Practical analysis for investment professionals
13 July 2016

The Microsoft-LinkedIn Deal and “The Nature of the Firm”

The Microsoft-LinkedIn Deal and "The Nature of the Firm"

Microsoft announced last month that it will acquire LinkedIn for $26.2 billion, a 50% premium over the social networking service’s closing share price around that time.

Massive merger and acquisition (M&A) transactions like this are one reason why the largest US corporations expanded in the last two decades. Between 1994 and 2013, the gross revenues of Fortune 500 companies grew from 58% of nominal GDP to 73%.

Why are these firms growing so fast? Nobel laureate Ronald Coase’s 1937 essay, “The Nature of the Firm,” gives a hint at the classical reasoning behind this trend, but acquisitions like the Microsoft-LinkedIn deal may not be rational according to its framework.

If supply and demand efficiently directs resources, independent contractors and one-off sales should organize economic activity, not firms, the private equivalent of planned economies. Coase writes, however, that there are disadvantages to using the market. Firms try to avoid transaction costs — the costs of learning the market price, negotiating with suppliers, and writing contracts — by controlling factors of production they would otherwise need to acquire from the market.

This applies most directly to the labor market. Consider how impractical it would be to negotiate a fee and hire a contract lawyer every time your boss asked you to do something. It is difficult, however, for your employers to predict everything they might ask of you in a long-term agreement, so they agree to pay you a salary to do whatever the firm needs, within agreed-upon limits. When buyers obtain control over factors of production in this way, they establish firms.

So Why Shouldn’t One Big Firm Do Everything?

Firms face increasing marginal costs of incorporating additional transactions into the firm relationship. At some point, firms will face diminishing returns to management or scale. A firm will take control over transactions until the marginal cost of doing so is equal to the marginal cost of performing the transaction with another firm or in the market.

Coase’s theory applies most directly to a firm buying one if its suppliers, but it also explains why conglomerates form. In the basic model, a firm acquires a supplier. The large firm cannot run the supplier’s business as efficiently, but if the transaction costs avoided are greater than the difference between the supplier’s cost of running itself and the large firm’s cost, it makes economic sense to purchase the supplier.

The LinkedIn acquisition does not strictly follow this framework because Microsoft and LinkedIn are in dissimilar industries. Though Microsoft may save on some transaction costs incurred when recruiting or advertising, LinkedIn does not build semiconductors or write code for Microsoft.

Coase was quick to point out that firms can participate in more than one industry. Like sharks, firms need to keep moving to survive. Only so much cash flow can be reinvested in the same thing. Increasing marginal costs lead firms to diversify or improve market penetration with new products. In Coase’s words, “There may be a point where it is less costly to organize the exchange transactions of a new product than to organize further exchange transactions of the old product.”

This explains why a conglomerate like Berkshire Hathaway expanded from textiles to a variety of holdings by acquiring undervalued companies. What Coase’s theory cannot explain is why the majority of mergers fail.

And Yet They Do

It is unlikely that so many firms would routinely underestimate the operating costs of acquired firms and overestimate the transaction costs avoided. Likewise, firms would have to be inept at identifying companies with growth potential for M&A deals to provide negative value on average. LinkedIn, only months removed from a poor revenue forecast and an $11 billion sell-off, may be an overpay.

“The Nature of the Firm” does not address the possibility of synergies, the hope of many mergers. Buyers often think they can provide capital, skills, oversight, or capabilities to make their new subsidiaries more profitable.

Statistically, they are wrong most of the time. The lessons from “The Nature of the Firm” are simple: Vertical integration and expanding into industries where high economic profits can be had are often rational. Banking on synergies to grow revenue or save on costs, on the other hand, is a gamble with poor odds.

LinkedIn is neither part of Microsoft’s supply chain, nor is it a firm with strong or even positive profit margins. It is not a competitor Microsoft can acquire to achieve market hegemony, as it has in the past. The acquisition of LinkedIn depends on synergies to succeed. Specifically, Microsoft needs to sell Office 365 to LinkedIn members, and use its new data on them to improve its other services.

These synergies may not materialize. Microsoft is no stranger to regrettable acquisitions, having written down $6.3 billion after acquiring aQuantive and $7.6 billion related to its Nokia acquisition.

LinkedIn might better mesh with Microsoft, but as with all mergers, the deck is stacked against it.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockphoto.com/Jason Doiy

About the Author(s)
Matthew Borin

Matthew Borin was an intern at CFA Institute. He was pursuing a bachelor's degree in economics from Williams College, Williamstown, Massachusetts.

2 thoughts on “The Microsoft-LinkedIn Deal and “The Nature of the Firm””

  1. As a recovering academic myself, I am familiar with the work of Ronald Coase. In fact, I read ‘The Nature of the Firm’ more than three decades ago when I was in a PhD program. He was a remarkable man who lived a long and productive life. Seven years before he died in 2013 at the age of 102, he published the lead paper in the Journal of Economics and Management Strategy (link: http://onlinelibrary.wiley.com/doi/10.1111/j.1530-9134.2006.00100.x/abstract). Still, a phrase echoed in my mind as I read Mr. Borin’s article: ‘It’s a lot more complicated than that.’ Therefore, I have offered my own comments below. In the interest of time and space, I have made them as concise as I can—but others could undoubtedly have done better.

    1. The article overlooks a long and rich stream of research that spun out of Coase’s original paper. That often falls under the rubric of ‘transaction cost economics’ (TCE). The foremost TCE scholar in the world, Oliver Williamson, was a co-winner of the Nobel Prize in economics in 2009; he wrote a nice overview of TCE that same year (http://bit.ly/Williamson_on_TCE). TCE helps us understand why we have firms and companies rather than everyone being self-employed: Business entities are more efficient, not because of lower cost in an accounting sense, per se, but because of the avoidance of both uncertainty (when one most needs them, that self-employed HR director or self-employed Controller might be in the hospital or away on vacation) and opportunistic behaviors (e.g., price-bullying of one party by the other).

    2. The article also ignores major empirical research about diversification, especially Rumelt’s 1973 Harvard dissertation, later published in book form (‘Strategy, Structure, and Economic Performance’). In a study of 249 multi-business companies over the period 1949-1969, he found two types of diversification that performed best: he called them ‘dominant-constrained’ and ‘related-constrained’. My review (http://bit.ly/Rumelt_SSandEP) explains these terms and others. ‘Unrelated passive’ (think conglomerates with no ongoing acquisition programs) performed the worst. Investors don’t much like such companies because buying shares of a conglomerate means investing in at least one component business that an investor doesn’t like. That results in lower relative stock prices for such companies than would otherwise be the case. Conglomerates, whether passive or acquisitive, are also hard to understand and hard to analyze. As capital markets have gotten much more efficient over the last 35 years, most of these types of conglomerates have either gone out of business or gotten taken over, broken up, and sold off. Examples of dead conglomerates include Textron, ITT Corporation, Ling-Temco-Vought, Enron, Litton Industries, Teledyne, and Phillip Morris International.

    To be sure, there are exceptions to low-performing conglomerates—Berkshire Hathaway and GE are two such. But they are the rare ones. The classic “How Not to Do It” in conglomerates was Beatrice Companies, Inc. Under one roof there were the following businesses: Esmark, Tropicana, and LaChoy—so far, so good. But a bunch of others were there, too: Avis, Max Factor, Del Mar (window coverings), Waterloo Industries (tool boxes), Stiffel (lamps), Samsonite, Playtex, Airstream, Altoids, Hart Skis, Halston/Orlane, Best Jet (painting equipment), Harmon/Kardon (vehicle and home audio equipment), Chapelcord (school uniforms and religious apparel), Pfister & Vogel (tanneries), Morgan Yacht Co., Brillion Iron Works (foundries), Campus Casuals (clothing), and Day-Timers. Besides these, there were > 100 other companies inside Beatrice, too. Details are here: https://en.wikipedia.org/wiki/Beatrice_Foods – for the list, scroll down.

    KKR bought Beatrice in a 1986 LBO for $7.3 billion—$6.9 billion in debt, $417 million in equity. It took a while, but KKR eventually sold off the various Beatrice divisions. How much did KKR make? It has never said, but it did achieve a compounded annual rate of return of 45% during the preceding ten years.

    3. Companies that were vertically integrated also performed poorly. This type of organization sounds as if it should work—Company A will buy its suppliers, Company B, Company C, and Company, D—and increase its own profit by eliminating the profits those three used to make doing business with A. The reality is different. Vertically integrated companies tend to have operating entities with different technologies. Those inefficiencies and those more-efficient capital markets largely account for the decline in the numbers of vertically integrated companies over the past several decades.

    The biggest oil companies remain vertically integrated, though even that is changing at the lower end of that industry’s food chain. The economic fact of life is that the ‘upstream phases’—exploration and production–have almost nothing in common with the downstream activities—refining and marketing. Most recently, Hess Oil Co. was forced to get out of downstream activities by a large investor. ConocoPhillips and Marathon Oil had previously bailed out of their own downstream activities.

    4. Let me offer a few words about ‘synergy’. In at least 99% of M&A deals, it turns out to be the greatest hoax since ‘One size fits all.’ Synergy—which is spelled more accurately as s-i-n-e-r-g-y—is often a synonym for ‘CEO ego.’ When nuts-and-bolts economic analysis doesn’t justify a deal, sInergy often steps into the breach. To be sure, there can be synergies among different businesses under one corporate umbrella. In fact, that’s why we have ‘corporate strategy’ – identifying realizable synergies between and among businesses is one of its key charges. But true synergy occurs much less often than i-bankers and corporate war stories would have us believe.

    5. Besides price—which, by itself, is not sufficient for an acquisition to be accretive to earnings—there is a key determinant—THE key determinant, I would argue—of whether an acquisition will be accretive or not: the compatibility of the corporate cultures. Blending corporations successfully is at least as difficult (and often impossible) as blending existing families in a new and subsequent marriage. My favorite definition of corporate culture comes from a 1983 magazine story. It defined corporate culture as “a system of shared values [what is important] and beliefs [how things work] that interact with a company’s people, structure, and control systems to produce behavioral norms [how we do things around here].” (Source: “The Corporate Culture Vultures” – Fortune, October 17, 1983 [Vol. 108, No. 8]: 66.)

    One of the truly spectacular train-wrecks in American M&A history occurred early in 2000 in the wake of American On-Line’s acquisition of Time-Warner. As soon as I read that the journalists at Time, Fortune, et al., had decided as a group to refuse to use AOL email addresses, I knew that deal was going to be a blood-letter on the buy side. Sure enough, in 2002, AOL wrote off $99 billion of goodwill in connection with that purchase. Eventually, the value of AOL contracted from $226 billion to $20 billion.

    6. Cultural incompatibility and lack of synergy lead me to my final comment: More than 80% of acquisitions fail to earn back their cost of capital. Acquirers overpaid. Whether that’s because of i-banker hype, post-closing inability to execute, slipshod due diligence that failed to detect cultural incompatibilities that ensured a pending corporate marriage would end in an ugly divorce, a combination of these factors, or something else entirely, there’s a whole lot more to it than academic abstractions such as ‘marginal cost’.

    In fact, I would bet that the phrase ‘marginal cost’ never came up in the negotiations or the rationales on either side of the Microsoft-LinkedIn deal. Besides Microsoft’s willing to do an all-cash deal, only one thing mattered: whether Reid Hoffman (LinkedIn’s founder, chairman, and controlling shareholder) liked the price. He did, so the deal should close.

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