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DISCUSSION PAPER SERIES ABCD www.cepr.org Available online at: www.cepr.org/pubs/dps/DP3998.asp and http://ssrn.com/abstract=445741 www.ssrn.com/xxx/xxx/xxx No. 3998 CROSS-BORDER ACQUISITIONS AND GREENFIELD ENTRY: PROFITABILITY AND ST OCK MARKET VALUE Pehr-Johan Norbäck and Lars Persson INDUSTRIAL ORGANIZATION ISSN 0265-8003 CROSS-BORDER ACQUISITIONS AND GREENFIELD ENTRY: PROFITABILITY AND STOCK MARKET VALUE Pehr-Johan Norbäck, Research Institute for Industrial Economics (IUI), Stockholm Lars Persson, Research Institute for Industrial Economics (IUI), Stockholm and CEPR Discussion Paper No. 3998 August 2003 Centre for Economic Policy Research 90–98 Goswell Rd, London EC1V 7RR, UK Tel: (44 20) 7878 2900, Fax: (44 20) 7878 2999 Email: cepr@cepr.org, Website: www.cepr.org This Discussion Paper is issued under the auspices of the Centre’s research programme in INDUSTRIAL ORGANIZATION. Any opinions expressed here are those of the author(s) and not those of the Centre for Economic Policy Research. Research disseminated by CEPR may include views on policy, but the Centre itself takes no institutional policy positions. The Centre for Economic Policy Research was established in 1983 as a private educational charity, to promote independent analysis and public discussion of open economies and the relations among them. It is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-run policy questions. Institutional (core) finance for the Centre has been provided through major grants from the Economic and Social Research Council, under which an ESRC Resource Centre operates within CEPR; the Esmée Fairbairn Charitable Trust; and the Bank of England. These organizations do not give prior review to the Centre’s publications, nor do they necessarily endorse the views expressed therein. These Discussion Papers often represent preliminary or incomplete work, circulated to encourage discussion and comment. Citation and use of such a paper should take account of its provisional character. Copyright: Pehr-Johan Norbäck and Lars Persson CEPR Discussion Paper No. 3998 August 2003 ABSTRACT Cross-Border Acquisitions and Greenfield Entry: Profitability and Stock Market Value* This Paper studies cross-border acquisitions and greenfield entry in a multi- firm setting. Acquisition entry is more likely when the acquirer gains a strong position in the product market, relative to greenfield entrants. We also show that such acquisitions might have a low profitability, however. The reason is that the bidding competition over the domestic assets is then so fierce that the firms involved would be better off not starting a bidding war. Moreover, this implies that domestic firms will then sell their assets at a substantially higher price than their reservation price. Implications for stock market values are also derived. JEL Classification: F23, G34 and L13 Keywords: FDI, mergers and acquisitions and stock market value Pehr-Johan Norbäck Research Institute of Industrial Economics (IUI) Box 5501 S-11485 Stockholm SWEDEN Tel: (46 8) 665 4522 Fax: (46 8) 665 4599 Email: pjn@iui.se For further Discussion Papers by this author see: www.cepr.org/pubs/new-dps/dplist.asp?authorid=153438 Lars Persson Research Institute of Industrial Economics (IUI) Box 5501 S-11485 Stockholm SWEDEN Tel: (46 8) 665 4504 Fax: (46 8) 665 4599 Email: larsp@iui.se For further Discussion Papers by this author see: www.cepr.org/pubs/new-dps/dplist.asp?authorid=134788 *We are grateful for helpful discussions with Jonas Björnerstedt, S-O Fridolfsson, Chiara Fumagalli, Mattias Ganslandt and Monika Schnitzer, participants at IUI seminars and the 2001 SAET conference in Ischia. Financial support from the Marianne and Marcus Wallenberg Foundation, and Tom Hedelius’ and Jan Wallander’s Research Foundations, is gratefully acknowledged. Submitted 10 July 2003 1. Introduction Multina tion al Enterprises (MN Es) are often associated with firm specific assets. 1 Suc h assets, which includ e marketing ab ility, brand names, patents o r tec hn ology, enable th ese firm s to profitably expand production abroad. W hen expanding business abroad, MNEs canbasicallyusetwotypesofbusinessstrategies; they can e ith er a cquire (or m erg e with) a firm in the host co untry or invest greenfield, i.e. set up a new p lant in th e h ost coun try. Sev eral factors ha ve been argued to be important for e xplaining wh y MNEs p refer to gro w via M &As rather than through organic gro wth: the quest for strategic or com- plementary assets, such as b ra nd names, the possession s of local permits or d istrib ution netw or ks and patents. When the time to mark et is vital, the takeover of an existing firm with an established distributio n system m ig ht also b e preferable. 2 The importance o f the d om estic assets will d epend on the strength of complementarities between MNEs’ firm -specific assets and the domestic assets. For example, the com b ination of a n MNE ’s strong brand name and the acquired firm’s knowledge of the market or strength in dis- tribution, may provide the acquiring M N E with a strong mark et position. In order to capture th ese aspects, the dom estic assets will be said to b e strategically valuable when combining an MNEs firm specific asse ts with the do m es tic assets gives t he acqu irer a stron g position in the product mar ke t, re lative to greenfield entrants. We present a model where we indeed sh ow that a h igh str ategic value of the dom estic assets is conducive to acquisitions. Howev er, while acquisition entry is associated with a high strategic value of the dome stic assets, we also show that su ch a cqu isitions might hav e a lo w expected profita bility. In the model, a domestic firm is initia lly located in th e dom estic market in country H. There are also sev eral symm etric M N E s located in the world market. T h e domestic m arket will now be exposed to intern ational competition. The interaction ta kes place in thr ee stages. In the firststage,theMNEsmightacquire the dom estic firm’s assets. In the seco nd sta ge, MNEs h ave the option o f investing 1 See for instance, Caves (1996), Dunning (1977) and Markusen (1995). 2 See World Investment Report (WIR) 2000 and its reference to different studies of cross-border M&As. 2 greenfield in new assets in country H, where green field entry is associated with a risk of failure. Finally, in the third stage, firms compete in oligopoly fashion in country H. Theresultthattheexpectedprofit of the acquirer (i.e. the expected product market profit net of the acquisition price), ma y decrease in the strategic value of the dom estic assets seems counter-intuitive a t first sight, since the domestic firm’s assets are then m ore va luab le to the MNE s when acquired. Howev er , this result is in tu itive, when taking in to account how the level of stra teg ic value of the domestic assets affects the acquisition price. The price of the assets is a non-acquiring MN E ’s willingness to pay, whic h consist of t wo profit terms: t he expected produ ct market profitforthisfirm if it were instead to obta in the domestic firm’s assets net of the corresponding profit w hen not buying. Itthenfollowsthatthefirst profit term increases to exactly the same exten t as that of the acquirer from an in crease in the strategic value of the d om estic assets, and will thus off-set the acquirer’s increase in profit. M oreover, the second profit term will decrease, the more stra tegically valuable the domestic assets are, since the non-acquirer will then face a stronge r competitor in the product market. This implies that the willingness to pay fur ther increases for the non-acqu irer. Consequently, the a cquisition price in creases more than the a cquirer’s p roduct market profit, when the dom estic assets becom e more strategically valuable. We furth er sho w that the bidding co m petition over the domestic firm implies th at this firm will sell its a ssets at a higher price than its reservation price, or to a substantially higher price wh en the d om estic assets are su fficiently strategically va luab le. We then use our results on how expected profits are affected b y an a cquisition to derive imp licatio ns for s tock market valu es for t he di fferen t entry m odes. Follow ing the standard approach in the so-called ev en t studies on M&A performance, assum ing that the merger com es as a surprise for th e financial markets, the empirical im p licatio n is then that the ta rget firm’s sha reh olders benefit f r om the acqu isitio n and that th e takeo ver premium is increasing in t he stra tegic im portance of the d omestic assets. T he predictions for the poten tial acquiring firms are more in volved. H owev er, w e find that the share value of both the acquirer and a non-acquirer will decrease w hen an acquisition is announced, if the domestic assets a r e sufficiently strategically valuab le. This is due to 3 the fact that the bidding com petition is then so fierce that the firms involv ed wou ld be be tter off not starting a bidding war. IntheliteratureonMNEs 3 , it has also been argued that one of the main benefits from acquiring a local competitor instead of en tering greenfield is that the acquisition helps the firm avoid risks due to lack of knowledge of the specific characteristics of the local market. By entering by an M & A , a n M N E avoids the individual risk of un successfu l greenfield entry. Ho wever, w e show that the bidding competition over being successfully loca ted in the mark et with certaint y may driv e up the acquisition price to suc h a lev el that being a greenfield entrant is more profitable ex-post. B ut firmsalsofaceamarket risk as realized product market profitforafirm may differ from the expected one. It is th en sho w n that if firms a re sufficiently s ym m e tric, the stoc k market value of the acquirer is reduced relative to that of a successful greenfield entrant, since the market risk will then be similar between the two entry mod es and only the individual risk differ . However, if competition becomes s ufficiently softer than expected and the strategic value is sufficiently high, the aquirer’s stoc k m arket valu e will in crease relative to that of a successful green field entrant. The related theoretical lit erature on foreign direct in vestm ent FDI and MNE s is sur- v e yed in Markusen (1995). Th is literatu re does no t explicitly address th e q uestion of wheth er en t ry in to a foreign market is greenfield or th ro ugh the acquisition of a ssets already in the mark et, or both, a n issue wh ich is at focus i n our study, h owev er. 4 There is also a recent theoretical literature addressing aspects of cross-border mergers in in- ternational oligopoly mark ets. 5 However, the equilib riu m acqu isition price, wh ich is in focus in our study, is not determined in those studies. 3 See Caves (1996). 4 See, Das and Sengupta ( 2001), Görg (1997) and Norback and Persson (2003) for papers addressing the choice of entry mode. However, these papers abstract from the competition between MNEs, which is at focus in our study. Bjorvatn (2001) allows for competition between MNEs, but studies how the pattern and profitability of cross-border acquisitions depend on trade cost and greenfield cost. 5 This literature includes papers by, for example, Head and Reis (1997), Horn and Persson (2001), Lommerud, Straume and Sorgard (2003), Neary (2003), Norbäck and Persson (2002), Saggi and Yildiz (2002), Straume (2003), Yildiz (2003). 4 The m odel is spelled out in Section 2. In Sectio n 3, we derive the equilibriu m market structure and the equilibrium net profits fo r different entry modes. Section 4 , derives implicatio ns for stock market va lues for the different e ntry modes. Section 5 concludes. Finally, most proofs appear in the Appendix. 2. The M odel Consider a country H, where the mark et has previously been served b y a single domestic firm , denoted d, possessing on e unit of domestic assets, denoted k 0 . This mark et will now be exposed to in ternation al competition . Th ere are several different reasons wh y the mark et is now suddenly exposed to international competition. For instance, the country might be investment liberalizing, the exp a nsion might be a natu ral step i n the life cycle of a product or stem from increasing local d ema nd , or the admin istrative co sts of cross- bo rder acq uisition s and gree nfield entry may have been reduced in the globalization process. We assume there to be M>1 symmetric MN E s in th e world market. A t the o utset, the MNEs ha ve no assets in Co untry H, but might n ow invest. The interaction takes place in three stages. In the first stage, t he MNEs migh t a cquire the domestic firm’s assets. In the second stag e, M N E s have the option of investing green field in n ew a ssets in country H. Finally, in the third stage, firm s compete in oligopoly fashion in country H. The next sections describe the product market intera ction, the greenfield investm ent game, and the acquisition game. 2.1. Stage three: product mark et in teraction Theproductmarketprofits in the industry will depend on the distribu tion of asset o w n ership. An asset o w nership v ector k is d efined as k ≡ (k d ,k 1 ,k 2 , , k M ),whereentry one r efers to firm d’s asset holdings, entry two to M N E 1’s asset holdings, etc. In order to simplify the presentation, we will distinguish between two types of o w nersh ip structures: (i) the on e where the d om estic assets are so ld to o ne of the MNE s, denoted k m ,and(ii) 5 the one where the domestic assets remain in the hands o f the dom estic owner, denoted k d . Vectors k m and k d are defined as follo w s: k m ≡ k m (α, N m ,k 0 ,k G ) ≡ (0,αk 0 ,k G ,k G, , k G, | {z } N m 0, , 0 | {z } M−N m −1 ), α>0 (2.1) k d ≡ k d (N d ,k 0 ,k G ) ≡ (k 0 ,k G ,k G, , k G, | {z } N d 0, , 0 | {z } M−N d ). (2.2) The first en try in each v ector shows the asset o w nership of the domestic firm, the second en try is the asset ow nership of the, poten tially, acqu iring MNE. The parameter α>0 captures that an MNE a nd the domestic firm may differ in h ow efficien tly they c an use the a ssets k 0 . We s hall discuss parameter α in detail belo w . The r e m a ining entries show the asset ow nership o f the no n-a cquiring MNEs, being either successful g reenfield en trants (hav ing assets k G ) or ”exporters”, i.e. M N E s which do not succeed in in vesting greenfield (havin g assets k E ≡ 0). U nder MN E ownership, there is one acquiring MNE and N m non-acquiringMNEsthatinvestgreenfield, whereas M − N m − 1 MNEs do not in vest. Under domestic ownership, there a r e N d MN E s su ccessfu lly investing gr eenfield and M − N d MN E s th at do no t. Under MNE own ersh ip of th e dom estic assets k 0 ,weletπ A (k m ) denote the reduced- form product market p rofit for the acquiring M NE , π G (k m ) the c orresponding pro fit for a non-acquiring MN E as a greenfield entrant, and π E (k m ) the corresponding profit for a non-ac quirin g M NE as an export e r (i.e. a non-inves t ing MNE). Under domestic o wnership of the assets k 0 , M N E s are either greenfield entrants or exporters, with the product mark et profits π G (k d ) and π E (k d ), r espectively. The corresponding profits for the d omestic firm u nder the respectiv e ow nersh ip structures are π d (k l ),l= {d, m}. We ma ke the f ollowing assumptions a bout profitsintheproductmarketassumma- rized by t able 2.1: Assum p tion A1 states th at the product mark et profit f or all types of firms decreases in the n umber of s uccessful g r eenfield entrants, N l . Assum p tion A 2 states that a firm’sproductmarketprofit increases in its own capital stock in coun try H. This assum ptio n then forms the basic motive for FDI in terms 6 Table 2.1: Basic assumptions. Assumption A1: π h (k l (·,N l ) >π h (k l (·,N l +1) A2: π h (k l ) >π E (k l ) ≡ 0,h= {A, G} π d (k d ) >π d (k m ) ≡ 0 A3: ∂π A (k m ) ∂α > 0, ∂π G (k m ) ∂α < 0, ∂π h ¡ k d ¢ ∂α ≡ 0,h= {d , G } of acquisition or greenfield en try, stem m ing from trade cost avoidance or lower factor costs. To facilitate the readability, but with no loss of generalit y, we norm a lize such that π E (k l ) ≡ 0, i.e. the product mark et profitinexportingissettozero. Moreover,we also assume that the domestic firmwillnotmakeanyproductmarketprofit w ithout its assets, π d (k m )=0. The loc al assets k 0 may be used differen tly und er dom estic and foreig n ownership. As- sumption 3 then states that an increase in the strategic value, α, increases the acquirer’s profit, whereas the mark et profit for a non-acquirer (i.e. greenfield in vestor) decreases. Thesizeoftheseeffects depends on the strength of co m plem entarities betw een MN E s’ firm -specific assets and the domestic assets. For example, the com b ination of a n MNE ’s strong brand name and the acquired firm’s knowledge of the market or strength in dis- tribution, may pro vide the acquiring MNE with a strong market position. If the brand nam e of the domestic assets is locally v ery strong, the strategic valu e of the assets will also be high. Or, if the domestic assets are sold at an early stage, the a cqu irer ma y gain astrongfirst-mover a d vanta ge, b u ilding up a dom inant position in the produ ct market. 7 2.2. Stage t wo: Greenfield inv estm ents At this stage, MNE s that did not enter the m arket through the acquisition o f firm d, can e nter by undertaking a greenfield investment at a fixed cost, G. To sim p lify the analysis, w e assum e that in vestments in greenfield assets k G are ”lumpy”, i.e. they come in discrete assets or plan ts and the domestic firm does not find it pro fitable to invest in this stag e due to, fo r instance, financial o r manager ial restrictions. Assum ption A2 states th at there are locational advantages for MNEs of producing in coun try H . In the literature on M NE s, greenfield entry is considered risky due to the lack of knowledge of th e specific c ha racteristics of the local mark et. For exam ple, Caves(1996)arguesthatoneofthemainbenefits of acquiring a local competitor instead of entering green field is the avoidance o f such r isks. Moreove r, greenfield in vestm ents contain a large initial investm ent under uncertain ty, w h ich is likely to be sunk to a large degree. This is motivated by the fa ct that these a ssets are likely to be designed to fit the p roduction in a particular industry an d the cost of restructuring them in to suitable assetsinotherindustriesisassumedtobehigh. 6 To model this, we assum e that eac h potential greenfield entrant enters suc cessfully with pr obab ility p ∈ [0, 1] and will n ot enter with p robab ility 1 − p. N l is th en simply the MNEs drawn as successfu l in the greenfield stage. Note that w e abstract from the possibilit y that the n umber o f greenfield entrants under domestic and foreign own ership of t he domestic assets is affected b y the strategic value, α (i.e. we assume p to be independent of α). We will discuss the modelling of the greenfield un certainty in more d eta il o f the end of Section 4 . 2.3. Stage one: the acquisition game To focus o n t he b id din g co m petition am on g MNEs as t he d ete rm in ant of the e q uilibrium buyer, we assume that MNEs post bids for the domestic firm , which that firm m ay accept or reject. More specifically, the acquisition process is depicted as an auction where M 6 To our knowledge, the only empirical paper studying sector-specific assets is Ramey and Shapiro (2001), which finds capital to be very sector-specific. 8 [...]... demand without any qualitive changes in results 27 Table A.1: Prots for the dierent types of rms in the linear Cournot model Domestic ownership, kd A : G : d : Foreign ownership, km à +2kG k0 N d +2 2 Ă k0 +2kG 2 G +(N d +1)k0 N d kG N d +2 +N m k0 (N m 1)kG N m +1 N m +1 2 2 G G (km ) = A (km ) A (Km ) + p [ G (Km ) G] [G (km ) G] under I1, I2 or I3 and A (km ) G (km ) = A (km ) d... School of Economics and Business Administration, Bergen 30 [21 ] Ramey, V A., and Shapiro, M D., 20 01, Displaced Capital: a study of Aerospace Plant Closing., Journal of Political Economy, vol 109, 958-99 [22 ] Saggi, K and H.M Yildiz, 20 02, On the international linkages between trade and merger policies, MImeo, Southern Methodist University, Dallas [23 ] Scherer, F M., and Ross, D., 1990, Industrial Market... Structure and Economic Performance, Houghton Miin Company [24 ] Straume, O.R., 20 03, International mergers and trade liberalization: implications for unionized labour, International Journal of Industrial Organization, 21 , 717-735 [25 ] UNCTAD, World Investment Report 20 00, (United Nations Conference on Trade and Development, Geneva) [26 ] Yildiz, H.M, 20 03, National versus international mergers and trade liberalization,... See the Appendix 19 Number of greenfield 10 entrants, N l 9 Competition more intense than expected 8 7 A k m G k m 6 N m 5 EOS k d 4 Competition less intense than expected 3 2 1 A k m G k m 0.4 1 .2 k0 1 2. 8 2 kG 2 3.6 Strategic value, i.e k A k 0 Figure 4.1: The linear Cournot model the acquirer has a large expected market share, and therefore gains more from a price increase associated... Stock Market,, Journal of Finance, Vol XLVI, NO 3, 825 -845 [ 12] Head K, and J Reis, 1997, International Mergers and Welfare under Decentralized Competition Policy, Canadian Journal of Economics v30, n4: 1104 -23 [13] Horn, H and L Persson, 20 01, The Equilibrium Ownership of an International Oligopoly, Journal of International Economics, Vol 53, No 2 [14] Kamien, M I and Zang, I., 1990, The Limits of... b = (b , b , , no), where b < vd i M It then 1 2 i follows directly that no rm has an incentive to deviate Thus, b is a Nash equilibrium Then note that rm d will accept a bid i bi vd But bi vd is a weakly dominating bid in these intervals, since vd > max{vmm , vmd } Thus, the assets will not be sold in these intervals 26 A .2 Proof of Proposition 2 and 3(ii) We need to show that for a suciently... a non-acquiring MNE under I1, I2 and I3, but decreases under I4 18 4 .2 Stock market eects in the long run Let us nally examine the stock market value after greeneld entry uncertainty has been resolved for the acquirer and a successful greeneld entrant This can be examined by investigating the MNEs Post-Greeneld Prots, h (km ), as illustrated in Figure 3 .2 In Section 3 .2, we showed in Proposition 4 that... (km ) d (Kd ) [ G (km ) G] under I4 h (Kl ) is calculated l Nmax Ê Ô X (N l )N l making use of (2. 3) Similarly, we have N l E N l N l =0 28 References [1] Bjorvatn, K., 20 01, On the Protability of Cross-Border Mergers, Mimeo, Norwegian School of Economics and Business Administration, Bergen [2] Blonigen, B A., 1997, Firm-Specic Assets and the Link between Exchange Rates and Foreign Direct Investment,... Working Paper No 511, (Stockholm: The Research Institute of Industrial Economics) [9] Fridolfsson, S.-O and J Stennek, 20 00, Why Event Studies Do Not Detect AntiCompetitive Mergers, Working Paper No 5 42, (Stockholm: The Research Institute of Industrial Economics) 29 [10] Gửrg, H., 20 00, Analyzing Foreign Market Entry: The Choice between Greeneld Investment and Acquisition, Journal of Economic Studies... Profit: Greenfield entrant) (Post-Greenfield Profit: Exporter) Kd Km 0 Investment Liberalization 1 Acquisition game Ek m 0 km 2 Greenfield game and 3 Oligopoly interaction Figure 3 .2: Illustrating the evolution of MNE prots under I1 or I2 Proof See the Appendix Proposition 2 thus shows that a high strategic value of the domestic assets is conducive to foreign acquisitions A high strategic value is, . CROSS-BORDER ACQUISITIONS AND GREENFIELD ENTRY: PROFITABILITY AND ST OCK MARKET VALUE Pehr-Johan Norb ck and Lars Persson INDUSTRIAL ORGANIZATION ISSN 026 5-8 003 CROSS-BORDER. PROFITABILITY AND STOCK MARKET VALUE Pehr-Johan Norb ck, Research Institute for Industrial Economics (IUI), Stockholm Lars Persson, Research Institute for Industrial Economics (IUI), Stockholm and. Expected (Net) Profit: Post-Greenfield (Net) Profit: Pre-Acquisition Expected (Net) Profit: Post-Acquisition Expected (Net) Profit: Post-Greenfield (Net) Profit: Acquirer (A): Non-acquirer (NA): Domestic