A Theory of Young Firm Acquisitions

Abstract

Evidence suggests that young firm acquisitions have outgrown both IPOs and established firm acquisitions. To study this phenomenon, we develop a dynamic equilibrium model of mergers and acquisitions as efficient reallocation of assets. A firm may build assets that it may not be able to manage successfully. If so, the firm may be acquired by an established firm that has proved its ability to manage such assets successfully. A young firm has not yet proved its ability to manage assets, and can only do so by remaining independent and managing assets. We find that when the transaction costs of acquisition decrease and/or the costs of building and managing assets increase, an established firm switches from building new assets internally to acquiring a young firm. We also find that when the young firm's attempt to manage assets are less likely to fail and/or assets obsolete sooner, more young firms become acquisition targets and the fraction of independent young firms such as IPO firms declines. Our model is consistent with some stylized facts of mergers and acquisitions such as the bidder discount, the target premia and the size distribution of acquirers and targets.