Why do companies choose to acquire rather than form a partnership? And when they do decide to buy another firm, what makes them choose one target over another? Wharton research reveals that companies pursue M&A when there are both internal synergies at work as well as network synergies. Research on mergers and acquisitions has typically focused on exploring internal synergies — where the deal generates value by combining the internal assets that each firm owns and controls.
Two Wharton papers mine the less beaten path of network synergies — the idea that the external partnerships of the combined company prove to be more valuable than separate partnerships the two firms would have inked on their own. The research papers are “Network Synergy,” authored by Wharton management professor Exequiel (Zeke) Hernandez and University of Minnesota professor J. Myles Shaver; and “Acquisitions, Node Collapse, and Network Revolution,” by Hernandez and fellow Wharton management professor Anoop Menon. Hernandez recently spoke with Knowledge at Wharton to discuss the two papers’ complementary research. (Listen to the podcast at the top of the page.)
An edited transcript of the conversation follows.
Knowledge at Wharton: Can you tell us more about your research? How did you pick this topic, and what did you set out to discover?
Zeke Hernandez: For a long time, I had been interested in two things that companies do all the time, but nobody had really put them together. The first is that we’ve known for quite a long time now that strategic alliances or collaborative partnerships with other companies are valuable.
For example, firms collaborate all the time to do R&D or share knowledge or commercialize a product, etc. Each of those alliances on its own has a certain value, but most important is that the portfolio of alliances of a company is valuable because it’s a network of external resources. And research has shown before that how a firm is positioned in that network is valuable.
For example, if your firm is a central hub in an alliance network, it gets more resources and controls the flow of those resources. Or if your firm is exposed to a lot of different ideas through the network, it will produce more innovative products. That’s the first part.
Secondly, another thing that firms do all the time is mergers and acquisitions. And we know from literature — whether it’s academic literature or just talking with managers — that value in mergers and acquisitions happens through synergy. Synergy is just when the combination of the two firms or the assets of the two firms is more valuable put together than separate.
But what I noticed is that managers and researchers had focused on synergies coming from assets that the two companies own and control. Think machinery, or patents, or teams and people, or rights over markets. But I was surprised that they overlooked these alliance networks. I started wondering whether they would be valuable when firms are choosing to do mergers and acquisitions, even if they don’t own and control those relationships.
“We wanted to know whether firms make acquisitions to get these network synergies.”
What my coauthors did was combine those two ideas and ask a question that had never been asked before, which is this: Could synergies come from combining the alliance networks by acquiring a target? We called those synergies “network synergies.”
Knowledge at Wharton: What is the importance of network synergies, and how is it different from what you described as corporate or internal synergies?
Hernandez: A network synergy we define as the value or the benefit that an acquirer can get from combining its network of alliance partners with the network of alliance partners of a target firm.
Let’s say my company has five alliances and your company has its own five alliances with other firms that I don’t have alliances with. So I could acquire you, and if I inherit those five alliances that you had, I’m going to generate a new network that now has 10 alliances. Or let’s say my company and your company each have five alliances. But our networks perfectly overlap. What that means is that your five partners are the same as my five partners. I can acquire you now and be the only firm in control of those five alliance relationships.
In the first example, there are probably some benefits associated with gaining those five new alliances, or eliminating redundancies in the five alliances in the second case. We call those benefits network synergies.
How they’re different from other kinds of synergies is also important. We distinguish in the paper between network synergies and internal synergies, which come from combining assets that you and I own and control internally. So again, think of those patents and machinery and teams and people I mentioned earlier.
There’s also other synergies, I think what you’re referring to as corporate synergies, which is more about giving me more power in the market. So for those who do mergers and acquisitions, that would be something like vertical integration or horizontal integration, which allows me to maybe eliminate a rival or consolidate with a supplier.
But network synergies don’t come from that. They come from a very different kind of asset, which is these external collaborative alliances with other firms.
Knowledge at Wharton: What were your key findings?
Hernandez: We wanted to know whether firms make acquisitions to get these network synergies. And really, it was a very simple question. We gathered a sample of acquisitions made by firms in the biotechnology industry. And here’s what we found.
We found that firms are much more likely to pick a target firm among a choice of other potential targets, if the combination of the two firms’ alliance networks puts the acquirer in a better position. So if I’m going to choose among A, B and C, I’m more likely to choose A over B and C, if A generates greater network synergies.
Also, let me give you two very specific types of network synergies we discovered. The first one is what I would call an additive network synergy. And that’s the five plus five example I gave you earlier. The target brings to the acquirer a set of new partners it didn’t have before. And the benefit of that is that now [the acquirer is] more central in the network, it gets more resources than before.
The second type was what I’ll call a subtractive network synergy. The target had overlapping redundant alliances, like the example I mentioned earlier. And the merger allows the acquirer to take exclusive control of those alliances.
Any one of those two could be a network synergy, be it additive or subtractive.
Knowledge at Wharton: Comparing internal synergies versus network synergies, which one weighed more in the decision to acquire a company?
Hernandez: I was actually surprised at this finding — they actually weighed about the same. If you think about it, that’s quite surprising. You’re trying to acquire another company; you’re thinking about a million different things. You’re trying to value if your systems … or your people are compatible, or your market positions.
“I would expect network synergies to matter in industries where … resources are widely distributed.”
Are you really thinking about these strategic alliances and these network synergies? I would have expected or at least hoped that yes, network synergies had an effect in terms of which target I choose. But it didn’t have to be as strong as internal. But they were similar, in the same range [of magnitude].
To make it very concrete, we found that, for example, if you’re going to pick a target [between] one that has produced about 90 patents versus [a company with] one patent. That’s a big difference, right? And there are some benefits in combining my patents with the target’s. [Having more patents] increased the likelihood I would acquire that target by about 3.5% [in an example of internal synergies]. In comparison, additive network synergies increase the likelihood of acquisition about 2.5%. So a little bit less, but within the same order of magnitude, which was surprising to me.
Knowledge at Wharton: Can you give us some examples in the corporate world? Are there some companies out there that have actually exhibited these things that you found in your research?
Hernandez: Yes, I’ll give you two examples, one of each kind of network synergy I mentioned. For the additive network synergy, there was a deal a few years ago between two biotech firms, Hyseq and Variagenics. Before they merged, each had about nine to 10 alliance partners. They were doing joint R&D and drug commercialization through these alliances. But their alliance portfolios actually had zero overlap, meaning that the partners of these two firms had no interactions, no alliances with each other.
Hyseq buys Variagenics. It gets in one transaction 10 new strategic alliance partners. So what this does effectively is it double’s Hyseq’s external sources of knowledge and access to resources.
Now, you know, at first that seems rather obvious when stated that way, but here’s a counterfactual. What would it have taken for Hyseq to reach the same effect without an acquisition? It would have to go and get 10 separate firms, negotiate 10 separate alliance contracts, develop trust with each one of those 10 partners, etc. You see that that may not be possible. There may not be 10 partners available. Those 10 partners might not all want to partner with Hyseq. It’s much more efficient to pay a reasonable amount to inherit the network of Variagenics and get those partnerships all at once. When you put it that way, it highlights the power of seeking these network synergies.
Now, a second example of a subtractive network synergy was a deal that happened some years ago between two firms, Lynx and Solexa. In contrast to the previous example, these two companies had about 15 partnerships each, but they were very, very overlapping. If Lynx had a partnership with company A, so did Solexa.
“What this research is offering is … a new source of value that you hadn’t thought about before.”
So what can that company A do because it has partnerships with both Lynx and Solexa? It can basically play them off each other. It can also perhaps share part of its knowledge with one, part with the other. But neither Lynx nor Solexa are getting the full benefit of what each individual partner is offering. By merging, all of a sudden, you have one exclusive partner, like one hub that controls all the alliances. Now it has more control and more influence.
Again, let’s think of the counterfactual. What would it have taken for Solexa to do that? Solexa couldn’t just go to Lynx and say ‘Hey, I want you to end your partnerships just because I want to be the exclusive hub’ for these alliances. That’s impossible, right? So you can only accomplish that by taking ownership of the other firm and consolidating all the alliances [under one firm].
Knowledge at Wharton: Are there specific sectors or industries where network synergies are more critical for M&A deals? Or they are pretty much the same across the board?
Hernandez: We need to keep in mind that we only tested this in one industry, in biotechnology. That choice was a bit intentional, because we know from prior research that this is an industry where strategic alliances and external relationships are valuable. And they’re valuable there for two reasons. The first is that this is an extremely technologically complex industry. So what it takes to develop molecules, to develop drugs, to take them through the FDA approval process, etc., — no firm has everything it takes to do it all internally. That leads to the second point: Partnerships are just very common [in that industry]. You have to collaborate. You can’t go at it alone. So these alliances end up being quite valuable to being profitable in this industry. And it makes sense that firms should — and they do — seek network synergies.
Now, the general point is that I would expect network synergies to matter in industries where I would say resources are widely distributed. What I mean by that is that no individual firm can systematically do everything needed to be profitable on its own.
What industries is this true of? Clearly high tech industries — biotech, electronics, software. I also think it’s true in industries that are very global. If you think of an industry where talent, resources, technology are spread across many countries — it’s very hard to control all of that internally. Probably this is where these network effects would be important [and you’d be more likely to see firms pursue network synergies via M&A].
Knowledge at Wharton: What are some practical implications of your research? What can companies take away from it that they can apply it?
Hernandez: Here’s one very, very practical consequence. I’ve observed that in many, not all, but many companies, the corporate development groups are split into an M&A team and an alliance team or a strategic partnerships team. Often, these teams are in different buildings. They might even be in completely different cities. Sometimes, companies might have an M&A team but not an alliance team or vice versa.
If alliances and acquisitions are mutually affecting each other, then a very practical implication is that you need the team to be together, right? You need the same group to be managing alliances and M&A as a unified corporate strategy as opposed to two separate things.
And importantly, if you are an M&A manager or an M&A researcher, what this research is offering is that there is perhaps a new source of value that you hadn’t thought about before. Maybe you thought about combining the teams and the internal stuff. Maybe you thought about how the merger changes your market position.
“Acquirers choose targets that create … network synergies.”
But my guess is that probably not everyone has thought about value coming from combining strategic alliance networks. And I think the reason for that is that unlike the assets I just mentioned, you don’t own and control those [external alliances]. You don’t technically own a partnership. It’s a contractual relationship that in part is controlled by someone else or partially controlled. However, it doesn’t mean it’s not valuable. It doesn’t mean that a merger can’t change your position in that network. So think of [network synergy] as a new source of value [for acquirers].
Knowledge at Wharton: You’ve alluded to this earlier — how your research is different from prior work that’s done in this area. Can you give us more details about how you’re different?
Hernandez: There’s a very clear division between people doing and studying mergers and acquisitions and people doing and studying strategic alliances. And really, this is one of the very few studies so far that has combined both perspectives. And so I think the research is different because we integrate the two — and the two sides do need to talk to each other. It’s exciting because there’s probably a lot of implications that we haven’t explored yet.
Knowledge at Wharton: How will you follow up this research?
Hernandez: We have really just scratched the surface. … What we’ve done is show that acquirers choose targets that create … network synergies. Another way to think of that is we’ve shown that acquirers expect network synergies, and that they’re willing to pay for them, at least in some industries. But we still need to learn a lot about what happens afterward.
Think of post-merger integration. What do firms need to do to actually realize the expected network synergies? And also, how long do those network synergies last? Especially when we compare them to the other synergies about which we’ve known a lot more. There’s a lot of research to be done on just comparing network synergies with the other types of synergies.
Then there’s a question that’s been intriguing me: How do the capital markets react? I don’t know if, say, the stock price of a firm is affected by announcing a deal that has network synergy. I don’t see analysts talking about alliance networks too much [when valuing acquisitions], so that would be an interesting question, maybe even in the finance realm.
Lastly, a very different but related issue, is thinking about divestitures. If you think about it from a network’s lens, a divestiture is a fission or splitting of two networks. That has a whole series of other implications. It’s very interesting to see how these strategic alliances are reassigned after a divestiture, and what domino effects occur.
Those are just a few examples of things that I want to do. But certainly, what’s exciting is that there’s so much to be done because it’s … new territory.