The effects of integration and organization on investment decisions and performance : theory and evidence from the pharmaceutical industry

Abstract

This thesis explores different aspects of the effect the organization and the level of vertical integration of an organization have on the investment decisions the firm takes and subsequently the effect of such decisions on the performance of the firm. This thesis uses the biopharmaceutical industry in order to investigate these issues due to the heterogeneity of organizations and of the levels of integration that can be observed in this industry. The first chapter is joint work with David Scharfstein. This chapter compares the clinical trial strategies and performance of large, established ("mature") biopharmaceutical firms to those of smaller ("early stage") firms that have not yet successfully developed a drug. We study a sample of 235 cancer drug candidates that entered clinical trials during the period 1990-2002 and were sponsored by public firms. Early stage firms are more likely than mature firms to advance drug candidates from Phase I to Phase II clinical trials. However, early stage firms have much less promising clinical results in their Phase II trials and their Phase II drug candidates are also less likely to advance to Phase III and to receive Food and Drug Administration approval.

(cont.) This pattern is more pronounced for early stage firms with large cash reserves. The evidence points to an agency problem between shareholders and managers of single- product early stage firms who are reluctant to abandon development of their only viable drug candidates. By contrast, the managers of mature firms with multiple products in development are more willing to drop unpromising drug candidates. The findings appear to be consistent with the benefits of internal capital markets identified by Stein (1997). The second chapter explores the effect of vertical integration on investment behavior in the pharmaceutical industry. We study a detailed, project-level sample of 4057 drug candidates that were sponsored by 40 large pharmaceutical firms during the period 1984-2001. Of these projects, 447 were conducted through a contractual alliance with another, smaller company that had discovered the drug candidate. The existence of these two types of governance structures allows me to compare integrated and non-integrated projects within the same firm.

(cont.) Controlling for project and firm characteristics, we document that pharmaceutical firms are more selective in continuing their integrated projects than in continuing projects governed by contract. We hypothesize that this difference is caused by the rigidity of the contract that governs non-integrated projects, making them less flexible in adapting to changes in the firm's situation. In line with this hypothesis, we document that although more frequently continued, non-integrated projects have a lower probability of success. The third chapter explores the internal capital markets of large pharmaceutical firms. We compare the behavior of those firms in prioritizing projects inside their internal capital markets between projects they own and projects they manage in alliance with other firms. Although both sorts of projects are inside the same internal capital market, we document that the firm treats them differently. We find evidence that investment in alliance projects is less sensitive to the firm's cash flow and to the existence of other projects in the firm. Moreover, we find evidence that diversified firms have a tendency to invest more in divisions where they are weak and relatively less in divisions where they are strong.