1 of 11

Specialized Investment and Firms’ Boundaries: Evidence from Textual Analysis of Patents�Jan Bena Isil Erel �Daisy Wang Mike Weisbach �

November 2022

Kristoph Kleiner

Indiana University

2 of 11

Key Result I: A Target Firm’s Patents become more similar (in non-common terms) to the Acquirer’s Patents after Acquisition

3 of 11

Key Result II: Patent Similarity Increases Primarily among Vertically-Integrated Firms

Vertical-Integrated Innovation Observations: 3,685

100 Completed Deals (Estimate)

12 Withdrawn (Estimate)

4 of 11

Overview According to the Authors

Grossman-Hart-Moore Theory: When two firms enter a business relationship that requires substantial specialized ownership, they are likely to merge to avoid contracting challenges arising from potential hold-up problems

Simple Implication: The need to make specialized investment can provide a motive for acquisitions

Empirical Hypothesis: Merging firms’ investments should become more specialized to their respective relationships following the acquisition

This paper: We provide evidence that is consistent with this prediction

5 of 11

My Questions for the Authors

Grossman-Hart-Moore Theory: When two firms entering a business relationship that requires substantial specialized ownership, they are likely to merge to avoid contracting challenges arising from potential hold-up problems

Simple Implication: The need to make specialized investment can provide a motive for acquisitions

Empirical Hypothesis: Merging firms’ investments should become more specialized to their respective relationships following the acquisition

This paper: We provide evidence that is consistent with this prediction

Question I: Are you providing evidence of Grossman-Hart-Moore?

My Answer: I don’t think so, I think you are testing Williamson (1975, 1979, 1985) and Benjamin Klein et al. (1978)

Question II: Should you focus on Grossman-Hart-Moore?

My Answer: Yes! It’s much more interesting

6 of 11

Two theories of vertical integration

Transaction Cost Economics (TCE) approach of Williamson (1975, 1985)

Property Right Theory (PRT) approach of Grossman and Hart (1986) and Hart and Moore (1990).

Both approaches emphasize the importance of incomplete contracts and ex post opportunistic behavior (hold up) on ex ante relationship-specific investments.

But …
Williamson approach views vertical integration as a way of circumventing the potential holdup problems

Predicts vertical integration common when there is greater specificity and holdup is more costly
Vertical integration should enhance investments by all contracting parties

Hart approach focuses on the role of ownership of assets as a way of allocating residual rights of control

Both costs and the benefits of vertical integration in terms of ex ante investment incentives.
These costs and benefits decides whether integration occurs and who acquires who

7 of 11

Review of Forward and Backward Integration

Forward Integration: buying part of the process that occurs after the company's manufacturing process.

a clothing manufacturer that typically sells its clothes to retail department stores; instead, opens its own retail locations.

Backward integration: buying part of the supply chain that occurs prior to the company's manufacturing process

A clothing manufacturer buying a textile company that produces the material for their clothing.

8 of 11

Overview of Hart (1995)

Two assets, a1 and a2, and two managers operating them, M1 and M2

Step 1: Suppose that M2, in combination with a2, supplies a widget to M1

Step 2: M1, in combination with a1, then uses this widget to produce output

Three possible ownership structures:

Proposition A: If assets a1 and a2 are independent, then non-integration is optimal.

Proposition B: If assets a1 and a2 are complementary, then integration is optimal.

Prop C: If M1's (M2's) human capital is essential, then type 1 (type 2) integration is optimal.

Prop D: If both M1's human capital and M2's human capital are essential, then all ownership structures are equally good.

9 of 11

Testing Proposition C of Hart�

If Customer’s human capital is essential, then customer purchases Supplier: Backward Integration

Why? Because we don’t want to reduce customer’s incentives, or have their human capital leave

If Supplier’s human capital is essential, then supplier purchases customer: Forward Integration

Why? Because we don’t want to reduce supplier’s incentives, or have their human capital leave

Testing these theories requires:

Identifying whether the target is upstream or downstream to the acquirer

Fully available from Fresard, Hoberg and Phillips (2019)

2. Developing a measure of essential human capital

Possible from Patents

10 of 11

Incorporating Direction into Patent Similarity

Authors follow Kelly, Papanikolaou, Seru, and Taddy (2020) to measure the similarity of patents between acquiring and target firms

Measures similarity in uncommon terms across both patents
Patents can become more similar because acquirer’s new patents are more similar to target, or vice-versa

My suggestion: Easy! Just incorporate direction into your patent similarity measure

If acquirer’s patents stay the same, and target firm’s patents become more similar to acquirer, then acquirer has the essential human capital

Hart Theory: Acquirer should be the customer and integration will be backward

If target’s patents stay the same, and acquirer firm’s patents become more similar to target, then target has the essential human capital

Hart Theory: Acquirer should be the supplier and integration will be forward

Including this simple test, should allow you to directly test Hart’s Theory (which in my view is less obvious and more interesting!)