Buyout and Divestiture Decisions in Biotechnology
ANN ARBOR, Mich.---When firms face technological and market uncertainties, they often invest simultaneously in multiple projects that may represent growth options. Many times these options take the form of strategic alliances with start-up companies to help spread risk and deal with uncertainty, without added governance costs.
Through these alliances, firms increase their prospects for future expansion and secure upside gains while limiting their downside losses. In the biotechnology industry, for example, large pharmaceutical corporations build portfolios of equity-based growth options by investing in smaller biotech companies with specialized R&D capabilities in hopes of capitalizing on new drug or therapy discoveries.
It is difficult, however, to value a collection of related options or to make strategic investment decisions about buyouts or divestitures without considering the positive and negative interactions among such alliances within a portfolio, say researchers.
In a study of firm behavior under conditions of multiple investments, Jay Anand of the Michigan Business School, Roberto Vassolo of IAE-Universidad Austral in Argentina and Timothy Folta of Purdue University demonstrate the importance of considering sub-additivity and super-additivity effects among options.
Their study, forthcoming in the Strategic Management Journal, also provides a framework for determining the optimality of a portfolio of R&D strategic alliances. This framework can be used to analyze how well companies are building their technological capabilities through investments in multiple technological and market-entry projects and to guide managers' acquisition and divestment decisions.
In cases where firms hold only a single option, previous research has shown that higher uncertainty lowers the likelihood of both divestitures and buyouts, because termination reduces the set of possible avenues for firm growth. However, when firms make multiple investments in options to achieve a first-mover advantage, their governance decisions become more complicated.
"When option investments in a portfolio are competitive and overlapping, their value is sub-additive," says Anand, assistant professor of corporate strategy and international business. "In other words, the overall portfolio value is less than the value of the options if they were not held in the same portfolio."
This correlation increases the likelihood a firm will divest the least attractive of its related alliances while retaining the best ones as possible candidates for future acquisition. Failure to recognize the effect of sub-additivity could lead to over-investment.
Conversely, option investments in a portfolio are super-additive when the portfolio value is greater than the value of the individual options if held separately. Super-additivity may result when a firm is able to leverage its own capabilities and assets to make investments in alliances, thus reducing the cost of each investment.
"The value of the real option does not depend exclusively on uncertainty but also on the cost of buying the option," Anand says. "When the investment is partially redeployable, or fungible, among alliance agreements, the cost of a related option diminishes, making it more valuable."
Greater levels of fungibility increase the probability of acquisition, enabling a firm to consolidate related alliances with its existing capabilities, thereby leading to economic gain. Failure to recognize this super-additivity effect may lead to under-investment, with some projects being more valued than others.
The researchers gathered data on 30 national and international pharmaceutical firms that initiated 363 equity agreements with 183 different biotechnology partners between 1989 and 1999. Their goal was to observe how portfolio effects influence firms' equity-alliance decisions in an industry setting where other factors (option clauses, interest rates, company size and industry returns) come into play. Over the 10-year period, there were 76 terminations---14 instances where the pharmaceutical firm bought out the biotech partner and 62 divestitures.
"Our results suggest when a pharmaceutical firm has a growth option that is more highly correlated with the rest of the firm's portfolio of options, it is more likely to divest," Anand says. "On the other hand, when a firm's growth option is more similar to its own technological domain, it is more likely to do a partner buyout. This underscores the importance of emphasizing the interactions within a portfolio."
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