Corporate Acquisitions, Diversification, and the Firm's Life Cycle

• DOI: http://doi.org/10.1111/jofi.12362
• Published date: 01 February 2016
• Date: 01 February 2016
• Author: RENÉ M. STULZ,ASLI M. ARIKAN

THE JOURNAL OF FINANCE •VOL. LXXI, NO. 1 •FEBRUARY 2016

Corporate Acquisitions, Diversification, and the

Firm’s Life Cycle

ASLI M. ARIKAN and REN ´

E M. STULZ∗

ABSTRACT

Agency theories predict that older firms make value-destroying acquisitions to ben-

efit managers. Neoclassical theories predict instead that such firms make wealth-

increasing acquisitions to exploit underutilized assets. Using IPO cohorts, we estab-

lish that, while younger firms make more related and diversifying acquisitions than

mature firms, the acquisition rate follows a U-shape over firms’ life cycle. Consistent

with neoclassical theories, we show that acquiring firms have better performance

and growth opportunities and create wealth through acquisitions of nonpublic firms

throughout their life. Consistent with agency theories, older firms experience negative

stock price reactions for acquisitions of public firms.

EXISTING THEORIES ON THE ROLE OF ACQUISITIONS and diversification over the

life cycle of firms offer two very different views. Agency theories predict that

firms make wealth-destroying acquisitions and diversify when they are mature

because their cash flow outstrips their internal growth opportunities and man-

agement becomes more entrenched, so that it pursues growth at the expense

of shareholders (e.g., Mueller (1972) and Jensen (1986,1993)). Neoclassical

theories predict, instead, that firms pursue acquisitions in an effort to make

the best use of their valuable scarce assets (see Maksimovic and Phillips (2013)

for a review). As a result, better-performing firms and firms with better growth

opportunities create value through acquisitions, including diversifying acqui-

sitions. To the extent that firms that go public are better-performing firms,

we would expect them to acquire those assets that they can make better use

of after going public and having easier access to external finance. As newly

public firms exploit their growth opportunities, their acquisition rate should

fall. Eventually, however, firms with valuable scarce assets may acquire new

assets to keep making optimal use of these scarce assets, so that these theories

∗Aslı M. Arıkan is with Kent State University. Ren´

e M. Stulz is with Ohio State University,

NBER, and ECGI. We thank participants at seminars at Purdue University, City University of

New York, London Business School, Ohio State University, and University of Maryland, as well

as Harry DeAngelo, Cam Harvey, Gerard Hoberg, Jim Hsieh, Max Maksimovic, John Matsusaka,

Gordon Phillips, Jay Ritter, Henri Servaes, Mike Weisbach,Liu Yang, and two anonymous referees

for useful comments. We are grateful to Brian Baugh, Andrei Gonc¸alves, Yeejin Jang, and Robert

Prilmeier for research assistance. The authors do not have any potential conflict of interest, as

identified in the of Disclosure Policy.

DOI: 10.1111/jofi.12362

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Mean Conditional Acquisition Rate

Age

Figure 1. Mean value of the post-IPO cohort conditional acquisition rate over the firm’s

life cycle. IPOs are identified using the SDC Global Issues Database. The IPO sample includes

all IPOs over the 1975 to 2008 period excluding reverse LBOs, spinoffs, rights and unit offerings,

ADRs, closed-end funds, REITs, and IPO firms with stock price data available from CRSP before

their IPO announcement date. Acquisition deals of the IPO firms include all acquisitions in SDC’s

M&A database over 1981 to 2012. Age refers to number of years since the IPO year.The conditional

acquisition rate is the number of acquisition announcements of an IPO cohort in year tdivided by

the number of firms in that cohort that are alive at the beginning of year t.

predict both an increase in the acquisition rate and in diversifying acquisitions

as firms age.

In this paper, we investigate whether firms’ acquisition rate changes over

the life cycle and the extent to which such changes support the predictions of

the agency and the neoclassical theories. We find strong support for the predic-

tions of neoclassical theories that acquisitions are made by better-performing

firms and firms with better growth opportunities, and that acquisitions create

value. The only evidence consistent with agency theories is that the stock price

reaction to acquisitions of public firms by older firms is negative.

As far as we know, no prior study examines the acquisition behavior of firms

over their life cycle. Using a sample of 7,506 firms that have an IPO in the

United States over the 1975 to 2008 period, we find that the acquisition rate of

young firms, which we define as firms that are less than four years from their

IPO, is higher than the acquisition rate of other firms. However, as Figure 1

shows, the acquisition rate follows a U-shape over firms’ life cycle: the acquisi-

tion rate falls sharply early on, stays relatively constant for a number of years,

and then increases. When we separately examine acquisitions within a firm’s

industry and diversifying acquisitions, we find that firms diversify throughout

their life cycle and mature firms do not make more diversifying acquisitions

than young firms.

Note that Figure 1does not account for cohort or economic conditions ef-

fects. The relation between a firm’s acquisition rate and life cycle stage may

Corporate Acquisitions, Diversification, and the Firm’s Life Cycle 141

therefore be driven by these effects. For instance, it could be the case that, on av-

erage, economic conditions are better when the firms from our IPO cohorts are

mature, so that these firms make more acquisitions not because of their life

cycle stage but rather because of economic conditions. We estimate regressions

that account for these effects and find a stronger U-shaped pattern for the

acquisition rate. The fact that the U-shape becomes more pronounced is ex-

plained by the extremely high sensitivity of the acquisition rate of young firms

to economic conditions. Focusing on diversifying acquisitions, we find evidence

of a U-shaped pattern for these acquisitions as well, but the pattern is weaker

compared to the pattern for all acquisitions.

The patterns in Figure 1could be consistent with older firms making acqui-

sitions and diversifying because they have insufficient growth opportunities in

their industry.To investigate this possibility, we examine whether the determi-

nants of the acquisition rates of young and mature firms differ using firm-level

regressions. We use Tobin’s q, measured as the ratio of the market value of firm

assets to book value, as our proxy for growth opportunities. If firms are more

likely to make acquisitions because they exhaust their growth opportunities

as they mature, we would expect mature firms that make acquisitions to have

a lower qthan the firms that do not make acquisitions. This is not the case.

We show that the average qof acquiring firms is higher than the average qof

nonacquiring firms over the life cycle and that the acquisition rate increases

with qregardless of whether a firm is young or mature.

Our evidence of a positive relation between a firm’s acquisition rate and its

Tobin’s qsupports the neoclassical view of acquisitions, which holds that firms

use acquisitions to reallocate corporate assets to more productive uses. High

qfirms are expected to have more valuable assets and hence to pursue more

acquisitions. In this vein, Jovanovic and Rousseau (2002) develop a q-theory of

mergers. In their theory, investment can take place through capital expendi-

tures as well as through acquisitions. High qfirms make acquisitions because

they have greater productivity that they can transfer to the acquired firm.

In our sample, younger firms have substantially higher qs than more mature

firms, and thus are expected to undertake more acquisitions than mature firms.

Under this theory, we would also expect better-performing firms to make more

acquisitions (Warusawitharana (2008)).

Under the agency theories, CEOs benefit from growing their firm. If mature

firms have poor internal growth opportunities but high cash flow, they acquire

such growth opportunities through diversifying acquisitions. To see whether

this is the case, we examine how the determinants of diversifying acquisitions

change over the firm’s life cycle. Strikingly, mature firms are more likely to

make diversifying acquisitions when they have a high Tobin’s q. This finding

is hard to reconcile with agency theories but is consistent with neoclassical

theories of diversification such as that developed by Maksimovic and Phillips

(2002). In their model, a firm’s valuable scarce asset is managerial talent. When

managerial talent can be applied across several industries, it is optimal for the

firm to be diversified and to equate the marginal product of managerial talent