The Q-Theory of Mergers: International and Cross-Border Evidence by Peter L. Rousseau

1. The Fifteenth Dubrovnik Economic Conference Organized by the Croatian National Bank The Q-Theory of Mergers: International and Cross-Border EvidencebyPeter L. Rousseau Discussant: K. Zigic CERGE-EI Prague, Czech Republic

2. Summary of the Research • The article belongs to the line of work made by the author and his co-author B. Jovanovic. • High importance in the context of macroeconomics • It endogenizes incentives and trade-off between alternative means of capital expansion • direct investments vs. M&As. • Very compelling story that belongs to the family of neoclassical models of investment choice with adjustment costs of investments • The theory of the choice of investment: directly or by means of acquisition • From partial equilibrium insight to the tractable GE model that gives predictions on the choices of direct investments vs. M&As • Response to the productivity shocks explain M&A waves as being driven by episodes of major technological change (Jovanovic & Rousseau, 2004: Mergers as Reallocation)

3. Predictions of the Model • Three predictions of the model: • 1) M&A are preferred if the level of total investments is high • 2) M&A investments depend on difference between Q(acquirer) and q(targets) • 3) Q of acquirers should be higher than Q targets. • The contribution of this article is in providing further empirical evidence for their story.

4. First Hypothesis • M&As are preferred if the firms make very large investments. The point i0 at which acquisition investments overtake direct investments can be linked to the fixed costs of M&As (Φ). • For analytical tractability Φ assumed proportional to the size of acquirer • This is implausible: • Large firms are more likely to have lower costs of entering M&A deal relative to their assets

5. First Hypothesis(2) • Conditional on firms being of the same size, Φ => higher if M&As are more difficult to pursue due to either regulatory reasons, difficulties in obtaining finance, or "distance" costs, => cross-border merger • The higher the Φ, the higher should be the i0. • M&As are less costly if domestic and less costly in US than in EU (see Figures 2 and 3; latter being presumably due to less frictional US market and easier access to external finance). • The story meets data very nicely here.

6. Second Hypothesis • Regressions of investments, direct or M&A, on Q or Q-q, respectively. • Extension: • inclusion of cash-flow a)to test the responsiveness of M&As/direct investments to excess cash (managers drive to expand the span of control) and b) to explain cross-border mergers • This methodology is subject to substantial debate in corporate finance literature • What is proper interpretation of estimated coefficients on cash-flow? (we reaaly don’t know!) • Fromthe structural model to the linear regression specification=>several strong assumptions have to be made • Theseassumptions may drive the results (most notably Kaplan&Zingales 1997, 2000). • Endogeneity between Q and CF

7. Second Hypothesis (2) • Sample is restricted to firms that engaged in M&A, leaving out firms that invested only directly. • So not surprising that for these firms we observe larger sensitivity of cash-flows in case of M&A investments than direct investments. • Opposite would be true for firms not engaging in M&A as for those the sensitivity of M&A investment to CF would be 0 by definition. • It would be more interesting here to actually estimate selection equation • e.g. investigate whether excess cash leads to decision to engage in MA => run probit where M&A binary dependent variable and CF is one of the regressors • Pretty large difference in sensitivity of y on Q-q between US and EU (order of 4). Why?

8. Third Hypothesis • Not completely new • The author mentioned that similar result is obtained by Andrade, Mitchell and Stafford, 2001. So this result is not so surprising.

9. Other Objections and Comments • It is based on firm specific factor, z (industry specific and macro factors ignored) and yet it is kind of macro model • z is random variable representing technological shock, so it seems to indicate that merger wave coincides with business cycle insofar the latter is governed by the real business cycle model • Discuss more the underlying assumptions needed to come to the figure 1:

10. Other Objections and Comments(2) • It is not clear if this holds in general, that is, for any shape of unit cost function c(x,y). • Marginal costs of adjustment of the capital by direct investments or by M&A (cxor cy) have to meet some condition in order for the M&A investments to be preferable (see eq. 9). • For i>i*, => the minimum in the curly brackets has to be such that y > 0 • If cy > cxfor every i => more costly to invest additional dollar through MA than through plain direct investment

11. Cross-border Mergers from International Trade and IO Perspective • Cross-border mergers are an increasingly important phenomenon in the world economy • well over half of all foreign direct investment (FDI) trough cross-border mergers, considerably more than greenfield investment • Importance of strategic interactions • Cross-border mergers also constitute an increasing proportion of all mergers • Considerable anecdotal and other evidence suggesting that cross-border merger waves coincide with episodes of trade liberalization and market integration • There is ample anecdotal evidence that cross-border mergers tend to reflect comparative advantage

12. “Out of the Model” Criticism • No strategic interaction • No insight from international trade literature • The model under consideration does not explain why M&A intensify in periods of adjustment to trade liberalization • No discussion about competitive and social welfare effects of these mergers

13. “Out of the Model” Criticism(2) • “If (...) M&A is not clearly linked to cross- bordertechnological transfers, it may make more sense for researchers to pursueframeworks that model cross-border mergers as attempts to exploit established organizationalstructures with an eye to gaining “footholds” and ultimately substantialmarket shares in targeted foreign sectors. When the nature of cross-border mergersis largely extractive as the latter case suggests, some restrictions on the activity maybe justifiable.”

14. Prediction from an IO/Trade model • Appropriate methodology => oligopolistic interaction in general equilibrium (see Neary, 2002, and 2009) • International differences in technology generate incentives for bilateral mergers in which low-cost firms located in one country acquire high-cost firms located in the other • Consistent with the prediction from Rousseau paper. •  As a result, cross-border mergers serve as instruments of comparative advantage

15. Prediction from an IO/Trade model(2) •  Implications for income distribution: putting downward pressure on wage => tilting the distribution of income towards profits at the expense of wages in both countries. • Social welfare considerations: • the fall in wages puts downward pressure on prices in all sectors, which tends to increase the gains from trade in both countries potentially offsetting price increase in the sectors in which mergers occur. On balance, the net effect on welfare is likely to be positive.

16. Prediction from an IO/Trade model(3) • the pattern of cross-border mergers which results from market integration follows that of comparative advantage, in the sense that low-cost firms acquire high-cost foreign rivals (no cost synergies!). • As a corollary, the model predicts that cross-border mergers and exports are complements rather than substitutes, in the sense that exporting sectors tend to be sources of rather than hosts for foreign direct investment • see also Helpman, Melitz and Yeaple, 2004 and Nocke, V. and S. Yeaple, 2007

17. How to obtain Rough Welfare Effects in Rousseau (2009)Setup • A simple test is the behavior of stock price of the competitors at the announcement day of M&A • If the price of competitors’ share decrease => the M&A is considered pro-competitive and vice versa (see Duso, Roeller, and Neven,2003) • Thus, if M&A lead to the diffusion of technology and there is stock price decrease of the competitorsafter M&A announcement => welfare effects are likely to be positive.

18. References • Duso, T, Neven, D. and Röller, L-H, (2003): "The Political Economy of European Merger Control: Evidence Using Stock Market Data," CEPR Discussion Papers 3880, C.E.P.R. Discussion Papers. • Helpman, E., M.J. Melitz and S.R. Yeaple (2004): .Exports versus FDI with heterogeneous firms, American Economic Review, 94:1, 300-316. • Jensen, J.B. and A. Bernard (2005): .Firm structure, multinationals, and manufacturing plant deaths,Working Paper No. CES-WP-05-18, Washington D.C.: U.S. Census Bureau, Center for Economic Studies. • Kaplan, S and Zingales, L. (1997) "Do Investment-Cash flow Sensitivities Provide Useful Measures of Financing Constraints?", Quarterly Journal of Economics • Kaplan, S and Zingales, L. (2000): “Investment-cash flow sensitivities are not valid measures of financing constraints” (joint with S.Kaplan). Quarterly Journal of Economics (2000) 115: 707-712. • Kastrinaki, Z., and Stoneman, P. (2008): Merger Patterns in the European Food Supply Chain, draft FOODIMA project, Warwick Business School • Kastrinaki, Z., and Stoneman, P. (2008): An empirical model of merger and acquisition timing, draft, Warwick Business School • Neary, P (2003):The Road Less Travelled: Oligopoly and Competition Policy In General Equilibrium in R. Arnott, B. Greenwald, R. Kanbur and B. Nalebuff (eds.): Economics for an Imperfect World: Essays in Honor of Joseph E. Stiglitz, MIT Press, 2003. • Neary, P (2009):International Trade in General Oligopolistic Equilibrium, http://www.economics.ox.ac.uk/Members/peter.neary/papers/pdf/gole.pdf • Neary, P (2007): "Cross-border mergers as instruments of comparative advantage," Review of Economic Studies, 74:4, October 2007, 1229-1257. • Nocke, V. and S. Yeaple (2007): .Cross-border mergers and acquisitions vs. greenfield foreign directinvestment: The role of .rmheterogeneity,.Journal of International Economics, 72, 336-365.