focus on relatedness for the most part (though some recent work by Kim and Finkelstein (2006), among others, have extended this to encompass complementarity), but relatedness requires some combination of similar assets to create value. How can this occur in the absence of careful orchestration during integration? In fact, the greater the potential synergy in a deal, the more difficult the integration process often is because conflict and coordination costs both increase with potential synergy. Hence, the articles here that tackle different aspects of integration and process are absolutely important. Annette Ranft examines a central issue in integration, the process of knowledge transfer. Her setting is high-tech, where such knowledge transfer is likely a matter of survival, and often the rationale for making a deal in the first place. She focuses specifically on tacit knowledge, defined as the ‘‘implicit, non-codified skills and expertise accumulated through experience.’’ It is this tacit knowledge that is often at the heart of successful high-tech mergers, so it is easy to see how effective knowledge transfer is a critical requirement for success. Ranft tests three hypotheses that examine whether autonomy, communication, and employee retention increase the likelihood that tacit knowledge will be effectively transferred, and finds support for all three. Of particular note is the result for autonomy. In contrast to some other work that argued against autonomy (Chatterjee, 1986), Ranft explains that autonomy is necessary to preserve acquired knowledge and this seems to ring true in high-tech environments. For example, Cisco has been one of the most successful acquirers in this sector over the last decade, and the hallmark of their approach is that they provide autonomy to the software engineers and other technical experts that form the core of the companies they acquire. This is where the knowledge lives, and it is critical to capture this in high-velocity settings. In addition, retaining key employees is another Cisco practice, and Ranft also finds some support in her study. Although the data in this article is not without its limitations, the questions, and answers, Ranft focuses on are valuable and very much in line with established practice by the most successful acquirers in high-tech today. The next article by Stahl, Chua, and Pablo is a terrific complement to Ranft’s work. These authors develop, and test in a decision-making simulation, a model of trust in M&A. What is particularly noteworthy about their effort is the relatively comprehensive model they develop to explain the

Introduction

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level of trust in the management of acquiring companies among target company managers. They argue, and find, that the key antecedents of trust are the mode of takeover, national cultural distance, the extent of past interaction between acquirer and target, retained autonomy, and perceived attractiveness of the acquiring firm’s human resource polities. The third in the series of integration articles takes us to a more personal level by considering emotions in M&A. Verena Kusstatscher points out that the role of emotions has generally not been given a great deal of attention in the organizations literature, or in the M&A literature for that matter. While it is easy to see that studying emotions among managers might be challenging, she makes a rather compelling case that this is an area that is deserving of more work. What’s more, Kusstatscher interviews 18 managers who were involved in post-merger integration in four companies to identify what types of emotions these managers expressed. While the results can only be taken as suggestive (twice as many negative as positive emotions; positive emotions related to such positive outcomes as trust, relationships between the two companies, and even performance), they do open the door to a relatively fresh area of inquiry on M&A. Perhaps the most comprehensive article in this volume is the sixth one by Harry Barkema, who uses a case study format to analyze Ahold, the giant Dutch retailer whose disclosure of accounting irregularities in 2003 cut the company’s market valuation to one-third within an hour of making the disclosure. Ahold was a major acquirer, expanding internationally to gain market share. However, they fell into a pattern of serious mistakes that Barkema lays out in terms of lessons learned. Hence, this article takes on M&A in a rather different way than the others in the volume, but offers two critical contributions to researchers – (1) it focuses on what went wrong and what lessons can be learned from those mistakes, and (2) it offers specific lessons that represent interesting research questions, indeed, an entire research agenda, on M&A. We were struck by how fundamental many of the lessons were that came out of the Ahold story. Managers overestimated their ability to create value from international acquisitions by assuming that their capabilities in the home market would extend to other markets as well. This problem has been studied in some other contexts, including Finkelstein and Haleblian’s (2002) work on negative transfer, yet it remains on the periphery of research on M&A. Certainly an important research opportunity. Barkema also highlights culture, not so much in the way most researchers consider its role in M&A as much as the detrimental affect it can have on clear information flow. Different cultures make it difficult to truly

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understand the merging partner, not only leading to misunderstandings but to missed signals as well. This article is a very rich one, and we are confident that a careful reading will help generate numerous new research directions for subsequent work. The final paper in the volume stands out for two reasons – it is the only purely conceptual paper among the seven, and it focuses on alliances more than it does M&A. Dovev Lavie develops new theory on interconnectedness and how network resources can be exploited by alliance partners. He carefully identifies the conditions that give rise to shared and non-shared network resources and considers what types of economic rents accrue. One of the ideas he develops is around ‘‘relational rents,’’ which are all about how an alliance partner can use network relationships to extract value. While he does not really say this, it is not hard to see how such relational rents in alliance scenarios are analogous to the rents that accrue to merging partners. In both cases, relationships are critical. After all, even when there is ownership, the dominant (e.g., acquiring) firm is not assured of capitalizing on the value inherent in the target firm. Many of the previous papers in this collection are all about the challenges that exist in trying to do so. Issues of trust, culture, emotions, and strategy all play a major role. In this respect, it would be interesting to extend Lavie’s ideas specifically to the merger context, where in practice there may well be areas of sharing and non-sharing. For example, Cisco may allow target firm engineers their autonomy (non-sharing), they most certainly closely integrate the sales and marketing team (sharing). In conclusion, bringing together a set of seven different papers by scholars from different disciplines, with different research agendas, and even hailing from different countries – yet all of whom are tackling the same general phenomenon – offers something that cannot be easily replicated in other forums. The diversity of disciplines, perspectives, and countries is remarkable, but so are the diversity of topics, issues, methodologies, and research questions they bring to bear to shed light on the same fundamental, and critical, feature of organizational life – M&A.

REFERENCES Chatterjee, S. (1986). Types of synergy and economic value: The impact of acquisitions on merging firms. Strategic Management Journal, 7, 119–139. Finkelstein, S. (1997). Interindustry merger patterns and resource dependence: A replication and extension of Pfeffer (1972). Strategic Management Journal, 18, 787–810. Finkelstein, S., & Haleblian, J. (2002). Understanding acquisition performance: The role of transfer effects. Organization Science, 13, 36–47.

Introduction

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Hitt, M. A., Harrison, J. S., & Ireland, R. D. (2001). Mergers and acquisitions: A guide to creating value for stakeholders. New York: Oxford University Press. Kim, J., & Finkelstein, S. (2006). The effects of strategic and locational complementarity on acquisition performance: Evidence from the U.S. commercial banking industry, 1989–2001. Working paper. Pfeffer, J. (1992). Merger as a response to organizational interdependence. Administrative Science Quarterly, 17, 382–394. Ramaswamy, K. (1997). The performance impact of strategic similarity in horizontal mergers: Evidence from the U.S. banking industry. Academy of Management Journal, 40, 697–715. Seth, A. (1990). Value creation in acquisitions: A re-examination of performance issues. Strategic Management Journal, 11, 95–115.


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RELATEDNESS AND ACQUIRER PERFORMANCE Lasse B. Lien and Peter G. Klein ABSTRACT While the strategic management literature suggests that related diversification is superior to unrelated diversification, there is little evidence that acquirers benefit from pursuing related targets. We argue that the empirical literature is plagued by poor measures of relatedness. Moreover, many empirical studies do not control adequately for the characteristics of the market for corporate control. We argue that not only value creation, but also value appropriation, depend on the relatedness of acquirer and target. Using an improved measure of relatedness, we provide empirical evidence that acquirer returns are positively and significantly correlated with relatedness.

1. INTRODUCTION Resource-based and capabilities theories of the firm suggest that diversification can add value when the firm’s activities are closely related (Montgomery & Wernerfelt, 1988; Prahalad & Hamel, 1990; Rumelt, 1974; Wernerfelt, 1984). However, there is little evidence that acquirers benefit from pursuing related, rather than unrelated, targets (Datta, Pinches, & Narayanan, 1992; Kaplan & Weisbach, 1992; Lubatkin, 1987; Seth, 1990b; Advances in Mergers and Acquisitions, Volume 5, 9–23 Copyright r 2006 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1016/S1479-361X(06)05001-0

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LASSE B. LIEN AND PETER G. KLEIN

Singh & Montgomery, 1987; Sirower, 1997). Some studies even find a negative correlation between acquirer returns and the relatedness of acquirer and target (Agrawal, Jaffe, & Mandelker, 1992). The overall consensus appears to be that even if relatedness creates value, the additional value is largely captured by target shareholders, leaving little gain for the acquiring firm. We question this consensus for two reasons. First, relatedness is difficult to measure. Most studies use the distance between SIC codes, or the FTC’s categories of ‘‘product extension,’’ ‘‘market extension,’’ and ‘‘conglomerate,’’ to measure the relatedness of pairs of business units. However, such measures are not derived from theoretical models of scope, spillovers, experimentation, or other reasons for diversification, and are probably poor proxies for the kinds of relatedness that matter for value creation (Robins & Wiersema, 1995, 2003; Markides & Williamson, 1996; Silverman, 1999; Lien & Klein, 2004, 2005). Second, the acquirer’s returns depend not only on value creation, but value appropriation, which depends on the characteristics of the market for corporate control. As explained by Barney (1988), acquirers benefit from acquisitions when (a) the acquisition creates unique and valuable synergies, (b) the acquirer has private information about the combined value of acquirer and target, (c) the acquirer is lucky, or (d) there are more targets than acquirers. Ignoring luck, we argue that the remaining three conditions are more likely to obtain in related transactions. Assuming relatedness is properly measured, then, acquirers pursuing related targets should be in a better position to appropriate a share of the value created by the transaction. The chapter proceeds as follows. We begin by discussing the conditions under which relatedness creates value. Next, we evaluate common measures of relatedness, asking if they are sensitive to these conditions. Third, we outline the relation between value appropriation and relatedness. Finally, we supply some preliminary evidence that when an improved measure of relatedness is substituted for conventional SIC-based measures, there is a positive and significant relationship between relatedness and acquirer performance.

2. RELATEDNESS AND VALUE CREATION Do diversifying acquisitions create value? The answer depends on whether combining particular business activities within a firm provides performance advantages unavailable to single-business firms or firms with other combinations of activities. In the resource-based view, value is created when resources useful in one industry are substitutes for, or complements to,

Relatedness and Acquirer Performance

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resources useful in another industry.1 Substitute resources are those developed in one industry that are functional substitutes for resources required in another industry. Complementary resources exist when there are positive spillovers between resources used in different industries. Without such complementarities – either static or dynamic – it is hard to make economic sense of relatedness.2 However, while substitutability or complementarity are necessary conditions for relatedness to enhance performance, they are not sufficient conditions, as we argue below. 2.1. Resource Substitutability Consider resources that are substitutes across industries (leading to economies of scope). If resources are perfectly divisible, then substitutability provides no advantage to a related diversifier. However, if resources are not perfectly divisible,3 then single-business firms or unrelated diversifiers will be left with costly excess capacity, which can be exploited through related diversification (Willig, 1979). Penrose (1959) was one of the first writers to relax the assumption of perfect divisibility. She noted that excess capacity arises not only because some resources are inherently indivisible (e.g., half a truck is not half as valuable as a truck), but also due to learning; accumulated production generates new resources along with excess capacity in existing resources. These learning effects, combined with resource indivisibilities, suggest that related diversification can improve performance (assuming that unused capacity is costly). However, as Teece (1980, 1982) points out, while the existence of such indivisibilities explains joint production, it does not explain why joint production must be organized within a single firm. If the excess capacity created by indivisibilities can be traded in well functioning markets, single-business firms and unrelated diversifiers can simply sell or rent out their excess capacity or buy the capacity they need from others. In other words, absent transactional difficulties, two separate firms could simply contract to share the inputs, facilities, or whatever accounts for the relevant scope economies. If they do not, it must be because the costs of writing or enforcing such a contract are greater than the benefits from joint production. Whether the firms will create value by integrating thus depends on the comparative costs and benefits of contracting, not on the underlying production technology. Indeed, if contracting costs are low, the related diversifier may actually compete at a disadvantage relative to the single-business firm, because the diversified firm faces the additional bureaucratic costs of low-powered incentives, increased complexity, and so on.

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2.2. Resource Complementarity More recent attention has focused not on resource substitutability, but resource complementarity (Christensen & Foss, 1997; Foss & Christensen, 2001; Larsson & Finkelstein, 1999; Teece, Rumelt, Dosi, & Winter, 1994). Complementarities exist when investment in one industry increases the value of resources used in another industry, or when decisions about resource use in one industry affect similar decisions in another. These positive spillovers create a quantitative and qualitative coordination problem which may be best managed within a diversified firm (Milgrom & Roberts, 1992; Richardson, 1972). As before, to explain why this coordination problem cannot be solved in the market (i.e., between single-business firms or unrelated diversifiers), we must appeal to some form of contracting costs. Hence, transaction costs are also relevant to situations involving complements. Recently literature emphasizes dynamic complementarities, the ability to identify new ways of combining existing resources or speed up the development of new resources.4 The benefits to similarity in this context arise because such dynamic complementarities may be greater if the industries in question share some basic features (March, 1991), or because some common characteristics facilitate their exploitation (Finkelstein & Haleblian, 2002; Prahalad & Bettis, 1986). The degree of dynamic complementarity between industries thus depends on the balance between variety and similarity (Christensen & Foss, 1997). Industries with appropriate balances between variety and similarity produce larger dynamic complementarities than industries that are too different or too similar. Empirically, this implies that portfolios of businesses with strong inter-industry complementarities should be considered related (or, in Teece et al.’s, 1994 language, ‘‘coherent’’), and that firms with related activities should outperform firms with unrelated combinations of activities and single-business firms, ceteris paribus (again, assuming positive contracting costs).

3. CONVENTIONAL MEASURES OF RELATEDNESS Most of the empirical work in mergers and acquisitions use either the SIC system or the FTC’s merger classification system to label transactions as either related or unrelated (conglomerate). The simplest SIC-based measures label a transaction related if the firms’ core businesses share the same twodigit SIC code and unrelated otherwise (e.g., Doukas & Kan, 2004). Other


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approaches label transactions related if any of the firms’ largest businesses share a four-digit SIC code (e.g, Morck, Shleifer, & Vishny, 1990). The most sophisticated versions use distances between SIC codes to compute continuous measures of relatedness. Finkelstein and Haleblian (2002), for example, consider up to six lines of businesses for each firm. They assign scores of two, four, and six if the primary businesses match on the two-digit, threedigit, and four-digit levels, respectively. Comparison of the secondary businesses yields scores of one, two, and three for matches on the two-digit, three-digit, and four-digit levels, respectively. Such continuous measures have obvious advantages over discrete ones, not only because the former allow for more sophisticated econometric analysis, but also because, conceptually, relatedness is a matter of degree.5 Even these SIC-based measures are problematic, however. One problem is that the SIC’s four-digit system allows only four levels of distance. No matter how the weighting scheme is devised, the four available distance categories are different two-digit SIC codes, same two-digit SIC codes, same three-digit SIC codes, and same four-digit SIC codes.6 The underlying distance measure is in other words not truly continuous. In effect, this imposes the rather brave assumption that any pair of industries equally distant within the SIC hierarchy are equally dissimilar. However, the most serious problem with measures based on SIC codes is that these measures do not capture indivisibilities and transaction costs, the conditions under which relatedness creates value. Because these conditions are not incorporated into conventional measures of relatedness, these measures will tend to exaggerate relatedness in cases where resources are close substitutes but these additional conditions are not met. Moreover, as pointed out by Larsson and Finkelstein (1999) and Foss and Christensen (2001), SIC-based procedures have an implicit bias toward economies of scope and against dynamic complementarities, suggesting that specific types of relatedness are systematically underestimated. For these reasons, even the best SIC-based measures have serious limitations for studying relatedness and value creation. Evidence of these problems can be observed in the data on diversification. A good measure of diversification patterns is the frequency with which a given pair of industries is combined inside a firm, compared to what one would expect if diversification patterns were random (Teece et al., 1994). Assuming that firms tend to combine industries that are related, this difference can be interpreted as a measure of relatedness. If the difference is large and positive, then the industries in question are closely related. If the difference is negative, then the industries are unrelated. Table 1 provides this

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Table 1.

Correlation between SIC Distances and Actual Patterns of Diversification. SIC distance

Actual Actual Actual Actual Combinations Combinations Combinations Combinations 1981 1983 1987 1985

Actual combinations 1981 0.320 N 122,105

1 122,105


0.941 113,061


0.895 96,707

0.930 109,232


0.834 58,897

0.857 64,325

1 133,868 1 126,993 0.889 67,728

1 125,297

N refers to the number of 4-digit industry pairs actually combined inside any firm. po0.01.

measure for all four-digit industry pairs that were combined within firms during the 1980s. Our source is the AGSM/Trinet database, a detailed, establishment-level dataset covering all US firms (Voigt, 1993). Table 1 shows how this measure correlates to an SIC measure in which industry pairs in the same three-digit SIC code are given a value of 3, industries in the same twodigit SIC code are given a value of 2, and industries in different two-digit industries are given a value of 1. As seen in the table, the correlation between observed diversification patterns and the SIC-based relatedness measure is surprisingly low, ranging from 0.32 to 0.338. More detailed analysis also shows that some of the most frequently combined industry pairs are not related according to the SIC system. For example, the most frequently combined industries, Offices of Physicians (8011) and Outpatient Care Facilities (8081), do not share the same three-digit SIC code, though they are obviously closely related businesses. Other industry pairs in the top 1% in terms of observed combinations are not even in the same two-digit SIC code, such as Deep Sea Foreign Transportation (4411) and Freight Transportation Arrangement (4723), and Wood Cabinets for Television (2517) and Radio, Phonography and Cathode Ray Television Tubes (3672). Conversely, many industry pairs sharing a three-digit SIC code were never once combined during this period. This raises not only theoretical, but also empirical, concern about the reliability of SIC-based measures.


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The FTC classification system was used in several studies published in the 1980s and early 1990s (Chatterjee, 1986; Elgers & Clark, 1980; Lubatkin, 1983, 1987; Seth, 1990a, b; Park, 2003), but the FTC’s Large Merger Series was discontinued in 1979. The FTC classified mergers as horizontal if the merging firms were in the same product market, product extension if there were functional similarities in production or distribution (without direct competition), market extension if the parties sold similar products in different geographical markets, vertical if the firms were actual or potential trading partners, and other/conglomerate if none of these conditions held. Most studies using these classifications collapsed the categories into horizontal, vertical, and conglomerate, or simply related and conglomerate.7 These measures unfortunately suffer from the same problems as those based on SIC codes. Moreover, as the FTC classifications cannot be converted into continuous measures, they are also less flexible. Finally, the reliability of the FTC’s classifications depends on the judgment of the FTC’s staff. Because we know little about how these judgments were rendered, it is impossible to verify the means used to classify complex mergers into mutually exclusive categories.

4. VALUE APPROPRIATION AND RELATEDNESS Our argument so far is that relatedness is likely to create value only when specific conditions are present, and that existing measures of relatedness do not adequately capture these conditions. To understand acquirer returns, however, we must focus not only on value creation, but also value appropriation. Barney (1988) argued that acquirers (of any type) can earn supranormal returns only when the market for corporate control is not perfectly competitive. This could occur if a particular bidder and target make a unique combination and if the source of this unique value is not easily imitated. Alternatively, the bidder may have private information about the value of the combined firm.8 Finally, bidders can appropriate value if the number of targets is larger than the number of bidders. Are these conditions more likely to hold when bidder and target are related? First, consider the case in which a particular combination of firms creates unique value that is not easily imitated. We assume that unrelated acquirer–target pairs seek value creation opportunities associated with generic resources, while related acquirer–target pairs seek value creation opportunities associated with specific resources. Montgomery and Wernerfelt

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(1988, p. 625) argue that generic resources ‘‘normally yield less advantage because they are in wider supply y [M]any firms have the opportunity to develop factors that apply to many different industries (e.g., teams of general managers), whereas fewer firms have natural opportunities to create more specific factors (e.g., teams of biochemists).’’ This suggests that the equalizing forces are stronger with respect to generic factors, and consequently that generic factors tend to be more evenly distributed across firms than specific factors. Because unique value creation opportunities requires heterogeneity, bidders pursuing related targets are more likely to be able to generate unique value than bidders pursuing unrelated targets. Moreover, bidders pursuing related targets can often realize the gains associated with the target’s generic resources, while bidders pursuing unrelated targets cannot realize the gains associated with the target’s specific resources, giving related bidders an edge in bidding contests. For these reasons, we expect unique and inimitable value creation opportunities to be more likely for related bidders, and that the bidding process should systematically select for such bidders when they are present. Next, consider the case of private information about opportunities to create value. The likelihood of discovering such opportunities should be increasing in the acquirer’s knowledge about the target firm and its markets, and firms in related industries – possibly with overlapping technology, customers or suppliers – are likely to know more about the target firm and its markets. Put differently, private knowledge about opportunities for value creation is more likely to be discovered by firms in a related industry. Finally, consider the relative number of bidders and targets. The bidder’s bargaining position is strongest when there are more targets than bidders. The more generic the source of the value creation opportunity with the target, the fewer the restrictions on the number of potential bidders. The bidder could essentially come from any industry. Consequently it becomes more likely that many bidders will be competing for the same target. Conversely, if the value creation opportunity derives from specific resources, the number of potential bidders is likely to be smaller. In addition, it is possible that a value creation opportunity based on specific resources can be realized with several (or all) firms in the target industry, while a value creation opportunity of a more generic type may only be relevant for a particular target (with particular needs or shortcomings). The point here is that the ratio of potential bidders to potential targets should tend to be higher in unrelated transactions. For these reasons, the conditions specified by Barney (1988) as necessary for acquirers to appropriate value are more likely to obtain when acquirers


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are pursuing related targets. Of course, these advantages are mitigated by the market for corporate control, so at least some related acquirers will not earn abnormal returns. Still, we expect to find a positive relationship between acquirer returns and relatedness, given that relatedness is properly measured.

5. PRELIMINARY EMPIRICAL EVIDENCE 5.1. An Alternative Measure of Relatedness It is one thing to criticize measures based on SIC codes or FTC categories, another to provide a better one. We propose as a possible candidate the survivor-based measure that produced the patterns of diversification summarized Table 1. As described above, this procedure measures relatedness by comparing the observed combinations of activities within firms to what one would expect if diversification patterns were random. Here the knowledge of local decision makers and the screening function of competitive markets reveal what activities are related. Moreover, such a measure is both holistic and flexible, holistic in the sense that it captures all aspects of relatedness relevant for performance, including the conditions specified in Section 2 above, and flexible in the sense that it allows the causes of relatedness to vary from case to case. Of course, the survivor-based approach assumes that local decision makers possess the relevant information and incentives to make good decisions about resource combinations and/or that the competitive selection process effectively corrects for errors. However, attempts to evaluate the survivor-based approach empirically find it better than SIC-based schemes in a variety of dimensions (Lien & Klein, 2004, 2005). Another concern is that by allowing the market to determine what activities are related, we are left not knowing precisely what relatedness is in each specific case (a limitation shared by SIC-based procedures). Nevertheless, such an approach may still reveal what relatedness does, in terms of how it affects other variables of interest, such as acquirer returns in mergers and acquisitions. The discussion above suggests the following two hypotheses: H1. Relatedness will not be positively associated with acquirer returns when relatedness is measured with SIC distances. H2. Relatedness will be positively associated with acquirer returns when relatedness is measured with the survivor-based approach.

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5.2. Methods To test these hypotheses we first calculate a survivor-based measure of relatedness for all US industry pairs using the AGSM/Trinet Large Establishment Database (Trinet). The Trinet database contains records of all US establishments with more than 20 employees, including variables such as four-digit SIC code, corporate ownership, and sales. By aggregating the establishments for each parent in each four-digit SIC code, and the different four-digit SIC codes for each parent, and different parents for each four-digit SIC industry, we get a comprehensive picture of diversification patterns in the US economy. Comparison with the Census of Manufacturers indicate that Trinet contains 95% of all establishments it should (Voigt, 1993), and that omissions are most likely for small firms (which are less likely to be diversified). Following Teece et al. (1994) we use the following procedure: Let K be the number of diversified firms in the economy. Let Jij be a count of how often industries i and j are actually combined within the same firm. Jij will be larger if industries i and j are related, but will also increase with the number of firms in the two industries (ni and nj) To remove the effect of the size of industries i and j, the number Jij is compared with the number of expected combinations if diversification patterns were random. The random diversification hypothesis can be operationalized as a hypergeometric situation where a sample of size ni is drawn (without replacement) from a population of K firms. Those chosen are considered active in industry i. A second independent sample of size nj is then drawn from the population of K firms. Those chosen are considered active in industry j. The number xij of firms active in both i and j is then a hypergeometric random variable with population K, special members ni and sample size nj. The distribution function for this variable is then: K n ! ni i nj x x ! PrðX ij ¼ xÞ ¼ f hg ðx; K; ni ; nj Þ ¼ K nj

The mean and variance of Xij are mij ¼ EðX ij Þ ¼ s ¼ mij 1 2

ni nj K

ni K K K 1


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A standardized measure of the relatedness between industries i and j is then constructed based on the difference between Jij and mij in the following fashion: J ij mij Survivor Relatednessij ¼ sij The measure Survivor Relatednessij is thus a standardized measure of how much actual combinations exceed expected combinations under the random diversification hypothesis.9 Next, we draw a sample of transactions from the Thompson/SDC Platinum database from 1982 to 1985. We include only those transactions in which the acquirer acquires full ownership, both acquirer and target are listed in Compustat, the transaction has an ‘‘effective date’’ (to ensure it was completed), acquirer and target are have different primary four-digit SIC codes, and data are available from CRSP to compute cumulative abnormal returns (CARs). This yields 72 transactions. We calculate Acquirer CAR and Target CAR using a [ 30, +30] event window and the CRSP equally weighted index as the market proxy. SIC Relatedness is calculated as follows: if the two firms share the same primary three-digit SIC code, a value of 3 is assigned; if they share the same primary two-digit SIC code, a value of 2 is assigned; and if they are in different primary two-digit SIC codes, a value of 1 was assigned. The variable Survivor Relatedness uses the logic presented above to assign a survivor-based measure of the relatedness between the parties’ primary businesses. Note that we use the survivor-based measure for only 1981 and 1983 in our study (AGSM/Trinet data is only available biannually). To mitigate endogeneity the 1981 measures are used for merger announcements in 1982 and 1983, and the 1983 measures for announcements in 1984 and 1985. Table 2 presents means, standard deviations, and correlations for the key variables. The sample has a mean Target CAR of 0.29 and, a mean Acquirer CAR of 0.02, comparable to figures reported in other studies covering the same period. 5.3. Findings Table 3 reports a series of standardized OLS regressions of Acquirer CAR on measures of relatedness. Model 1 uses only Target CAR as a regressor; we interpret its coefficient as a proxy for the premium paid to selling shareholders. The coefficient is positive, but not statistically significant. Model 2

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Table 2.

Means, Standard Deviations and Correlation Coefficients (n ¼ 72).

Acquirer CAR Target CAR SIC Relatedness Survivor Relatedness

Mean

SD

Target CAR

SIC Relatedness

Survivor Relatedness

–0.02 0.29 1.40 12.57

0.19 0.31 0.68 16.26

0.16 1

0.18 0.10 1

0.27 0.01 0.47 1

po0.5; po0.01.

Table 3.

Standardized Regressions on Acquirer CAR (n ¼ 72).

Target CAR SIC Relatedness Survivor relatedness Adj R2 F

Model 1

Model 2

0.159

0.143 0.167

0.012 1.842

0.026 1.962

Model 3 0.156 0.266 0.070 3.715

Model 4 0.151 0.052 0.241 0.059 2.5

po0.1; po0.5.

adds SIC Relatedness. Adding this variable does not improve the model significantly; the coefficient on SIC Relatedness is not statistically significant, nor is the F value for the regression itself. This is consistent with Hypothesis 1, the claim that acquirer returns are unrelated to relatedness, when relatedness is measured using SIC distances. Model 3 substitutes Survivor Relatedness for SIC Relatedness, leading to a substantial improvement in the model. The coefficient on Survivor Relatedness is positive and statistically significant and the F value is also significant. We interpret this as evidence for Hypothesis 2, the claim that acquirer returns are positively related to survivor-based relatedness. Finally, in model 4 we include both SIC Relatedness and Survivor Relatedness to see if the two measures capture different, complementary aspects of relatedness. However, adding SIC Relatedness lowers the F- and adjusted R2-values and the SIC variable itself is not statistically significant. Hence SIC Relatedness does not seem to add useful information not already captured by Survivor Relatedness. Put differently, the two measures appear to be substitutes, with Survivor Relatedness being the better measure.


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6. DISCUSSION AND CONCLUSIONS Our main point in this chapter is that the empirical literature on relatedness and acquirer returns is affected by limitations in the way relatedness is usually measured. Conventional measures are inconsistent with underlying theories about how relatedness can increase value, and our preliminary empirical work shows that an alternative measure of relatedness – one that accounts for the complexity of factors determining the value of relatedness – leads to different results. Of course, the empirical analysis presented here is merely suggestive and does not constitute a thorough investigation of the relationship between survivor-based relatedness and value creation. The analysis would benefit from the inclusion of additional control variables and a more detailed breakdown of the business portfolios of the merging firms. Nonetheless, our preliminary findings suggest that future research on mergers and acquisitions should seek to incorporate more sophisticated measures of relatedness. We think the survivor-based approach is one of the most promising alternatives.

NOTES 1. Throughout the paper we use the term ‘‘resources’’ to include both resources and competences. 2. Because we are discussing diversifying acquisitions we ignore gains related to increases in market share or improvements in market positioning. Such gains are unlikely to come from acquisitions across industries. We also ignore here the ‘‘internal capital markets’’ explanation for unrelated acquisitions (Hubbard & Palia, 1999; Klein, 2001). 3. In this we include as a special case the situation where the resource in question is a public input, so that excess capacity will always exist. 4. Foss, Foss, Klein, and Klein (2007) describe this ability – organizing heterogeneous capital resources under conditions of Knightian uncertainty – as the key characteristic of entrepreneurship. 5. Finkelstein and Haleblian (2002) find a positive and significant relationship between acquirer performance and their continuous measure of relatedness. 6. The one-digit SIC level is usually disregarded because it is considered too highly aggregated to convey any information about relatedness. We are unaware of any studies using six-digit NAICS codes. 7. As pointed out by Seth (1990b) the FTC categories were collapsed in different ways, making it hard to compare findings across studies. 8. Barney adds to this condition a requirement that the combination creates a unique value. However, as long as the information about the firms’ combined value is private, this requirement is not necessary – other potential bidders will not act on information they do not have. 9. Note that this is the same measure we termed Actual Combinations in Table 1.

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ACKNOWLEDGMENT We thank Carl Voigt for sharing the AGSM/Trinet database.

REFERENCES Agrawal, A., Jaffe, J. F., & Mandelker, G. N. (1992). The post-merger performance of acquiring firms – a reexamination of an anomaly. Journal of Finance, 47(4), 1605–1621. Barney, J. B. (1988). Returns to bidding firms in mergers and acquisitions – reconsidering the relatedness hypothesis. Strategic Management Journal, 9, 71–78. Chatterjee, S. (1986). Types of synergy and economic value – the impact of acquisitions on merging and rival firms. Strategic Management Journal, 7(2), 119–139. Christensen, J. F., & Foss, N. J. (1997). Dynamic corporate coherence and competence based competition: Theoretical foundations and strategic implications. In: A. Heene & R. Sanchez (Eds), Competence-based strategic management. Chichester: Wiley. Datta, D. K., Pinches, G. E., & Narayanan, V. K. (1992). Factors influencing wealth creation from mergers and acquisitions – a metaanalysis. Strategic Management Journal, 13(1), 67–84. Doukas, J. A., & Kan, O. B. (2004). Excess cash flows and diversification discount. Financial Management, 33(2), 71–88. Elgers, P. T., & Clark, J. J. (1980). Merger types and shareholder returns – additional evidence. Financial Management, 9(2), 66–72. Finkelstein, S., & Haleblian, J. (2002). Understanding acquisition performance: The role of transfer effects. Organization Science, 13(1), 36–47. Foss, K., Foss, N. J., Klein, P. G., & Klein, S. (2007). The entrepreneurial organization of heterogeneous capital. Journal of Management Studies, 44(7). (forthcoming). Foss, N. J., & Christensen, J. F. (2001). A market-process approach to corporate coherence. Managerial and Decision Economics, 22, 213–226. Hubbard, R. G., & Palia, D. (1999). A reexamination of the conglomerate merger wave in the 1960s: An internal capital markets view. Journal of Finance, 54(3), 1131–1152. Kaplan, S. N., & Weisbach, M. S. (1992). The success of acquisitions – evidence from divestitures. Journal of Finance, 47(1), 107–138. Klein, P. G. (2001). Were the acquisitive conglomerates inefficient? Rand Journal of Economics, 32(4), 745–761. Larsson, R., & Finkelstein, S. (1999). Integrating strategic, organizational, and human resource perspectives on mergers and acquisitions: A case survey of synergy realization. Organization Science, 10(1), 1–26. Lien, L. B., & Klein, P. G. (2004). Yet another way of measuring relatedness – this one: Let competition do it! Best paper proceedings of the Academy of Management annual meeting, New Orleans. Lien, L. B., & Klein, P. G. (2005). Measuring inter-industry relatedness: SIC-distances vs. the survivor principle. Best paper proceedings of the Academy of Management annual meeting, Honolulu, Hawaii. Lubatkin, M. (1983). Mergers and the performance of the acquiring firm. Academy of Management Review, 8(2), 218–225. Lubatkin, M. (1987). Merger strategies and stockholder value. Strategic Management Journal, 8(1), 39–53.


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Markides, C. C., & Williamson, P. J. (1996). Corporate diversification and organizational structure: A resource-based view. Academy of Management Journal, 39(2), 340–367. Milgrom, P., & Roberts, J. (1992). Economics, organization and management. Englewood Cliffs, NJ: Prentice-Hall. Montgomery, C. A., & Wernerfelt, B. (1988). Diversification, Ricardian rents, and Tobin-Q. Rand Journal of Economics, 19(4), 623–632. Morck, R., Shleifer, A., & Vishny, R. W. (1990). Do managerial objectives drive bad acquisitions. Journal of Finance, 45(1), 31–48. Park, C. (2003). Prior performance characteristics of related and unrelated acquirers. Strategic Management Journal, 24(5), 471–480. Penrose, E. (1959). The theory of the growth of the firm. Oxford: Blackwell. Prahalad, C. K., & Bettis, R. A. (1986). The dominant logic – a new linkage between diversity and performance. Strategic Management Journal, 7(6), 485–501. Prahalad, C. K., & Hamel, G. (1990). The core competence of the corporation. Harvard Business Review, 68(3), 79–91. Richardson, G. B. (1972). Organisation of industry. Economic Journal, 82(327), 883–896. Robins, J., & Wiersema, M. F. (1995). A resource-based approach to the multibusiness firm – empirical-analysis of portfolio interrelationships and corporate financial performance. Strategic Management Journal, 16(4), 277–299. Robins, J. A., & Wiersema, M. F. (2003). The measurement of corporate portfolio strategy: Analysis of the content validity of related diversification indexes. Strategic Management Journal, 24(1), 39–59. Rumelt, R. P. (1974). Strategy, structure, and economic performance. Division of Research Graduate School of Business Administration Harvard University. Seth, A. (1990a). Sources of value creation in acquisitions – an empirical-investigation. Strategic Management Journal, 11(6), 431–446. Seth, A. (1990b). Value creation in acquisitions – a reexamination of performance issues. Strategic Management Journal, 11(2), 99–115. Silverman, B. S. (1999). Technological resources and the direction of corporate diversification: Toward an integration of the resource-based view and transaction cost economics. Management Science, 45(8), 1109–1124. Singh, H., & Montgomery, C. A. (1987). Corporate acquisition strategies and economicperformance. Strategic Management Journal, 8(4), 377–386. Sirower, M. L. (1997). The synergy trap: How companies lose the acquisition game. New York: Free Press. Teece, D. J. (1980). Economies of scope and the scope of the enterprise. Journal of Economic Behavior & Organization, 1(3), 223–247. Teece, D. J. (1982). Towards an economic-theory of the multiproduct firm. Journal of Economic Behavior & Organization, 3(1), 39–63. Teece, D. J., Rumelt, R., Dosi, G., & Winter, S. (1994). Understanding corporate coherence – theory and evidence. Journal of Economic Behavior & Organization, 23(1), 1–30. Voigt, C. W. (1993). The Trinet large establishment data. Anderson Graduate School of Management, University of California at Los Angeles: California. Wernerfelt, B. (1984). A resource-based view of the firm. Strategic Management Journal, 5(2), 171–180. Willig, R. D. (1979). Multiproduct technology and market structure. American Economic Review, 69(2), 346–351.


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RISK REDUCTION THROUGH ACQUISITIONS: THE ROLES OF FIRM-SPECIFIC INVESTMENTS AND AGENCY HAZARDS Heli Wang and Jeffrey J. Reuer ABSTRACT This paper provides a stakeholder-based rationale for firm risk reduction through diversification. While firm-specific investments from stakeholders are often important sources of firm competitive advantage and economic rents, there is a reduced incentive for stakeholders to make these investments due to the risk associated with firm-specific investments. Since the risk associated with firm-specific investments is often related to the total firm risk level, we argue that stakeholders’ difficulties in diversifying the risks associated with their firm-specific investments create incentives for risk management by firms. We test this argument in a diversification setting. Based on a sample of firms’ first acquisition moves, we find that firms are more likely to engage in risk reduction through diversification when high levels of firm-specific assets are important to the firm’s operations. Several proxies for stakeholders’ specific investments are found to be significant in explaining cross-sectional variation in the extent of ex ante risk reduction in acquisitions.

Advances in Mergers and Acquisitions, Volume 5, 25–49 Copyright r 2006 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1016/S1479-361X(06)05002-2

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HELI WANG AND JEFFREY J. REUER

Strategic management research describes a variety of ways that firms can generate above-normal economic profits and gain long-lasting competitive advantage. For example, the resource-based view suggests that firms will be able to generate economic rents by exploiting valuable, rare, inimitable, and non-substitutable resources in developing and implementing strategies (Barney, 1991; Peteraf, 1993; Amit & Schoemaker, 1993). Firm-specific investments made by a firm’s stakeholders such as its employees, suppliers, and customers, represent an important class of these resources and capabilities. However, little is understood about the incentives of a firm’s stakeholders in making firm-specific investments. This paper contributes to the literature by arguing that although stakeholders are often compensated for their firm-specific investments by sharing some of the rents generated as a result of making these investments (Becker, 1964; Hashimoto, 1981), they are often concerned about the risks associated with firm-specific investments and are thus reluctant to make them (Titman, 1984; Cornell & Shapiro, 1987; Miller, 1998). By definition, the value of firmspecific investments depends on their use in a transaction between a particular stakeholder and a particular firm, so these investments cannot be readily transformed into assets that can be widely traded without losing much of their value. Thus, concerned about the risk of their specific investments being rendered obsolete, stakeholders of a high-risk firm may ex ante underinvest in firm-specific assets or demand higher compensation for making these investments (Titman, 1984; Cornell & Shapiro, 1987; Miller, 1998). The paper further argues that the risk associated with stakeholders’ firmspecific investments is often closely related to the firm’s total risk level. The higher is the level of firm risk, the more likely the firm may be under financial distress and the more likely that its stakeholders’ investments lose value. A firm therefore has incentives to reduce its level of risk exposure in order to induce its stakeholders to make firm-specific investments. The interest of this paper is placed on examining the risk reduction effect of corporate diversification. To the extent that a business has a lower probability of financial distress, if it is a division of a diversified firm rather than a stand-alone identity, its stakeholders are less concerned about losing the value of their specific investment and thus have a greater incentive to engage in these investments. One implication of the above argument is that because these investments are in turn potential sources of firm competitive advantage and economic value, diversification based on a risk-reduction motive can indirectly benefit a firm’s shareholders. It is worth highlighting that the literature on corporate diversification has tended to maintain a very different view of why firms seek to reduce risks

Risk Reduction through Acquisitions

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through diversification (e.g., Amihud & Lev, 1981; Scharfstein, 1998). Using portfolio diversification as an analogy, corporate diversification based on a pure risk-reduction motive has often been considered to be value destroying since equity holders can reduce risks themselves at lower cost by holding a diversified portfolio of securities. Agency theory suggests that diversification in general, and unrelated diversification in particular, can stem from incentive misalignments arising from the separation of ownership and control. Owing to the costs of monitoring managerial decisions, these problems encourage managers to diversify in order to obtain private benefits in the form of reduced employment risk, but at the expense of equity holders’ interests (e. g. Amihud & Lev, 1981). The main objective of this paper is to develop a stakeholder-based rationale for firm diversification and further test the explanatory power of this perspective alongside the baseline predictions offered by agency theory. To do so, we select variables used in financial economics research to proxy the extent to which a firm relies on specific investments from its stakeholders, and we use variables reflecting firms’ ownership structures to account for agency hazards. We then examine the effects of these variables on the tendency of a firm to reduce risks through acquisitions. In order to examine firms’ motives behind acquisitions, we develop a new, ex ante measure of risk reduction via Mergers & Acquisitions (M&A). The remainder of the paper is organized as follows: the following section offers the theoretical underpinnings of a stakeholder-based explanation for risk reduction through M&A and presents the paper’s core proposition. This section also discusses how this proposition differs from prior treatments of corporate diversification relying on agency theory. The next section provides details on the research design, and the empirical results are contained in a subsequent section. Evidence from a sample of 316 acquisitions by single-business companies suggests that firms are more likely to seek to reduce risks through acquisition when firm-specific investments are relevant to their operations. In the last section, we conclude with a discussion of the study’s implications and directions for future research.

BACKGROUND THEORY Stakeholders’ Firm-Specific Investments and Firm Risk This paper provides a rationale for firm diversification based on the concept of stakeholder firm-specific investments. Note that the term ‘‘stakeholder’’

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used here is borrowed from the stakeholder view of the firm. However, there two unique characteristics of our usage. First, the stakeholder groups of interest to us are narrower in that they do not include financial stakeholders such as shareholders, debt holders, and the community at large. Second, even in considering the stakeholder groups included in our analysis, i.e., employees, suppliers, and customers, our main concern is with those parties that have specific investments in the firm. Therefore, for the remainder of the paper, we use the term ‘‘stakeholders’’ to mean ‘‘employees, suppliers, and customers who have firm-specific investments.’’ Resource-based logic suggests that firms can generate rents by implementing strategies that exploit valuable, rare, costly to imitate, and nonsubstitutable resources (Amit & Schoemaker, 1993; Barney, 1991). These resources are often acquired in imperfectly competitive strategic factor markets (Barney, 1986) and are characterized by time compression diseconomies, asset interconnectedness, and asset efficiencies (Dierickx & Cool, 1989). Among the pool of resources examined, firm-specific asset investments made by a firm’s stakeholders, which generally involves key employees, suppliers, or customers’ both physical and human capital investments, are often considered to have the most rent generating potential due to their causal ambiguity and social complexity (e.g., Coff, 1999). To better understand the role of firm-specific investments in generating rents, it is helpful to consider the two types of human capital classified by Becker (1964): specific and general. When the value of an asset investment varies depending on a particular firm’s business setting, the investment is said to the specific to that firm. Examples of firm-specific assets can include an employee’s knowledge of a firm’s administrative procedures, or a supplier or a customer’s loyalty to a firm due to product switching costs. An important feature of these firm-specific assets is that they cannot be put to other uses without significant loss to the stakeholder. The value of a general-purpose asset, on the other hand, does not vary depending on a particular firm’s business setting, and thus such investments increase the investor’s productivity when transacting with any firm. An example of a general-purpose asset is an employee’s general skills in sales and marketing (e.g., Milgrom & Roberts, 1992). Although general investments may be still necessary for most firm operations, they are often not sources of competitive advantage and economic rents for a firm. For example, when the inherent inventive ability of a firm’s scientist is not specific to any particular firm, the scientist will be able to appropriate any rents generated from this ability by demanding a high level of compensation, or otherwise leaving that firm and commanding higher wages elsewhere. However, when the same scientist’s inventive ability can


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only be most efficiently deployed in one particular firm, the firm will be able to appropriate at least some of the rents generated from this inventive knowledge. Since in this case the rents are in fact jointly produced and are as much due to the firm as to the employee who made specific investments (Peteraf, 1993), the rents are not entirely passed on to factors which are not traded in open market and thus will be shared between the employee and the firm (Rumelt, 1987; Becker, 1964; Hashimoto, 1981). This is one reason that employee compensation is often tied to employee tenure; the longer the employee stays with a firm, the more likely that this employee will have more firm-specific investments with the firm, and this employee will be more likely to receive a larger share of the profits. Similarly, a particular firm’s suppliers or customers who make investments specific to the firm often can appropriate part of the benefits generated from these investments in the form of more favorable contract terms and prices. On the other hand, however, although stakeholders generally benefit from making firm-specific investments though various forms of rent sharing, they may be reluctant to make firm-specific investments despite the potential benefits. Because the value of firm-specific investments depends on their use in an exchange relationship between a particular stakeholder and a particular firm, they cannot be transformed into assets that can be more widely traded without losing much of their value. Thus, unlike equity holders, who can efficiently diversify away idiosyncratic risks associated with their investments, other stakeholders often cannot efficiently diversify away the risks associated with their investments. Moreover, the risk associated with making firm-specific investments is often related to the firm’s total risk level because a firm with high total risk is more likely to be under financial distress, which puts a stakeholder’s firm-specific investments at risk. And in addition a firm under financial distress is less likely to be able to fully compensate stakeholders for risk bearing (Titman, 1984; Cornell & Shapiro, 1987; Miller, 1998; Stulz, 2000). Thus, the willingness of stakeholders to invest in firm-specific assets is inversely related to a firm’s total risks: the higher its total risks, the less specific investments will be made by its stakeholders. Consequently, a firm has incentives to reduce total risks in order to induce its stakeholders to make more firm-specific investments.

Diversification and Firm Risk Although there are a number of means by which a firm may manage risk, we focus on the strategy of corporate diversification, since this is the area where

30


we believe that our above framework has the most to contribute relative to the received literature relying on agency theory. At first glance, the rationale for product-market diversification to reduce risks may appear to be straightforward. Generally speaking, a firm that diversifies increases the number of its sources of cash flow, and to the extent that these cash flows are not perfectly correlated, diversification reduces the likelihood that serious problems in one business will put the entire firm at risk. The above argument implicitly assumes that diversification reduces firm idiosyncratic risks in a similar way as investors building diversified portfolios. Several studies have found that diversified firms do have lower cash-flow variability (e.g., Amit & Wernerfelt, 1990; Amit & Livnat, 1988a, b; Caves, 1996). However, the validity of portfolio theory as applied to the context of corporate diversification has been tested in studies that examine the relationship between diversification and firms’ ex post risk. In fact, there is some evidence that diversification, especially unrelated diversification, increases rather than decreases firm risk (Lubatkin & O’Neill, 1987; Lubatkin & Chatterjee, 1994). In explaining their findings, Lubatkin and O’Neill (1987) and Lubatkin and Chatterjee (1994) suggest that unlike portfolio diversification of financial assets, real asset diversification adds complexity to the firm, which leads to less effective management and higher risk after the fact. The mixed results of the relationship between diversification and firm risks may reflect differences in sample selection, measurement, and methodology. In this study, rather than examining the overall effect of diversification on risk, we focus on whether a subset of firms reliant on firm-specific investment by their stakeholders seek to reduce risk via M&A. The study is also unique in developing an ex ante measure of risk reduction appropriate to the M&A setting. The ex ante conceptualization of risk that is used here has the benefit of being consistent with prior research on strategy in general (e.g., Bettis, 1981; Jemison, Pablo, & Sitkin, 1996) as well as on acquisitions in particular (Amihud & Lev, 1981) and is more closely connected to firms’ motives for engaging in M&A activity. In sum, the stakeholder-based rationale for corporate diversification has implications for the relationship between the degree to which a firm relies on its stakeholders’ firm-specific investments and the firm’s diversification strategy. When a firm depends on stakeholders making firm-specific investments, it is in the firm’s interests to induce these stakeholders to make these investments by engaging in risk reduction activities. Based on these arguments presented, we posit that the benefits obtained from risk reduction will be higher for firms reliant on firm-specific investments by their stakeholders,


31

holding everything else constant. The specific prediction we wish to test is as follows: Proposition 1. The risk-reduction potential of an acquisition is positively related to the extent to which the acquiring firm depends on stakeholders’ firm-specific investments. Agency Theory and Risk Reduction in M&A In addition to the rationale provided above for why firms diversify to reduce risk, agency theory offers a different explanation. The well-studied case in the literature is the potential conflict of interests between managers of public corporations and their stockholders, who tend to be relatively small, dispersed, and uninformed about the firm’s operations. The separation between ownership and control and the conflicts that ensue lead to agency costs that reduce the value of the firm (Jensen & Meckling, 1976). The core argument of agency theory as it relates to our study is that, unlike dispersed stockholders who can generally reduce risk at low cost by building diversified portfolios, managers cannot efficiently diversify their employment risk, and managers therefore engage in risk-reduction activities such as corporate diversification that reduce the value of the firm. In a well-known study, Amihud and Lev (1981) provide evidence that managers engage in unrelated mergers and diversification unless large block shareholders exist to closely monitor a firm’s managers. There has been recent debate on agency theory’s appropriate domain and on the interpretation of the evidence as it stands. Lane, Cannella, and Lubatkin (1998) suggest that the range of managerial phenomena to which agency theory speaks is narrower than the finance field suggests. Citing stewardship theory (e.g., Donaldson, 1990), they suggest that the interests of managers do not diverge from those of shareholders for the majority of managerial decisions, which obviates the need for the monitoring role of large block holders in many circumstances. While the debate on the relationship between ownership structure and corporate diversification is ongoing (Amihud & Lev, 1999; Denis, Denis, & Sarin, 1999; Lane, Cannella, & Lubatkin, 1999), additional empirical analysis using different data and methodology should be helpful in providing further evidence on whether agency costs play a role in influencing firms’ risk-reduction motives in the M&A context. Moreover, in investigating the proposition above on the effects of firm-specific investments by stakeholders, we also seek to examine the following proposition based on agency theory for the sake of

32


completeness and because it provides a useful conceptual baseline in constructing our models. Proposition 2. The risk reduction potential of an acquisition is positively related to the acquiring firm’s agency hazards as reflected in its ownership structure. Note that there are no claims that the stakeholder-based explanation and agency theoretic explanation are mutually exclusive, nor that one explanation is more important than the other. It could well be the case that both perspectives play a role in determining firm’s diversification strategies. Moreover, the explanatory power of each perspective is ultimately a matter to be resolved empirically.

METHODS Model Specification The multivariate statistical models regress an ex ante measure of the level of risk reduction through acquisition on variables representing stakeholders’ firm-specific investments, variables representing agency motives, and other controls. The models take the following form: risk reductionijðt

3; tÞ

¼ a þ b1 pension planiðt

1Þ

þ b2 cost of goods soldiðt

þ b3 advertising intensityiðt þ b5 institutionsiðt þ controlsiðt

1Þ

1Þ

þ iðt

1Þ

þ b4 insidersiðt

þ b6 blockholdersiðt 1Þ

1Þ

1Þ

1Þ

ð1Þ

where t is the year of acquisition announcement, and i and j refer to the acquiring firm and the target firm, respectively. The first three variables in the specification represent proxies for the firm’s reliance on firm-specific investments, and the next three variables characterize the firm’s ownership structure. In the next section, we discuss the construction of these measures as well as the control variables. Measures and Data Risk reduction. The dependent variable is the degree of potential risk reduction through a firm’s acquisition, which is measured as the correlation in monthly stock returns between the acquiring firm and the target firm for


33

three years prior to the transaction. There are at least two advantages associated with this treatment of risk. First, the dependent variable is an ex ante conceptualization of the degree of risk reduction through acquisition, which is more closely connected to a firm’s acquisition motives (Jemison et al., 1996). Second, by focusing on the degree of potential risk reduction through an acquisition instead of on the likelihood or number of acquisitions, we can limit the heterogeneity for which the model must account, including factors such as potential economies of scope between two businesses (e.g., Montgomery & Hariharan, 1991; Silverman, 1999), potential increased market power (e.g., Tirole, 1995; Scott, 1982), and so forth. The correlation in pre-merger monthly stock returns between the firm and its target was transformed as follows: risk reductionijðt

3; tÞ

¼

log

1 þ dijðt 1 dijðt

3; tÞ

(2)

3; tÞ

The logarithmic transformation is used to convert an otherwise bounded dependent variable into an unbounded one (e.g., Demsetz & Lehn, 1985). The negative sign is added purely for ease of interpretation, so that the measure’s sign corresponds to the construct of the degree of potential risk reduction. Monthly returns data for both acquiring and target firms were obtained from the Center for Research in Security Prices (CRSP) data files. We assessed the sensitivity of the results to this transformation and to the construction of the measure in two ways. First, we reestimated the models using a non-transformed measure, and the interpretations remained the same. Second, to address the possibility that the correlation between returns of the two firms becomes higher in time intervals close to the acquisition announcement date due to information disclosures, we also estimated the models by excluding the returns data for the three months prior to the announcement. As before, the interpretations offered in the results section continued to hold for this alternative measure of risk reduction potential. Firm-specific investments by stakeholders. We selected several variables used in financial economics and accounting research to proxy the extent to which a firm depends on specific investments made by its stakeholders. Specifically, studies in financial economics and accounting have examined the role of stakeholders’ implicit claims in determining firms’ policies toward risk (e.g., Titman & Wessels, 1988; Helwege, 1989; Bowen, Ducharme, & Shores, 1995), and we rely on the proxies used in this literature to construct our models. Because direct data on firm-specific investments are very difficult to obtain in secondary sources, we follow the convention in financial economics and accounting research and rely upon proxies that are likely

34


to be associated with a firm’s reliance on these investments. Moreover, although we discuss each stakeholder group in turn, each variable is not necessarily uniquely associated with a single stakeholder group. Our first proxy for a firm’s reliance on stakeholder firm-specific investment is whether or not the firm has a defined benefit pension plan (i.e., Pension Plan). The labor economics literature has interpreted defined benefit pension plans as implicit claims with employees (e.g., Ippolito, 1985; Ippolito & James, 1992). It has been found that workers in defined benefit pension plans have strong incentives to remain with the firm since premature voluntary or involuntary departure from the firm will trigger a sizable capital loss (Ippolito, 1985). As employee tenure increases, firm-specific human capital also tends to increase (e.g., Becker, 1964; Topel, 1991; Hamermesh, 1988). It follows that firms with defined benefit pension plans are more heavily reliant on employee’s specific investments. We identify firms with defined benefit pension plans as those firms with a non-negative value for projected pension obligations (i.e., overfunded or underfunded) in Standard & Poor’s COMPUSTAT, and we use a dummy variable to indicate the existence of a defined benefit plan (e.g., Bowen et al., 1995). Our second proxy for a firm’ reliance on stakeholders’ firm-specific investments is its cost of goods sold (i.e., Cost of Goods Sold). This proxy has been used to reflect the degree to which a firm depends on suppliers’ specific investments (Bowen et al., 1995). Cost of goods sold represents the costs incurred in producing products or services, and the cost of raw materials tends to be a significant portion of this cost. Suppliers’ firm-specific investments may include specific knowledge about product features, manufacturing skills, after-sale service, and timely delivery of the products and services to the firm (Bensaou & Anderson, 1999). A firm is more likely to rely on these products and services from its suppliers if the costs of the products or services offered are high (Bowen et al., 1995). Following Bowen et al. (1995), we adjust cost of goods sold as reported on the income statement by subtracting the change in the LIFO reserve to attenuate the effects of accounting method choice on this variable. Without this adjustment, cost of goods sold scaled by total assets is likely to be a downwardly biased cross-sectional measure of specific investment for firms using FIFO vs. LIFO. Data on this variable were obtained from Compustat. Our third proxy for a firm’ reliance on stakeholders’ specific investments is advertising intensity (i.e., Advertising Intensity). Titman and Wessels (1988) and Bowen et al. (1995) use this variable as a proxy for all stakeholder claims. It is likely to more closely indicate the need for firm-specific investments by customers, however. Nelson (1974) finds that experience goods


35

(i.e., products whose quality cannot be ascertained prior to purchase) are advertised more than search goods (i.e., products whose quality can be ascertained prior to purchase). Generally speaking, experience goods require not only more of consumers’ specific knowledge in purchasing the goods, but also more warrantees and after-sale service, which in turn increases customers’ switching costs. Data for this variable were obtained from Compustat and were scaled by total assets. Following the literature in finance and accounting, we coded missing values for advertising expenditures as zero. This is justified by the fact that firms are required to report their advertising expenditures unless it is nil and thus can be neglected. However, as a robustness check, we used a different treatment of missing values by replacing them with industry averages. We found no significant difference in results between these two treatments. Agency hazards. We use several variables to characterize firms’ ownership structures in order to examine the effects of agency hazards on the degree of potential risk reduction through acquisitions. The association between ownership structure and agency costs can be traced back to Berle and Means (1932), who first observed that the large scale of modern technology makes concentrated ownership less likely in a large corporation. As ownership becomes more dispersed, however, incentive misalignments may become manifest in such corporations. Later seminal work by Jensen and Meckling (1976) more specifically discussed the agency costs that result from the divergence of interests between owners and managers. Following this literature, we use the inside ownership proportion as a negative indicator of agency hazards. Two additional ownership variables that are used to proxy agency problems are based on the shares owned by institutional investors and by large block holders. Theories generally suggest that the greater the extent to which shares are concentrated in the hands of large individual or institutional investors, the more effectively management behavior will be monitored and disciplined (e.g., Grossman & Hart, 1980; Shleifer & Vishny, 1986). In addition, Barclay and Holderness (1991) and Bethel, Liebeskind, and Opler (1998) provide empirical evidence that blockholders play a monitoring role, and Smith (1996) provides similar evidence for institutional investors. Thus, ownership proportions for institutional investors and large blockholders are used as indicators of the degree of monitoring, and these variables should also take on negative signs in the models. Data for these ownership variables were obtained from Compact Disclosure. Control variables. Although our objective is to develop a parsimonious model incorporating proxies representing the firm’s reliance on stakeholders’

36


firm-specific investments and measures characterizing the ownership structure of the firm, we incorporated a series of controls that might influence the risk reduction sought by acquirers and might be related to the variables from the two theoretical perspectives of interest. Data for all of these controls were obtained from Compustat. First, we controlled for the initial risk level of the acquiring firms prior to acquisition. Everything else equal, the higher the acquiring firm’s risk, the greater the potential benefits from risk reduction (Shin & Stulz, 2000). This variable also accounts for potential mechanisms other than corporate diversification by which firms’ can reduce their risk levels. Miller and Reuer (1996) discuss several rationales for moving from variance-based measures of risk to downside measures, and their empirical analysis connects different downside risk measures to different stakeholder groups’ interests. Income stream risk reflects the interests of various stakeholder groups and is therefore attractive for the present analysis. We calculated this measure as a second-order root lower partial moment as follows: ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi sffiffiffiffiffiffiffiffiX 1 downside risk; ROA ¼ (3) ðIROAi ROAi Þ2 n ROA oIROA i

i

where ROAi is firm i’s return on assets and IROAi is the average return on assets for firms in firm i’s two-digit industry in the preceding year, which serves as the firm’s target level. The squared difference term was summed over all n years of the five years prior to the acquisition announcement in which firm i’s ROA fell short of its target level. Following Miller and Leiblein (1996), we also constructed the same measure using ROE data, which we labeled downside risk, ROE. This measure is correlated with Altman’s Z, an indicator of bankruptcy risk (Miller & Reuer, 1996). Second, we controlled for the acquiring firm’s free cash flow prior to the acquisition (i.e., Free Cash Flow). On the one hand, free cash flow can be considered to be a form of organizational slack, which acts as a buffer in case of financial distress (e.g., Bromiley, 1991). In this view, firms with more free cash flow will have less need to diversify to reduce risks. On the other hand, Jensen’s (1986) free cash-flow theory suggests that firms use such resources to engage in unrelated acquisitions. Free cash flow is estimated as income before extraordinary items plus depreciation and amortization less capital expenditures, which is then scaled by dividing by the firm’s market value. Third, we incorporated a control variable for the acquiring firm’s financial leverage (i.e., Leverage). The motivation for this control is that a reduction in a firm’s level of debt utilization represents an alternative way of


37

reducing the firm’s risk than engaging in product–market diversification. Firm’s with lower leverage also have greater slack financial resources and therefore have less need to diversify to reduce risk. Leverage is measured as the ratio of the firm’s total debt to its total assets. Fourth, we controlled for the size of the acquiring firm (i.e., Size). Although to our knowledge there are no previous studies that have established a direct relationship between firm size and the firm’s tendency to reduce risks through diversification, some studies have found that firm size is related to market power (e.g., Rhoades, 1985), organizational slack (e.g., Bromiley, 1991), and lower risks (e.g., Walls & Dyer, 1996). Since firms with high market power, organizational slack, or low risks have less need to reduce risks through corporate diversification, the predicted sign on the coefficient of this variable is negative. We measured firm size based on the total assets of the acquirer, and given the evident positive skewness in this measure, we took the natural logarithm of total assets to be our proxy for firm size. Finally, we controlled for the Tobin’s Q of the acquiring firm’s industry. Tobin’s Q has often been used as a proxy for growth opportunities and intangibles (e.g., Pilotte, 1992; Yoon & Starks, 1995). Firms with these opportunities or resources should have less need to diversify into other less related industries. Following Chung and Pruitt (1994), we approximated Tobin’s Q as the market-to-book ratio since this measure explains over 96% of the variance in a more sophisticated Tobin’s Q ratio that would require arbitrary assumptions about depreciation and inflation rates for the calculation of assets’ replacement values (e.g., Lindenberg & Ross, 1981). The market value numerator is the year-end market value of common stock plus the book value of preferred stock and debt, and the book value denominator is year-end total assets. In addition to the above control variables that are used in all models, as a robustness test we included dummy variables for the acquiring firms’ industries and for year effects, and the results for the theoretical variables did not change. Sample To test the two propositions developed above, we analyze a sample of singlebusiness firms that engaged in their first acquisitions. Following Chevalier (2000), we specifically focus on diversifying acquisitions between two firms that have no business segments in common in any single 2-digit SIC code in the year prior to the acquisition. In addition, to better account for the acquiring firms’ characteristics, the acquiring firms in the sample are all single

38


business firms prior to the acquisition. This restriction implies that each transaction in our sample is an acquiring firm’s first diversification move and that multiple transactions were not made by the same acquiring company. The initial sample comes from the SDC Mergers & Acquisitions Database. In addition to the sampling criteria noted above, we focused on acquisition announcements made during the 1990–2000 timeframe. Given the construction of the dependent variable, both the acquirer and target must be on the CRSP monthly returns database. After accounting for missing data from these sources as well as for missing accounting and ownership data, the final sample consisted of 316 firms. Since the focus of our sample is on single business firms’ first diversification moves, we compared our sample with those single business firms that did not diversify in the same period. The comparison group from Compustat consists of 1,287 single business firms that did not diversify between 1990 and 2000. A two-sample t-test for firm size indicated that the sampled firms are on average 18% smaller than firms that did not diversify (po0.001). A w2 test also indicated that the sectoral distributions of the sampled firms and single business firms that did not diversify were different (po0.001). While there is a large overlap of both groups of firms in industries such as chemical an allied products, electronic equipments, instruments and related products, and business services, the deviations mostly come from electricity and gas, insurance, oil and gas extraction, and communications industries, where there are a significantly larger number of single business firms than our sampled firms. These data patterns provide additional motivations for controlling for firm size and bidder industry effects.

RESULTS Table 1 provides correlations among the variables as well as descriptive statistics. The correlations between the proxies for firm-specific investments by employees (Pension Plan), suppliers (Cost of Goods Sold) and customers (Advertising Intensity) are not significant. By contrast, the three ownership structure variables are significantly correlated with each other. Of the proxies for firm-specific investment, only the defined pension plan indicator is significantly correlated with the ownership structure variables. Firms with defined benefit plans tend to be larger and more highly leveraged (both po0.001) and have ownership structures involving lower levels of inside ownership (po0.001) and higher levels of institutional ownership (po0.01). These correlations as well as the relationships with the control variables

Variables 1. Risk reduction 2. Downside risk ROA 3. Downside risk ROE 4. Free cash flow 5. Leverage 6. Size 7. Tobin’s Q 8. Insiders 9. Institutional investors 10. Blockholders 11. Pension plan 12. Cost of goods gold 13. Advertising intensity y

Mean 0.43 0.08 0.27 0.04 0.18 5.76 1.54 0.21 0.37 0.34 0.18 0.70 0.009

SD 0.63 0.24 1.20 0.14 0.19 1.75 0.43 0.22 0.28 0.29 0.38 0.74 0.025

1

0.16 0.004 0.02 0.09 0.18 0.02 0.01 0.13 0.02 0.08y 0.08 0.11

Descriptive Statistics and Correlation Matrix. 2

0.19 0.29 0.14 0.10y 0.07 0.03 0.18 0.09 0.14 0.08 0.28

3

0.14 0.07 0.10y 0.04 0.00 0.12 0.10y 0.08 0.01 0.03

4

0.19 0.20 0.05 0.01 0.24 0.02 0.14 0.06 0.03

5

0.13 0.21 0.03 0.00 0.03 0.19 0.08 0.02

6

0.04 0.22 0.33 0.04 0.22 0.11 0.00

7

0.03 0.04 0.10 0.21 0.26 0.08

8

0.19 0.26 0.23 0.05 0.05

9

0.17 0.17 0.02 0.01

10

11

12


Table 1.

0.03 0.01 0.02 0.04 0.05 0.00

po0.10;

po0.05; po0.01; po0.001.

39

40


indicated that multivariate analysis is needed to examine the partial effects of the theoretical variables on the extent to which firms reduce risks through acquisition. We also investigated the possibility of multicollinearity, yet the maximum variance inflation factor (VIF) obtained from the models is 2.29, which is substantially below the rule-of-thumb cutoff of 10 for multiple regression models (Neter, Wasserman, & Kutner, 1985). Thus, multicollinearity does not present a problem for model estimation. Table 2 presents the multivariate models for testing the two core propositions. F-values for all of the models indicate strong overall significance (po0.001 for all models). Models I and II provide baseline models by restricting the analysis to the effects of the control variables. Models III and IV add ownership structure variables to examine the agency hypotheses. Models V and VI then presents the effects of firm-specific investment variables. Finally, the last two models, Models VII and VIII, offer full models with both sets of theoretical variables as well as the controls. By examining the full models, we find general support for our first proposition. The hierarchical F-values of adding the three firm-specific investment proxies are 3.56 (i.e., comparing Models VII and III, po0.10) and 4.14 (i.e., comparing Models VIII and IV, po0.05), respectively. Advertising Intensity is significant for models using the Downside Risk, ROE control (Models VI and VIII), and the parameter estimate for this variable does not reach significance for the two models relying on Downside Risk, ROA (Models V and VII). The other two proxies for firm-specific investment by shareholders have positive and significant coefficients as hypothesized in all of the models. These results provide overall support for the proposition that the risk-reduction potential of an acquisition is positively related to the extent to which the acquiring firm depends on stakeholders’ firm-specific investments. We also find some support for the second proposition motivated by agency theory (Models III, IV, VII, and VIII). The hierarchical F-values obtained from adding the ownership structure variables are 1.82 (i.e., comparing Models VII and V) and 2.08 (i.e., comparing Models VIII and VI), which are both marginally significant at the 0.10 level. Both of the coefficients on ownership by institutional investors and insiders exhibit negative signs and are significant in three out of the four models in which they appear. This provides evidence that firms with better monitoring, as implied by higher levels of ownership by institutional investors, and firms with incentives aligned with those of owners, as implied by higher levels of ownership by insiders, are less likely to seek risk reduction in acquisitions. In none of the models is the ownership by block holders significant, however.

Variables Intercept Controls Downside risk ROA

Model I 0.24 (0.17)

Leverage Size Tobin’s Q Ownership variables Insiders Institutional investors Block holders

y

0.15 (0.18)

0.63 (0.16)

Downside risk ROE Free cash flow

Model II

0.73 (0.27) 0.68 (0.20) 0.08 (0.02) 0.06 (0.08)

Multiple Regression Results.. Model III 0.17 (0.18)

Model IV

Model V

0.10 (0.19)

0.48

0.62 (0.16) 0.01 (0.03) 0.41 (0.27) 0.53 (0.20) 0.08 (0.02) 0.08 (0.08)

(0.20)

Model VI y

0.38 (0.20)

0.60 (0.17)

0.29y (0.17) 0.22y (0.11) 0.13 (0.12)

0.29y (0.17) 0.30 (0.14) 0.14 (0.13)

0.59 (0.27) 0.66 (0.20) 0.08 (0.02) 0.16y (0.08)

Model VIII

0.44

0.35y (0.21)

(0.21) 0.59 (0.17)

0.01 (0.03) 0.31 (0.27) 0.59 (0.20) 0.09 (0.02) 0.18 (0.09)

0.69 (0.27) 0.67 (0.20) 0.08 (0.02) 0.18 (0.09)

0.01 (0.03) 0.45y (0.27) 0.53 (0.20) 0.08 (0.02) 0.19 (0.09)

0.25 (0.17) 0.24y (0.14) 0.14 (0.12)

0.25y (0.13) 0.33 (0.14) 0.14 (0.13)

41

0.83 (0.28) 0.68 (0.20) 0.07 (0.02) 0.07 (0.08)

0.01 (0.03) 0.53 (0.27) 0.54 (0.20) 0.08 (0.02) 0.10 (0.08)

Model VII


Table 2.

Variables

Model I

Model II

Model III

Model IV

Model V

Model VI

Model VII

Model VIII

3.30 316

0.23 (0.09) 0.09 (0.05) 1.36 (1.31) 5.85 316

0.19 (0.09) 0.08y (0.05) 2.90 (1.33) 4.06 316

0.21 (0.10) 0.10 (0.05) 1.46 (1.32) 4.70 316

0.19y (0.10) 0.09y (0.05) 2.96 (1.33) 3.60 316

FSI variables Pension plan Cost of goods sold Advertising intensity F-value No. of observations

6.78 316

4.85 316


Standard errors are shown in parentheses. y po0.10; po0.05; po0.01; po0.001.

4.02 316

42

Table 2. (Continued )


43

Part of the lack of significance for these variables may reflect the linear restrictions imposed on the ownership structure variables in the models in Table 2. Indeed, prior research in finance has found nonlinear relationships between inside ownership and corporate decisions and outcomes (e.g., Morck, Shleifer, & Vishny, 1988; McConnell & Servaes, 1990). In order to explore whether nonmonotonic effects for this variable might exist, we reestimated the models by adding a squared term for inside ownership (McConnell & Servaes, 1990) and by estimating a piecewise linear regression using Morck, Shleifer, and Vishny’s (1988) cutoff values, but in none of the models was there evidence for such nonlinear effects. Finally, the control variables deserve some comment. The coefficients on the six control variables are generally significant, except for Tobin’s Q and Downside Risk ROE, which are either insignificant or are only significant in a subset of the models. Consistent with expectations, the coefficients for Downside Risk ROA take on a positive sign. Free cash flow has a positive and significant parameter estimate in all of the models, which is consistent with the explanation that managers use discretionary cash flows to reduce risk via acquisitions (Jensen, 1986). Consistent with the argument that firms with lower debt utilization ratios have greater slack resources and have less need to diversify via acquisitions to reduce risk, leverage takes on a positive sign in all of the eight models. Larger firms also do not tend to seek risk reduction through acquisitions, which is in accordance with prior observations that such firms have greater market power (e.g., Rhoades, 1985) and other slack resources (e.g., Bromiley, 1991).

DISCUSSION The main finding of this study is that the extent to which firms depend on specific investments from stakeholders has a positive effect on the tendency for firms to reduce risk via acquisitions. This relationship holds when considering different multivariate models, using different proxies for firm-specific investments, and controlling for other factors that affect firms’ decision to reduce risks. The results of this paper reveal the importance of firm-specific investments by stakeholders in determining a firm’s diversification strategy, and the findings shed light on several areas of corporate strategy research. First, the argument and evidence that firms are more likely to reduce risks through diversification when the extent to which they depend on stakeholders’ firm-specific investments is high offers another rationale for product–market diversification. Incorporating this perspective into research on

44


diversification motives holds out the potential for a more comprehensive understanding of this important phenomenon in modern corporations (e.g., Montogomery, 1994). Extensions to this study might consider other types of diversification involving geographic diversification or organic growth as well as whether the inducements offered by risk management for firm-specific investment indeed translate into enhanced firm-specific commitments and value gains to equity holders. Second, the fact that we find support for both the stakeholder and agency theory based motives for firms to reduce risks through diversification also has implications for research on corporate governance. It implies that when the degree to which a firm depends on its stakeholders’ firm-specific investment is high, managers’ incentives to diversify may not always be problematic. To the extent that the resulting managerial actions also induce other stakeholders to engage in more firm-specific investments, equity holders may also benefit. If self-interested behaviors by managers coincide with shareholders interests by stimulating firm-specific investments by other stakeholders, this suggests that the costs of setting up compensation contracts and monitoring mechanisms might be reduced. Third, the arguments and evidence presented here may contribute to the ongoing debate and research on whether a ‘‘diversification discount’’ exists and, if so, whether diversification per se causes the discount in firm value. Over the last decades, a number of studies have reported a diversification discount in the range of 10–40% (e.g., Lang & Stulz, 1994; Berger & Ofek, 1995; Denis, Denis, & Sarin, 1997; Rajan, Servaes, & Zingales, 2000), yet recent evidence from models accounting for firms’ unobserved attributes and the endogeneity of their diversification choices suggests the possibility of a diversification premium (e.g., Campa & Kedia, 1999; Villalonga, 2000). Because both positive (e.g., synergy, inducements to make firm-specific investments, etc.) and negative (e.g., agency hazards, inefficient internal capital markets, etc.) effects may be at work simultaneously, future research may specify more precisely which mechanisms contribute to diversification discounts or premia rather than examining the overall effects of diversification. The present study identifies a new, specific element that may affect the firm value implications of diversification. Specifically, our model suggests that the diversification discount (premium) will be smaller (larger) for firms that operate in environments where firm-specific investments by stakeholders are relatively more important for their operations. Finally, this paper contributes to research on stakeholder theory. Since Freeman (1984), much of the literature in stakeholder management operates in a normative mode, arguing that firms should attend to the interests of all


45

their stakeholders – not just their stockholders. A common theme in this literature is that firms should treat stakeholders as ‘‘ends’’ (e.g., Boatright, 1994; Clarkson, 1995; Goodpaster, 1991), implying that moral principles should drive stakeholder relations. More recent developments in stakeholder theory consider an alternative, instrumental view, which links ‘‘means’’ and ‘‘ends’’ (Jones, 1995). Under this perspective, the ultimate objective of corporate decisions is marketplace success, and stakeholder management is a means to that end. Such stakeholder management, however, requires an explication of the specific links between cause (i.e., different forms of stakeholder management) and effect (i.e., corporate performance) (Jawahar & McLaughlin, 2001). The arguments and evidence set forth in this paper are consistent with the instrumental view of stakeholder theory because the study begins to specify links between stakeholder management, corporate strategy, and performance. In addition to the suggestions for future research highlighted above, a number of areas for additional work stem from several of the current paper’s limitations. First, future research might further examine the relationships between alternative risk management mechanisms, firm-specific investments by stakeholders, and corporate actions and performance. Although our key findings are consistent with the basic proposition advanced in this study, future research would benefit from studies that use more finegrained, primary data to measure firm-specific investments. Such research might also construct longitudinal models that consider how stakeholders’ investments are responsive to risk management practices by the firm. Future studies could also examine the firm’s overall diversification profile rather than focusing on single corporate transactions such as acquisitions by single business firms. Research along lines such as these may contribute to the advancement of stakeholder theory, offer new insights into the debate surrounding the application of agency theory in strategy research and, more generally, lead to new insights at the intersection of research on corporate strategy and finance.

ACKNOWLEDGMENTS We thank Jay Barney, Natasha Burns, Jean Helwege, David Hirshleifer, David Hsu, Seunghyun Lee, Michael Leiblein, Seongyeon Lim, Michael Lubatkin, and Doug Miller for helpful comments in the development of this research. Financial assistance for this project was provided by the Fisher College of Business, Ohio State University.

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KNOWLEDGE PRESERVATION AND TRANSFER DURING POST-ACQUISITION INTEGRATION Annette L. Ranft ABSTRACT A model of knowledge-based resource transfer during acquisition integration is developed and tested in a sample of 75 high-tech acquisitions. Results indicate that transferring tacit knowledge is both desirable and difficult in acquisitions of technology intensive firms. It was found that acquired firm autonomy preserves tacit knowledge, while rich communication and retention of key employees facilitates transferring knowledge in acquisitions.

Many acquisitions of high-tech firms are motivated by the acquirers’ need to build and extend strategic technological capabilities (Bower, 2001). Technological resources and capabilities targeted by an acquiring firm often embody the collective learning, or knowledge, of the acquired company, particularly in knowledge-intensive industries such as computer software and electronics (Ahuja & Katila, 2001). Acquiring a firm with a valuable knowledge-based resource, however, does not ensure that the knowledge is successfully transferred to or combined with the resources of the acquirer during acquisition integration (Larsson & Finkelstein, 1999; Ranft & Lord, Advances in Mergers and Acquisitions, Volume 5, 51–67 Copyright r 2006 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1016/S1479-361X(06)05003-4

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2000, 2002). In fact, attempts to transfer these resources or to change their organizational context may alter or even damage the resource (Nelson & Winter, 1982). To increase the knowledge base of a firm, skills, capabilities, and know-how must first be preserved and then transferred between the acquired and acquiring firms (Haspeslagh & Jemison, 1991; Markides & Williamson, 1994). During acquisition integration, therefore, a tension exists between the need to preserve acquired knowledge and capabilities and the need to transfer them to a new organizational context. This research develops and tests a model of knowledge-based resource preservation and transfer during post-acquisition integration. The model integrates three literature streams. First, the resourcebased view conceptualizes the firm as a bundle of tangible and intangible resources, including knowledge-based resources. Second, the knowledgebased view of the firm describes the structure of knowledge-based resources. Third, the strategy literature on post-acquisition integration identifies important dimensions of the process: (1) the autonomy of the acquired firm, (2) the retention of key employees, and (3) the richness of communication.

CONCEPTUAL FOUNDATION The resource-based view of the firm focuses on the firm’s resource profile and its ability to combine and use various resources to achieve competitive advantage. In addition to tangible, physical resources, it recognizes that less tangible assets and capabilities are potentially important (Penrose, 1959). Several researchers argue that proprietary knowledge and organizational capabilities are a critical source of competitive advantage (Conner & Prahalad, 1996; Grant, 1996a; Prahalad & Hamel, 1990). For example, Grant suggests that, ‘‘the primary role of the firm, and the essence of organizational capability, is the integration of knowledge’’ (Grant, 1996a, p. 375). The knowledge-based view argues that firms are repositories of different types of knowledge. The stock of knowledge develops from the experiences of individuals in the organization over time (Nelson & Winter, 1982). For example, a firm’s propensity to innovate (Pennings & Harianto, 1992) and to apply externally developed technologies (Cohen & Levinthal, 1989, 1990) are a function of its past efforts and experiences with innovation. Knowledge-based resources often are particular skills, including technical, creative, and collaborative skills (Miller & Shamsie, 1996). They are protected from competitive imitation by knowledge barriers, which are related to the underlying structure of the resource, including both the type of knowledge

Knowledge Preservation and Transfer during Post-Acquisition Integration

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(tacit or articulated) and the location of that knowledge (physical systems, individuals, or social systems) (Badaracco, 1991; Grant, 1996b; Itami, 1987; Kogut & Zander, 1992; Nonaka, 1994; Winter, 1987). Tacit knowledge is the implicit, non-codified skills and expertise accumulated through experience (Polanyi, 1962; Reed & DeFillippi, 1990). It cannot be ‘‘specified and communicated independent from the possessor of the knowledge’’ (Winter, 1987, p. 168). The individual who possesses the knowledge may not be able to codify and to teach others this knowledge (Polanyi, 1962). Tacit knowledge may be learned only through experience (Nonaka, 1994). Articulated knowledge, however, may be fully codified and reside in documented procedures, in machines, and in product designs, and it may be more easily taught or transferred to other contexts (Kogut & Zander, 1992; Winter, 1987). In this research, tacitness is defined as the degree to which knowledge is teachable and codifiable (Zander & Kogut, 1995). With respect to location, knowledge within the firm may be independent or embedded. Independent knowledge resides primarily in physical assets such as databases and documentation, and it is separable from the firm’s human capital. Embedded knowledge is located in individuals or in the ways individuals interact, cooperate, and rely on one another to accomplish a task (Brown & Duguid, 1992; Kogut & Zander, 1992). Fully embedded knowledge arises from the organizing principles by which people cooperate within organizations (Kogut & Zander, 1992), and it is highly dependent upon the organizational context in which it resides (Grant, 1996b; Leonard-Barton, 1992). In this research, embeddedness refers to the degree to which knowledge is located in the social system of the firm. While embeddedness is conceptually distinct from tacitness, the two are related. Articulated knowledge is located in the physical capital of the firm, and tacit knowledge is located in the human capital of the firm. A firm’s most valuable resources are frequently capabilities that result from integrating the individual and collective knowledge of organizational members (Grant, 1996a; Reed & DeFillippi, 1990). Conner and Prahalad (1996, p. 477) argue that ‘‘the resource-based view generally addresses performance differences between firms using asymmetries in knowledge and in associated competencies or capabilities’’ that are tacit and embedded in the firm’s human and organizational capital. Strategic capabilities are the skills or knowledge sets of how to manage and combine other resources available to the firm to create competitive advantage (Prahalad & Hamel, 1990). They are based on tacit, embedded knowledge and represent the ‘‘know-how’’ of an organization. Strategic capabilities are critical for creating causal ambiguity and, therefore, are a source of competitive advantage for the firm

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(Barney, 1991; Grant, 1996b) due to knowledge barriers generated by their tacitness and complexity (Miller & Shamsie, 1996). Because strategic resources are socially complex, any change to an organization’s context may diminish a capability by altering interaction within the firm. A paradox arises in acquisitions that pursue strategic capability transfer because the capability may be destroyed as the organizational context is altered. Resources that are based on tacit, embedded knowledge are the most fragile and difficult to transfer (Barney, 1991; Spender, 1994). These resources must be preserved and protected while they are transferred during post-acquisition integration (Haspeslagh & Jemison, 1991). In an acquisition, for example, transferring a patent between firms during post-acquisition integration is relatively straightforward. Few knowledge barriers exist because the patent is fully articulated and separable from the human capital of the firm. Transferring the R&D capability that led to the patent, however, may be very difficult because of the knowledge barriers created by the tacitness and embeddedness of the R&D capability. This underlying capability may be the critical resource for creating long-term competitive advantage (Conner & Prahalad, 1996; Grant, 1996b; Prahalad & Hamel, 1990).

HYPOTHESIS DEVELOPMENT Dimensions of Post-Acquisition Integration: Autonomy, Communication and Retention Knowledge Structure and Autonomy As discussed above, an acquisition intended to create value through the transfer of a strategic capability may be difficult to integrate. For example, if the underlying assumptions and value systems of the firms collide, conflicts between organizational cultures or between top management teams may change the context and diminish the capability. Acquired managers and other key employees may leave the firm, jeopardizing the viability of tacit, embedded resources (Hambrick & Cannella, 1993; Ranft & Lord, 2000). Organizational autonomy may alleviate some common problems (Jemison & Sitkin, 1986). Acquired firm autonomy may limit direct contact between members of the two organizations, minimizing conflicts and protecting resources based on tacit, embedded knowledge and dependent on the social system of a firm (Hambrick & Cannella, 1993; Nahavandi & Malekzadeh, 1988; Ranft & Lord, 2002). In general then, autonomy may


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help preserve knowledge-based resources. Knowledge preservation is a critical precursor to knowledge transfer during acquisition integration. To test for this relationship, the following hypothesis is proposed: H1. The tacitness of knowledge interacts positively with autonomy between the parent and acquired firms during acquisition integration to preserve acquired knowledge. Despite its benefits, autonomy may prevent critical knowledge transfer during acquisition integration. If the two firms are completely autonomous, resource transfer and learning may never be realized. The tension between preservation and transfer was explicitly discussed by managers advocating autonomy as reported by Ranft and Lord (2002). In the case studies they reported, managers argued for a ‘‘balance’’ between autonomy and integration, and emphasized the importance of creating vehicles for learning. Haspeslagh and Jemison (1991) recommend that autonomy is viewed as a period of learning during which the parent and acquired firms overcome knowledge barriers through shared experience, and eventually combine or transfer strategic capabilities. Knowledge Structure and Communication Transferring or sharing articulated and independent knowledge can be achieved through communication mechanisms such as memos and other written forms of communication. To transfer a strategic capability and other forms of tacit, embedded knowledge, however, may require in-depth, action oriented, face to face communication processes (Cook & Brown, 1999; Lord & Ranft, 2000; Nonaka, 1994; Ranft & Lord, 2000, 2002). These activities are examples of ‘‘rich’’ communications (Daft & Lengel, 1986). Rich communication encourages face-to-face interaction and shared understanding of complex information. In their case studies, Ranft and Lord (2002) found that in order to facilitate rich communication during acquisition integration, firms created teams with managers from both the parent and acquired firm, arranged frequent interfirm meetings, encouraged travel between parent and acquired firm locations, organized social events, and conducted one-on-one interviews with acquired employees. Rich communication processes, then, were expected to facilitate learning and the transfer of tacit, embedded knowledge between the two firms. The following hypothesis reflects these issues: H2. The tacitness of knowledge interacts positively with rich communication between firms during acquisition integration to facilitate knowledge transfer.

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Knowledge Structure and Retention Previous research (Hambrick & Cannella, 1993; Walsh, 1988, 1989; Walsh & Ellwood, 1991) provides consistent evidence for top management and key employee turnover following acquisitions, often because of a perceived decline in prestige or autonomy. Furthermore, Cannella and Hambrick (1993) conclude that the departures of acquired executives are harmful to postacquisition performance, particularly those involving the highest ranking executives. Consistent with Castansias and Helfat (1991), Cannella and Hambrick argue that executives from acquired firms are an intrinsic component of the acquired firm’s resource base, and that their retention is an important determinant of post-acquisition performance. Further research extended these findings to other key employees in the firm (Ranft & Lord, 2000). If autonomy and rich communication processes help to preserve and transfer knowledge-based resources, then key acquired firm managers and employees must be retained. Not only are effective managers required to operate the autonomous units within a firm, but the transfer of valuable, knowledgebased resources that are tacit and embedded in the firm’s social system may be dependent on the retention of certain employees throughout the organization, rather than simply senior executives (Ranft & Lord, 2002). Rich communication processes require face-to-face interaction, therefore, retaining acquired employees and managers are critical to the use and effectiveness of these rich communication processes. This suggests the following hypothesis: H3. The tacitness of knowledge interacts positively with retention of key employees in the acquired firm to facilitate knowledge transfer.

METHODOLOGY Sample A total of 268 acquisitions of high-tech firms in 1994 and 1995 with a transaction value of $10–250 million were identified in the SDC Platinum Worldwide Mergers and Acquisitions database. Press releases were available for 236 of these acquisitions through a Lexis/Nexis search of PR Newswire and Business Wire. The releases were examined to identify whether a knowledge-based resource or capability was important for acquisition success; 187 acquisitions were identified. The researchers identified and contacted by telephone the individual responsible for acquisition integration in each of the identified acquisitions.


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This contact secured top management endorsement and agreement to participate, while resolving questions and identifying other managers involved in the integration. The survey was sent to the primary contact person and the CEO of the parent. In total, 369 surveys were sent to managers in 187 acquisitions. A total of 81 complete surveys were returned. Two responses were received for six acquisitions. The average rate of agreement was very high, and responses were averaged (Very, Lubatkin, & Calori, 1997). Analysis found no significant response bias with respect to sample year, firm affiliation prior to the acquisition, and management level of the respondent. To check for non-response bias, respondents and non-respondents were compared on the average value of the acquisition, the average size of the parent firm, and the relatedness of the acquisition. All tests were insignificant. The final analysis included 75 acquisitions, accounting for 40% of the acquisitions. Measures Knowledge Structure Each survey respondent was asked to identify the primary knowledge-based resource or capability to be transferred in a particular acquisition. Examples were provided. Table 1 lists the types and frequencies of knowledge-based resources identified as most important to the acquisition. The structure of the selected resource was assessed using the dimensions of tacitness. Tacitness was measured using a modified seven-point Likert scale developed by Zander and Kogut (1995). A composite score for tacitness Table 1.

Most Important Knowledge-Based Resources (n ¼ 75).

Knowledge-Based Resource Identified Product technology Sales relationships and customer knowledge Product innovation capabilities Engineering capabilities Process or production technology Research capabilities Managerial capabilities Marketing expertise Low-cost manufacturing capability Supplier relationships and knowledge Total

Percentage of Acquisitions 40.0 20.0 18.7 8.0 5.3 5.3 2.7 0.0 0.0 0.0 100.0

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was obtained from six items assessing codifiability and teachability. The Cronbach-a for the scale was 0.7509 exceeding minimum acceptable levels (DeVellis, 1991; Nunnally, 1978). The composite score for tacitness used in subsequent analyses was calculated by averaging the scores on all scale items (Koberg, 1987). Autonomy of Acquired Firm The research used an established scale to measure autonomy by functional area (Very et al., 1997). On a 12-item scale, respondents were asked to what extent various functional areas were consolidated with the parent (1 ¼ totally independent; 7 ¼ totally consolidated). The areas were production, supply sources, R&D, engineering, distribution, sales, marketing, personnel management, strategic planning, financial and budget controls, accounting, and senior management. The Cronbach-a for the scale was 0.9458, providing strong evidence of the reliability of the scale and high inter-item correlations. This measure was compared to responses for a single item measure of ‘‘overall autonomy’’ (Hambrick & Cannella, 1993). The measures were highly correlated (r ¼ 0.776, po0.001), indicating response consistency. Rich Communication Based on Daft and Lengel (1986), respondents were asked to rate the extent to which personnel from the parent and the acquired firm interacted or communicated through various means such as written memos, reports, e-mail, phone conversations, meetings, social events, or mixing of personnel on a temporary or permanent basis. Each communication type was assigned a weight based on its degree of richness. An overall weighted score for rich communication was obtained for each acquisition. The higher the score, the richer the communication between firms. Retention of Key Employees Survey items were developed to determine the areas in the acquired firm where employees were important for acquisition success. The percentage of employees retained in each area of the firm was also obtained. A retention score was calculated based on a weighted average of the importance of retaining a particular group of employees, and the actual percentage retained from that group. Knowledge Transfer This measure modified Capron’s (1997) scale examining the transfer of resources and capabilities. On a seven-point scale, respondents indicated the


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extent to which the parent firm benefited from the transfer of each of the ten knowledge-based resources or capabilities identified in Table 1. The measure of specific knowledge transfer was the score of the item that matched the knowledge-based resource identified by the respondent as most important to the acquisition. Data Analysis Univariate statistics and scatterplots of the residuals were examined to check for outliers, out-of-range values, missing data, and assumptions of normality and homoscedasticity (Tabachnick & Fidell, 1996). No univariate outliers were found. All variables were within normal ranges for skewness and kurtosis, except for knowledge transfer, which was negatively skewed. This variable was transformed using the square root of its reflection to return it to a normal distribution (Tabachnick & Fidell, 1996). Hierarchical multiple regression analyses tested the hypotheses on the interactions between the structure of knowledge and the three dimensions of acquisition integration. Due to multi-collinearity between the three hypothesized interactions, the three hypotheses were tested with separate hierarchical regressions (Aiken & West, 1991; Jaccard, Turrisi, & Wan, 1990). A Bonferroni error adjustment was applied to control for repeated tests on the same dependent variable (Fox, 1997). Each of the independent variables entered into an equation was first ‘‘centered’’ by subtracting the mean of the variable from each case as recommended by Aiken and West (1991).

RESULTS Tables 2 and 3 present descriptive statistics and the results of the regression analyses. Table 2.

1. 2. 3. 4. 5.

Tacitness Functional autonomy Rich communication Retention Knowledge transfer

*po0.05; po0.01.

Descriptive Statistics.

Mean

SD

1

3.4 3.7 148.3 46.1 5.5

1.3 1.8 75.9 19.7 1.4

0.130 0.029 0.162 0.112

2

.474 0.533 0.241

3

0.154 0.132

4

0.103

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Table 3. Hierarchical Regression Results Dependent Variable ¼ Knowledge Transfer (n ¼ 75). Ind Variable

(A) Tacitness and Autonomy Hypothesis 1 Autonomy Tacit

Step 1

Step 2

Std b (t value)

Std b (t value)

0.128 ( 1.119) 0.217 ( 1.895)

0.103 ( 0.923) 0.216 ( 1.948) 0.266 2.746 3.881 (3, 71) 0.019 0.013 0.105

Autonomy*Tacit F (degrees of freedom) Significance of change in F Model significance Adjusted R2 (B) Tacitness and Communication Hypothesis 2 Communication Tacit

2.746 (2, 72) 0.071 0.045 0.326 (3.015) 0.243 ( 2.252)

Communication*tacit F (degrees of freedom) Significance of change in F Model significance Adjusted R2 (C) Tacitness and Retention Hypothesis 3 Retention Tacit

6.891 (2, 72) 0.002 0.137 0.151 (1.313) 0.258 ( 2.251)

Retention*tacit F (degrees of freedom) Significance of change in F Model significance Adjusted R2 po0.05; po0.01.

2.994 (2, 72) 0.056 0.051

0.320 (2.898) 0.244 ( 2.242) 0.032 ( 0.289) 4.563 (3, 71) 0.774 0.006 0.126 0.166 (1.464) 0.268 ( 2.263) 0.195 (1.739) 3.061 (3, 71) 0.086 0.034 0.077


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Tacitness and Autonomy Table 3 shows the hierarchical regression results for Hypothesis 1. The first regression was marginally significant (F ¼ 2.746, po0.1). When the interaction term was added, the change in F was significant (po0.05), indicating that the interaction term makes a unique contribution to the overall model. The overall model was significant (F ¼ 3.881, po.05) and explained 10.5% of the variance in knowledge transfer. In the full model, the coefficient for autonomy was negative, but not significant. The regression coefficient for tacitness was negative and significant (b ¼ 0.216, po0.01), indicating a negative main effect of tacitness on knowledge transfer; the higher the tacitness, the lower the knowledge transferred. The coefficient for the interaction term was positive and significant (b ¼ 0.266, po0.01). This result supports Hypothesis 1; in the context of high tacitness, high autonomy may reduce the negative effect of tacitness on knowledge transfer. Tacitness and Communication Table 3 shows the hierarchical regression results for Hypothesis 2. The first regression was highly significant (F ¼ 6.891, po0.01) with significant regression coefficients for both communication (b ¼ 0.326, po0.01) and tacitness (b ¼ 0.243, po0.05). This model explained 13.7% of the variance in knowledge transfer. The positive coefficient for communication indicated a positive main effect of communication on knowledge transfer; the higher the communication, the higher the knowledge transferred. The negative coefficient for tacitness indicated a negative main effect of tacitness on knowledge transfer; the higher the tacitness, the lower the knowledge transferred. In the full model, the interaction term was added, but the change in F was insignificant, indicating that the interaction term did not make a unique contribution to the overall model. Hypothesis 2, therefore, was not supported. The main effects, however, provide additional support for the negative impact of tacitness on knowledge transfer, and the positive impact of communication in acquisitions on all types of knowledge transfer. Tacitness and Retention Table 3 shows the hierarchical regression results for Hypothesis 3. The first regression was marginally significant (F ¼ 2.994, po0.1). When the interaction term was added, the change in F was marginally significant (po0.1),

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providing some support that the interaction term makes a unique contribution to the overall model. The overall model was significant (F ¼ 3.061, po0.05) and explained 3.4% of the variance in knowledge transfer. In the full model, the regression coefficient for tacitness was negative and significant (b ¼ 0.268, po0.05), indicating again a negative main effect of tacitness on knowledge transfer. The positive coefficient for the interaction term, however, was marginally significant (b ¼ 0.781, po0.1), providing only limited support for Hypothesis 3.

DISCUSSION This study developed and empirically tested a model of knowledge-based resource preservation and transfer during post-acquisition integration. In this research, 40% of the acquisitions were designed to transfer knowledge about a particular product technology, 20% involved sales relationships and customer knowledge, and another 20% acquired product innovation capabilities. These descriptive statistics illustrate that, in high-tech industries, acquisitions are frequently focused on acquiring and transferring knowledge-based resources. Transferring tacit knowledge during acquisition integration was consistently difficult. Tacitness, however, contributes to the inimitability of knowledge-based resources, enhances their value for competitive advantage (Barney, 1991; Reed & DeFillippi, 1990), and makes them attractive for acquisition. A paradox develops where the most valuable resources may be the most tacit, and, therefore, the most difficult to preserve and transfer. Classic strategy literature indicates that, if strategic interdependencies exist between firms, autonomy prevents the firms from combining their resources and achieving the objectives of the acquisition (Chatterjee, 1986; Porter, 1987). This study, however, indicates that certain forms of autonomy are beneficial when attempting to transfer tacit knowledge. Autonomy may be necessary to preserve acquired knowledge long enough to facilitate learning, so that it may be transferred and used by the new organization in the long run. The analysis revealed that tacitness and autonomy interact positively to facilitate knowledge transfer in acquisitions. Haspeslagh and Jemison (1991) also argued for the benefits of autonomy in some cases. They suggested that autonomy should be used as a period of learning to facilitate resource sharing and knowledge transfer. They did not discuss, however, other dimensions of the integration process that can facilitate learning during the period of autonomy. If autonomy is critical to


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preserve tacit knowledge, then what other dimensions of the acquisition integration process are necessary to transfer acquired knowledge and to exploit autonomy for learning? This study indicates that rich communication and retention work with autonomy to facilitate learning and to transfer resources. Rich communication between the parent firm and the acquired firm may be critical to transform autonomy into learning. Tacit knowledge can be learned only through shared experience and action (Cook & Brown, 1999; King & Ranft, 2001; Nonaka, 1994; Winter, 1987). Shared experience results from face-to-face interactions and discussions. Integrating management teams or frequent visits to other locations promote these contacts and help to transfer tacit knowledge. Communications such as memos or written reports cannot adequately communicate the nuances of tacit knowledge. One of the most intriguing results of this research was that, regardless of the tacitness of the knowledge to be transferred, rich communication was important to successful knowledge transfer. A significant negative correlation was found between autonomy and communication (r ¼ 0.474, po0.01). Apparently, rich communication does not occur naturally with autonomy. Autonomy implies that acquired managers are left alone to manage the operations of their firm. If the parent firm acts as a rubber stamp or simply provides financial resources, the communication, learning, transfer, and benefits may be minimal. Eventually, the acquired firm may be seen as unimportant and simply a financial drain on the parent. The model also emphasized the importance of retaining key acquired employees. This effect was marginally significant in the survey data analysis. Previous research focused on the retention of top management following an acquisition (Cannella & Hambrick, 1993; Hambrick & Cannella, 1993; Walsh, 1988, 1989; Walsh & Ellwood, 1991). Our survey identified five groups of employees as most important to retain: R&D, middle management, top management, sales, and engineering, respectively. These groups are consistent with the knowledge-based resources viewed as critical to these acquisitions: product technology, sales relationships and customer knowledge, and product innovation capabilities.

CONTRIBUTIONS, LIMITATIONS, AND DIRECTIONS FOR FUTURE RESEARCH This study builds and tests a model of knowledge-based resource preservation and transfer during post-acquisition integration. In the acquisition

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context, several influences on knowledge transfer were identified. First, the underlying structure of knowledge, as defined by its tacitness, was a strong influence on knowledge transfer. Consistent with existing theory and research, tacit knowledge is more difficult to transfer (Szulanski, 1996). Second, the structure of knowledge interacted with various dimensions of the acquisition integration process to facilitate knowledge preservation and transfer, mitigating the negative impact of tacitness. This research emphasizes the need to balance preservation and transfer of knowledge, as well as the paradox that this tension creates in organizations. Another primary contribution of this research was to examine the acquisition integration process empirically. A common explanation of acquisition failure is poor implementation (Kitching, 1967; Ramanujam & Varadarajan, 1989). Little is known, however, about the integration process of mergers and acquisitions (Jemison & Sitkin, 1986; Haspeslagh & Jemison, 1991; Larsson & Finelstein, 1999; Pablo, 1994). The literature is primary conceptual, with limited empirical work focusing on a single dimension such as autonomy or retention. This study not only considers the type of resource critical to the acquisition, but also three important dimensions of the postacquisition integration process. This study contributes to our understanding of communication during acquisition integration. The previous work on communication in acquisitions focused on communicating with acquired ‘‘employees as soon as possible about all the anticipated effects of the change’’ (Schweiger & DeNisi, 1991, p. 111), minimizing employee uncertainty and anxiety about the acquisition. In this research, rich, face-to-face communication was shown to be critical for tacit knowledge transfer and acquisition integration. Interestingly, rich communication was beneficial in all acquisitions, not just those intended to transfer tacit knowledge. Future research should examine the influence of both the medium and the content of communication in acquisitions. Generalizability of this study is limited because of the focus on small firms in high-tech industries. Although this approach allowed for greater depth and understanding, future research should examine other types of industries (e.g., service industries and/or capital intensive industries) to highlight differences and similarities. Also, future research should investigate more complex acquisition integration issues in larger, multi-divisional firms. Finally, the link between knowledge-transfer and long-term performance was not explicitly examined in this study. Future research should employ longitudinal research designs to empirically assess this relationship.


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ANTECEDENTS OF TARGET FIRM MEMBERS’ TRUST IN THE ACQUIRING FIRM’S MANAGEMENT: A DECISION-MAKING SIMULATION Gu¨nter K. Stahl, Chei Hwee Chua and Amy L. Pablo ABSTRACT Prior research on post-acquisition integration has paid little attention to the factors that influence the development of trust between the members of an acquiring firm and those of the target firm. Using a policy capturing approach, we found that five aspects of the takeover situation and the integration process affect target firm members’ trust in the acquiring firm’s management: takeover friendliness, national cultural similarity, interaction history of the acquiring firm and the target firm, retained autonomy, and attractiveness of the acquiring firm’s HR policies. Our findings suggest that of the five trust antecedents, the attractiveness of the acquirer’s HR policies is by far the most powerful predictor of target firm members’ trust in the acquiring firm’s management. The implications for post-acquisition integration research and practice are discussed. Theoretical frameworks for explaining post-acquisition performance have traditionally focused on financial and strategic factors, such as the degree of Advances in Mergers and Acquisitions, Volume 5, 69–89 Copyright r 2006 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1016/S1479-361X(06)05004-6

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‘‘strategic fit’’ between the acquiring and target firms, the method of payment, the acquisition premium paid, and so forth. It was not until relatively recently that research endeavors have begun to analyze the ‘‘softer,’’ less tangible social, cultural, and psychological issues involved in integrating acquired firms. Factors such as cultural fit, management style similarity, the pattern of dominance between the acquiring and target firms, and the social climate surrounding a takeover have increasingly been recognized to be of critical importance to the success of acquisitions (e.g., Birkinshaw, Bresman, & Hakanson, 2000; Cartwright & Cooper, 1996; Schweiger & Goulet, 2000; Stahl, Mendenhall, Pablo, & Javidan, 2005). Another, largely underexplored factor that may play a key role in the success and failure of acquisitions is trust. Few attempts have been made to examine, either conceptually or empirically, the role that trust plays in the post-acquisition integration process. However, case studies of mergers and acquisitions (M&A) (e.g., Chua, Stahl, & Engeli, 2005; Olie, 1994; Sales & Mirvis, 1984) as well as interviews with managers and employees of acquired organizations (e.g., Krug & Nigh, 2001; Napier, Simmons, & Stratton, 1989; Schweiger, Ivancevich, & Power, 1987) consistently stress that trust is of critical importance to the success of M&A. Yet, these case studies and interview findings also suggest that trust is one of the qualities that suffers most during a merger or takeover. Daniel Vasella, CEO of Novartis, has summarized well the importance and fragility of trust in M&A when he noted: ‘‘Only in a climate of trust are people willing to strive for the slightly impossible, to make decisions on their own, to take initiative, to feel accountable; trust is a prerequisite for working together effectively. y Among all the corporate values, trust was the one that suffered most from the merger’’ (Chua et al., 2005, pp. 391–392). Despite the large body of anecdotal evidence supporting the critical role of trust in M&A, little is known about the factors that facilitate or impede the development of trust in acquired companies. Drawing upon Stahl and Sitkin’s (2001, 2005) theoretical work on the role of trust in the post-acquisition integration process, we will develop a set of hypotheses regarding the antecedents of target firm members’ trust in the acquiring firm’s management in the aftermath of a takeover and provide an empirical test using a policy capturing approach.

ANTECEDENTS OF TARGET FIRM MEMBERS’ TRUST IN THE ACQUIRING FIRM’S MANAGEMENT In the literature on intra- and interorganizational trust, there is a remarkable diversity in conceptualizations of trust. However, central to most

Antecedents of Target Firm Members’ Trust

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definitions are the notions of risk and vulnerability. Risk means that a party could experience negative outcomes if the other party is untrustworthy. The risk of negative outcomes must be present for trust to operate, and the trustor must be willing to be vulnerable. In the absence of risk, trust is irrelevant because there is no vulnerability (Mayer, Davis, & Schoorman, 1995; Rousseau, Sitkin, Burt, & Camerer, 1998). Rousseau et al. (1998, p. 395) define trust as ‘‘a psychological state comprising the intention to accept vulnerability based upon positive expectations of the intentions or behavior of another.’’ This conceptualization of trust has been applied to interorganizational relationships. For example, in the context of joint ventures, open communication and information exchange, task coordination, informal agreements, and low levels of surveillance and monitoring are all manifestations of trust based on a willingness to rely on or be vulnerable to another party under a condition of risk (Currall & Inkpen, 2002; Inkpen & Currall, 1997). Evidence about the critical role that trust may play in the post-acquisition integration process can be drawn from a large body of research on intraand interorganizational trust. This research suggests that trust is important in a number of ways: it can lead to increased employee commitment, citizenship behavior, and job performance; improve manager–subordinate relationships; enhance the firm’s ability to adapt to complexity and change; and facilitate the implementation of self-managed work groups. Trust can also decrease agency and transaction costs by limiting the need for monitoring and control and, ultimately, provide firms with a competitive advantage (see Dirks & Ferrin, 2001; Jones & George, 1998; Kramer, 1999; Mayer et al., 1995 for reviews). Furthermore, research on interorganizational trust has shown that the development of trust is crucial to the successful formation and implementation of cooperative alliances between firms, such as joint ventures, R&D collaborations, and marketing partnerships (Das & Teng, 1998; Inkpen & Currall, 1997; Ring & Van de Ven, 1992; Zaheer, McEvily, & Perrone, 1998). The latter line of research seems particularly relevant to the study of M&A because the factors which are held responsible for the poor performance of alliances are in part those theorized to be associated with M&A failure (Cartwright & Cooper, 1996; Evans, Pucik, & Barsoux, 2002; Marks & Mirvis, 1998). Stahl and Sitkin (2001, 2005) have suggested that the level of trust between the members of the target firm and the acquiring firm’s management is a key factor in the success and failure of acquisitions. Drawing on the organizational trust literature, they propose that target firm members’ trust in the acquiring firm’s management is affected by characteristics of the initial takeover

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situation, as well as process variables related to the acquiring firm’s integration decisions and actions. The following five factors seem particularly critical in influencing target firm members’ trust in the acquiring firm’s management: mode of takeover, national cultural distance, interaction history of the acquiring firm and the target firm, retained autonomy, and perceived attractiveness of the acquiring firm’s human resource (HR) policies and practices. Friendliness of the Takeover It has been argued that hostile takeover tactics can result in sharp interorganizational conflict and pose major obstacles to achieving integration benefits in M&A (Buono & Bowditch, 1989; Hambrick & Cannella, 1993; Hitt, Harrison, & Ireland, 2001). According to Hunt (1990), the tone of the negotiations – whether the tone is friendly or hostile – is one of the most important influences on the post-acquisition integration success because of its effect on the quality of the interpersonal relationships between the members of the combining organizations. Friendliness is likely to generate perceptions of goodwill and trust, and to enhance the quality of communication and collaboration between the acquiring firm and the target firm. In contrast, trust can erode when target firm executives and those of the acquiring firm battle each other in a public forum, each being suspicious of the other’s intentions and claiming the other party’s inadequacy and lack of trustworthiness (Hambrick & Cannella, 1993). Compared to friendly acquisitions, acquirers in hostile takeovers are also more likely to replace the management of the target firm and to impose rigorous controls on the target firm (Hambrick & Cannella, 1993; Krug & Nigh, 2001). As a result of the threat of a hostile takeover, in-group out-group bias may increase, with the target firm employees striving to maintain their positive social identity by denigrating the acquiring firm and its management (Buono & Bowditch, 1989; Elsass & Veiga, 1994). Employees of acquired firms have likened the unwanted takeover to a rape and described the acquiring firm managers as attackers or barbarians – people not to be trusted (Marks & Mirvis, 2001). Therefore, we hypothesize: Hypothesis 1. The level of target firm members’ trust in the acquiring firm’s management is positively related to the friendliness of the takeover. National Cultural Similarity The ‘‘cultural distance’’ hypothesis, in its most general form, holds that the difficulties, costs, and risks associated with cross-cultural contact increase


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with growing cultural distance between two individuals, groups, or organizations (Hofstede, 1980; Kogut & Singh, 1988). It has been argued that cross-border acquisitions are more difficult to integrate than domestic ones because they require ‘‘double-layered acculturation’’ (Barkema, Bell, & Pennings, 1996, p. 151), whereby not only different corporate cultures have to be integrated, but differences in national cultural values and practices also have to be managed. Although the relationship between national cultural differences and post-acquisition performance is likely to be more complex than the ‘‘cultural distance’’ hypothesis suggests (Schweiger & Goulet, 2000; Stahl & Voigt, 2005; Weber, Shenkar, & Raveh, 1996), studies that examined the impact of cultural differences on sociocultural integration outcomes have generally found a negative relationship (e.g., Krug & Nigh, 1998; Larsson & Finkelstein, 1999). Prior acquisition research has not explicitly addressed the relationship between cultural distance and trust. However, research on intra- and interorganizational trust has shown that shared values and other sources of cultural similarity facilitate the development of trust between organizational members (Sarkar, Cavusgil, & Evirgen, 1997; Sitkin & Roth, 1993). Since individuals are more likely to perceive out-group members as untrustworthy than they are to so perceive in-group members, an individual’s trust in another person or group will be greater when the two are culturally or ethnically similar (McAllister, 1995). In contrast, fundamentally different values, goals and beliefs are likely to limit the potential for trust to emerge (Elsass & Veiga, 1994; Sitkin & Roth, 1993). Therefore, Hypothesis 2. The level of target firm members’ trust in the acquiring firm’s management is positively related to the national cultural similarity between the acquiring firm and the target firm. Interaction History A large body of research on the role that trust plays in work groups, strategic alliances, and socially embedded partnerships suggests that trust evolves over time through repeated interactions between partners (Gulati, 1995; Ring & Van de Ven, 1992; Zaheer et al., 1998). Not unlike romantic relationships, interfirm relationships mature with interaction frequency, duration, and the diversity of challenges that partners encounter and face together (Lewicki, McAllister, & Bies, 1998). As Rousseau et al. (1998, p. 399) have noted, ‘‘[r]epeated cycles of exchange, risk taking, and successful fulfillment of expectations strengthen the willingness of trusting parties to

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rely upon each other and expand the resources brought into the exchange.’’ Further, partners come to learn each other’s idiosyncrasies and to have deeper mutual understanding over time, which improves the affective quality of the relationship (Parkhe, 1993). This indirect evidence from the strategic alliance literature suggests that, in the context of acquisitions, familiarity and positive exchanges facilitate the development of trust between the members of the target firm and those of the acquiring company. If the two firms involved in an acquisition have prior experience collaborating on a joint venture or some other form of alliance, this common history of interaction is likely to result in a shared identity and greater mutual trust. Hypothesis 3. The level of target firm members’ trust in the acquiring firm’s management is positively related to the extent to which a history of prior contacts exists between the members of the two firms. Retained Autonomy Although, theoretically, integration can result in a balanced merging of two organizations, cultures and workforces, this balance rarely occurs in practice. Instead, the acquirer typically imposes control on the target firm and, where changes occur in policies, systems, and culture, they affect the members of the target firm more strongly than those of the acquirer (Cartwright & Cooper, 1996; Hambrick & Cannella, 1993; Pablo, 1994). Imposed control refers to a situation in which the acquirer removes autonomy from the target firm and imposes a rigorous or standardized set of rules, systems, and performance expectations upon it in order to gain quick control (Datta & Grant, 1990; Jemison & Sitkin, 1986). Because controls tend to signal the absence of trust, their use typically hampers the emergence of trust in relationships (Sitkin, 1995; Sitkin & Roth, 1993). Autonomy removal can be devastating from the perspective of the members of the target firm. Being put under close monitoring and control can lead to feelings of helplessness, hostility, and resentment (Buono & Bowditch, 1989; Hambrick & Cannella, 1993) – a situation that Datta and Grant (1990) have termed the ‘‘conquering army syndrome.’’ In such situations, it seems likely that the acquiring firm’s management is perceived as uniformly malevolent and not to be trusted by the members of the target firm. Therefore, Hypothesis 4. The level of target firm members’ trust in the acquiring firm’s management is positively related to the extent of autonomy retained by the target firm.


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Attractiveness of Acquiring Firm’s HR Policies It has been suggested that the way employees react to a merger or takeover depends to a large extent on the personal benefits and losses attributed to it (Cartwright & Cooper, 1996; Hunt, 1990; Schweiger & Walsh, 1990). For example, if members of the target firm see the takeover as a chance for greater job security and increased prospects for compensation, promotion, and personal development, this is likely to affect their attitude toward the acquiring firm’s management. The perceived attractiveness of the acquirer, as manifested in its HR policies and practices, reduces the potential for conflict and makes smooth integration more likely (Nahavandi & Malekzadeh, 1988; Stahl, Pucik, Evans, & Mendenhall, 2004). Consistent with this line of reasoning, a study of the effects of a merger involving two brokerage firms by Graves (1981) found that the employee reactions depended primarily on the personal benefits and losses attributed to the merger. Similarly, Larsson’s (1990) study of Swedish acquisitions revealed that increased job security, rewards, and opportunities for future career advancement reduced target firm members’ resistance to a takeover. In a study of British takeovers conducted by Hunt (1990), the degree to which the target firm members’ career opportunities were expanded in the post-acquisition integration period was directly related to acquisition success. When taken together, these findings suggest the following hypothesis. Hypothesis 5. The level of target firm members’ trust in the acquiring firm’s management is positively related to the attractiveness of the acquiring firm’s HR policies. Interaction Effects In addition to the hypothesized direct effects on trust, the five aspects of the takeover situation and integration process discussed above may interactively influence target firm members’ trust in the acquiring firm’s management. First, there is evidence to suggest that the negative effects of a hostile mode of takeover on target firm members’ trust are more pronounced in crossborder acquisitions than in domestic ones, which suggests an interaction effect between mode of takeover and national cultural similarity. Feelings of helplessness and antagonism that result from hostile takeover tactics are likely to be augmented by cultural and communication barriers, and the associated stereotypes, misconceptions, and chauvinistic biases (Cartwright & Cooper, 1996; Olie, 1990). Angwin (2001), in explaining the emotionally

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charged atmosphere created by the takeover of Mannesmann by Vodaphone, likened hostile cross-border takeovers to wars of business and cultural systems. Therefore, Hypothesis 6. There is an interaction effect between national cultural similarity and mode of takeover such that the negative effects of hostile takeover tactics on trust will be stronger when there are significant national cultural differences between the target firm and the acquiring firm. Second, we predict an interaction effect for the relationship between national cultural similarity and retained autonomy. Compared to domestic M&A, cross-border ones which involve the removal of autonomy and imposition of rules, systems, and performance expectations by the acquiring firm are likely to be more devastating for target firm members as they are expected to conform to the acquiring firm’s cultural norms and practices that are significantly different from their own (Buono & Bowditch, 1989; Cartwright & Cooper, 1996). Therefore, Hypothesis 7. There is an interaction effect between national cultural similarity and retained autonomy such that the negative effects of autonomy removal on trust will be stronger when there are significant national cultural differences between the target firm and the acquiring firm. Finally, we expect an interaction effect between retained autonomy and attractiveness of the acquiring firm’s HR policies. The extent to which an acquirer removes autonomy from the target firm depends on the attempted level of integration, and this can range from total autonomy to total absorption (Datta & Grant, 1990; Larsson & Finkelstein, 1999). If the target firm retains complete autonomy, the acquiring firm’s HR policies are less relevant to the members of the target firm, as no major changes in the target firm’s HR policies and compensation and benefits system are intended. Although the possibility of interfirm comparisons among employees exist even in the case of an acquirer adopting a hands-off integration approach, the quality of the acquirer’s HR policies is likely to be a more critical issue for target firm members if the acquirer imposes its systems and practices on the target firm. Hypothesis 8. There is an interaction effect between retained autonomy and attractiveness of the acquiring firm’s HR policies such that the positive effects of perceived attractiveness of the acquirer’s HR policies on trust will be stronger in cases where the acquirer imposes its systems and practices on the target firm. Fig. 1 summarizes the hypothesized relationships.


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H1

Friendliness of Takeover H6

H2

National Cultural Similarity

H3

Interaction History

Level of Target Firm Members’ Trust in the Acquiring Firm’s Management

H7 H4

Retained Autonomy

H8 Attractiveness of the Acquiring Firm’s HR Policies

Fig. 1.

H5

Hypothesized Antecedents of Target Firm Members’ Trust in the Acquiring Firm’s Management.

METHODOLOGY Design and Measures We used a policy capturing design to test our hypotheses. Through the policy-capturing technique, individuals’ decisions in particular domains can be modeled by presenting them with experimentally designed decision scenarios to manipulate the level of a number of theoretically determined decision criteria. It has been used to study an array of decision-making processes within the organizational context, for example, job choice decisions (e.g., Judge & Bretz, 1992), judgments of sexual harassment (York, 1989), willingness to reconcile a relationship following a trust violation (Tomlinson, Dineen, & Lewicki, 2004), and integration decisions in acquisitions (Pablo, 1994). Since the level of trust that a given party has for another party can be conceived of as the result of a decision-making process

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(Mayer et al., 1995; McAllister, 1995), the policy-capturing design seemed particularly well suited for testing our hypotheses. The policy-capturing design offers several advantages that are important for this study. First, it allows researchers to examine how individuals ‘‘weight, combine, or integrate information’’ when making decisions (Zedeck, 1977, p. 51). Second, the policy-capturing design provides a relatively high degree of control over confounding variables (Aiman-Smith, Scullen, & Barr, 2002). Third, it overcomes many of the limitations inherent in other, more direct approaches to examining individuals’ decision policies (Karren & Barringer, 2002). Some studies have found that stated decision policies differ from actual (observed) decision policies when individuals were asked to rate or rank the variables of interest in order of importance, thus raising concerns about the validity of such self-report attribute ratings (e.g., Hitt & Middlemist, 1979; Sherer, Schwab, & Heneman, 1987; Stumpf & London, 1981). Such discrepancy may stem from social desirability response bias where respondents may not be candid due to their desire to be socially correct. The policy-capturing method is considered to be preferable to the self-report attribute ratings method as it weakens social desirability response bias by indirectly assessing the importance of explanatory variables (Arnold & Feldman, 1981; Judge & Bretz, 1992; Rynes, Schwab, & Heneman, 1983). In this study, five independent variables, (i.e., the hypothesized antecedents of target firm members’ trust in the acquiring firm’s management), were manipulated. Friendliness of the takeover was manipulated by indicating in the scenario either that the target firm was acquired with the support of the target firm’s management or that the target firm was acquired against the will of the target firm’s management. National cultural similarity was manipulated by indicating in the scenario that it was a domestic acquisition or that it was a cross-border acquisition. Interaction history was manipulated by indicating in the scenario that the acquiring firm and the target firm had a history of collaboration, and that the target firm members had some personal contact with members of the acquiring firm prior to the takeover. Retained autonomy was manipulated by indicating in the scenario either that the target firm would likely be allowed to retain its own culture and much of its autonomy or that the acquiring firm was likely to impose its culture, practices and systems on the target firm during consolidation of the two organizations. Attractiveness of acquiring firm’s HR policies was manipulated by indicating in the scenario either that the acquiring firm’s HR policies and reward systems were known to be employee-friendly or that they were known to be employee-unfriendly.


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Based on a one-half fractional replicate of a full factorial experimental design (Cochran & Cox, 1957) and with each of the five independent variables manipulated at two levels, we developed two different sets of scenarios that consisted of 16 takeover scenarios each (12 2 2 2 2 2). Since fractional designs give substantially the same results as fully crossed designs for nomothetic research (Graham & Cable, 2001), the one-half fractional design was used to avoid respondent overload by reducing the number of scenarios that each respondent had to evaluate. The two different sets of 16 takeover scenarios became part of two standardized questionnaires. For each of these questionnaires, we created another questionnaire and varied the sequencing of the 16 takeover scenarios to control for effects of order on responses. Hence, we had four different questionnaires in total. The dependent variable, level of target firm members’ trust in the acquiring firm’s management, was measured by a question using a five-point Likert scale. Respondents were instructed to adopt the perspective of a target firm member when reading the takeover scenarios and to indicate on the fivepoint Likert scale ranging from 1 (very little extent) to 5 (very great extent), the extent to which they would trust the acquiring firm management. Each respondent also provided demographic and background information (e.g., gender, age, position level in the current company, and prior experience with an acquisition situation). Pretesting was done at several stages of the development of the questionnaire using Canadian Executive MBA students. Pretests involved reading the scenarios for clarity and interest. Pretesting was also done to check the effectiveness of the manipulations, clarity of the instructions, and the amount of time needed to complete the questionnaire. Revisions were made at each stage of pretesting. Sample Surveys were administered to 820 Canadians working in different companies in Canada. They included currently employed students of a Canadian business school’s executive MBA program, Canadian alumni of an international business school, and employees at Canadian companies whose HR executives were willing to distribute the questionnaires to them. Two hundred nine surveys were returned for a response rate of 26%. Ten surveys were unusable, resulting in a final sample of 199. Eighty-two percent of respondents were in managerial positions and 71% had a college education. Eighty percent were male and 89% were above 30 years old. Seventy-three percent of the respondents had experienced an


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acquisition while working with their current or previous employer(s). This shows that the sample is appropriate and respondents are able to respond adequately to the acquisition scenarios presented in our questionnaire. Data Analysis Moderated regression analysis was used to test the hypotheses and assess the relative effect of each independent variable on the dependent variable across all respondents. Since our hypotheses are nomothetic, we pooled our data across all respondents to do the analysis as recommended by Aiman-Smith et al. (2002). Each respondent made 16 decisions, resulting in a total of 3,184 (199 respondents 16 decisions) observations available for analysis. This means that the data set consists of multiple responses by each respondent. Since autocorrelation was found by some policy capturing studies in their pooled sample (for example, Judge & Bretz, 1992; Tomlinson, Dineen, & Lewicki, 2004), we verified if there was autocorrelation in our pooled sample. When there is autocorrelation, standard statistical tests of regression coefficients using ordinary least squares (OLS) regression may be biased. The Durbin–Watson statistic can estimate the degree of autocorrelation. It has an expected value of 2 under the hypothesis of no autocorrelation. In the present case, the statistic was 1.34, suggesting that there is some degree of autocorrelation. To deal with autocorrelation, Rynes, Weber, and Milkovich (1989) recommended including a dummy variable for each respondent in the pooled sample OLS equation. In the present case, we created n 1, or 198 dummy variables and entered them in the first step of the pooled sample regression equation to partial out each respondent’s idiosyncratic contribution to the overall regression. This step controls for autocorrelation, as well as respondent characteristics such as gender, age, position level in the current company and prior experience with an acquisition situation. In the second step, we entered all five independent variables to assess the main effects. In the third step, the three hypothesized interaction terms were added.

RESULTS Moderated regression analysis was used to estimate the relative weight given to each of the five independent variables by respondents in their decision to trust the acquiring firm’s management. Table 1 shows the results. The respondent control variables entered in the first step accounted for 23.5% of


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the variance in respondents’ trust decision, i.e., 23.5% of the variance in the level of trust in the acquiring firm’s management is due to individual differences. In the second step, all five independent variables were entered to assess the main effects. Together, they explained an additional 34.3% of the variance in the level of target firm members’ trust in the acquiring firm’s management. As indicated by Table 1, all five independent variables, friendliness of the takeover, national cultural similarity, interaction history, retained autonomy, and attractiveness of the acquiring firm’s HR policies significantly influenced respondents’ trust in the acquiring firm’s management. In all cases, the direction of effects was as hypothesized. Thus, Hypotheses 1–5 are supported. However, the beta weights shown in Table 1 suggest that the five independent variables were not equally important in influencing respondents’ trust decisions. Attractiveness of the acquiring firm’s HR policies was given the highest weight, followed by friendliness of the takeover, interaction history, retained autonomy, and national cultural similarity. In the third step, the three hypothesized interaction effects were entered as a block. Table 1 shows that this interaction block was statistically significant (DR2 ¼ 0.002, po0.01) and that two of the three hypothesized interaction effects were statistically significant. However, the interaction block only explained an additional variance of 0.2% beyond the main effects, which suggests that the interaction effects are too small to be theoretically or practically meaningful. Hence, Hypotheses 6–8 received no support.

DISCUSSION Prior research on post-acquisition integration has paid little attention to the factors that influence the development of trust between the members of the acquiring firm and those of the target firm. We developed and tested a model that describes how various aspects of the takeover situation and the integration process interactively influence target firm members’ trust in the acquiring firm’s management. As hypothesized, the results of a policycapturing study suggest that takeover friendliness, national cultural similarity, interaction history of the acquiring and target firms, retained autonomy, and attractiveness of the acquiring firm’s HR policies all affect individuals’ trust decisions in the aftermath of a takeover. Specifically, we found that members of the target firm tend to have greater trust in the acquiring firm’s management when the mode of takeover is friendly than when it is hostile; when there is a higher degree of national cultural similarity, (i.e., when it is a


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Table 1.

Results of Moderated Regression Analysis.

Independent Variable

Trust b

0.235

Step 1: Respondent dummy variables Step 2: Main effects Friendliness of the takeover National cultural similarity Interaction history Retained autonomy Attractiveness of acquiring firm’s HR policies

DR2

0.252 0.069 0.240 0.126 0.464 0.343

Step 3: Interaction terms National cultural similarity friendliness of the takeover National cultural similarity retained autonomy Retained autonomy attractiveness of acquiring firm’s HR policies

0.037 0.051 0.046 0.002

2

Total model R Total model adjusted R2

0.580 0.551

Note: N ¼ 3184 (199 respondents 16 decisions). po0.05; po0.01; po0.001.

domestic acquisition than when it is a cross-border acquisition) when there is an interaction history between the members of the acquiring and target firms than when there is no history of collaboration; when the acquiring firm is likely to allow the target firm to retain its own culture and much of its autonomy than when it is likely to impose its culture, practices, and systems on the target firm during consolidation of the two organizations; and when the acquiring firm’s HR policies are perceived to be beneficial than when they are perceived to be employee-unfriendly. While the findings suggest that each of the five factors can undermine or enhance trust in the aftermath of an acquisition, the hypothesized trust antecedents do not seem equally important in influencing target firm members’ trust in the acquiring firm’s management. Attractiveness of the acquiring firm’s HR policies appears to be by far the most powerful predictor of trust. This finding is consistent with prior research that has shown that the way employees react to a takeover depends primarily on the personal benefits and losses attributed to it (Cartwright & Cooper, 1996; Graves,


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1981; Schweiger & Walsh, 1990). It is also consistent with recent research on organizational trust suggesting that employees’ trust in management is rooted in the fairness and support they perceive in the organization’s HR policies and practices (Whitener, 2001, 2005). In takeovers, not only do the acquiring firm’s HR policies and practices – especially those related to compensation and benefits and promotions – have a major impact on acquired employees’ lives and careers, they also reveal much about the acquiring firm management’s fairness, concern for employees, etc. – and, thus, its trustworthiness. Perhaps for the same reason, the mode of takeover – whether the social climate surrounding the acquisition is friendly or hostile – was found to be another key factor influencing target firm members’ trust in the acquiring firm’s management. Among the five aspects of the takeover situation and integration process that were hypothesized to influence trust, cultural similarity had the least impact on respondents’ trust decisions. This finding contradicts the ‘‘cultural distance’’ hypothesis, but is consistent with recent studies that have shown that cultural differences do not always have a negative effect on postacquisition performance and other integration outcomes (e.g., Morosini, Shane, & Singh, 1998; Olie & Verwaal, 2004; Very, Lubatkin, & Calori, 1996). For example, a study of acculturative stress in cross-border M&A by Very et al. (1996) found that cultural differences elicited perceptions of attraction rather than stress, depending on the nationalities of the buying and acquired firms. Thus, the ‘‘cultural distance’’ hypothesis is too simplistic an explanation for the cultural processes involved in integrating merging or acquired organizations. Whether cultural differences have a positive or a negative impact on target firm employees’ reactions is likely to depend on the nature and extent of cultural differences, the integration approach taken, the interventions chosen to avoid or manage culture clashes, and a variety of other factors (Schweiger & Goulet, 2000; Stahl & Voigt, 2005; Weber et al., 1996).

LIMITATIONS AND IMPLICATIONS FOR RESEARCH This study has provided some new insights into the antecedents of target firm members’ trust in the acquiring firm’s management. However, there are several possible limitations that need to be discussed, as well as avenues for future research. Perhaps the most critical question is related to the external validity of the findings, i.e., whether the results of policy-capturing research can be generalized to real-world situations. This study used hypothetical scenarios to

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simulate individuals’ trust decisions in a variety of takeover situations. Although doing so was necessary to preserve the experimental control required to test the hypotheses advanced in this study, the responses to hypothetical takeover scenarios may differ from organizational members’ reactions to similar actual situations. However, several researchers have found that results from contrived situations used in policy capturing studies are not significantly different from results from real-world situations, particularly when decision makers are experienced in the types of decisions they are being asked to make (Brown, 1972; Pablo, 1994). Nevertheless, more empirical research, using alternative methodologies such as in-depth interviews and large-scale survey designs are needed to substantiate the critical role that the proposed trust antecedents play in the post-acquisition integration process, particularly in the development of trust between the members of the acquiring and target firms. Another possible limitation to the external validity of this study should be noted. Simulation of individuals’ decision processes through policy capturing allows for evaluation of how respondents use a limited set of information to make decisions in a specific domain. Since the purpose of our study was to examine the relationships proposed by a particular theoretical model (Stahl & Sitkin, 2001, 2005), we included only variables suggested by this model as important antecedents of target firm members’ trust. To the extent that additional variables outside this theoretical model have a significant influence on respondents’ trust decisions, the decision models obtained through the policy-capturing technique in this study are likely to be incomplete.

IMPLICATIONS FOR PRACTICE In corporate acquisitions, special emphasis is usually placed on the strategic and financial goals of the transaction, while the ‘‘human factors’’ do not receive as much attention. The findings of this study suggest that the ‘‘softer,’’ less tangible psychological, social, and cultural aspects of acquisition management play a key role in the post-acquisition integration process. Aspects of the takeover situation and the acquirer’s integration approach such as hostile takeover tactics, lack of familiarity with the target firm, and autonomy removal can be obstacles to achieving integration benefits because they undermine trust. Hence, the sociocultural and people implications have to be considered at an early stage in the acquisition process, in the evaluation and selection of a suitable target, as well as the integration planning process.


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Consistent with a ‘‘process perspective’’ on acquisitions (Haspeslagh & Jemison, 1991; Hunt, 1990; Jemison & Sitkin, 1986), the findings of this study suggest that acquisition outcomes such as employee trust and commitment depend on the ability of the acquirer to manage the integration process in an effective manner. While strategic and financial factors such as buyer strategy, acquisition premium paid, etc., determine the value creation potential of an acquisition, the acquirer’s integration decisions affect the employee reactions to the takeover and thus the extent to which that potential is realized. On the part of the acquiring management, an awareness of the tendency to remove more autonomy from the target firm than might be necessary in order to achieve projected synergies, and resisting this tendency, is likely to have a positive impact on trust. Carefully setting the appropriate tone during and after the negotiations, providing opportunities for interaction between members of the acquiring and the target firms, and introducing employee-friendly HR policies and practices can also go a long way toward building a relationship that is based on trust rather than domination and control.

ACKNOWLEDGEMENT The authors gratefully acknowledge financial support for the project ‘‘Managing Sociocultural Integration in Mergers and Acquisitions’’ (INSEAD research grant ] 2010-468 R).

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CULTIVATING POSITIVE EMOTIONS IN MERGERS AND ACQUISITIONS Verena Kusstatscher ABSTRACT The chapter should help managers to realize what they could do in order to enhance positive emotions and well being during challenging times of a post-merger integration. Indeed, negative affects, such as anxieties, aggressions, uncertainties, and stress are a very common phenomenon in mergers and acquisitions. On the other side, positive emotions are proved to be particularly suited for preventing and dealing with negative emotions. For researchers this chapter serves as an encouragement to shift their attention to positive emotions, and it aims to instill some ideas for further research.

RESEARCH CONTEXT AND PURPOSE Mergers and acquisitions (M&As) are widely reported in the popular business press and researched with scrutiny in academic contexts. M&As are sought after for reasons of increasing market power, synergy development, competitive advantage and financial rewards. However, on the level of Advances in Mergers and Acquisitions, Volume 5, 91–103 Copyright r 2006 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1016/S1479-361X(06)05005-8

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employees, these organizational change processes are largely connected with stress, negative emotions, increased uncertainty and therefore anxiety about the future. Given a bias for attention-grabbing negative news flashes, most of the perspectives on M&As which are reported in the media, are of a negative nature. Academic research largely follows this tradition and studies report widely about the unpleasant effects of M&As. Seventy percent of all M&As fail to reach their desired financial outcomes. Hence, there are ample of opportunities to focus on the negative aspects in merger management. This study takes a different stand. It builds on the emergent M&A literature and introduces a particularly novel dimension, the role of positive emotions in the creation of successful M&A outcomes. Emotions in general have not received the attention they deserve in M&A literature, although positive as well as negative emotions1 have crucial effects on employee behavior and therefore on the organization as a whole. While it is recognized that big organizational changes, such as M&As are arousing emotional events for all those affected (Cartwright & Cooper, 1996; Huy, 2002), there is little empirical evidence in literature. If we follow cognitive appraisal theories, we know that emotions shape human thinking and acting (Frijda, Manstead, & Bem, 2000). Therefore it is even more surprising that emotions have only been casually mentioned in the context of the so-called ‘‘merger syndrome’’ (Appelbaum, Gandell, Yortis, Proper, & Jobin, 2000; Marks & Mirvis, 1986). But they have almost never been studied systematically. Empson (2001), Fugate, Kinicki, and Scheck (2002), and Kiefer (2002) are exceptional examples. Yet, while they consider emotions in their M&A research, there is no clear focus on positive emotions in their studies. This perfectly reflects the trend to mainly spotlight negative emotions, which is not only a tendency in M&A literature, but in organization studies in general (Fredrickson, 2000a; Kiefer & Briner, 2003). The purpose of this chapter is to create awareness for the significance of positive emotions in M&As. First, literature on positive emotions in the context of organizational changes is reviewed and then positive emotions which are experienced by affiliates of four merging companies during the M&A integration process are presented. Both, managers and researchers should understand the importance of cultivating and studying positive emotions. There are obvious practical limitations in measuring emotions over time. Indeed, traditional emotion measurement methods like experimental methods (i.e., the measurement of corporeal reactions and displayed emotions) are not applicable to real world research prospects. Our second aim is

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therefore to introduce a suitable method that allows for capturing a longitudinal perspective in in-depth interviews.

CONCEPTUAL BACKGROUND Emotions and Action Tendencies Across the variety of disciplines, which frequently offer radically different perspectives on emotions, many diverse definitions of emotions are offered and little consistency can be found in the use of terminology. Most of the current definitions describe emotions as a mental state of (action) readiness that arises from cognitive appraisals of events, social interactions or thoughts. There is also a consensus that emotions are accompanied by physiological processes that are often expressed physically (see, for example, Bagozzi, Gopinath, & Nyer, 1999). Most emotion researchers also agree that emotions are multi-component response tendencies that manifest over relatively short time spans – compared to moods which are often conceived as being longer lasting than emotions, lower in intensity, more diffuse, objectless or free-floating. Moods are constantly evolving and not directly coupled with action tendencies or explicit actions (Frijda, 1986; Holbrook & Gardner, 2000; Oatley & Jenkins, 1996). As per definition, most of the emotion models tend to associate emotions with specific action tendencies (Frijda, 1986; Lazarus, 1991; Oatley & Jenkins, 1996). Anger and resentment, for example, are consequences of perceived attack or threatened loss and are associated with the urge to attack, termed ‘fight mechanism.’ Fear and anxiety emerge when the individual perceives to be threatened, which leads to the ‘flight mechanism.’ Guilt is about blaming oneself for the misfortune of others, while shame is about blaming oneself for the own thoughts, words, behavior or emotions (for instance, for having been angry). Disgust is associated with the urge to expel, and so on (Frijda, 1986, 1993; Lazarus, 1991; Lazarus & Cohen-Charash, 2001; Smith & Lazarus, 1993; Stanley & Burrows, 2001). Such perspectives point at a reduction of the individual’s action repertoire when experiencing one of these emotions. Fredrickson (2000a, 2001) points out that these specific sets of behavioral options are not invariable predictions of people’s reactions. However, they are among the actions that worked best in evolution to get our ancestors out of life-or-death situations. Emotions thus help to make humans evolutionary adaptive and to survive. Fredrickson therefore argues that these

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prescriptive action tendencies may have their validity when it comes to negative emotions like anger, fear, sadness, etc. But when we consider positive emotions, she argues that action tendencies are not specific any more. Joy, for example, is linked to aimless activation, contentment with inactivity, and interest with attending (Frijda, 1986). Fredrickson’s explanation is that positive emotions are not linked to threats and do not requiring quick action. Indeed, several studies show that positive emotions broaden an individual’s momentary thought–action repertoire, instead of limiting it (Fredrickson, 1998). Positive Emotions and their Impact on Individuals Fredrickson (2001) therefore calls for a differentiation between positive and negative emotions and for the development of different theoretical models for these. In her ‘broaden-and-build theory of positive emotions’ she shows that positive emotions broaden people’s mindsets, encouraging them to discover novel lines of thoughts or action. Positive emotions, for instance, trigger play and the interest to explore, which help the individual to increase enduring personal resources. Positive emotions are therefore valuable ingredients for building physical, intellectual, social and psychological resources on which the individual can draw on during later challenging times. This means, positive emotions do not only have an instant pleasant effect on people’s well-being. They build durable reserves and therefore they also increase the likelihood of feeling good in the future. Experiments have shown that positive emotions are also able to undo negative emotions. They can counteract individual and societal problems that stem from negative emotions (Fredrickson & Levenson, 1998). We should not forget that negative emotions per se do have important functions. Anxiety promotes vigilance, and anger triggers seeking justice (‘flight and fight mechanisms’). Nevertheless, we have to be aware that these negative emotions easily go beyond their usefulness, and turn into destructive psychological and physical states. Unhappiness and grief may swell into pessimistic thinking and even depression (Nolen-Hoeksema, Morrow, & Fredrickson, 1993), which can lead to a weakening of the immune system and loss of work productivity (Coryell, Scheftner, Keller, & Endicott, et al., 1993; Klein, Moon, & Picard, 2002). Similarly, anger and poor coping mechanisms may lead to aggression and violence (Buss, 1994), the increase of the heart rate and the blood pressure, and ultimately to heart disease (Butlera et al., 2003) and even to some forms of cancer (Eysenck, 1994). In other words, negative emotions follow a downward spiral, leading to ever


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worsening functioning and moods. In contrast, positive emotions trigger upward spirals toward enhanced emotional well-being (short and long term) and optimal functioning. Positive emotions are therefore shown to be the best remedy to alleviate negative emotions and to fuel resilient coping for the future (Fredrickson, 2000b). The Impact of Positive Emotions on Organizations Recently, emotion researchers have begun to study the effects of positive emotions on physical and psychological well-being in the specific context of work (e.g., Fredrickson, 1998; Katwyk, Fox, Spector, & Kelloway, 2000; Kiefer & Briner, 1998; Tsai, 2001). They found that positive emotions – in contrast to negative ones – enhance activity levels, motivate people, have health-protecting physiological effects and the ability to further increase emotional well-being (Fredrickson, 1998; Fredrickson & Joiner, 2002). They are hypothesized to promote skill building and learning, positive social behaviors, commitment and other important aspects of organizational effectiveness (Shirom, 2003). Hope, for example, has been proposed to have a positive impact on performance (Luthans, 2002; in: Simmons, Nelson, & Phillips, 2004). Joy or contentment and an optimistic orientation lead to playful thinking and therefore to increased innovations (Fredrickson, 1998) and engagement with the environment (Shirom, 2003). Positive emotions do not only provoke positive changes within the individual, they are also contagious and may produce optimal functioning of groups and organizations. This is particularly good news for the management of M&As. Individuals experiencing positive emotions are more helpful and compassionate in the interaction with others (Fredrickson, 2000b). Those who benefit from the good deeds feel grateful, those who witness them feel elevated, and those doing good deeds feel pride. With each of these positive feelings, the likelihood of further compassionate acts is increased, which will have a positive impact on the whole group or organization. George (1995) points out that positive emotions demonstrated by an organizational leader are especially contagious and that they predict the performance of the entire group. We have seen that negative emotions are connected with action or action readiness. Following this cognitive appraisal approach I suggest that emotions of employees have an influence on their willingness to contribute towards a successful integration of the merging companies or – alternatively – to oppose to the organizational change. The more employees experience positive emotions, the better they will be able to cope with the inevitable

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negative emotions which come along with a merger or an acquisition, its changes, uncertainties and challenges. Measuring Emotions in M&As The measurement of emotions in general is a challenging endeavor. And despite Fredrickson’s (2001) call for a distinction between positive and negative emotions in theoretical models, there are no specific measurement tools for measuring positive emotions yet. Emotions have a physiological, an expressive and an individual experience component (O¨hman, 1986). Therefore, measurement methods traditionally concentrate on techniques which are able to (a) quantify corporeal reactions (Dawson, 1994; Dimberg, 1988; Levenson, Ekman, Heider, & Friesen, 1992; Tassinary & Cacioppo, 1992), (b) help to analyze displayed emotions of others (Ekman & Friesen, 1971, 1975; Izard, 1971, 1990) or (c) support the collecting of self-reports from the individual (Averill, 1982; Ellsworth & Smith, 1988; Leventhal, 1984; Scherer, 1988; Scherer & Wallbott, 1994; Smith & Ellsworth, 1987). Given practical limitations in the application of experimental methods (i.e., a and b) to real world research prospects, self-report measurement is considered particularly suitable to the M&A context. Leventhal (1984) considers emotions as an individually felt experience, which is best explored through the individual him/herself. He therefore suggests verbal self-reports and related response methods such as rating scales, checklists, bipolar scales and structured or formless diaries as ideal methods for the study of emotions of adults. Self-report measurement allows to capture multiple facets of emotional and perceptual experience, and although difficult to validate (Averill, 1982), it is the most convenient way for recalling past emotions and their circumstances (Ellsworth & Smith, 1988; Hochschild, 1983; Scherer, 1988). This is why in-depth interviews with those affected were chosen in the present study. Given that most of the emotion research confines itself to capturing short timescales (Gray & Watson, 2001) the ‘temperature curve’ was considered a suitable instrument for following a longitudinal perspective. The ‘temperature curve’ is a projective technique that was used to measure emotions over time. This novel measurement instrument consists of a system of coordinates where the x-axis represents the time horizon (with pre-determined time intervals) and the y-axis the intensity of emotional experience. The interviewees were asked to draw perceptions of emotional arousal during the post-merger integration stage into the grid (i.e., the


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‘temperature curve’). The official announcement of the merger was defined as the origin of the coordinate system. This instrument proved very suitable for the measurement of perceived emotional intensity over time. And the ‘temperature curve’ became the fundamental building block for the interviews.

EMPIRICAL STUDY Sample The empirical study was based on four post-merger integration stages. The four companies differed in size, industry sector, national backgrounds and with respect to their M&A situation. This means, partial and full (100%) takeovers were considered, members from acquiring as well as from acquired firms were interviewed. The analyzed cases involved a variety of sometimes daunting organizational changes; in some cases dismissals were necessary, in others they could be avoided. Three hierarchy levels were sampled. Eighteen in-depth interviews were conducted with top-managers or company owners, middle managers and employees without leading function. This approach allowed for a broader picture of the situation. The interviews were tape-recorded and transcribed, then formal analyzes were pursued using N*Vivo software. For the in-depth interviews projective techniques and critical incident technique were used to elicit rich response from interviewees. A total of 264 pages of transcripts and 58 pages of interviewer notes established the text corpus. Emotion Intensity As regards emotions and their intensity, strong variations were identified, according to the events that triggered these and according to the perceived likelihood that these events might impact on individuals. Merger announcement, first meeting(s) with partner organizations and prospective starting dates of effective changes to work and work environment were identified as emotionally most crucial events. Interestingly, even when managers decided to delay implementation strategies in order to ease potential problems, emotional turmoil could not be avoided. In such cases, emotional turmoil started to kick in with delay, sometimes even aggravating and extending insecurities of employees over longer than necessary time periods.

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Capturing Positive (and Negative) Emotions in M&As In a second step positive and negative emotions were captured. Open interview questions facilitated unaided response about emotions during M&As. Positive and negative emotions were extracted from interview response, following a grounded theory approach (see e.g., Harlos & Pinder, 2000; Martin & Turner, 1986). This allowed going beyond typical M&A studies in that there was room for interviewees to freely talk about positive emotions, which are traditionally underestimated in the M&A literature. Further, interviewees were asked to describe and to explain the ‘peaks’ and ‘turns’ of their ‘temperature curve.’ They presented their individual accounts of the M&A and tried to find the appropriate emotion or emotion related terms for each arousing event. Emotions and cognition related affect terms were coded with N*Vivo software following respondents’ listing of specific affects in the context of the ‘temperature curve,’ or codes were attributed to corresponding statements by the researcher. The voicing and the story helped, for example, to deduce the emotion ‘jealousy’ from statements about perceived injustice in favor of ‘the others.’ Frequency counts of codes provided an indication of emotions which were felt particularly prominent during the post-merger processes. Negative or unpleasant emotions appeared about twice as often as positive emotions in the four case studies. However, a whole range of positive emotions existed as well. Positive emotions were mentioned 366 times, negative emotions 786 times. Evidently, positive emotions provide for an important characteristic in M&A emotions, which further highlights the importance to have a closer look at them. Positive Emotions in M&As and their Impacts on M&A Outcomes Amongt the positive emotions and cognition related affect terms both, joy/ contentment and motivation, were mentioned 61 times. Trust and confidence were mentioned 49 times. Forty-four nominations appeared for feelings of certainty and safety, 39 for pride and 32 for hope and positive expectations. Interview partners mentioned 22 times the emotional attraction of a merger event and the positive challenge. Enthusiasm and euphoria were counted 21 times. Interview partners with a rather positive M&A experience talked more positively about the organizational change, reported more positive emotions and seemed more willing to contribute to a successful integration of the two companies compared to interview partners with less positive M&A


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perceptions. Case studies have shown that there is a positive correlation between employee’s emotions and their identification with the merged company and with their commitment to contribute to its success. Employees who experienced predominately positive emotions demonstrated also higher job satisfaction, perceived the partner company in a more positive way and the performance of the merged organization as successful. Also relationships within and across the two companies turned out better, the more positive emotions were experienced (see also Kusstatscher & Cooper, 2005).

CONCLUDING REMARKS: THE IMPORTANCE TO CULTIVATE POSITIVE EMOTIONS IN M&As Negative emotions are predominant during times of M&A announcements and integration periods. In this chapter it was demonstrated that positive emotions have the capability to undo negative emotions and to build resiliency for future trying times. Positive emotions are therefore worth to be cultivated with great attention. During a merger or an acquisition, people typically have to adapt to new strategies, structures and processes. Very probably they have to deal with new faces on a management level, perhaps they are also asked to identify with a new company name and sometimes they even have to accept former competitors as their new colleagues. This requires high levels of resiliency and a willingness to change and to adapt to new situations. Under such demanding circumstances it is easy to fall into the downward spiral of negative emotions. But at the same time it is extremely important to cultivate and to experience positive emotions, to learn new skills, to keep up optimism and to stay openminded. Indeed, post-merger situations are often characterized by high absenteeism and turnover rates. In this chapter we have also seen that positive emotions increase emotional well-being and that they have a health protecting effect. They further foster commitment and could therefore help companies to prevent people from voluntarily leaving the newly merged company. It was argued that positive emotions increase effectiveness, performance and therefore innovation. These outcomes are certainly needed in turbulent times of organizational restructuring. Positive emotions are also catalysts in the building of social skills and enhancing behavior and compassionate acts. What else could a manager wish to happen in the post-merger integration stage? Managers are therefore asked to pay careful attention to employees’ (and their own) emotions. They should strive to do their best to make the merger or the acquisition a pleasant – or at least an acceptable and

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‘‘human’’ process. Managers should be aware of their impact on employees’ emotions and of their important role as ‘emotion managers.’ This is true for every line manager, given that his or her emotions are especially contagious and given that they predict performance of the entire group or department. Unpleasant news or information can be very frustrating at any time, however, when delivered openly and without delay it is perceived less negative. In all, the more employees felt their line managers’ optimism – or at least their openness to communicate honestly and frequently – the higher was the chance for employees to experience positive emotions. Contrastingly, the line manager’s incapability to communicate contributed to feelings of uncertainty among employees, to destructive rumors and to negative emotions like distrust, fear, anger, frustration or aggression. In order provide a balanced view it is important to mention that also ‘negative’ emotions contribute positively to greater motivation and higher effectiveness. But this is valid – but only in the short term and with negative effects in the middle and long run. People who are able to find alternatives on the job market are not willing to show commitment to a company that is characterized by a climate of fear and anger. Positive emotions, on the other side, are able to promote identification with the newly merged organization. Hence, this chapter demonstrates that it is important to better understand how to make mergers work better and to pay more attention to the driving forces of human thinking and acting – to the emotions. However, certain methodological limitations have to be pointed out. While capturing using the ‘temperature curve’ proved worthwhile in the context of this study, the instrument should be tested and validated in further studies. A second point that has to be clarified through follow-up studies is whether the positive emotions are indeed predictive of merger success or whether they are an indicator of merger success. I suppose it is more than just an indicator, and suggest further research to check its potential causal effects. In other words, it has to be examined whether people express more positive emotions because of experienced merger success or whether perceived merger success is indeed the consequence of positive emotions.

NOTES 1. In literature it is common sense to talk about ‘positive’ and ‘negative’ emotions instead of talking about ‘pleasant’ and ‘unpleasant’ emotions. However, considering that emotions have signaling functions (Hochschild, 1983) all emotions – thus ‘negative’ emotions included – are actually ‘positive.’


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HOW TO AVOID RUINING YOUR COMPANY THROUGH INTERNATIONAL ACQUISITIONS? THE AHOLD CASE$ Harry G. Barkema ABSTRACT After three years of decline, the size and number of international acquisitions is picking up again. We show that there is every reason to believe that some of the mistakes of earlier acquisition waves will be made again. This paper presents five lessons from recent research that will help to avoid costly mistakes and instead build a successful multinational corporation. These lessons are illustrated with a case that has attracted much attention recently: the Ahold case.

After three years of decline, the size and number of international acquisitions (IAs) is picking up. With rising stock markets providing the ammunition to buy other companies with shares, interest on debt at low levels, cost cutting and restructuring completed in many firms, and the economy recovering, executives have begun buying again. Although the current $

I would like to thank IESE MBA-students (May, 2003) for their comments on the text.

Advances in Mergers and Acquisitions, Volume 5, 105–125 Copyright r 2006 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1016/S1479-361X(06)05006-X

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upturn is different from previous ones, are we again going to see an M&A spree including the hubris and herd effects of prior M&A waves? Many acquisitions in the previous wave failed: some research suggests as many as 3/4 of all acquisitions. Companies may avoid some of the worst mistakes of the 1990s when many mergers and acquisitions lacked a clear strategic rationale; current acquisitions seem to be taking place within existing businesses, and giant mergers have been sparse so far. However, there is every reason to believe that many acquisitions will fail again. Acquisitions always involve problems, as different information systems need to be integrated, cuts in the labor force are needed to realize anticipated efficiency gains, and so on. Additional problems arise in the case of IAs as managers in acquired companies have a different understanding of boss–worker relationships and of relationships with headquarters, different negotiation styles, and different human resource policies. The likelihood of failure is further increased because executives, like other people, show a tendency to underestimate problems, particularly when faced with complex tasks, which acquisitions certainly are (Lovallo & Kahneman, 2003). However, smart executives will want to be informed about their cognitive biases, the costly mistakes they cause, and the strategies that help to avoid them and instead help to build a successful multinational corporation (MNC). Underestimation of IA-related problems is supported by recent research showing a tendency for companies to rush in through IAs, thinking they know how to play the game, but in fact increasing the likelihood of costly mistakes being made and acquisitions failing (Barkema & Nadolska, 2004). When the accumulated problems can no longer be ignored, failed acquisitions are sold off, and companies learn. After this phase, foreign acquisitions pick up to higher levels than before, this time with an increasing success rate, making untimely IA sell-offs increasingly unlikely. Below, I will first discuss some key reasons for why IAs fail and how cognitive biases contribute to failure. Then – building on recent research – I will introduce five strategies that will help to avoid costly mistakes and instead build a successful MNC. This will be illustrated with the story of Ahold, the third retailer in the world, which rocked the financial press and the stock market on February 24, 2003. Ahold is an interesting case precisely because it appeared to be highly successful, impressing investors with a clear strategic logic and by being a ‘‘learning company,’’ reflecting the management wisdom of the early 21st century (Doz, Santos, & Williamson, 2001; Bartlett, Ghoshal, & Birkinshaw, 2003). However, like other companies, it underestimated the problems of IAs and rushed in confidently – in their case with dramatic results.

How to Avoid Ruining your Company through International Acquisitions?

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AHOLD On Monday morning February 24, 2003, the capital markets opened with a shock. Just minutes before, Ahold – the third retailer in the world – had announced major irregularities in its income statements. One hour later, two-thirds of its market value had evaporated, leaving investors baffled. For years, Ahold had articulated a clear strategic logic and take-over strategy, applauded by investors and the business press alike. Its CEO – Cees van der Hoeven – had received many prizes from investors. Ahold appeared to be applying recent management lessons and be a learning company, applying best practices everywhere. How could it happen to this company? And – the question reverberating in many boardrooms since – if this happened to Ahold, could it happen to us as well? Interestingly, many things actually went right at Ahold’s. Its strategy of selling high-quality products attracted medium- and high-income buyers to its supermarkets and allowed it to command premium prices. Ahold understood that its industry was globalizing and was racing against competitors Wal-Mart, Carrefour, and Tesco for global leadership. It expanded from the Netherlands to other countries in Europe, to the U.S (acquiring Stop & Shop, Giant Food, US Foodservice), Latin America (Bompreco, Disco), and Asia. Ahold’s acquisition strategy implied buying healthy companies with good management. This allowed Ahold to leave the management of acquired companies in place and to stay in tune with local customer needs. It also helped to exchange ‘‘best practices’’ among acquired and existing businesses.In the words of its CEO Cees van der Hoeven, Ahold was ‘‘the perfect take-over machine.’’ His well-articulated strategy and consistent increases in earnings and market value earned Van der Hoeven seven times the title of ‘‘CEO of the year’’ and his CFO – Michiel Meurs – several times ‘‘CFO of the year,’’ most recently in 2002. Then, all of a sudden early in the morning of February 24 2003, before the stock market opened, Ahold announced that US Foodservice had overstated income with $500 million – a mortal sin in the post-Enron era and a sum that would rise to $1.2 billion later. It also reported huge losses at its Argentinean acquisition Disco. Ahold’s CEO and CFO resigned, dwarfing its market value and leaving it with a huge scandal. That morning, the stock markets and the business press suddenly remembered what had seemed to be a minor thing one year earlier: that Ahold had misreported small acquisitions as organic growth. It also remembered lingering doubts about some of its acquisitions, such as those in Spain.

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We will now see why things went so terribly wrong at Ahold. It will allow you to check whether your company is about to make similar mistakes when global M&A activity is picking up again, your rivals may have started acquiring again, and you may be about to do so the same. Next, we will discuss five strategies suggested by recent research on how to avoid ruining your company through IAs.

DO YOUR CAPABILITIES CREATE A COMPETITIVE ADVANTAGE ABROAD? Many companies understand today that they need unique capabilities to create and sustain a competitive advantage and to achieve superior performance. Yet, internationalizing firms often fail to leverage their capabilities abroad. These firms may not have answered – or even asked themselves – the following two questions. First, what is our unique value-creating set of capabilities? Second, do these capabilities signify a competitive advantage in the new setting? These questions are particularly important because executives may be over-optimistic about the outcome of IAs (Barkema & Nadolska, 2004). Research suggests that executives, like other people, tend to overestimate the degree of control they have, discounting the role of luck and other factors. Second, the limits of human imagination imply that they do not see all the problems from the outset, causing them to ignore or underestimate problems. Third, executives often overestimate their own talents; like most people, they tend to believe that they are more successful than their peers. This tendency is bolstered by the cognitive mechanism of attributing successes to one’s own actions, and failures to external circumstances. This is particularly likely in the case of complex processes such as acquisitions, in which the relationship between action and success is ambiguous and there is much room for attributing failure to other causes (Lovallo & Kahneman, 2003). As a result, problematic acquisitions may not be immediately interpreted as failed actions, while successes build confidence even if this is not justified. Asking the right questions before entering new environments through IAs is a first antidote against over-optimism and may avoid costly mistakes. What are our Unique Value-Creating Capabilities? The first question is: what is our unique, value-creating set of capabilities? One reason why this question is often not answered, or incompletely so, is


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that value is often created by a complex of capabilities, where the value of one capability may be contingent on the other. Ahold came a long way in understanding its capabilities. It believed it had developed a unique capability in screening, selecting, and implementing acquisitions, perfecting its criteria and procedures to the point it believed it was the best in the business. Ahold also developed a second capability: the exchange of best practices among acquired and existing subsidiaries. It developed procedures for internal benchmarking to identify and exchange best practices; it set up steering committees supervising exchange processes and an Intranet system for internal communication and exchange. This learning capability depended on its acquisition capability in two ways: first, its ability to identify and select acquisition targets which enabled a valuable exchange of best practices; second, its ability to acquire companies with a culture that fitted Ahold’s and with good management that was willing to cooperate, exchange, and learn. Ahold’s complex of capabilities supported its strategy of selling high-quality products in a globalizing world with changing customer needs and helped to drive costs out of its business processes. Hence, Ahold had a clear view of what its unique complex of value-creating capabilities was, or so it believed. y And do they Create a Competitive Advantage in the New Setting? The second question is: Do the company’s capabilities imply a competitive advantage in the new setting? Or do they need to be adapted or supplemented, for instance? Ahold’s capabilities helped it to develop from a laid-back retail chain in the Netherlands – ‘‘born in the wrong place’’ to be truly globally competitive (Doz et al., 2001) – to the third-largest MNC in retailing. Learning about management and quality when it acquired Stop & Shop in 1996. Installing 25 task forces after acquiring Giant Food in 1998 to leverage and exchange best practices in IT, purchasing, logistics, management development, and other domains. Improving its procedures for learning in the process. Building a learning company and what seemed to be a highly successful global competitor in retailing, with a much-cherished top management team, and with ever increasing firm value. Then it confidently rushed into a new industry in the U.S., when it acquired US Foodservice in 2000 for $3.6 billion and quickly snapped up other companies in this industry, believing that its capabilities would also create a competitive advantage in this new setting. The foodservice industry supplies major customers such as hotel chains, restaurants, and government agencies. Ahold envisioned much synergy through the exchange of best practices.

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However, as it turned out, the substantial differences between this industry and retailing left only limited potential for exchanging of best practices and for creating a competitive advantage. Moreover, with US Foodservice, Ahold bought a company with a very different culture and incentive structure. Foodservice in the US is a cutthroat market where winning major customers such as restaurant chains, prisons, and hospitals may imply large increases in sales and in purchasing power regarding one’s own suppliers, sometimes enabling price reductions of more than 40%, and dramatically influencing profits. Bonuses at US Foodservice were strongly geared to increasing sales rather than to cooperation and exchange of best practices, which further eroded the basis for creating a competitive advantage in this new industry. In fact, its culture and bonuses inspired totally different behavior, which brought Ahold to the brink of bankruptcy, as we will see later on. Ahold also expanded into Latin America – using joint ventures instead of outright acquisitions and leveraging rather than exchanging practices – and in Asia, using the Tops formula. Its buying spree in Latin America included Disco in Argentina; however, when the local economy went down, highquality but high-priced supermarkets were hit hard as customers fled in droves, contributing to huge losses at Disco’s. Ahold also entered Asia, including China, by setting up new stores, failing in part because it ignored local ‘‘wet markets’’ with fresh vegetables at a much lower price, which Chinese customers love. Again, its capabilities, developed in mature Western markets, failed to create a competitive advantage. After Cees van der Hoeven had stepped down in February 2003, his successor – former IKEA CEO Anders Moberg – was confronted with such problems that one of his first decisions was to sell all operations in Latin America and Asia, reversing a strategy in which Ahold had poured billions of dollars. A decision on whether or not to sell US Foodservice would made be in two years time. No longer was there any talk of mutual learning between Ahold and US Foodservice. Moberg said Ahold was now trying to understand the foodservice business. Answering these two questions correctly before entering a new setting makes a difference for success, as recently illustrated by Toyota in China. Toyota understood that its strategy of stressing quality needed to be supported by its complex of capabilities, which included workers understanding the technology and a supportive culture. It first trained locally hired Chinese workers in the technology (Business Week, 2003). It also put a demo car on the factory floor for workers to practice, because many of them did not own cars and did not know how they worked. Using simpler technology, which workers could


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understand, implied using more manual labor than in Japan. However, Toyota felt it was justified in doing so, not only because labor was cheap, but – as Toyota officials explained – quality can suffer if too much automation is introduced into a plant too soon and workers do not get a chance to learn from their mistakes. With new hires jointly building their workbenches, component bins and trolleys from kits were shipped from Japan – to teach teamwork and responsibility. The Chinese attended seminars to get to know the Toyota culture from staff brought over from Japan and Chinese staff members regularly visited Japan to acquaint themselves with the Toyota culture better. All this was done because, in some countries, as Toyota officials said, ‘‘we never reached the quality levels of Japan’’ – a mistake they wanted to avoid in the new setting by building from scratch the capabilities they felt were lacking and by offering continued support from Japan. The new car was a big hit in China, despite the presence of successful competitors that had moved in earlier, such as Volkswagen and General Motors Corp. While most companies will use less rigorous methods, Toyota clearly understood what its complex of capabilities was. It had also learned – after earlier failures abroad – how they needed to be adapted or complemented to create a competitive advantage. This led to a successful entry into the Chinese market. Smart executives today should ask themselves – and try to answer – these questions from the beginning, when starting to expand abroad, which may help to avoid learning the hard way through costly failures. We will now turn to a second reason why many IAs fail and which may also be at the root of underestimating IA problems.

CULTURAL DIFFERENCES AS A FILTER As most executives know today, cultural differences aggravate IA problems, as managers in acquired companies have a different understanding of boss– worker relationships and of relationships with headquarters, and different negotiation styles. Acquired companies also tend to have different human resource policies and other organizational structures and processes rooted in the national culture, all of which hamper integration of the IA into the company. However, what is less frequently appreciated is that cultural differences may also act as a filter or ‘‘membrane,’’ preventing vital information from flowing from the IA to the acquiring company and hampering an adequate understanding and appreciation of clues, signals, and other bits and pieces of

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relevant information. This increases the likelihood that problems remain under the radar until they blow up and it is too late. Clues and signals ‘‘disconfirming’’ success are even weaker and more distorted during the screening, selection, and integration of IAs, reducing the likelihood that illusions of control and success are falsified and making costly mistakes more likely. These problems are even more likely if internationalizing companies also enter a different industry with its own industry culture, practices, and so on. Ahold initially expanded in the U.S. by acquiring retail companies such as Bi-Lo, Stop & Shop, Tops, and Giant Food, and it did so successfully. When US anti-trust authorities blocked further expansion in retailing, it quickly entered the foodservice industry by buying US Foodservice in 2000, hoping to leverage its purchasing power and to exchange best practices. As late as 2001, Michiel Meurs, the CFO, was quoted as saying: ‘‘It sounds like we’re adding complexity. But we’re not.’’ (CFO Asia, 2003). Then Ahold quickly snapped up other companies in foodservice in the U.S. to build critical mass in this industry, which was still more fragmented than the retail sector. As mentioned earlier, Ahold insufficiently recognized that the culture in US Foodservice differed from its chains in retailing, which undermined the value of its learning capability in the new setting. However, it also had a second, even more disastrous effect. The culture and incentive-structure at US Foodservice led to ordering large piles of stock from suppliers for future periods – to ensure price reductions – booking the income from the projected sales in the current period. This practice was actually revealed in the due diligence process when US Foodservice was acquired, but Ahold did not interpret it as a big problem. After the takeover, the control of US Foodservice remained in the hands of Jim Miller, who had aggressively grown the company before it was acquired and who was given a seat on Ahold’s executive board. As became clear to the stock markets on February 24, 2003, the high-powered incentives had promoted fraudulent practices to such an extent that – with higher penalties for accounting firms in the post-Enron era – the external accountant of US Foodservice no longer condoned it. The news of an estimated $500 million overstatement of income over 2000–2002, later increasing to $1.2 billion, caught Cees van der Hoeven by surprise. He spent a hectic weekend securing a multi-billion dollar loan from a consortium of banks to save Ahold from going under. Then, on Monday morning, he broke the news of the fraud to the stock markets, after which he and his CFO stepped down. This coincided with bad news from Disco’s, the retail chain Ahold acquired in Argentina. What Van der Hoeven had initially announced as a good buy from a befriended family turned out to be a family using intricate


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legal structures to suck funds from the chain, with most of the family finally ending up behind bars for fraud. This was aggravated by the economic crisis in Argentina – hitting retail chains selling high-quality but expensive goods particularly hard – plus having debt from the acquisition in dollars but revenues in heavily devaluated pesos, which contributed to huge losses from a relatively small operation. Ahold was not insensitive to cultural differences. Cees van der Hoeven said he could sense a company’s culture by walking through its shops. He believed that other companies in retailing underestimated the importance of cultural issues. Cultural fit was an explicit criterion for evaluating potential IAs at Ahold. Ahold rushed in confidently, believing it had adequately evaluated IAs with different cultures and their fit with Ahold, buying for billions of dollars and accumulating problems and debt to the point that its new CEO Anders Moberg felt compelled to withdraw from Asia and Latin America. US Foodservice was given two years to straighten out its problems under new management; selling it immediately would have brought in only a fraction of the $3.6 billion Ahold had paid for it in 2000. Ahold is not the only one experiencing problems when racing for global leadership. Its competitors in retailing also experienced problems, although with less dramatic results. Wal-Mart is a huge success in North America and in the UK (Asda), for instance, which has a similar culture, but it is struggling in Germany. Carrefour is successful in Europe and Asia – including its hypermarkets in China, selling everything from refrigerators to caviar – but not in North America. And it is not just retailing. Recent research shows that 80% of the Fortune top 500 firms succeeded so far in only one continent and a total of 90% in at most two continents (Rugman & Verbeke, 2004) – exactly Ahold’s position after it will have withdrawn from Asia and Latin America. Global players such as Coca Cola, McDonalds, and Unilever mask the reality that the overwhelming majority of even the largest companies in the world have so far succeeded in only one or at most two continents. Even in the digital age, companies should not underestimate the problems involved in applying capabilities abroad and in entering different cultures (see also Ghemawat, 2003). Ahold might have saved billions of dollars of market value and Van der Hoeven might still have been the admired CEO of a ‘‘learning company’’ which successfully overcame the limitations of being born in the wrong place. A first step, as discussed above, is to ask the right questions. However, this is not sufficient as companies, particularly in early stages of internationalization, often have insufficient knowledge to be able to answer them. Hence, these companies may benefit from the following five

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strategies suggested by recent research. Two of these strategies originate from the high-velocity industry.

LEARNING FROM HIGH-VELOCITY INDUSTRIES Companies operating in high-velocity environments, such as the computer industry, digital imaging, and the telecom industry, face constant change: new products and services, new client needs, and new competitors entering their markets. Internationalizing companies face similar amounts of change, particularly in the early stages of foreign expansion, encountering new products, new client needs, and new competitors. They also face new cultural, political, and economic environments. Hence, it is perhaps not surprising, as recent research shows that strategies of successful firms in high-velocity environments work for internationalizing companies as well. Research dealing with the computer industry showed that successful companies, contrary to less successful firms, made product innovations at a certain pace and rhythm: every 12, 18, or 24 months (Brown & Eisenhardt, 1997). This allowed them to focus sufficiently on individual projects, while transferring attention and people to the next in time. A similar pattern was recently found for internationalizing companies. Firms that showed a certain optimal pace and rhythm in foreign expansions were more profitable over long periods of time (Vermeulen & Barkema, 2002). Obviously, this requires that new take-over targets are available, but companies that were able to approach the pattern were more profitable. This result is particularly salient because it is not what many companies do. Top executives are sensitive to ‘‘herd effects,’’ contributing to expansions in the form of acquisition waves. And, as mentioned earlier, they may be liable to ‘‘hubris’’ (for a more extensive explanation of the term, see Roll, 1986) and spend insufficient time and attention on identifying and evaluating potential problems. When problems accumulate and can no longer be ignored, failed acquisitions are sold off and companies learn, after which IAs rise to higher levels than before, with untimely sell-offs becoming increasingly unlikely this time (Barkema & Nadolska, 2004). Instead of this turbulent roller-coaster ride initially boosted by over-optimism, a more balanced pace and rhythm – allowing companies to screen, evaluate, and integrate acquisitions into the company carefully – decreases the likelihood of costly failures and subsequent sell-offs, conducive to building a profitable MNC. Clearly, foreign expansion should not be too slow either or companies will risk losing opportunities to gain economies of scale and scope and to apply


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or acquire new capabilities contributing to building a successful MNC. However, even in the digital age, there is still a speed limit. While fiber-optic cables can process data at lightning speed, human brains cannot. Companies ignoring this simple truth may fall into a ‘‘speed trap,’’where increasing speed is self-imposed by executives who believe that it is vital for success but in fact reduces the quality of the decision-making process and endangers the company (for an illustration of this effect, see Perlow, Okhuysen, & Repenning, 2002). A more careful acquisition pace might also have given Ahold more time to integrate its acquisitions into the company with greater care. Even a mature company like Unilever recently learned by trial and error how to restructure its acquisitions in Europe to optimize regional efficiency and learning while remaining locally responsive to customer needs. It eventually implemented an appropriate mix of pay schemes and human resource policies, organizational structures and processes, with the clearly articulated support of senior executives. Ahold is only beginning to enter this stage when it integrates its retail operations in the US such as Stop & Shop and Giant Food to be able to compete better with its formidable local competitor Wal-Mart. A more careful pace might also have given Ahold more time to build a shared culture to support its strategy. As former Unilever CEO Morris Tabaksblatt emphasized when commenting on the Ahold case, it takes time to build a corporate culture, for instance, through career paths leading young managers – and future senior executives – through various parts of the company, synchronizing norms and values and building networks supporting the flow of information within the company. Tabaksblatt said it had taken Unilever half a century to build a corporate culture. In contrast, Ahold quickly assembled an archipelago of relatively autonomous companies, with the former head of US Foodservice running his company as before and managers at US Foodservice and Disco’s insufficiently engrained with Ahold’s norms and values. Toyota, on the other hand, had learned from earlier mistakes to build a shared culture supporting its strategy. Expanding at a more balanced pace and rhythm would probably have been a faster route for Ahold to building a successful MNC. Probing There is also a second strategy that internationalizing firms can learn from firms in high-velocity industries. Successful companies in the computer industry regularly ‘‘probe’’ the future, using prototypes, alliances, or even

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asking gurus for advice (Brown & Eisenhardt, 1997). These probes allow them to test whether potential scenarios will unfold or can perhaps be created, moving in quickly if a probe is successful, withdrawing without large losses if it is not. Low-cost probes allow companies to test a range of opportunities in a changing and uncertain world with limited resources. Recent research shows that similar strategies may substantially increase the shareholder value and profitability of internationalizing firms (Barkema & Piaskowska, 2003). For instance, if they start with small investments in new countries or regions whose culture they do not know well, or if political or economic risks are high. This allows them to withdraw if the probe fails and to make larger investments if a successful local scenario unfolds, for instance, if they have learned how to handle the local culture or if economic or political risks have decreased. The research showed that companies that were very active in probing new countries and continents in this particular fashion had a profitability of up to 50% higher and higher market value than firms that did not use this strategy. The latter firms also had a larger probability of being taken over or of going bankrupt. Ahold did not use this strategy when it entered the foodservice industry in the US. Instead, it bought US Foodservice for $3.6 billion and almost immediately snapped up other firms in this industry to quickly build critical mass. It believed it would create value through greater purchasing power, by exchanging best practices, and by applying its acquisition capability to the foodservice industry, which seemed to be behind retailing in terms of consolidation and mergers. Instead, its unfamiliarity with the industry caused it huge problems, which blew up in its face before it had learned enough about this industry. Probing, through a smaller acquisition or a stake in US Foodservice rather than an outright acquisition would have allowed Ahold to test whether its capabilities implied a competitive advantage in this industry, whether and how they would have to be adjusted or complemented, and whether it was able to gain accurate and sufficient information through the cultural filter present when entering a new industry abroad. As a result, it might have avoided the huge scandal, the loss of billions of dollars of shareholder value, and the ousting of a dozen senior executives including its CEO and CFO. As it did with other acquired chains in Latin America, Ahold actually took a stake in Disco’s first but fled forward when it heard about problems, acquiring the rest of Disco and multiplying its problems. A more careful approach might have prevented Ahold from buying chains in almost all countries on this continent and accumulating huge losses before selling off all Latin American operations later.


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Other companies have used probing successfully. Heineken, the fourth brewer in the world, often started licensing the Heineken brand or buying a small stake in a foreign brewer. After initial success, Heineken would enlarge its stake, bring in technological and marketing knowledge and send managers over. This careful expansion strategy – characterizing much of its expansion in Asia, Central and Eastern Europe (CEE), Africa, and the Middle-East – was critically monitored by investors during the past acquisition wave. They blamed Heineken’s family holdings for an expansion policy that seemed too careful. Under new leadership, Heineken recently acquired a large company, BBAG in Austria, which held 14% of the beer market in CEE. However, Heineken avoided disasters like Ahold’s and kept a healthy balance sheet, while Ahold had to shed assets to lower its debt. Heineken also avoided the problems of its nearest competitor, Interbrew, which grew faster through acquisitions, surpassed Heineken as the thirdlargest brewer, but recently ousted its CEO for lowering profitability and market value. Another example is Starbucks, which has a policy of granting licenses to local partners meant to secure excellent locations and to motivate partners with the prospect of being able to sell their stake back to Starbucks at a favorable price if the venture is a success. Only if the venture is a success will Starbucks buy back the remaining share. This strategy is not a panacea for all problems, for instance, for global forces rendering a formula less attractive over time, currency swings, or a global slump. It also comes at a price – a higher price if the venture is a success. However, it allows Starbucks to capture upside potential while limiting local risks. Probing is not always optimal. It may create shareholder value and increase profitability if entry risks are high and if there is much value in acquiring information after the start of the probe, for instance, if political or cultural risks are high when entering a new country or continent (Barkema & Piaskowska, 2003) or if it is uncertain whether the company’s capabilities will create value in the new setting, particularly, if the company is also entering a new industry. Morris Tabaksblatt, the former CEO of Unilever – reflecting on Ahold’s expansions in the US – emphasized that the simultaneous expansion into relatively new countries and new industries was particularly challenging. Alternatively, the importance of probing diminishes after information has been obtained and uncertainty has been resolved, for instance, confirming that the company’s capabilities do indeed create a competitive advantage in the new setting or that the firm is able to handle the local culture. Then firms may create more shareholder value and boost profits by moving in at full scale.

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Moreover, in some situations, control of foreign subsidiaries is needed to make sure that capabilities are implemented. For instance, in acquiring banks in Latin America, the Spanish Banco Santander typically used the more aggressive approach of gaining majority ownership to ensure that its innovative market approach was implemented effectively. Alternatively, other Spanish banks entering this region, such as BBVA and BCH (before it was acquired by Banco Santander), used a more careful approach of taking minority shares in acquisitions, only expanding if it worked. Companies may also want to move in quickly to pre-empt competitors and seize the best locations, for instance, in the case of franchise-outlets, to secure the best suppliers, or to build local brand awareness before competitors can do so. However, as the research showed, companies also rushed in for the wrong reasons, erroneously believing that capabilities that applied in familiar settings also applied in new environments, fearing that competitors might be first, only to find out that their capabilities failed to create a competitive advantage and withdrawing with huge losses, as Ahold did. Probing is an antidote against over-optimism, over-confidence and illusions of control. It complements strategies such as selecting an optimal pace and rhythm. It also complements asking the ‘‘right’’ questions, such as what the company’s value-creating set of capabilities is and whether and how this signifies a competitive advantage in the new setting. Companies cannot anticipate all potential problems from the outset even if they try; probing allows them to test the water first. Probing is becoming more important in a world where accounting problems may bring down a whole company. In addition, outsourcing software development, credit risk evaluations, R&D, and other activities to India, China, and other countries and problems regarding a single element of the value chain may cause huge problems for the entire company. Probing – preceded by careful screening of potential partners with due diligence – increases the likelihood that problems are discovered in time. This should be complemented with a careful strategy of regular and objective evaluations of the various probes to reduce the likelihood of the company’s maintaining pet projects even after they have proven unsuccessful (Carr, 2002). Consider, again, Toyota’s entry into China. It started with a relatively small operation, well below the minimum efficient scale. Only after it established that it had successfully adapted its capabilities to the local market and that they implied a competitive advantage did Toyota step up its production capacity, as planned from the start should the entry prove a success. Paying a price in case of success – due to waiting lines for its products and excluding the possibility to sell even greater quantities from the start – but avoiding disasters incurred by companies such as Ahold upon entering a new and risky market.


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PATHS OF LEARNING Understanding a foreign culture can be crucial for foreign success. For instance, if a specific culture is needed as part of the mix of capabilities to create a competitive advantage, as Ahold and Toyota found out in different ways. It is also needed for screening and implementing IAs and detecting problems that otherwise remain under the radar until it is too late. Much knowledge of foreign cultures is tacit and can only be learned through experience. A successful strategy is to design ‘‘paths of learning:’’ series of foreign expansions, which allow companies to learn from their cultural experience to avoid costly mistakes later. Evidence shows that firms learn, for instance, from prior expansions in the same ‘‘cultural block’’ (Barkema, Bell, & Pennings, 1996). Cultural blocks are groups of countries with similar cultures. Examples are the Anglo-Saxon countries (including the US, UK, Canada, and Australia), Latin America, South East Asia, Latin Europe, CEE, the Germanic block (which includes Germany and Austria), and the Nordic block (Sweden, Norway, Denmark, and The Netherlands) (Ronen & Shenkar, 1985). Research shows that entry experience in one country helps companies to be more successful in subsequent expansions in the same cultural block. Hence, starting in a cultural block and expanding there is one example of designing a path of learning. The research also suggests that ‘‘jumps’’ to new cultural blocks should not be too large. For instance, Dutch companies that immediately invested in CEE, without gaining international experience first in ‘‘intermediate’’ Germanic countries, for instance, were more likely to fail in CEE (Barkema & Drogendijk, 2003). In addition, they had problems learning from their local experience, which further diminished the success of their later investments in CEE. Apparently, the local experience insufficiently related to what they already knew, making it difficult to interpret the experience, to assimilate it, and to put it to commercial ends. In contrast, Dutch firms that gained international experience first were more successful when they entered CEE. In addition, they learned from their local experience, which further increased the success of subsequent investments in the region. This way, another path of learning is expanding to cultural blocks that are not too far away from the current base of operations of the company. Some companies that followed the latter path of learning entered the CEE using licensing or sales agents first, learning about local conditions, which made them more successful in subsequent investments. Other firms skipped the intermediate stage of licensing or sales agents and invested immediately. This made their initial FDI projects less successful, but they learned more

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from their initial investments, catching up after two FDI projects, on average (Barkema & Drogendijk, 2003). This suggests two additional paths of learning: an incremental approach, using licensing or sales agents first, which makes subsequent investments relatively successful from scratch. Or, alternatively, to do FDI directly. This comes at a cost – the initial FDI projects are less successful – but there is a clear benefit: firms enter markets more quickly, which is attractive when racing for local leadership. Which path is optimal depends on the company’s strategy; both can be paths of learning and stepping-stones to building a successful MNC. Even today, companies can make strides that are too big when they move to new countries and cultural blocks, reducing the success of their initial investments and – for lack of learning – even more of their later investments. People may globally converge in terms of drinking Coca-Cola or Pepsi, watching CNN or MTV, and wearing Armani suits or Levi’s jeans. However, at a deeper level, cultural differences converge more slowly if at all. Designing foreign expansions as paths of learning about foreign cultures continues to be important in the early 21st century. How this can be done successfully was illustrated by the entry of the Spanish ‘‘Conquistadors’’ Banco Santander Hispano-Central (BSCH) and Banco Bilbao Vicaya Argenta (BBVA) into Latin America. In the late 1980s after the privatization in Spain, these banks emerged from domestic mergers as powerful competitors in the banking retail industry. Having competed and exhausted expansion opportunities at home, they entered Latin America by acquiring retail banks across the Spanish-speaking countries using their capabilities in privatizing and innovations such as lotteries. Their knowledge of the Spanish culture made the jump to Latin America natural. They sent over managers to Spain for training to support the successful integration of their acquisitions. They also acquired capabilities from their acquisitions such as Internet portals and quite effectively blocked mass retail banks from other continents. At one point, Spanish companies such as BBVA, BSCH, and Telefonica reaped 40–50% of their profits from Latin America and became some of the most valuable companies on the Madrid Stock Exchange, creating tremendous wealth for their stockholders. Like Ahold, they were severely hit by the monetary and economic crisis in Latin America, which caused them to seek and exploit new opportunities in the stable market at home to hedge their risks, but without the intention of leaving Latin America. These banks became highly efficient corporate powerhouses with the resources, managerial depth, and capabilities to acquire and restructure companies. They might be ready to conquer other parts of the world, such as


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Italy, France, and perhaps even Germany or other countries, if the long awaited consolidation of the banking industry will finally set in. However, they should be careful not to get over-confident and need to consider each time whether their complex of capabilities (negotiating with governments after privatization in emerging economies, restructuring inefficient companies, and innovations like lotteries) would imply a competitive advantage, especially, in less familiar cultures and more mature markets.

BALANCE ACQUISITIONS AND ORGANIC GROWTH Acquisitions have many advantages. If selected and integrated successfully, they allow companies to reach economies of scope and scale in R&D, manufacturing, or purchasing. They bring in new people, fresh ideas, and new practices. And, as recent research shows, they help companies to avoid becoming inert and losing vitality over time (Vermeulen & Barkema, 2001). IAs always imply short-term problems as firms with different pay structures and human resource policies, information systems, and corporate and national cultures merge. However, they also help to break inertia, bring in variety needed to respond to a changing environment, and keep companies successful over long periods of time. Although many companies may be unaware of these effects, there are exceptions. HP CEO, Carly Fiorina recently said that one of the main reasons she wanted the merger with Compaq was that HP was ‘‘frozen in time,’’ lacking the speed and agility needed in this high-velocity industry (Financial Times, 2003). Bringing in Compaq and its emphasis on speed unleashed ideas and energy for change in HP, although recent departures of former Compaq executives suggest that the process is not without friction. Yet, too much emphasis on acquisitions is harmful if it shifts top executives’ limited time and attention away from internal affairs, causing it to ignore or underestimate internal problems. Ahold’s organic growth was even lower than it claimed because it reported small acquisitions as organic growth. There were also signals in the press suggesting imperfect linkages with internal departments. The head of Ahold’s internal markets department claimed he was ignored several times when he warned top management about the currency risks of acquisitions in Argentina (where the peso was still tied to the dollar at the time Disco was acquired). And managers of a chain in Spain voiced frustration after a senior executive from HQ flew in and quickly vetoed a proposal that local management had carefully developed to increase ailing local sales.

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Moreover, in Ahold’s oldest business – retailing in the Netherlands – prices for high-quality products have recently spiralled to the point they were out of touch with customers. Ahold had always commanded premium prices, reflecting its high-quality products and service, but, in recent years, the price gap with lower-priced competitors had risen to more than 15%. With the economy in the doldrums, customers balked and Ahold lost market share, which it is now trying to win back with a major advertising campaign and costly price reductions. Less emphasis on external growth and more attention for internal affairs might have given Ahold more scope for careful monitoring of existing businesses, rich and deep internal networks within the company, more relevant bits and pieces of information flowing through these networks, and less problems. From this perspective, it is not surprising that Ahold’s Board of Directors appointed Anders Moberg, a former CEO of Ikea – a classic case of building success through internal growth. Moberg almost immediately announced a buying stop, reversing unsuccessful expansion into Latin America, Asia, Spain, and Poland, and amassing cash to reduce Ahold’s huge debts. He also announced greater emphasis on internal growth, on streamlining operations, and on further integrating acquired chains such as Stop & Shop and Giant Foods in the US, in an attempt to unlock the value contained in these acquisitions. However, as research shows, too much emphasis on internal growth for too long may ultimately also be bad, as companies may become inert and miss opportunities in terms of speed, new people, and ideas, as their industry changes and competitors race for leadership. Successful companies tend to strike a balance between acquisitions and organic growth over long periods of time (i.e., decades).

STRONG BOARDS Over the past years, a push towards stronger and more independent boards of directors has swept over the U.S. and Europe. Initiated by investors and the business press, it recently got a fresh boost from scandals such as Enron, World-Com, Ahold, and Parmalat. What is generally less appreciated is that strong and independent boards are in the interest of top executives as well. Executives, like other people, can perhaps not be blamed for being over-optimistic or over-confident, because it is part of how our brains work. However, what they can do is compensate, by soliciting an outside view. Installing a strong and independent board of


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directors will trigger questions about proposed takeovers, building on information from the due diligence process and from other sources. It will also sharpen the executives’ analysis of whether the company will be able to create a competitive advantage in a new setting; whether it has the right pace and rhythm of foreign acquisitions; whether probing is used wisely and sufficiently; and whether the company strikes the right balance between acquisitions and organic growth. Such boards correct for over-optimism and over-confidence, illusions of control, and for ignoring or underestimating problems, which reduces the likelihood that executives will be surprised by what they did not know and make costly mistakes, in the worst case ruining their company and setting the stage for their own dismissal. Ahold’s board of directors condoned its expansion policy, with disastrous results and leading to the departure of its CEO and a dozen other executives. A strong and independent board might have prevented some of the worst mistakes and the downfall of leading executives. The new CEO Anders Moberg almost immediately ousted the chairman of the board of directors that had condoned Ahold’s acquisition policy. In addition, a strong and diverse top management team, reflecting a variety of viewpoints and experiences and stimulating constructive debate, decreases the likelihood of naı¨ ve mistakes being made. Unless the diversity comes in such a form that it splits the team, creating ‘‘fault-lines’’ that hamper interaction and the exchange of information and ideas (Barkema & Chvyrkov, 2001). Cees van der Hoeven’s top team eventually contained Jim Miller, running US Foodservice and insufficiently exchanging information with the CEO, and young executives appointed by Van der Hoeven, who were perhaps unlikely to criticize his proposals and views. Especially in complex, rapidly changing environments such as those faced by internationalizing firms, a diverse top team that communicates well is important to appreciate the rich variety of opportunities and threats. CEOs may shield themselves from hubris by appointing strong team members who are not ‘‘in their own image,’’ but are nevertheless cooperative and exchange relevant information and viewpoints, stimulating constructive debate. This decreases the likelihood of costly mistakes being made such as the acquisitions that almost destroyed Ahold and led to the downfall of its CEO.

CONCLUSIONS The opening up of markets across the globe and the digitization of a wide range of technologies has boosted the pace at which firms compete with

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rivals to develop new technologies and products and connect the globe through acquisitions, alliances, and outsourcing. Tapping into – and contributing to – awakening giants such as China and India, which further boosts the pace of development of new technologies and products and global competition. Global competition may get a fresh impulse as a new acquisition wave may be about to begin. For internationalizing companies there may be tremendous gains from building global efficiency and from worldwide learning. However, they should defy herd and hubris effects. Ahold is an interesting case precisely because at least initially, it did so many things right. This article discussed the questions that companies acquiring abroad must ask themselves and five strategies implied by recent research that may help them to avoid costly mistakes and a disastrous expansion path, and build a successful MNC instead. Legends of different cultures and different times tell the same story of the young hero who leaves his village or town to look with friends for a holy grail or golden fleece. After a hazardous journey, in which the fearless young hero is tricked into danger, he eventually finds redemption and comes back successfully as a more mature man. This story of many times and places suggests that overconfidence and consequently meeting disaster is part of human nature. However, just like Odysseus – the man of a thousand ruses as Homeros called him – tied himself to the mast to avoid being tempted by the songs of sirens, smart executives may use strategies that help them to avoid costly mistakes and some of them are described in this article.

REFERENCES Barkema, H. G., Bell, J. H. J., & Pennings, J. M. (1996). Foreign entry, cultural barriers, and learning. Strategic Management Journal, 17, 151–166. Barkema, H. G., & Chvyrkov, O. (2001). Top management team diversity: Promoting or inhibiting foreign expansion. Research Memorandum, Tilburg University. Barkema, H.G., & Drogendijk, H. J. (2003). Should internationalizing firms expand through small incremental steps or through bigger steps. Research Memorandum, Tilburg University. Barkema, H., & Nadolska, A. (2004). The speed and success of international acquisitions. Research Memorandum, Tilburg University. Barkema, H. G., & Piaskowska, D. (2003). Creating value through probing using minority and majority international joint ventures. Research Memorandum, Tilburg University. Bartlett, C. A., Ghoshal, S., & Birkinshaw, J. (2003). Transnational management. Boston: McGraw-Hill. Brown, S. L., & Eisenhardt, K. M. (1997). The art of continuous change: Linking complexity theory and time-paced evolution in relentlessly shifting organizations. Administrative Science Quarterly, 42, 1–34.


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Business Week. (2003). April 7. Carr, N.G. (2002). Unreal options. Harvard Business Review, (December), 22. CFO Asia. (2003). 18 April. Doz, Y., Santos, J., & Williamson, P. (2001). From global to metanational. Boston: Harvard Business School Press. Financial Times. (2003). 21 November. Ghemawat, P. (2003). The forgotten strategy. Harvard Business Review, (November), 76–87. Lovallo, D., & Kahneman, D. (2003). Delusions of success: How optimism undermines executives’ decisions. Harvard Business Review, (July), 56–63 Perlow, L. A., Okhuysen, G. A., & Repenning, N. P. (2002). Academy of Management Journal, 45, 931–956. Roll, R. (1986). The Hubris hypothesis of corporate takeovers. Journal of Business, 59, 197–216. Ronen, S., & Shenkar, O. (1985). Clustering countries on attitudinal dimensions: A review and synthesis. Academy of Management Review, 10, 435–454. Rugman, A. M. & Verbeke, A. (2004). Regional and global strategies of multinational enterprises. Journal of International Business Studies (forthcoming). Vermeulen, F., & Barkema, H. G. (2001). Learning through acquisitions. Academy of Management Journal, 44, 457–476. Vermeulen, F., & Barkema, H. G. (2002). Pace, rhythm, and scope: Process dependence in building a profitable multinational corporation. Strategic Management Journal, 23, 637–653.


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INTERCONNECTED FIRMS AND THE VALUE OF NETWORK RESOURCES$ Dovev Lavie ABSTRACT In recent years, alliances have become even more popular than mergers and acquisitions. Alliance formation has led to the emergence of interconnected firms, which are embedded in alliance networks. This paper offers a theory of network resources to evaluate the competitive advantage of interconnected firms. It distinguishes shared resources from non-shared resources, identifies various types of rent, and illustrates how firm-, relation-, and partner-specific factors determine the contribution of network resources to the rents that interconnected firms extract from their alliance networks. This paper revisits traditional assumptions of the resource-based view and suggests that the nature of relationships may matter more than the nature of resources in creating and sustaining the competitive advantage of interconnected firms.

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This is a revised and updated version of a paper originally published in the Academy of Management Best Paper Proceedings of the 2002 Annual Conference in Denver. An elaborated version of this paper is available in the July 2006 issue of the Academy of Management Review. Helpful comments on earlier versions were received from Harbir Singh, Sid Winter, Ranjay Gulati, Lori Rosenkopf, Nicolaj Siggelkow, Mauro Guillen, and Stanley Wasserman.

Advances in Mergers and Acquisitions, Volume 5, 127–141 Copyright r 2006 by Elsevier Ltd. All rights of reproduction in any form reserved ISSN: 1479-361X/doi:10.1016/S1479-361X(06)05007-1

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Traditional perspectives on competitive advantage, such as the resource-based view (RBV), have envisioned firms as independent entities. Consequently, these perspectives have provided only a partial account of competitive advantage in view of the recent growth and significance of interfirm alliances. Unfortunately, the rapidly evolving alliance literature has developed its own agenda by focusing on phenomenon-driven research and by drawing from various theories such as the RBV, transaction-cost economics, learning and knowledge management, game theory, and social network theories (Osborn & Hagedoorn, 1997). The emphasis on alliance formation and alliance performance in this literature has left a theoretical gap between traditional theories of the firm and observations concerning the performance of interconnected firms. This paper seeks to bridge this gap by extending the RBV and conceptualizing the competitive advantage of firms that are embedded in alliance networks. First, the theoretical implications of alliance proliferation for theories of the firm are discussed. This is followed by examination of the limitations of the RBV in addressing the competitive advantage of interconnected firms. Next, this paper reassesses the applicability of the RBV assumptions and offers a reformulated version of the RBV that takes into account the impact of network resources. The notion of network resources was introduced by Gulati (1999) to describe external resources embedded in the firm’s alliance network that provide strategic opportunities, and thus affect firm behavior and value. Unlike research on mergers and acquisitions that has already acknowledged the value of newly acquired resources (Capron, 1999; Seth, 1990), network resources have not been traditionally considered in firm valuation. This paper discusses the implications of network resources for the competitive advantage of interconnected firms and offers a rationale for evaluating firms’ competitive advantage in networked environments. Instead of applying the traditional RBV to explain the phenomenon of alliance networks, this paper revisits the theoretical underpinning of the RBV by considering the implications of alliance networks. It reveals how an interconnected firm can extract value from resources that it does not fully own or control, thus allowing for the estimation of various types of rent that the firm generates by relying on its network resources.

THE THEORETICAL IMPLICATIONS OF ALLIANCE FORMATION Since the early 1980s, scholars have been observing the proliferation and increasing importance of interfirm alliances (Gulati, 1998; Gulati, Nohria, &

Interconnected Firms and the Value of Network Resources

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Zaheer, 2000; Hagedoorn, 1993, 1995). An interfirm alliance (henceforth termed alliance) is a voluntary arrangement among firms that exchange or share resources and engage in the co-development or provision of products, services or technologies (Gulati, 1998). Alliances can take different forms, including joint ventures, franchising, long-term marketing and licensing contracts, reciprocal trade agreements, R&D partnerships, and affiliation in research consortia. Alliance research has considered the role that alliance networks play in affecting the performance of member firms (Gulati et al., 2000). It has focused on the motivation for alliance formation, the identity of firms participating in alliances, the selection of partners, the management of alliances, the determinants of the governance structure or mode of alliance, learning dynamics in alliances, and alliance performance (Gulati, 1998). Interestingly, this research has evolved almost independently from traditional theories of the firm that in turn highlighted interfirm competition rather than cooperation. The gap between traditional theories of the firm and alliance research has left open the question of how interconnected firms gain competitive advantage. Hence, theories such as the RBV (Barney, 1991; Wernerfelt, 1984) cannot, in and of themselves, explain how firms gain competitive advantage by maintaining frequent and multiple collaborative relationships with alliance partners. The alliance research has provided tools for evaluating value creation and appropriation at the dyad or network level, but the integrated contribution of internal and external sources of competitive advantage to firm performance deserves more attention. The RBV is one of the most influential frameworks in strategic management. Rooted in the early contribution of Penrose (1959), the RBV adopted an inward-looking view conceptualizing firms as heterogeneous entities consisting of bundles of idiosyncratic resources. Wernerfelt (1984) and Rumelt (1984) advanced the RBV by arguing that the internal development of resources, the nature of these resources, and different methods of employing resources are related to profitability. Hence, firms can develop isolating mechanisms or resource-position barriers that secure economic rents. Dierickx and Cool (1989) provided a more dynamic perspective, arguing that it is not the flow of resources but the accumulated stock of resources that matters, and that only those resources that are nontradable, inimitable, and nonsubstitutable are essential for competitive advantage, typically measured in terms of above-normal rents. By tying the nature of resources to competitive advantage, the RBV suggests that resources enable the generation of Ricardian rents and quasi-rents (Peteraf, 1993). To explicate this phenomenon, Barney (1991) identified

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value, rarity, imperfect imitability, and imperfect substitutability as resource characteristics that are essential for gaining sustainable competitive advantage. Similarly, Peteraf (1993) elucidated the link between resources and economic rents by identifying resource heterogeneity, limits to competition, and imperfect resource mobility as conditions for competitive advantage. These studies latently assumed that the appropriability of rents requires ownership, or at least complete control of the rent-generating resources. The RBV recently has been applied to the study of alliances (e.g., Das & Teng, 2000; Eisenhardt & Schoonhoven, 1996) but retained the fundamental assumption of the RBV, according to which resources that confer competitive advantage must be confined by the firm’s boundaries. The RBV’s assumption of ownership and control is embedded in most resource definitions. For instance, Wernerfelt defines resources as ‘‘tangible and intangible assets which are tied semi-permanently to the firm’’ (1984, p. 172). Barney classifies resources as ‘‘all assets, capabilities, organizational processes, firm attributes, information, knowledge, etc. controlled by the firm that enable the firm to conceive of and implement strategies that improve its efficiency and effectiveness’’ (1991, p. 101). Finally, Amit and Schoemaker defines resources as ‘‘stocks of available factors that are owned or controlled by the firm’’ (1993, p. 35). This proprietary assumption is not limited to resource definitions but rather concerns the core idea that firms secure rents by imposing resource-position barriers that protect their proprietary resources from imitation and substitution. The traditional RBV has assumed away cooperative interactions via which resources of counterpart firms may enhance firm performance. This proprietary assumption of the RBV poses a limitation in view of the accumulated evidence on the contribution of network resources to firm performance. Empirical research has found that firms benefit from their alliance partners’ technological resources and reputation and that firm performance and survival depend on the nature of complementary resources of partners (Afuah, 2000; Lee, Lee, & Pennings, 2001; Rothaermel, 2001; Saxton, 1997; Singh & Mitchell, 1996; Stuart, Hoang, & Hybels, 1999; Stuart, 2000). Hence, the RBV has failed to acknowledge the direct sharing of resources and the indirect transferability of benefits associated with these resources. The fundamental assumption that firms must own or at least fully control the resources that confer competitive advantage, turns out to be incorrect. Ownership or control of resources is not a necessary condition for competitive advantage. A weaker condition of resource accessibility, which establishes the right to utilize and employ resources or enjoy their associated benefits, may suffice.


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The proprietary assumption of the RBV prevents an accurate evaluation of an interconnected firm’s competitive advantage. Following the rationale of the RBV, a firm should be valued based only on the contributions of its internal resources. However, the empirical studies showing abnormal stock market returns following alliance announcements (Anand & Khanna, 2000; Balakrishnan & Koza, 1993; Das, Sen, & Sengupta, 1998; Koh & Venkatraman, 1991; Reuer & Koza, 2000) suggest that firm valuation should be based not only on the internal resources but also on the resource endowments of alliance partners. Hence, needed is an overarching theoretical framework that relates network resources to competitive advantage.

REFORMULATION OF THE RBV FOR AN INTERCONNECTED FIRM For the purposes of this paper, I follow Barney’s (1991) formulation of the RBV, which refers to the broad definition of resources as all types of assets, organizational processes, knowledge, capabilities, and other potential sources of competitive advantage that are owned or controlled by the focal firm. Traditionally, the firm has been said to possess a set of resources, which can produce a positive, neutral, or negative impact on its overall competitive advantage. This impact depends on two characteristics of each resource, namely its value and its rarity (Barney, 1991). In addition, the firm’s competitive advantage is influenced by interactions, combinations, and complementarities across internal resources of the firm (Amit & Schoemaker, 1993). The competitive advantage of the firm can be understood as a function of the combined value and rarity of all firm resources and resource interactions. Before reformulating the RBV, it is necessary to examine whether the fundamental resource heterogeneity and imperfect mobility conditions still hold for interconnected firms. Resource heterogeneity requires that not all firms possess the same amount and kinds of resources, whereas imperfect mobility entails resources that are nontradable or less valuable to other users besides the firm that owns them (Peteraf, 1993). The heterogeneity condition is tied to the conceptualization of firms as independent entities. This condition remains critical, although alliances may contribute to resource homogeneity by facilitating asset flows among interconnected firms. Generally, alliances do not enhance competitive advantage by contributing to resource heterogeneity. However, under conditions of pure resource homogeneity, alliances will be formed solely for collusive purposes, rather than to gain access to complementary resources. Mergers and acquisitions may

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be even more effective than alliances for such purpose since they entail unified governance. The imperfect mobility condition is also relevant for interconnected firms. Under perfect mobility, resources can be traded and accessed without forming alliances. However, alliances can serve for mobilizing resources that have traditionally been considered immobile. Even when resources cannot be mobilized, alliances enable the transfer of benefits associated with such resources, and thus weaken the imperfect mobility condition. Relaxing the proprietary assumption of the RBV allows for the resources of partners to affect the competitive advantage of the focal firm. When an alliance is formed, each participating firm endows a subset of its resources to the alliance with the expectation of generating common benefits from the shared resources of both firms. Therefore, each firm possesses a subset of shared resources and a subset of non shared resources that together form its complete set of resources. Different degrees of overlap may exist between the resources of the focal firm and the resources of its partner. When the intersection of shared resource sets, which includes similar resources that both the firm and its partner own, is substantial, we can identify the alliance as a pooling alliance in which partners pool their resources to achieve a greater scale and enhanced competitive position in their industry. In contrast, when this intersection is diminutive, the alliance can be described as a complementary alliance in which firms seek to achieve synergies by employing distinct resources. The resource-based competitive advantage of a focal firm participating in an alliance can be partitioned into four elements corresponding to four different types of rent: (a) internal rent, (b) appropriated relational rent, (c) inbound spillover rent, and (d) outbound spillover rent. Fig. 1 depicts the composition of rents that the focal firm extracts from the shared and non shared resources of an alliance. Internal Rent Internal rent refers to the combination of Ricardian rents and quasi-rents that accrue due to the internal resources of the focal firm (Peteraf, 1993). Ricardian rents result from scarcity of resources, which limits their supply in the short run, whereas quasi-rents encompass the added value that a firm can extract from its specialized resources relative to the value that other firms can extract from similar resources. The traditional RBV focuses on internal rents; however, when considering an interconnected firm, we need to incorporate not only the contribution of intrafirm resource complementarities but also that of interfirm resource


Internal Rent

Nonshared Internal Resources

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Outbound Spillover Rent

Shared Resources

Nonshared Network Resources

Appropriated Relational Rent Inbound Spillover Rent

Fig. 1. Composition of Rents Extracted by the Focal Firm in an Alliance. This figure depicts the composition of rents from the perspective of the focal firm. Internal rent can be extracted from the focal firm’s internal shared and non shared resources. Appropriated relational rent can be extracted only from shared resources of both partners. Inbound spillover rent applies to the partner’s shared and nonshared resources. Whereas outbound spillover rent applies to the focal firm’s internal resources. Unlike other rent types, outbound spillover rent results from the transfer of benefits from the focal firm to the partner, and is thus in the opposite direction.

complementarities. A firm can leverage the value of its own resources by accessing complementary resources of an alliance partner. For instance, Stuart et al. (1999) have demonstrated that the reputation of start-up firms’ prominent alliance partners reflects on their own reputation. Unlike relational rents, which rely on interfirm complementarities in creating common benefits to alliance partners, internal rents are private benefits enjoyed exclusively by the focal firm. Notably, alliances can produce not only positive synergies but also negative implications for the value of the focal firm’s internal resources. Hence, the value of a particular internal resource depends on all other internal resources as well as on network resources. Proposition 1. Internal rent derived from the focal firm’s internal resources will depend on positive and negative complementarities with its network resources. Appropriated Relational Rent Dyer and Singh (1998) have defined relational rent as a common benefit that accrues to alliance partners through combination, exchange, and

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co-development of idiosyncratic resources. This type of rent cannot be generated individually by either partner and is therefore overlooked in the traditional RBV. Relational rents are extracted from relation-specific assets, knowledgesharing routines, complementary resources, and effective governance mechanisms. Relational rents can be extracted only from resources that are intentionally committed and jointly possessed by the alliance partners, and thus involve the shared resources of the focal firm and its partner. The contribution of relational rents to alliance outcomes depends on the total value of these shared resources. Although the relational view (Dyer & Singh, 1998) does not specify the proportion of relational rents appropriated by each participant in an alliance, unless predetermined, ex post relational rents are rarely distributed equally between the partners. Several factors determine the proportion of relational rents appropriated by the focal firm: (a) Relative absorptive capacity. Firms often enter alliances with the expectation of learning new knowledge and acquiring external rent-generating resources. Distinctive learning capabilities of the firm and its partners explain the distribution of rents in such alliances (Dussauge, Garrette, & Mitchell, 2000; Hamel, 1991; Kumar & Nti, 1998). Firms differ in terms of their absorptive capacities as a result of idiosyncratic resource stocks, path dependencies, and heterogeneous communication channels. Prior studies have shown that a firm’s absorptive capacity accounts for the actual learning from partners and eventually contributes to firm performance (Lane, Salk, & Lyles, 2001). Therefore, the better the absorptive capacity of the focal firm relative to that of its partners, the higher the proportion of relational rents appropriated by the focal firm. (b) Relative scale and scope of resources. Relational rents accrue because of interfirm resource complementarities (Dyer & Singh, 1998), and therefore, they are greater for complementary alliances than for pooling alliances. The degree of overlap in shared resources of partners varies across alliances. Consider a hypothetical case where the shared resources of the focal firm are a subset of the shared resources of its partner. In this case, the resources that the focal firm can share are internally available to the partner regardless of the alliance. Thus, the partner’s potential benefit from the jointly generated rent is limited relative to that of the focal firm. Similarly, the relative scale of alliance partners’ resources affects the potential for appropriation. A larger resource set of a partner can provide greater benefits to the focal firm insofar as resources are idiosyncratic. In support of this relative scale argument, empirical studies have shown that small firms benefit more than their


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affluent established partners, even when controlling for firm age (Stuart, 2000). Ceteris paribus, the smaller the scale and scope of the focal firm’s shared resources relative to those of its partners, the higher the proportion of relational rents appropriated by the focal firm. (c) Contractual agreement. Most alliances involve the signing of formal contractual agreements at the time of alliance formation. These contracts provide formal safeguards and determine the distribution of common benefits ex ante. A favorable contract may provide a firm with exclusive access to network resources, specify a relatively high share of returns on joint activities, protect the firm’s internal resources from misappropriation by defining the scope of shared resources, and offer legal remedies that secure the firm’s investments in the alliance. (d) Relative opportunistic behavior. Since contracts are incomplete and cannot specify all future developments (Williamson, 1975), informal safeguards and trust-building initiatives play an important role in deterring potential opportunistic behavior of alliance partners (Dyer & Singh, 1998; Mody, 1993). Still, after a contract is signed, opportunistic behavior can result in extraction of a disproportionate share of rents by the opportunistic party (Gulati, Khanna, & Nohria, 1994; Parkhe, 1993). Hence, the more opportunistic the firm relative to its alliance partner, the higher the proportion of relational rents appropriated by the focal firm. However, the more opportunistic the firms participating in the alliance are, the smaller the potential relational rents ex ante, since firms that recognize potential opportunistic behavior of partners tend to limit the scope of collaboration and knowledge transfer which are critical for the creation of relational rent (Dyer & Singh, 1998; Parkhe, 1993). (e) Relative bargaining power. Firms rely on their bargaining power at the stage of alliance formation and contract formulation. Yet, because of the incompleteness of contracts and dynamics that affect the relative bargaining power of partners during the course of the alliance, relative bargaining power plays a continuous role in determining the potential for rent appropriation. For instance, Hamel (1991) has argued that relative bargaining power complements relative learning skills in determining rent appropriation in alliances. Inkpen and Beamish (1997) have demonstrated that alliance partners accumulate knowledge and skills that shift their relative bargaining power over time. Finally, Khanna, Gulati, and Nohria (1998) have posited that an alliance partner’s share of common benefits generated through an alliance depends on the partner’s relative bargaining power. Hence, the stronger the bargaining power of the focal firm relative to its alliance partners, the higher the proportion of relational rents appropriated by the firm.

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The combined impact of the aforementioned relation-specific factors on appropriated relational rent can be described as follows. Proposition 2. At the time of alliance formation, (a) the more favorable the contractual agreement, (b) the smaller the relative scale and scope of resources, (c) the more attenuated the relative opportunistic behavior, and (d) the stronger the bargaining power of the focal firm relative to its alliance partners, the greater the firm’s ex ante appropriated relational rent will be. Proposition 3. After an alliance is formed, (a) the stronger the relative absorptive capacity, (b) the more salient the relative opportunistic behavior, and (c) the stronger the bargaining power of the focal firm relative to its alliance partners, the greater the firm’s ex post appropriated relational rent will be. Inbound Spillover Rent Inbound spillover rent is a form of private benefit that is exclusively derived from network resources as a result of unintended leakage of both shared and non shared resources of the alliance partners. Spillover rents are usually associated with horizontal alliances among co-opetitors that seek to internalize the resources of their partners, and thus ultimately improve their competitive position vis-a`-vis these partners (Hamel, 1991). When both the firm and its alliance partner pursue such objectives, the parties are said to engage in learning races; however, when only one party holds latent objectives, such as targeting the core assets of its partner, it is said to be acting opportunistically (Kale, Singh, & Perlmutter, 2000). When a firm exploits the alliance for its private benefit outside the agreeable scope of the alliance, it enjoys an unintended leakage of rents with no synergetic value creation. In the case of inbound spillover rent, the competitive advantage of the focal firm depends on several factors. Firm-specific factors determine the capacity of the firm to extract rents from the shared resources of the partner in an involuntary way for unintended purposes. Both firm- and partnerspecific factors determine the potential for appropriating spillover rents from the non shared resources of the partner. Because alliances grant access to the shared resources of partners, the leakage of resource benefits is difficult to prevent ex ante using contractual instruments. Coevolving trust and conflict resolution mechanisms can limit such leakage (Kale et al., 2000); however, the bulk of the appropriation potential hinges on the good faith of the focal firm. Hence, firm-specific factors including the firm’s opportunistic behavior, bargaining power, and absorptive capacity, affect its ability to accumulate spillover rents from the partner’s shared resources.


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Proposition 4. The more salient the focal firm’s opportunistic behavior and the stronger its bargaining power and absorptive capacity, the greater the inbound spillover rent that the firm will derive from both the shared and non shared resources of its alliance partners. When considering spillover rents derived from non shared resources, we assume that alliances provide opportunities that range beyond their immediate scope. Hence, the appropriation factors that represent the focal firm’s motivation and capacity to identify and exploit such opportunities also apply to the partner’s non shared resources. However, partners acknowledging the risk of such unintended appropriation and its adverse consequences for their long-term competitive standing will invest in preventing resource leakage. Partners protect their non shared resources by utilizing isolating mechanisms such as causal ambiguity, specialized assets, patents, trademarks, and other forms of legal and technical protection (Rumelt, 1984; Wernerfelt, 1984). According to Peteraf (1993), isolating mechanisms protect the firm from imitation and secure its rent streams. Specifically, these isolating mechanisms prevent the outbound diffusion of rents by limiting the imitability, substitutability, and transferability of strategic resources (Barney, 1991). While the relational view (Dyer & Singh, 1998) acknowledges the role of isolating mechanisms that the firm and its alliance partners jointly employ to protect their shared resources from the external environment, the partners can individually develop other isolating mechanisms that protect their non shared resources from inbound spillover that benefits the focal firm. Proposition 5. The stronger the isolating mechanisms used by alliance partners, the smaller the inbound spillover rent that the focal firm will derive from the non shared resources of its alliance partners. Outbound Spillover Rent Much as the resources of the alliance partners are subject to spillover rent appropriation, the resources of the focal firm are subject to unintended leakage that benefits its partners. Hence, a symmetrical argument can be developed for the impact of outbound spillover rent, which diminishes the competitive advantage of the focal firm, as described below. Proposition 6. The more salient the opportunistic behavior of the focal firm’s alliance partners and the stronger their bargaining power and absorptive capacity, the greater the firm’s loss of outbound spillover rent derived from both its shared and non shared resources will be.

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Proposition 7. The stronger the isolating mechanisms used by the focal firm, the smaller the loss of outbound spillover rent derived from its non shared resources will be. The overall impact of network resources on the interconnected firm’s competitive advantage can be conceptualized as the combination of the four rent components, namely, internal rent, appropriated relational rent, inbound spillover rent, and outbound spillover rent. This formulation suggests that the competitive advantage of an interconnected firm based on the combination of internal resources and network resources is either greater or smaller than the competitive advantage of the same firm if evaluated only on the basis of its internal resources. Firm-, partner-, and relation-specific factors play a role in determining the type and magnitude of rents extracted from both the internal resources of the focal firm and the network resources of its alliance partners.

DISCUSSION The proposed framework overcomes a limitation of the traditional RBV, which has focused on resources that are owned or controlled by a single firm. This framework incorporates the notion of network resources that play a role in shaping the competitive advantage of interconnected firms. In addition, this framework extends prior research on joint value creation in dyadic alliances (Dyer & Singh, 1998; Zajac & Olsen, 1993) by considering unilateral accumulation of spillover rents that produce private benefits. It then proposes that the mechanisms of value creation differ for shared and non shared resources and that the value of internal resources is affected by complementarities that span firm boundaries. Overall, engagement in alliances can either benefit or impair a firm’s quest for rents. By extending the RBV, this paper sheds light on the conditions under which interconnected firms can gain competitive advantage. The proposed framework can be further advanced by analyzing the conditions for sustainability of competitive advantage (Barney, 1991). For instance, causal ambiguity and social complexity may become insufficient for preventing imitation. Partners can access resource benefits without obtaining the resources themselves and become exposed to the path-dependent development of proprietary resources, which thus become less causally ambiguous and socially complex. Moreover, by engaging in proactive learning, partners can internalize the resources of the firm (Hamel, 1991).


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Consequently, inimitability is tied to the nature of alliance relationships more than to the nature of resources. While factors such as contractual safeguards, absorptive capacity, and opportunistic behavior determine the degree of imitation, interconnected firms generally experience greater erosion of rents as a result of imitation. In addition, imperfect substitutability becomes less relevant to sustainability in networked environments because partners can gain access to desired resources through alliances, mitigating the need for their substitution. Hence, the capacity of interconnected firms to create and appropriate value depends less on traditional RBV conditions and more on their ability to maintain valuable interaction with partners. Future research may extend the proposed framework in several ways. First, it may evaluate the impact of network structure relative to relational aspects such as trust building, knowledge sharing, bargaining power, and learning. Second, it may acknowledge the fact that different appropriation processes require dissimilar spans of time. For instance, the benefits of complementarities that enhance the value of internal resources may be available at the outset, but relational rents are accumulated gradually as a result of continuous collaboration. The benefits associated with spillover rents may consume even more time because firms need to bypass their partners’ isolating mechanisms. Third, future research may be able to consider not only the impact of direct ties, but also the influence of indirect ties. From the perspective advocated in this paper, resource-based rents are transferable to some extent. Thus, firms may be able to access network resources through intermediaries. Finally, the proposed framework should be corroborated empirically to further advance our understanding of the value of network resources.

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