Research: Innovation Suffers When Drug Companies Merge

Print 08 August 2016
Justus HaucapJoel Stiebale / Harvard Business Review

We know that mergers and acquisitions are challenging for the companies involved. But we spend less time thinking about the challenge they pose for antitrust authorities. This regulator has to decide whether to approve a merge based on its predicted outcome for the businesses and society as a whole. Generally, if consumers are likely to be harmed, authorities prefer to block the merger. If not, it gets the nod. Sometimes, approval is granted on certain conditions.

It’s mind-bogglingly tricky, though, to predict a merger’s effects. Regulators try to model how prices, sales, and even the combining parties’ research and development efforts will change after a merger. On the one hand, M&As can help companies use their resources more efficiently. That can benefit consumers through lower prices, more innovation, and better products. On the other hand, M&As can also strengthen the market power of the combined entity, reducing competition in a way that harms consumers. That’s why antitrust authorities bear an awesome responsibility. This is especially true in pharmaceutical markets where new and affordable drugs can improve and even save the lives of many people.

Unfortunately, our recent research shows that antitrust authorities have been too lenient, at least when it comes to drug company mergers. We find that regulators have been overlooking how these mergers reduce innovation and research and development at the merging firms. That’s not the only thing regulators are largely ignoring. These mergers are also having a sizable negative impact on innovation and R&D at the combined firm’s rivals.

It’s not unexpected that merging companies reduce their R&D spending following a merger. That may be due to the cost savings of pooling efforts and combining their labs. Research has shown that pharma mergers reduce innovation. But what’s suprising and troubling is that our new evidence shows that the merging companies’ competitors also spend less on R&D after the merger. Hence, industry competition and innovation become less dynamic overall.

To be more precise, we analyzed 65 pharma mergers that were all scrutinized, but eventually approved, by the European Commission and also other jurisdictions. We wanted to know measurements of innovation (such as R&D spending and resulting patents) change after a merger for both the merging parties and for their rivals. What makes our study unique is that we compared firms’ innovation activities not only before and after acquisitions, but we also compared those merging companies to firms in similar pharmaceutical markets without merger activities.

Our results very clearly show that R&D and patenting within the merged entity decline substantially after a merger, compared to the same activity in both companies beforehand. Then we applied a market analysis, the same one used by the European Union in its models, to analyze how the rivals of the merging firms change their innovation activities afterward. On average, patenting and R&D expenditures of non-merging competitors also fell — by more than 20% — within four years after a merger. Therefore, pharmaceutical mergers seem to substantially reduce innovation activities in the relevant market as a whole.

What’s the reason for this? At least for the mergers we looked at, acquirers often target firms that have a relatively similar patent portfolio. That means there’s less competition for discovering and developing new therapies. If a non-merging rival is also researching similar therapies, that outside firm also now has one less competitior. It experiences a similar reduction in competition as the acquiring firm.

So if these mergers have been reducing competition and the prospects for new life-improving and life-saving drugs, why are U.S. and European regulators approving them? It’s not that authorities are unaware that mergers may reduce innovation incentives of competitors. As long ago as in 2000, an EU report on the merger between Glaxo Wellcome and SmithKline Beecham recognized that “competitors have also indicated that the operation as notified would discourage any tentative research and development attempts by third parties to develop anti-viral drugs.” Still, innovation activities rarely play a decisive role in merger decisions.

The chief reason is that innovation effects have been difficult to predict. It’s far easier to predict short-run changes in prices and quantities in the current market. And so pharmaceutical firms appear to be benefitting from regulators’ incomplete decision process. In our sample, the firms are not necessarily those which have the highest market shares of competiting products. That raises red flags with regulators. Instead, acquiring firms and their targets tend to have overlapping research programs. In other words, they are developing drugs that one day could be competiting against each other, but aren’t yet.

Our data also indicates that reduced innovation is most likely to occur in drug markets with high levels of pre-merger R&D and patenting. It may be that acquiring firms are specifically targeting companies in order to reduce competition in innovation projects. We have also found that innovation is reduced when relatively small firms are acquired. These mergers aren’t getting the attention of regulators because they have little to no effect on short-run drug prices. Even so, they can reduce the incentive for companies to research and develop new therapies.

Fortunately, antitrust authorities are becoming aware of the problem. Recently, the EU competition commissioner Margrethe Vestager acknowledged that companies are increasingly defending themselves against competition by buying up innovative rivals:

Last year, we looked at a merger between the drug company Pfizer and its rival, Hospira. We only approved the deal after Pfizer agreed to sell the European rights to an arthritis drug it was developing. One concern was that Hospira already had a competing drug on the market, and we thought Pfizer might stop work on its own drug if the deal went ahead as planned. Which would have meant less of the innovation that we depend on as patients.

Our research shows that Commissioner Vestager is completely right to pay closer attention to mergers’ impacts on innovation, especially in pharmaceutical markets where innovation is key for the well-being of many patients. We also expect that, in other research-intenstive industries, mergers would have a similar negative effect on rivals’ innovation.

These new insights from our research and the forthcoming work of other scholars are likely to affect the decision-making of antitrust authorities. We believe that potential effects on innovation activities will very soon become a much more important factor in the approval or rejection of M&As in the future.

For now, drug company executives should take notice. Mergers and acquisitions are extremely costly, even when they’re not approved. Senior leaders should take into greater consideration how a potential merger will affect innovation at the combined company and at its rivals. Regulators may no longer be so quick to approve mergers between companies with overlapping drug pipelines. By the same token, if the merging parties can show that R&D synergies may increase their capabilities to be innovative, or induce their rivals to innovate, antitrust authorities might be more willing to say yes to the acquisition.

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