COMPLEMENTARITY, SIMILARITY, AND VALUE CREATION
IN MERGERS AND ACQUISITIONS
AKBAR ZAHEER
Carlson School of Management 3-365
University of Minnesota
Minneapolis, MN 55455
Telephone: (612) 626-8389
Fax: (612) 626-1316
e-mail:
XAVIER CASTAÑER
HEC School of Management (Paris)
1 Rue de la Libération
78351 Jouy-en-Josas
France
Telephone: 33.1.39.67.94.45
Fax: 33.1.39.67.70.84
e-mail:
DAVID SOUDER
Carlson School of Management 3-365
University of Minnesota
Minneapolis, MN 55455
Telephone: (612) 625-6723
Fax: (612) 626-1316
e-mail:
Version: January, 2005
Acknowledgements: We are grateful for research access and financial support from the member companies of the M&A Consortium project of the Strategic Management Research Center (SMRC), Carlson School of Management, University of Minnesota (U of M), without which this project would not have been possible. We also thank Keith Bahde, Phil Bromiley, Pierre Dussauge, Mehmet Genç, Maggie Schomaker, Harbir Singh, Sri Zaheer, Maurizio Zollo and seminar participants at Cornell University and Tilburg University for their comments on presentations and earlier versions of this paper. We are also grateful to members of the M&A Consortium, who in addition to the U of M faculty and doctoral students acknowledged above, included George Meredith and Mary Nichols, for their involvement, participation, and suggestions along the way. We thank Sharon Hansen for both administrative and research support and the SMRC for financial support. All errors are ours.
COMPLEMENTARITY, SIMILARITY, AND VALUE CREATION
IN MERGERS AND ACQUISITIONS
Abstract
Although M&A researchers associate relatedness with acquisition value creation, there is little research that distinguishes between the different sources of synergy that are inherent in relatedness. We argue for distinguishing between three dimensions of relatedness – business similarity, product complementarity, and geographic complementarity – because each implies a different source of synergistic value in M&As. Furthermore, realizing value from these synergies requires integration between the acquiring and target firms, with the appropriate degree of integration depending in part on which dimension of relatedness is producing synergistic value. Empirical validation for our arguments comes from 88 M&As. We find that acquisition performance is higher when each dimension of relatedness is appropriately matched with the degree of integration. Specifically, business similarity and product complementarity are associated with negative performance when integration is low and become more valuable as the degree of integration increases, although surprisingly, product complementarity is not a significant source of value even at the highest level of integration. In contrast, geographic complementarity is associated with higher performance under low integration conditions, while high integration is detrimental to performance.
Prior research has established the importance of relatedness between acquiring and target firms as a potential source of synergy – ultimately leading to value creation – in mergers and acquisitions (M&As) (Seth, 1990; Singh & Montgomery, 1987). The degree of relatedness is often conceptualized as the ‘closeness’ or similarity between the target and acquirer’s products, customers, or resources (Chatterjee, 1986; Lubatkin, 1987). However, scholars have long observed that it is not exclusively similarity that is the source of value creation in acquisitions, but also the potential to combine attributes of the two firms in ways that are complementary(e.g., Penrose, 1959). While the concept has been widely discussed, few empirical tests unpacking the components of relatedness have been conducted. It is important to do so because including both similarity and complementarity allows us to more comprehensively understand the M&A phenomenon and because the logic of value creation in M&As differs noticeably for each type of relatedness.
At the same time, the literature on post-merger integration has argued that the appropriate degree of integration of the two previously independent organizations is crucial to acquisition success (Haspeslagh & Jemison, 1991). High integration is necessary if value creation depends on high degrees of interdependence between activities or resources of the two hitherto independent organizations. However, if value creation does not require a high degree of interdependence, then integrating the two organizations to a high degree may in fact be detrimental to acquisition performance, since integration involves high coordination and other costs. Consequently, matching the degree of integration with the type of relatedness is likely to significantly explain acquisition success since the logic of value creation differs among the different types of relatedness.
Within the overall rubric of relatedness, we distinguish between three sources of in M&As: business similarity, product complementarity, and geographic complementarity. We draw on theory to posit that these three types of relatedness cover a wide range of value sources, but importantly do not all imply the same degree of integration as a necessary condition for attaining value. By unpacking the sources of value creation, establishing the degree of integration as a contingent condition for the actual attainment of value, and demonstrating empirically that correctly matching the degree of integration with the type of relatedness creates value while inappropriate matching reduces acquisition performance, we advance the literature on M&As and more broadly, provide a possible explanation for the much-touted failure of M&As to create value.
Empirical validation for our arguments comes from a study of 88 recent acquisitions, with data collected through a mailed questionnaire. The results support our contention that M&A performance is improved when appropriate fit is achieved between the type of relatedness and the degree of integration. Specifically, we find strong support for the idea that business similarity needs high integration to yield value, and is related to poor performance when integration is kept low. Product complementarity is also associated with negative performance at low levels of integration, with meaningful improvements in performance as integration increases. Contrary to expectations, however, the positive value of product complementarity is tenuous at best, even in high integration scenarios. For geographic complementarity, we find unambiguous support for our postulates that its benefits are achieved at low degrees of integration, while increasing integration is associated with lower performance. In sum, by a fine-grained disaggregation of the concept of relatedness in M&As and a more precise articulation and demonstration of the conditions under which it yields value, we present a deeper understanding of the nature of relatedness and its relationship with acquisition performance.
THEORY AND HYPOTHESES
Disaggregating Relatedness
Much of the acquisitions literature has attributed the source of value creation to relatedness between the acquirer and the target organizations (Lubatkin, 1987; Singh & Montgomery, 1987). Often construed as similarity, relatedness has been studied broadly, in areas such as products, distribution channels, customers, and technologies (Chatterjee, 1986; Seth, 1990). Yet similarity of attributes is not the only source of relatedness that leads to value creation in M&As. Differences in attributes between target and acquirer firms can also be sources of value if the differences are synergistic (Harrison, Hitt, Hoskisson, & Ireland, 1991), thus constituting complementarity across the two firms.
Broadly speaking, relatedness refers to the degree to which two independent firms are synergistic. In this paper, we use the term synergy to represent the antecedent potential for value creation through a merger or acquisition, as opposed to the post-merger realization of value, which we refer to as value creation. For example, potential complementarity refers to the mere existence of potentially mutually reinforcing attributes across the two organizations. When these are appropriately combined through managerial action, complementarity can be realized and value created.
We identify three distinct types of relatedness in M&As: business similarity, product complementarity, and geographic complementarity. Business similarity describes the extent to which attributes such as the product-market portfolio or the internal operations of the acquirer resemble the same attributes from the target. Value is created from similarity in M&As through the exploitation of scale economies and the possible exercise of market power (Capron, 1999). Product complementarity refers to the target’s ability to extend the acquirer’s domain into additional product lines or technologies that are in some way related to its existing ones, allowing them to ‘round out’ their product offerings or technological bases. An acquirer may seek to combine its products with the target’s to form a single offering that better meets market preferences (Ansoff, 1965; Larsson & Finkelstein, 1999) or combine their complementary technologies to create new products (Galunic & Rodan, 1998). Finally, geographic complementarity arises from the addition of non-overlapping geographies in which the acquiring firm is able to achieve cost savings by expanding its footprint into new geographic markets (domestically or internationally).
Having defined the three different dimensions of relatedness (business similarity, product and geographic complementarity), the issue is one of establishing the conditions under which these potential sources of value creation yield up actual value. The most crucial contingency that we identify to establish out these conditions is that of acquisition integration, to which we turn next.
The Integration Challenge
While prior M&A research acknowledges similarity and complementarity as different concepts, it has also implied that the processes by which value is created from these two concepts in M&As are not differentiated. For example, in their pioneering work, Larsson and Finkelstein (1999) define ‘combination potential’ to include both similarity and complementarity, and find that this single construct is associated with both a higher degree of integration and value realization. The position we take in this paper is that the value creation processes for each type of complementarity are fundamentally distinct both from each other and from the value creation processes for business similarity. The distinctions between the effectiveness of each of the value creation processes revolve around the degree to which the target firm is integrated into the acquirer organization in the post-acquisition integration phase.
The M&A literature points to the challenges of post-acquisition integration, or the degree to which different functions of the two previously separate organizations are brought under a single hierarchical structure. In particular, choosing and implementing the appropriate integration approach is posited to lead to acquisition success (Haspeslagh & Jemison, 1991). Combining this stream of research with the studies of relatedness, we contend and argue below that the realization of value in M&As results largely from matching each of the dimensions of relatedness with the appropriate degree of post-merger integration.
In the context of M&As, only after the transaction is completed and the integration process gets under way is it possible to begin extracting value from the dimensions of relatedness. Given the complexity of an acquisition, an acquiring firm decides to purchase the target under conditions of uncertainty and incomplete information; it may anticipate the potential for realizing value but cannot know whether it is achievable until after the fact (Barney, 1988). Moreover, to realize the benefits of relatedness, the acquiring firm needs to determine precisely how the similar and complementary components should be combined across the two hitherto independent firms (Haspeslagh & Jemison, 1991).
For many acquiring firms, determining and implementing the appropriate integration approach is a critical decision that varies across acquisitions. The degree of integration between the target and its acquirer reflects a tradeoff between autonomy granted to the target, to preserve the attributes which provided the original rationale for the acquisition, and assimilation with the acquirer to exploit those attributes (Haspeslagh & Jemison, 1991). Prior research underscores the difficulty in bringing together two firms’ knowledge bases, creating social connections, and building a shared identity (Ghoshal & Gratton, 2002). Under low integration conditions the operations and the structure of the target remain largely independent of the acquirer. On the other hand, high integration implies that many or most of the activities and resources of the two organizations are managed and organized in a unified fashion.
Given the well-established importance of appropriate integration to acquisition success in broad terms, we develop our hypotheses by drawing on the M&A literature and applying them to the specific circumstances of business similarity as well as product and geographic complementarity. Specifically, as we argue below, the synergy inherent in business similarity and product complementarity demands a high degree of integration for their potential value to be realized, while the synergy of geographic complementarity requires the opposite – a low degree of integration.
Business Similarity
Business similarity is a potential source of value creation in M&As because of the efficiencies made possible through the consolidation of similar elements of the two firms’ operations. The rationale is that similarities allow for the straightforward elimination of overlapping or redundant activities (Capron, 1999), or an increase in overall turnover which can generate economies of scale. Another source of value may arise from the greater market power of the resulting larger firm in both input and output markets. Many of the large and well-known bank mergers, such as that between Chase Manhattan and Chemical Bank, have relied heavily on the logic of business similarity, as similar products, customers, and distribution channels enabled the consolidation of back-office operations and the rationalization of branches.
It is important to note, however, that for business similarity to achieve its promise in an M&A, the two organizations must structurally and operationally integrate the parts of their respective businesses that are similar. Similarity between the businesses only results in greater efficiency when redundancies are eliminated and scale economies actually begin to get realized. Put differently, the actual creation of value, or the realization of the benefits of similarity requires an appropriate management effort to bring together under the same organizational structure the elements that are similar from the two businesses. Such a major reorganization implies that the two organizations are required to become highly integrated. Only then can scale economies – in any part of the value chain – flow through into positive gains from the acquisition.
Conversely, when business similarity is high but the degree of integration is low, the acquiring organization may have identified the potential economies of scale but is unable to realize them despite incurring the costs of acquisition, resulting in poor acquisition performance. Therefore, we argue that the degree of integration represents a contingency factor that moderates the ability for the potential synergies from business similarity to generate positive acquisition performance. Extending this logic further, we expect that business similarity will have a negative relationship with acquisition performance when integration is kept low, and will show a positive relationship with acquisition performance when firms integrate their operations to a high degree. Formally,
H1A: Integration positively moderates the relationship between business similarity and acquisition performance
H1B: Business similarity has a positive relationship with acquisition performance when the degree of integration is high.
H1C: Business similarity has a negative relationship with acquisition performance when the degree of integration is low.
Product Complementarity
Product complementarity is a source of synergy when firms seek to extend their domains into additional product lines or technologies that are partially related to their existing ones. Such extension allows them to ‘round out’ their product offerings or technological bases in ways that are potentially valuable due to economies of scope (Teece, 1980). The value of complementarity in M&As has a long history in the field of strategy, from Penrose (1959) to Ansoff (1965) to more recent work of scholars such as Harrison et al (1991). In the recent organizational economics literature, complementarity has also attracted considerable attention. Milgrom and Roberts (1995), in their much-cited work, define complementarity as being present when having more of one organizational attribute increases the returns from having another. The core of Milgrom and Roberts’ concept of complementarity constitutes the notion of mutual reinforcement between distinct organizational elements.
We adapt this notion to the M&A context and define product complementarity in M&As as the potential value arising from the mutually-reinforcing combination of a target firm attribute with a different attribute from the acquirer firm, where attributes could include products or their underlying technologies. For example, bundling and cross selling involve the marketing of products that are different – but related – to the same customer segments, thereby achieving revenue enhancement from targeting the customer bases of each erstwhile firm. In this way, product complementarity may enable the combined firm to better serve existing customers as well as attract new ones that see value in such integrated solutions of compatible products. One firm that has pursued this logic is Cisco Systems, which acquired a series of companies with high product complementarity and developed an integrated offering because its customers valued the more reliable systems integration that a full-line supplier could provide (Finkelstein, Choi, & Tran, 1998). Furthermore, product complementarity may also lead to cost savings arising from better utilization of the sales forces and distribution systems of each organization.
We argue that economies of scope – which give rise to value from product complementarity – are realized through a high level of integration between the relevant activities of the post-acquisition organization. Complementarity theory supports this view by arguing that potential value is realized provided that firms tightly couple the potentially complementary elements (Milgrom & Roberts, 1990; 1995). In essence, the theory implies that the means by which value is created is through careful meshing of reciprocally interdependent firm activities. Applied to the M&A context, the potential value of product complementarity comes from the successful coordination and combination of a range of diverse activities that were previously part of two separate organizations.
For example, with cross selling, sales initiatives need to be developed that highlight the benefits of combining two products that were previously sold separately, and salespeople need to be educated about the attributes of unfamiliar products. In the case of integrated offerings, products have to be redesigned and interfaces ought to be developed, production needs to be coordinated, and new marketing programs created. In such cases, design and production activities that were previously distinct should be combined into single functions. To combine complementary technologies in a meaningful way, research labs need to be brought together and tacit knowledge exchanged. Moreover, while coordination mechanisms such as cross-organization task forces may be set up, they may not achieve the deep level of mutual understanding and the emergence of a common organizational language (Teece, 1982). Research has demonstrated that physical proximity is a requirement for the successful transfer of tacit scientific knowledge (Allen, 1977). Using the example of Cisco Systems again, the company ensured that every acquisition target was physically co-located with one of its existing locations (Finkelstein et al., 1998). Thus, the processes that give rise to value from product complementarity require a high level of post-acquisition integration.