Think at London Business School
New research into antecedents of corporate venture capital in China finds significant new explanation for corporate collaboration
By Gary Dushnitsky, Nick Mickshik
Why do incumbents buy startups? Pioneering research by LBS Assistant Professor of Strategy and Entrepreneurship Colleen Cunningham finds that in the pharmaceutical industry, firms may acquire targets simply to shut down potentially threatening projects and pre-empt future competition.
Innovating firms are often acquired by incumbents, typically in the early stages of product development. Economists have traditionally viewed this behaviour positively and the theory taught in business schools, like ours, says that incentives for these purchases are typically the realisation of synergy or to acquire the development capacity - the talent, infrastructure and intellectual property (IP) - to accelerate innovation.
But there has been an undercurrent of speculation that an alternative motive – a pernicious motive – exists: that an acquiring company will buy an entrepreneurial startup specifically to shut down its activities and projects before they develop into a competitive threat. This, of course, would be considered anticompetitive behaviour and, if proven, would be investigated by the relevant regulatory authorities.
The challenge is to prove the acquire-to-kill theory.
These acquisitions – by an incumbent of an early-stage target – are typically well below the price threshold that would trigger a red flag to the competition authorities. In addition, in most sectors, collecting the data as systematic evidence of this behaviour would be extremely difficult – if possible at all. After all, on most occasions, the acquirer could plausibly argue that redeploying the human capital, technology and any other firm resources onto an alternative project with a better outcome was a more effective and perfectly valid business decision.
“This is why we chose the pharmaceutical sector to test the hypothesis of the ‘killer acquisition’,” says Colleen Cunningham, Assistant Professor of Strategy and Entrepreneurship at London Business School, who conducted the research with Florian Ederer, Associate Professor of Economics at the Yale School of Management and Song Ma, Assistant Professor of Finance, also at Yale. Their joint research has caught the attention of key antitrust authorities and global law firms.
“Our MBA students had been asking whether there was evidence in this area, and there wasn’t,” says Dr Cunningham. “This triggered the idea for the research, but it’s not an easy subject to explore.
“The pharmaceutical industry, being regulated, has comprehensive data on drug projects that we were able to track over the entire product lifecycle, and over a long enough timeframe to investigate the hypothesis: does such anticompetitive behaviour occur in the context of pharmaceutical development?
“Do incumbent companies really acquire nascent competitors for the purpose of shutting them down?”
In the context of the pharmaceutical industry, killer acquisitions – those that eliminate potentially promising, yet likely competing innovation– will potentially have a harmful impact on society, in terms of choice and thus pricing and in terms of societal wellbeing.
“Do incumbent companies really acquire emerging competitors for the purpose of shutting them down?”
Yet the research is shockingly clear.
“Using pharmaceutical industry data, we show that acquired drug projects are less likely to be
developed when they overlap with the acquirer's existing product portfolio, especially
when the acquirer's market power is large due to weak competition or distant patent
expiration,” the paper finds.
“Conservative estimates indicate 5.3% to 7.4% of acquisitions in our sample are killer acquisitions. These acquisitions disproportionately occur just below thresholds for antitrust scrutiny.”
“Patients suffer because there are fewer drugs and the drugs that are developed and brought to market are sold at higher prices,” argues Jeff Skinner, Executive Director of the Institute of Innovation and Entrepreneurship (IIE).
These findings are the result of exhaustive and pioneering research. To begin with, the authors created an economic model that models the circumstances under which a monopolist (or oligopolistic set) of competitor(s) would have an economic incentive to ‘acquire-to-kill’ (AtK) an invention. They then consider a number of parameters including:
“The AtK strategy can be profit-maximising for an incumbent and that the incentive is at its highest when the market overlap is high and the product development overlap is low,” says Skinner.
“Colleen also models the situation where the existing industry is an oligopoly. For example, a small number of existing firms dominate the market between them. She finds that the same incentives exist, although the AtK strategy is of less benefit to any one incumbent.
“She then proceeds to find out whether such behaviour exists in the real world. To do this she needs comprehensive data on project-level outcomes of both acquired and non-acquired projects, overlaps between acquirer and acquired (ie target) firms and market and technological competition. Such data exists for pharmaceutical project development and is thus a great ‘laboratory’ for testing her model.”
The authors used the Pharmaproject database, covering about 16,000 projects initiated by some 4,600 firms between 1989 and 2010 and acquisition data from a wide range of credible financial databases, thoroughly ‘cleaned’ to prevent duplicate acquisition events.
Cunningham and co-authors write in the paper: “For each drug in our database, we can identify whether it went through any acquisition event during its development life cycle and if it did, the acquirer, the timing of acquisition, and development activity in the years pre- and post-acquisition.”
The parameters of the earlier model (product and development overlap) are constructed for each acquisition, and used for the empirical tests, comparing post-acquisition development of drugs acquired by incumbents with overlapping projects, to otherwise similar projects acquired by non-overlapping incumbents, to otherwise similar non-acquired projects.
To supplement their main analysis, the authors compare the behaviour of firms making acquisitions at just below and just above the antitrust review thresholds. They find that the eventual product launch rate is much lower (1.8% versus 9.1%) and the discontinuation rate is much higher (94.6% versus 83.3%) for below-threshold acquisitions compared to those right above the threshold.
Skinner says: “This provides supporting evidence of strategic behaviour by acquiring firms that is consistent with killer acquisition motives.”
He adds: “Moreover, an alternative hypothesis that firms quite legitimately acquire entrepreneurial firms for human capital doesn’t hold water. Only 22% of pre-acquisition inventors move to the acquirer post-acquisition, while 78% move to other firms.
“So, what’s the impact of the ‘acquire to kill’ incentive? Well, first, Colleen estimates that without the incentive, achieved, perhaps, by lowering the antitrust threshold, the total number of viable drug projects would increase by 4.3%, or around 13 projects a year.
“The acquisition-to-kill strategy can be profit-maximising for an incumbent and the incentive is at its highest when the market overlap is high and the product development overlap is low”
“She compares this with the impact of other targeted innovation policies. One policy, the Orphan Drug Act gives substantial tax breaks ($30 million per trial) and other benefits for drugs targeting small patient pools. This results in 25 extra clinical trials a year. Eliminating killer acquisitions would result in ‘innovation effects’ that are as much as half as big as those from the Orphan Drug Act.
“Simply, the results of this analysis are stark; when an acquired project overlaps with a product in the acquirer’s existing product portfolio, the project really is less likely to be continued.
“Another tactic used by pharmaceutical companies is the ‘pay-for-delay’ tactic which temporarily thwarts the entry of generics and generates a deadweight loss of at least $21 billion over a period of 25 years. The authors believe that killer acquisitions likely cause at least as much anticompetitive harm as these pay-for-delay settlements.”
Apart from the harmful societal implications of killer acquisitions, they could also affect the direction of innovation.
Skinner argues: “If entrepreneurs can choose between originating projects that overlap with existing products or those that do not, increased takeover activity and killer acquisitions by incumbents may spur innovation of very similar me-too drugs at the expense of origination.
“This distortion of the direction of innovation in response to the prospect truly novel products of acquisition will add to the negative welfare impact of killer acquisitions.
As the paper concludes: “Finally, the magnitude of the Schumpeterian gale of creative destruction – whereby start-ups’ inventions topple entrenched and less innovative incumbents – may be smaller than previously documented. Innovation and the share of young firms in economic activity may have declined not only because incumbents are more reluctant to innovate but also because incumbent firms with market power acquire innovators to eliminate future competition - and thereby inhibit technological progress.”
Colleen Cunningham is Assistant Professor of Strategy and Entrepreneurship at London Business School.