10 May 2004  Research & Ideas

Rethink the Value of Joint Ventures

Why are joint ventures losing favor with transnational companies? Professor Mihir A. Desai discusses research that suggests globalization makes go-it-alone strategies pay off.

 

For many multinational firms doing business in unfamiliar countries, it made sense to create joint ventures with local firms. After all, that local knowledge of customs, suppliers, and markets could save the newcomer months—maybe even years—of riding a painful learning curve.

But new research on more than 3,000 American transnationals suggests that JVs are falling out of favor. Why? Increasing forces of globalization such as increasingly fragmented production processes make the decision not to collaborate pay off.

That's one finding from work done by Mihir A. Desai, HBS professor in finance and entrepreneurial management, done with colleagues C. Fritz Foley and James R. Hines Jr. at the University of Michigan. Their research will appear in a forthcoming issue of the Journal of Financial Economics.

In this interview, Desai discusses the research and its implications for managers who are considering JVs.

Cynthia D. Churchwell: You and your colleagues found that companies are increasingly willing to "go it alone" without local partners. Did these results surprise you?

Mihir Desai: Given the popular rhetoric on the importance of alliances and joint ventures, we were surprised. The popular logic is that the importance of such collaborations has increased with the rapid pace of globalization. This research and conversations with multinational firms suggest that an alternative dynamic is at work.

That alternative dynamic is that globalization has increased the returns to going it alone even more than the returns to partnering with local firms. The reasons are that the forces of globalization—particularly reduced trade costs leading to more fragmented production processes—are making it more and more attractive for multinationals to take advantage of what different markets offer without incurring the costs of collaborating.

Two examples stick out. First, if your production processes are fragmented all around the world, then a relationship with a local partner is rife with conflict as the multinational is interested in maximizing worldwide profits while the local partners have a narrower view. For instance, decisions on where to source materials become more complicated if the multinational is trying to balance and manage a worldwide production process. Second, the multinational wants to leverage their worldwide network of affiliates financially by mobilizing capital and tax planning globally and this can come at the expense of the local partner. Imagine the conflicting objectives in trying to put a price on a component purchased by the joint venture from a related party of the multinational? While joint ventures were always fragile entities, they appear to be both more fragile and less rewarding.

Q: What did you observe on the evolution of financial and ownership arrangements of transnational corporations in recent years?

A: The quest for control of their subsidiaries reflects the increasing importance of intrafirm transactions to multinational firms—more and more, these firms are trading and transacting with different parts of themselves as production processes become fragmented. Previously, their global outposts were about sourcing local materials or serving local markets. Now, these outposts are tightly integrated into worldwide operations.

While joint ventures were always fragile entities, they appear to be both more fragile and less rewarding.

This puts enormous pressure on the infrastructure of global multinationals to support these myriad transactions. How do you design capital budgeting processes and repatriation policies for such far-flung but tightly integrated subsidiaries? How do you ensure that financial reporting is effective while simultaneously optimizing your tax position? How do you design compensation systems that provide for local accountability but don't make cooperation between these subsidiaries impossible?

These internal capital and product markets are growing in importance for these firms creating many opportunities and many obstacles. Our research shows that some firms are adapting quickly to this while others continue to leave many opportunities unexploited.

Q: What do you think are some of the potential pitfalls of pursuing sole ownership of a foreign affiliate?

A: Sole ownership is most likely to be second best in settings where either local sourcing or local selling are the defining characteristics of the affiliate's activities. In these settings, it may be useful to have access to a local partner. Of course, one final example of where local owners are useful is in countries where local knowledge is especially useful in navigating political considerations.

Q: What's your advice for managers considering a joint venture?

A: First and foremost, isolate the reasons you're considering a joint venture and make sure that you can't buy those services or that knowledge through an arms-length contract that doesn't require sharing ownership. Most of what managers want from joint ventures is likely to be available through such arrangements. View joint ventures as a last resort given how costly giving up equity is.

Second, explicitly lay out expectations for the partners in legal and informal documents prior to the creation of the entity so that it's clear what each party is providing. Third, try out partners without setting up a joint venture by conducting business with them in some way—there's no substitute for real contact with the whole organization. Finally, specify simple exit provisions at the onset and then don't be afraid to walk and go it alone.

I think understanding and then incorporating risk-return tradeoff correctly into capital budgeting practices is critical.

More generally, multinationals often create incentives to have joint ventures by penalizing the risk-taking involved in going it alone. The overall multinational entity must reevaluate its attitude toward joint ventures and make sure that managers on the ground don't feel pressured to have local partners.

Q: What changes in the expansion tactics of multinationals do you foresee in the next three to five years?

A: The increased pressure on existing joint ventures within these networks reflects a greater pressure to rationalize worldwide operations, more generally. As it becomes easier to fragment and coordinate production around the world, multinationals will be able to rationalize operations more by concentrating productive activities and disposing of secondary activities. This rationalization, in turn, will require an internal financial infrastructure that can guide this coordination so that firms can fully capitalize on these opportunities. This reduction of coordination and transport costs is continuing to create more and more opportunities for rationalization and, consequently, bigger penalties for those that don't do it effectively.

Q: What opportunities do you think multinationals are most likely to overlook in global expansion?

A: I'm quite interested in how multinationals view investments in emerging markets. My sense is that firms vary greatly in their appetite for risk in these settings and that many firms informally or formally have very high hurdle rates for such countries. There is a popular intuition that these countries are extremely risky and, consequently, capital budgeting practices reflect this notion by requiring extremely high rates of return on activities in these countries. My sense from a variety of cases I've written is that these practices seldom map to realistic approximations of true underlying risks and that coarse rules-of-thumb are used in pretty ad hoc ways. Given the importance of large emerging markets to the future growth of multinationals, I think understanding and then incorporating risk-return tradeoff correctly into capital budgeting practices is critical.

Q: What research is next for you?

A: We (C. Fritz Foley, and James R. Hines Jr. of the University of Michigan, and I) have been in the process of analyzing many of the financial decisions multinationals must make around the world in order to isolate best practices, but also as a lab for many basic questions in finance. For example, multinationals must design repatriation policies for their subsidiaries around the world. Their incentives in doing so bear a striking resemblance to how firms design dividend policies more generally with the important exception that there are not diffuse shareholders in the multinational-subsidiaries. Surprisingly, many of the same puzzling patterns we see in dividend policies more generally—smoothed payments, a willingness to incur avoidable tax costs—persist inside the firm.

In a related vein, multinationals must design a capital structure for their subsidiaries around the world and allocate internal funds among them. As a consequence, analyzing their choices provides a clean test of what matters for capital structure decisions more generally. Here, we see internal capital markets providing substantial investment in settings where local firms, their competitors, are the most constrained.

Finally, I'm most excited about turning toward questions of how outbound investment impacts domestic investment. There is a tremendous amount of ill-founded popular rhetoric about the interactions of domestic and foreign activities of multinational firms and we hope to actually add some evidence to this debate.