Introduction of Joint Ventures and the Option to Expand and Acquire By Bruce Kogut Presented by Kitty Wang
Index background main body comments Introduction Option- Analogs- Hypothesis Timing of exercise Testing Cues and specifications Data collection Statistical specification Discussion of market signals Conclusion
New product markets (uncertain demand) firms Enter? unrelated New product markets (uncertain demand) Enter??? In this sense, a firm’s initial investments in new markets can be considered as buying the right to expand in the future The right to expand is an example of a “real option” real option An investment in operation, as opposed to financial capital It is not necessarily to be exercised Introduction
Definition of Option: An agreement that gives an investor the right (but not the obligation) to buy or sell a stock, bond, commodity, or other instrument at a specified price within a specific time period. P 45 Out of the money In the money At the money exercise Not exercise Call options P E gain 0 Introduction- Option St-E 0 Value of Call option St St Securitie s St>E St<=x
Joint venture An agreement between two or more firms to undertake the same business strategy and plan of action. Acquisition When a firm buys another firm
Share the cost
Share the risk
Decrease the total investments
To exercise the option to expand requires further commitment of capital, thus requiting renegotiation among the partners. One possible outcome is that the party placing a higher value on this new capital commitment buys out the other. Obtain an call option into new markets Exercise the option
Acquisition for the buying party
Divestment for the selling party
Termination for the joint venture
When the market is proven, The buying party has acquired the skills of partner firm and no longer needs to invest in the development of capability to expand into the target market. 1 Waiting to invest, whereby it pays to wait before committing resources 2 Option of expanding production, where investment is necessary to have the right to expand in the future Two poplars of real option strategies Value to wait: 1 the possibility that the market does not develop 2 draws resources from other projects Value to invest: 1Benefit in investing today 2 gain experience 3 establish brad images 1 pooling resources from two or more firms. 2 sharing or even reducing investments 3 buying flexibility now and waiting to invest and focus later The divesting firm is willing to sell 1, it realizes capital gains 2 it may also not have the downstream assets to bring the technology to market Buying conditions : The net value of purchasing the joint venture must be at least equal to the value of purchasing comparable assets on the market Introduction- Analogs A joint venture serves as a way to bridge these options
1 the divesting party is contracted to pass on complex know-how on the running of the business 2 to low an erosion in customer confidence 3 in industries where few competitors exist, tying up a potential acquisition target prevents other parties from making the acquisition. And full owner ship is attained without adding further capacity to the industry by entering with a new plan * In this case, a joint venture is a phased divestiture with a future exercise date. Introduction- Analogs Assets in their current use dominates the option Partial divestments Acquired for exercising the option to expand 1 share scale economies 2 to coordinate the management of potentially excess capacity Building an option to expand in new markets Mature and concentrated markets New product markets
1 Joint ventures are designed as options that are exercised through a divestment and acquisition decision.
Such factors as unexpected increases in the value of the venture and the degree of concentration in the industry increases the likelihood of an acquisition.
3 Though a signal that the venture’s value has increased should lead to an acquisition, a signal that it has decreased should not lead to dissolution, as long as further investment is not required and operating costs are modest.
= value of the venture as estimated by the jth firm = the value of the assets in current use = the value of the future growth opportunities = state variable in prices, either of production or the inputs (assume that changes in a state variable are normally distributed) π * t T No further investments Option to acquire is exercised The expected value is the current value plus the expected increase; the variance is . If realization of is greater than some critical value of π * , the derived vale of the venture is greater than its acquisition price and the option to acquire is exercised. If less, no investments are made, Nor is it necessary to divest the assets, for there is the possibility that future changes may be favorable. Timing of exercise v
The acquisition is justified only when the perceived value to the buyer is greater than the exercise price. The exercise of option to acquire the joint venture is likely to be immediate for two reasons: 1 the value of the real option is only recognized by making the investment and realizing the incremental cash flows. If the investment in new capacity is not made in a period, the cash flows may be lost. 2 The necessity to increase the capitalization of the venture invariably requires a renegotiation of the agreement, which often leads to its termination. The option to expand the investment is likely to coincide with exercising the option to acquire the joint venture. Why not hold to maturity? Timing of exercise St-E 0 Value of Call option St St Securitie s St>E St<=x
the venture will be acquired when its valuation exceeds the base rate forecast Environmental cues informing managerial decisions
1 It is not likely that managers possess clear base rates and valuation signals
2 Most research on environmental cues has been oriented to identifying biases in the interpretation of information rather than in the selection of the information itself.
3 Base rates are frequently ignored, especially when the causal relationships are not explicit.
4 There is little guidance for establishing the base rates that might be used for irregular decisions, such as the acquisition of a joint venture.
We would expect, as Camerer(1981) notes, that individuals rely upon only a few cues of those available. We experiment with two time-varying specifications of the market cues relevant to the acquisition decision Testing- cues Hypothesis:
The short-term annual growth rate (PS= value of product shipment) =Changes in the value of PS for the jth industry over an annual interval Testing- cues The residual error (derived from an estimated regression of the time trend in shipment growth) t PS R
The appropriateness of linear specifications:
1 The above variables vary with time. Both are derived from a constant dollar series of industry product shipments.
2 The annual growth rate measure always uses the previous year as benchmark; The residual error indicates that decision makers establish a long term base rate for each industry’s historical growth and look at year to year departures from this trend.
3 Unlike the growth measure, the residual error assumes that managers act to acquire or divest when a market cue signals a rise in valuation relative to a long-term trend
4 The two variables, (by our argument), proxies for changes in the unobserved state variable (given as earlier ) that determines the value of the joint venture.
5 As (our) interest does not lie in the pricing of the option but in the likelihood or (hazard) of acquisition, differences in the scales of the proxies are unimportant.
Positive movements in the value of industry shipments signal improved investment opportunities and an increase in the value of the real option to expand the investment and, hence, a renegotiation of the capital commitment of the parties to the venture. The likelihood of an acquisition should increase with positive movements of the proxy variables. Testing- cues specifications
First hand Second hand -questionnaires
Names and info about joint ventures are acquired from the publication Mergers and Acquisitions for the years 1975 and 1983
Samples included only ventures located in the U.S. with at least one American firms in the joint venture. 475 firms are contacted in two mailings and 55.5% responded, of which 140 are useable.
92 samples are in manufacturing industry. This was used as sub sample in the paper.
-Bureau of census Four-firm concentration ratio at the four-digit SIC level -Department of Commerce Unpublished data on Annual shipments (at the four digit in constant 1982 dollars for the years 1965-1986)
3 dummy variables (R&D, Production and Marketing) are created from questionnaire data
Testing- data collection
Low degree of collinearity among these variables Testing- statistical specifications
i s derived directly from the shipment series. To normalize the data, each industry time series was divided by the first year of the series; thus each series begins with 1965 set to 100. By first differencing the normalized series and dividing by the lagged year, growth in shipments were calculated for each year. This measure was then entered into the analysis as a time-varying covariate with a one-year lag. 1 the normalized series of shipments for each four-digit SIC industry were used 2 A time trend was derived by a linear regression. 3 The residual is calculated as the forecasting error for each year, using the normalized linear time trend as the base-rate predictor and the actual normalized shipment as the realized value. The residual error was also entered into the analysis as a time-varying covariate with a one-year lag. Testing- statistical specifications The annual growth data… The residual error is calculated…
(We) use a partial likelihood specification to estimate the influence of these factors on termination by acquisition among a sample of joint ventures.
Partial likelihood estimates the influence of explanatory variables on the hazard of termination without specifying a parametric form for the precise time to failure.
Instead, it rank orders ventures in terms of the temporal sequence of terminations . For each event time, it specifies a likelihood that the observed terminated venture should have terminated.
Testing- statistical specifications B : coefficients X : covariates i : indexing the venture which failed at time ti j : indexing the ventures at risk at time ti : the baseline hazard L : the likelihood for the ith event The time-varying covariates are indexed by the time of the event (ti)
Significance under two tail T-test : (T statistics in yellow) P<0.01 p<0.05 P<0.10 Testing- statistical specifications
Concentration is significant. 1 In concentrated industries, joint ventures appear to be used as an intermediary step towards a complete acquisition. 2 Joint ventures are also often part of the restructuring of mature industries, either due to new, and perhaps foreign , competition or to efforts to stabilize the degree of rivalry. 3 by acquiring the assets, a shifting of ownership occurs without an increase in industry capacity. Ventures with R&D activities or marketing and distribution activities are more likely to be acquired. The production variable is positive, though insignificant. Explanations about annual growth and residual error It is reasonable to conclude that the decision by managers whether to acquire or divest the joint venture is more significantly sensitive to annual departures from a long term trend than to short term indices of industry growth. Testing- statistical specifications
The above findings indicate that increases in excess of the long term trend in shipment growth are significantly related to the timing of the acquisition of ventures. Managerial decisions are cued by market signals that the venture’s value has increased. Argument 1: the take -off in growth signals industry consolidation, thus forcing exits. Disproval : 1 Shakeout should occur when the market does poor than its historical record. 2 The relationship between residual error and the likelihood of acquisition suggests that acquisition tend to occur when the market does better then its historical record. 3 No support is shown that consolidation leads to an increase in acquisition Argument 2: Managers are myopic and fail to consider that short term deviations may be outliners Disproval : 1 Managers do not simply react to any short-term change. Tested by the same model , it can be concluded that it should not lead to a dissolve decision when the market turns down. 2 Keep in mind the nature of an option. Once the capital is committed, the downside risk is low, especially there is a market for the acquisition of the assets and operating costs are not high. The selling of the venture means that one firm puts a higher value on the assets. It does not mean that the venture is unprofitable. Discussion of market signals
Significance under two tail T-test: (T statistics in yellow) P<0.01 p<0.05 P<0.10 Change in concentration indicates the percentage change in the four-firm concentration at the 4-digit SIC level during the life of the venture Discussion of market signals
1 Joint ventures are designed as options that are exercised through a divestment and acquisition decision. 2 Such factors as unexpected increases in the value of the venture and the degree of concentration in the industry increases the likelihood of an acquisition. 3 Though a signal that the venture’s value has increased should lead to an acquisition, a signal that it has decreased should not lead to dissolution, as long as further investment is not required and operating costs are modest. Conclusion