Does innovation drive mergers and acquisitions in the financial sector?

• Published date: 01 June 2024
• Author: Tram H. Dang
• Date: 01 June 2024
• DOI: http://doi.org/10.1111/eufm.12440

DOI: 10.1111/eufm.12440

ORIGINAL ARTICLE

Does innovation drive mergers and

acquisitions in the financial sector?

Tram H. Dang

Department of Finance, Norwegian

School of Economics, Bergen, Norway

Correspondence

Tram H. Dang, Department of Finance,

Norwegian School of Economics,

Helleveien 30, 5045 Bergen, Norway.

Email: tram.dang@nhh.no

Abstract

Does innovation drive mergers and acquisitions in the

financial sector? This issue is challenging because

classical measures of innovation are unavailable in the

financial sector. Thus, we introduce an innovation

measure that can be used for financial firms. Consid-

ering US financial deals, we highlight the impact of a

financial firm's innovative activities on the likelihood

of becoming an acquirer or a target. We detect a ‘like

buys like’effect, implying that financial mergers and

acquisitions are more likely when firms are at a similar

level of innovation. We further show that this effect is

associated with greater synergistic value.

KEYWORDS

financial sector, innovation, mergers and acquisitions

JEL CLASSIFICATION

O30, G20, G34

1|INTRODUCTION

There is a significant body of literature on the determinants of mergers and acquisitions

(M&As). Innovation is theoretically and empirically admitted to being a key driver of M&As

(Bena & Li, 2014; Hart & Holmstrom, 2010; Phillips & Zhdanov, 2013; among others). However,

academic research has mainly examined nonfinancial firms; and the relationship between

Eur Financ Manag. 2024;30:1238–1270.wileyonlinelibrary.com/journal/eufm1238

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I owe special thanks to John A. Doukas, Managing Editor, and two anonymous reviewers for their valuable comments.

Also, I owe thanks to Eric de Bodt, Frédéric Lobez, and the seminar participants at the 6th Entrepreneurial Finance

(ENTFIN) Annual Meeting, Bath, UK, 10th International Conference—Financial Engineering and Banking Society,

Lille, France for their helpful feedback.

financial innovation and M&As remains an open question. Hence, we aim to fill this gap by

investigating whether innovation drives M&As in the financial sector (SIC codes 6000–6999).

We first develop a new measure of innovation that can be computed for financial firms. We

then use this measure to examine the relationship between a financial firm's innovation and

the probability that it will become an M&A participant. Finally, we investigate whether and

how innovation is associated with the probability of two financial firms pairing, and the

combined synergy of the merger.

In reality, numerous M&A deals, in various industries, including the financial industry,

have been conducted owing to innovation. An example is the top acquisition of USD 15.3

billion in 2018 by AXA for the XL group. In the press release on the day of the announcement,

Thomas Buberl, Chief Executive Officer of AXA, the largest French insurance group,

highlighted the reasons why they targeted XL Group Ltd.: ‘XL Group has the right geographical

footprint, world‐class teams with recognized expertise and is renowned for innovative client

solutions’. Mike McGavick, Chief Executive Officer of former XL Group Ltd., stated: ‘We are

excited at the opportunity to build the scale, geographical footprint, product portfolio and the

unmatched commitment to innovation that relevance in the global insurance industry requires.

In AXA we have found like‐minded partners committed to the absolute necessity to innovate

and move this industry forward’.

1

Innovation appears to be one of the drivers of this top deal in

the financial sector. The relationship between financial M&A activities and innovation is

undoubtedly an important question that requires the attention of researchers.

Surprisingly, to the best of our knowledge, no study has investigated this relationship in the

financial industry. One reason is that financial M&As should be examined independently from

corporate M&As because of the presence of a complex set of regulations that affect the

probability of becoming a takeover in the financial sector (Ambrose & Megginson, 1992). The

main reason, however, is the lack of a measure of financial innovation (Frame & White, 2004),

even though financial innovation is all around us and the literature on corporate innovation is

large.

Our aim is to fill this gap. We introduce Product Similarity Variability (PSV)—a measure of

product innovation based on the Product Similarity Score (PS) of Hoberg and Phillips (2010)

(H&Ph). The PS of H&Ph measures the product similarity between two firms obtained from a

text‐based treatment of the product description section (Items 1 or 1A) of SEC. 10‐K filings. Our

strategy starts from the simple proposition that innovation, if productive, should lead to new

product development and, therefore, to changes in the product portfolio of the firm as described

in the product description section. We argue that changes in a firm's product portfolio affect the

distance between the firm's product portfolio and those of all other firms in the economy. That

is why we build PSV, which is equal to the variance of the change in PS between firm iand all

other firms jpresent in the H&Ph database from year t−1 to year t. The more a given firm

innovates, the more its product portfolio changes, and its vector of product similarity scores

with all other firms varies.

We validate our measure of product innovation, using both direct and indirect tests. For the

direct tests, we report that PSV is significantly and positively correlated with Research and

Development (R&D) and patents, the two classic measures of innovation used in the literature.

For the indirect tests, we report that PSV has the same relationship with firm profitability

(ROA), Sales Growth (SG) and valuation (Tobin's Q)asR&D and patents. From these tests, we

1

https://www.axa.com/en/newsroom/press-releases/20180305-AXA-to-acquire-XL-group, consulted on 30 May 2022.

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conclude that PSV is a valid measure of firm‐level innovation activities. Most importantly, the

H&Ph database, which covers all industries in the economy, allows us to compute the PSV as a

measure of innovation for financial firms. As such, our PSV measure opens the door to a large‐

scale study of innovation determinants in the banking industry, a key contribution of this paper

and an element of response to Frame and White's (2004) call for ‘financial regulators to

undertake more surveys of financial innovation and to make the resulting data available to

researchers’.

Armed with PSV, we investigate the relationship between a firm's innovation and the

probability of becoming an M&A participant, using US financial deals and US financial firms

over the period of 1990–2021. Concerning the probability of being an acquirer, we run probit

regressions and show that a one standard deviation increase in the logarithm of the change in

the Product Similarity Score between a financial firm and all other firms from year t−1 to year t

increases the probability of being an acquirer of that firm by 0.30 percentage points relative to

the sample mean. Moreover, we find that this relationship persists across three subperiods:

before, during and after the financial crisis.

We also find that the probability of being a target is positively related to a financial firm's

product innovation. A one standard deviation increase in the logarithm of the change in the

Product Similarity Score between a financial firm and all other firms from year t−1 to year t

increases the probability of that firm being a target by 0.52 percentage points relative to the

sample mean. This relationship is also statistically significant during the three subperiods, that

is, before, during and after the financial crisis of 2007–2009.

In addition, we conduct robustness checks. Instead of probit models, we run logit and linear

probability regressions and obtain similar results. Instead of using the whole data, we follow

Bena and Li (2014) to apply Propensity Score matching to form two matched control samples:

the Size‐Matched Control Sample; and Size‐, and Book‐to‐Market (BTM)‐Matched Control

Sample; the regression results obtained from the two matched control samples are similar.

Thus, we conclude that a financial firm's product innovation is positively related to its

probability of engaging in M&A deals. These results are consistent with prior studies on

nonfinancial firms, such as Bena and Li (2014), who also state that innovation, measured by

R&D and patents is a significant driver of corporate M&As.

Next, we examine the role of product innovation in explaining the pairings of financial

firms. In the literature, there are two different points of view on ‘who buys whom’. On the one

hand, the Q‐theory of mergers suggested by Jovanovic and Rousseau (2002) states that more

productive firms with better management practices are more likely to acquire underperforming

firms with poor management (high buys low). Mergers are a channel through which capital

flows to better projects, assets are relocated for the best possible use. Jovanovic and Rousseau

(2008), among others, lend support to this ‘high buys low’effect. Under this Qhypothesis, we

should find a positive relationship between the difference in the innovation level of one

financial firm and another and the probability that the former becomes an acquirer and the

latter a target.

On the other hand, property rights theory of the firm (Grossman & Hart, 1986; Hart &

Moore, 1990) and the theory of mergers of Rhodes‐Kropf and Robinson (2008) suggest that

firms are merging with other firms with a similar relative rank, that is, ‘like buys like’(LBL)

effect. Firms trade off searching for increased synergies with the diminished bargaining power

they may possess if they face a high‐quality partner. They continue to search for a partner until

they find a match on quality. Low‐quality firms prefer to merge with low‐quality firms than to

wait for a higher‐quality partner but face a disadvantaged bargaining position. High‐quality

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