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CONSTANCE E. HELFAT
University of California at Davis
DAVID J. TEECE
1. INTRODUCTION
In this paper we propose an indirect test of the "new institutional economics"
(Williamson, 1975, 1981,1985) by exploring the relationship between vertical
integration and uncertainty. We present evidence that suggests that vertical
integration, executed by merger, may reduce a firm's systematic or undiver-
sifiable risk. That is, vertical mergers reduce risk by more than the simple
portfolio effects that arise from combining business units in which returns are
not perfectly correlated, suggesting that internal organization does have dis-
tinctive properties which cannot be easily replicated by stockholders taking
separate asset positions in specialized companies operating at each stage of an
industry.
Uncertainty creates several kinds of problems for the organization of
production. One is that it complicates decisionmaking. Because of uncertainty
and bounded rationality, comprehensive contingent planning on how to
We are indebted to Richard Castanias, Pablo Spiller, an anonymous referee, and the editor for
their many useful suggestions, and to Amy Abramson for her research assistance. We wish to
thank Henry Armour and Garth Saloner for extensive help on an earlier version which was widely
ciruclated in 1980. The earlier version (Teece et al., 1980) outlined the methodology employed
here but contained several technical errors. This paper refines that methodology and reports new
results computed on a different and more satisfactory sample. The technical errors brought to our
attention have been corrected. John Cox, Jeffrey Pfeffer, Steven Ross, and Robert Wilson also
provided useful comments on the earlier draft.
47
48 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION III-.l, 1987
deploy resources in the future is impossible. Not only are there too many
contingencies, but many contingencies are simply unknown—the "event set"
simply cannot be fully specified.' Decisionmakers accordingly find advantage
in being able to adapt to unanticipated contingencies as they are revealed over
time. In fact, afirmthat is able to do so quickly is likely to be considered well
managed. Putting it differently, "uncertainty appears as the fundamental
problem for complex organization and coping with uncertainty is the essence
of the administrative process" (Thompson: 159).
Several sources of uncertainty can be recognized. One approach adopted
security market line (Sharpe, 1964). In short, the total risk involved in holding
an asset can be decomposed into two parts:
3. Roll specifically criticized beta as a risk measure on two grounds:first,that it will always be
(significantly) positively related to observed average individual returns if the market index is on
(not significantly off) the positive sloped section of the ex-post efficient frontier, regardless of
investors' attitudes toward risk; and second, that it depends, nonmonotonically, on the particular
market proxy used. These criticisms are theoretically valid and imply, as suggested above, that
estimated betas may be unreliable measures of diversifiable risk.
4. We wish to warn that the test presented, since it assumes the validity of the CAPM, is
exposed to some of the criticims of this particular theoretical construct, the most serious of which
questions the empirical usefulness of the model. Roll has pointed out that while the underlying
theory of the CAPM suggests a relationship between an asset's returns and the covariability of
these returns with the returns of all other assets (including human capital), empirical application
of the market model, by necessity, restricts examination and estimation of covariability to a much
smaller population of assets, typically publicly traded securities. Thus an estimate of the system-
atic risk (covariability) associated with an asset may differ from the "true" theoretical risk.
Further, two individual investors holding different efficient portfolios, neither containing a
complete representation of all assets, may obtain different systematicriskestimates for the same
asset due to differing covariability with the returns associated with the other assets in their
portfolios. Ross has questioned the empirical appeal of two alternative assumptions required to
derive the basic model, that of quadratic preferences or, alternatively, that asset returns are
multivariate normally distributed. The implication of these limitations to the present study lie in
making the results conditionally applicable to the population of assets utilized. That is, the
comparison of pre- and post-merger systematic risk estimates is strictly relevant only to those
investors holding the portfolio used to generate the risk estimates.
VERTICAL INTEGRATION AND RISK REDUCTION / 5 1
forward in time one can see that the market will be significantly affected by
changes in the expected rate of inflation, interest rates, regulation, the growth
rate of real GNP, and many other factors. There are also a number of less
general events, related to these, that deserve greater attention: movements
in crude oil and other raw material prices, developments in alternative domes-
tic energy supplies, changes in public attitudes toward regulation, and possible
changes in the tax law, among others. Each of these events is important in
contributing to the uncertainty of future market returns; and for each, one can
anticipate the effect upon any particular security.
different approach to that employed here, has also used vertical mergers in his
examination of the gains to merger and risk reduction.5
The general design employed here involves forming an "experimental"
group of U.S. firms that have participated in vertical mergers. Each pair of
experimental firms is then matched against a pair of control firms similar in
most important respects save that of merger activity. There is sometimes a
presumption, based on studies such as Blume (1971), that betas do not change
greatly over time. Other studies have showed, however, that individual firm
betas may be nonstationary and do tend to regress to the grand mean of all
5. In an excellent recent study, Pablo Spiller explored market power versus efficiency
explanations of the risk reduction associated with vertical mergers and found that latter more
compelling. In particular, he found that vertical mergers amongst firms with geographically
proximate vertically related facilities (his proxy for specialized assets) showed largest gains from
merging as well as a larger reduction in their systematic risk.
6. Estimated beta coefficients tend to regress toward the grand mean of all betas over time.
According to Blume (1977), part of this observed regression tendency represents real nonstation-
arities in the betas of individual securities. In other words, companies of extreme risk—either
high or low—tend to have less extreme risk characteristics over time. See Blume (1977:31) for
possible explanations.
7. This information is based on unpublished work by Richard Castanias.
8. In its 1981 Statistical Report on Mergers and Acquisitions.
VERTICAL INTEGRATION AND RISK REDUCTION / 5 3
9. Studies have shown that the stock market anticipates mergers well before their announce-
ment dates. We rely on Halpern's results showing abnormal returns as early as the end of the
seventh month prior to the announcement date. The announcement date is the first public
announcement of possible intentions to merger appearing in the Wall Street Journal or in the
New York Times where Wall Street journal information is not readily available.
10. The merger date is taken as the last month when the acquired company's stock was traded
or a return recorded on CRSP.
11. Many firms were involved in smaller mergers of less than $10 million not listed by the
FTC. We expect that mergers involving relatively small firms will not greatly affect the com-
puted values of the betas.
12. In his work on vertical mergers, Spiller uses similar criteria to select a sample of firms
using monthly CRSP data, with the omission of criterion number 4. Because we incorporate the
impact of other nonvertical mergers on the estimates of beta, our sample of vertical mergers is
smaller than Spiller's.
13. This sample provides a strong test of our hypothesis in that we do not attempt to screen
out those vertical mergers for which transactional considerations are unimportant, or for which
transactional economies were not realized because of managerial ineptitude or failure to imple-
ment the organizational linkages necessary to improve scheduling and coordination advantages
and the like. To the extent that firms with these characteristics are in our sample, the data will be
biased against our hypothesis.
Table 1. Sample Firms Involved in Vertical Mergers, 1948-79 Monthly Return
Data (Acquired firms listed first)
Market value ($MM)*
Case no. Firm name (equity and debt) Merger date**
'Debt includes long-term debt plus preferred stock. Stock market equity is valued as of the last trade
date on CRSP of the acquired company. Debt is valued at year-end prior to the merger.
••Merger date is that of last CRSP record for the acquired company.
a. The post-merger sample has only 40 observations.
b. Cities Service acquired Tennessee Corp. in a nonvertical merger. Tennessee Corp. had previously
acquired Miami Copper in a nonvertical merger.
c. The pre-merger sample has only 42 observations due to lack of CRSP data for another nonvertical
merger at the beginning of the pre-merger period.
d. General Cable acquired Automation Inds. in a nonvertical merger. The post-merger sample has only
35 observation because Genera! Cable (then called CK Technologies) was acquired by another firm and
delisted.
VERTICAL INTEGRATION AND RISK REDUCTION / 5 5
where
and
E(eJt) = 0, E(eitejt) = 0, t * j .
debt \ „ / equity
+
7TTT7 IW'" TTTT7
\debt + equity/ \debt + equity
where
14. More specifically, RJt = (PJt + DIVJ( - Pj,-l)IPJ,,-l where Pjt is the price of security,;
in period t, and DIVjr is the dividend associated with security j in period /.
15. See Brealey and Myers (chap. 9). Although the beta for debt may not in fact be zero, this
approximation is often used.
16. Due to the difficulty of estimating the market values of firm debt, we have used book
values, a common procedure in computing firm asset betas. This may introduce some bias in the
net risk reduction calculations. For hypothetically perfect controls, which have the same relation
of market to book values of debt and the same pre-merger betas as do the merging firms, the use of
a book value greater than the true market value yields a lower absolute net risk reduction than is
actually the case. The reverse occurs if book value is less than the true market value of debt.
17. See Sharpe (1970: chap. 7) for the derivation of this algorithm.
56 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION 111:1, 1987
where
In cases where one of the firms had other nonvertical mergers during the
control firms was . 124 for the acquiring firms and .236 for the acquired firms.
The selected control firms for the monthly sample are listed in table 2, and
the asset betas for the original and control companies are displayed in tables 3
and 4. 2 0
The risk effect of vertical integration can be isolated by the following
measure:
Pcp = the predicted post-merger weighted asset beta for the control
group
Pc.a = the actual post-merger weighted asset beta for this group.21
Ho:D = 0 (5)
HA. D > 0.
Rather than resorting to distributional assumptions about D, we use the
Wilcoxon Matched Pairs Signed Ranks Test to test the null hypothesis.22 This
test ranks D according to the magnitude of the difference in the pre- and
post-merger risk reduction of the merging firms and that of the firms in the
control group. The highest number is assigned to the D with the highest
absolute value. The ranks are then signed so that where the merging firms had
20. Note thatfirmsin the original sample could also serve as control companies for other firms
providing the original firms had no vertical mergers during the time period for which they serve as
a control.
21. The weights used to compute fjc,, and p cn are those that existed at the start of the
post-merger period.
22. The power-efficiency of the Wilcoxon test for small samples is near 95 percent. Its
asymptotic efficiency compared with the parametric f-test is 3/ir = 95.5 percent (Mood). This
means that 3/n is the limiting ratio of sample sizes necessary for Wilcoxon test and f-test to attain
the same power.
58 / JOURNAL OF LAW, ECONOMICS, AND ORGANIZATION 111:1, 1987
a greater risk-reduction than the control firms, the rank receives a positive
sign. If the null hypothesis is correct the summation of the positively signed
ranks and that of the negatively signed ranks summed separately should be
approximately equal. The smaller sum of the like-signed ranks, T, is approxi-
mately normally distributed for large sample sizes, while for smaller sample
sizes approximations exist.23
23 Critical values were obtained from Biometrika Tables for Statisticians, volume 2 (1976).
VERTICAL INTEGRATION AND RISK REDUCTION / 5 9
5. RESULTS
The methodology described above is, in many ways, biased against a finding
that vertical mergers reduce risk. The generally small sizes of the acquired
companies compared to that of the acquiring companies makes it more diffi-
cult to discern an impact of a given merger on the estimated post-merger
betas. This is due to the lower weights which smaller firms have in the
weighted beta calculations. In addition, the merger sample size is small.
Table 3 shows the calculations of the measured risk reduction in the
24. Since it is possible that the assumption that P^-i,, = 0 may be incorrect, we also
performed this test under the extreme assumption that P<i,.|,, = P,.,,,,^- Under this assump-
tion, the null hypothesis of no risk change for the merging firms can be rejected at the 91.4
percent level of significance.
Table 3. Risk Reduction in Merging Firms
13 .8109566 .42445
14 .8331745 ll .5773559 .6145383 1.070555d 1.2522501 1.2546624 -.6377118
(.9734299)c- (1.2930393)c
the significance level. Table 6 shows the results of this procedure for the
samples with and without controls. Where controls are used, the deletion of
the top four net risk changes, over one quarter of the sample, still produces a
significance level of over 90 percent; similarly, for the sample without con-
trols, the deletion of the top three net risk changes produces a significance
level of approximately 90 percent.
To provide yet another check on our results, we have calculated the net risk
reductions using an alternative control group—industry indexes. Each merg-
ing firm is assigned a value-weighted industry index, composed of all firms in
the industry who were listed on CRSP during the entire pre- and post-merger
periods and were not involved in mergers during that time. The asset beta for
14 None 99.3
13 11 98.7
12 11, 15 97.4
11 11, 5, 14 94.9
10 11, 5, 14, 3 90.3
Wilcoxon test results without controls
Sample size Cases deleted Significance level (%)
14 None 98.5
13 7 97.1
12 7,5 94.5
11 7, 5, 11 89.7
Table 7. Risk Reduction in the Industry Index Control Group
(1) (2) (3) (4) (5) (6) (7) (8)
Pre-merger Pre-merger Post-merger Post-merger
(3 of industry P of industry Weighted P of industry P of industry Weighted
index matched index matched average of index matched index matched average of Risk
Case with acquired with acquiring pre-merger with acquired with acquiring post-merger reduction
no. firm firm p's firm firm (4)-(7)
each firm in the index is weighted by the share of thefirm'sasset value relative
to the industry total.25 For each merger in the sample, the predicted and
actual post-merger industry betas are computed using the weights assigned to
the merging firms themselves to weight the matched industry index for each
firm. Table 7 displays the computed risk changes for the industry index
controls.
An industry index provides a much less precise control for a merging
company than does a single matched company. Neither regression toward the
mean nor firm size differences are taken into account. One or more relatively
25. Firm debt figures are only available on an annual basis, rather than on a monthly basis as
are the CRSP stock market returns and stock market equity values. Furthermore, the debt figures
are not available on COMPUSTAT prior to 1966 and must be obtained from Moody's. Due to
these data availability problems, the betas in the industry indexes are weighted by firm values at
the time of the merger.
VERTICAL INTEGRATION AND RISK REDUCTION / 6 5
6. CONCLUSION
The results, both with and without controls, suggest that vertical integration,
at least when executed via vertical mergers, may be associated with a reduc-
tion in systematic risk. Although further work is needed to affirm the general-
ity of these findings, the results are encouraging and appear to be robust. The
statistical findings were sustained using "matched pairs" as controls, using
industry indexes as controls, and using no controls at all. Most important,
using control firms which were similar in many important ways, we obtained
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