978-0134200057 Chapter 15 Lecture Notes

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CHAPTER FIFTEEN

DIRECT INVESTMENT AND

COLLABORATIVE STRATEGIES

OBJECTIVES

15-1 Comprehend why export and import may not suffice for companies’ achievement of

IB objectives

15-2 Explain why and how companies make wholly owned foreign direct investments

15-3 Ascertain why companies collaborate in international markets

15-4 Compare and contrast forms of and considerations for selecting an international

collaborative arrangement

15-5 Grasp why IB collaborative arrangements fail or succeed

CHAPTER OVERVIEW

Although most companies operating internationally would prefer exporting to other market entry

modes, there are circumstances in which exporting may not be feasible. In these cases,

companies may engage in direct investment in other countries, or enter markets through various

collaborative strategies such as joint ventures and alliances. Collaborative strategies allow firms

to spread both assets and risk across countries by entering into contractual agreements with a

variety of potential partners. Chapter Fifteen first discusses reasons for not exporting and then

explores the motives that drive firms to engage in noncollaborative and collaborative

arrangements, as well as the various types of possible arrangements, including foreign direct

investment, licensing, franchising, joint ventures, and equity alliances. It goes on to explore the

various problems that may arise in FDI and collaborative ventures and concludes with a

discussion of the various methods for managing these evolving arrangements.

CHAPTER OUTLINE

OPENING CASE: Meliá Hotels International

Meliá Hotels International is a Spanish hotel chain founded by Gabriel Escarre in 1956, leasing

his first hotel in Majorca. In 2000, Meliá merged with another Spanish hotel chain, TRYP, thus

adding 45 hotels in Spain. Meliá is now the largest hotel operator in

Spain, and Spain is the largest location for Meliá. Despite the importance of Spain to Meliá,

where it still concentrates 49 percent of its hotels, 75 percent of its current income is from

international operations.

I. INTRODUCTION

Companies must choose an international operating mode to fulfill their objectives and carry

out their strategies. When forming objectives and implementing strategies in a variety of

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country environments, firms must either handle international business operations on their

own or collaborate with other companies. Although exporting is usually the preferred

alternative since it allows firms to produce in their home countries, participating in some

markets may require using a variety of other equity and nonequity arrangements. These can

range from wholly owned operations to partially owned subsidiaries, joint ventures, equity

alliances, licensing, franchising, management contracts, and turnkey operations.

II. WHY EXPORT AND IMPORT MAY NOT SUFFICE

Companies may find more advantages to locating production in foreign countries than export

to them. The advantages occur under six conditions:

When production abroad is cheaper than at home

When transportation costs are too high for moving goods or services internationally

When companies lack domestic capacity

When products and services need to be altered substantially to gain sufficient consumer

demand abroad

When governments inhibit the import of foreign products

When buyers prefer products originating from a particular country

[see Fig 15.2]

A. When it’s Cheaper to Produce Abroad

Competition requires companies to control their costs and to choose production

locations with costs in mind.

B. When Transportation Costs Too Much

Some products and services become impractical to export after the cost of

transportation are added to production costs. In general, the farther the target market is

from the home country, the higher the transportation costs. Also, the higher

transportation costs are relative to production costs, the more difficult it is to be

competitive through exporting. Some services are impossible to export and require

establishing operations in the target country.

C. When Domestic Capacity Isn’t Enough

As long as a company has excess capacity, it can service foreign markets and price on

the basis of variable rather than full costs. When demand exceeds capacity, however,

new facilities are needed and are often located nearer to the end consumers in other

countries.

D. When Products and Services Need Altering

Special requirements for products in some markets may require additional investments

that are often better made in the country the company intends to sell to. The more that

products must be altered for foreign markets, the more likely production will shift to

those foreign markets.

E. When Trade Restrictions Hinder Imports

Although import barriers have been on the decline, some significant tariffs continue to

exist. In these situations, avoiding barriers through production in the target country

must be weighed against other considerations such as the market size of the country and

the scale of technology used in production. When barriers fall within a group of

countries, companies may be attracted to make direct investments to serve the entire

region since the expanded market may justify scale economies.

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F. When Country of Origin Becomes an Issue

Consumers may prefer goods produced in their own country to imports because of

nationalistic feelings. For some products, consumers may prefer imported goods from

specific countries due to a perception that those products are superior. Other

considerations like the availability of service and replacement parts for imported

products, or adoption of just-in-time manufacturing systems may influence production

locations.

III. WHY AND HOW DO COMPANIES MAKE WHOLLY OWNED FDI

Two forms of foreign direct investment (FDI) that do not involve collaboration are wholly

owned operations and partially owned operations with the remainder widely held.

A. Reasons for Wholly Owned Foreign Direct Investment

To qualify as a foreign direct investment, the investor must have control. This can be

established with a small percentage of the holdings if ownership is widely dispersed.

The more ownership a company has, the greater its control over the management

decisions of the operation. There are four primary explanations for companies to make

a wholly owned FDI: market failure, internalization theory, appropriability theory, and

freedom to pursue global objectives, appropriability theory, and freedom to pursue

global objectives.

1. Market Failure. The failure of the market to connect firms as collaborators

will entice a company to enter with wholly owned operations only if it

perceives having operating advantages to overcome its liability of foreignness.

2. Internalization. Control through self-handling of operations is known as

internalization. Transactions cost theory holds that companies should

organize operations internally when the costs of doing so are lower than

contracting with another party to handle it for them. Internalization may result

in lower costs because:

• Different operating units with the same company likely share a common

culture, which expedites communications

• The company can use its own managers, who understand and are committed

to carrying out its objectives

• The company can avoid protracted negotiations with another company on

such matters as how each will be compensated for contributions

• The company can avoid possible problems with enforcing an agreement

2. Appropriability. Appropriability theory is the idea that companies want to

deny rivals and potential rivals access to resources such as capital, patents,

trademarks, and management know-how that might be captured through

collaborative agreements.

3. Freedom to Pursue a Global Strategy. When a company has a wholly

owned foreign operation, it may more easily have that operation participate in a

global strategy. Furthermore, the fact that most countries have laws to protect

minority shareholders’ interest means that sharing of ownership may restrict a

company from implementing a global strategy.

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B. Acquisition versus Greenfield

FDI usually involves international capital movement, but could also involve the transfer

of other assets, such as managers or cost control systems. Companies can either acquire

an interest in an existing company or construct new facilities, known as a greenfield

investment.

1. Acquisition. Companies may acquire existing operations in order to avoid

adding further capacity to the market, to avoid start-up problems, obtain easier

financing, and get an immediate cash flow rather than tying up funds during

construction. A company may also save time, reduce costs, and reduce risks by

buying an existing company.

2. Making Greenfield Investments. Companies may choose to build if no

suitable company is available for acquisition, if the acquisition is likely to lead to

carry-over problems, and if the acquisition is harder to finance. In addition, local

governments may prevent acquisitions because they want more competitors in the

market and fear foreign domination.

3. Leasing. This is much like an acquisition, but one that forgoes the need to invest.

IV. WHY COMPANIES COLLABORATE

Each participant in a collaborative arrangement has its own basic objectives for operating

internationally as well as its own motives for collaborating with a partner. [see Fig 15.3]

A. General Motives for Collaborative Arrangements

Companies collaborate with other firms in either their domestic or foreign operations in

order to spread and reduce costs, to specialize in particular competencies, to avoid or

counter competition, to secure vertical and/or horizontal linkages, and to learn from

other companies.

1. To Spread and Reduce Costs. When the volume of business is small, or one

partner has excess capacity, it may be less expensive to collaborate with another

firm. Companies should periodically reappraise the question of internal versus

external handling of their operations.

2. To Specialize in Competencies. The resource-based view of the firm holds

that each firm has a unique combination of competencies. Thus, a firm can

maximize its performance by concentrating on those activities that best fit its

competencies and relying on partners to supply other products, services, or support

activities.

3. To Avoid or Counter Competition. When markets are not large enough for

numerous competitors, or when firms need to confront a market leader, they may

band together in ways to avoid competing with one another or combine resources

to increase their market presence.

4. To Secure Vertical and Horizontal Links. If a firm lacks the competence

and/or resources to own and manage all of the activities of the value-added chain, a

collaborative arrangement may yield greater vertical access and control. At the

horizontal level, economies of scope in distribution, a better smoothing of sales

and earnings through diversification, and an ability to pursue projects too large for

any single firm can all be realized through collaboration.

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5. To Gain Knowledge. Many firms pursue collaborative arrangements in order to

learn about their partners’ technology, operating methods, or home markets and

thus broaden their own competencies and competitiveness over time.

C. International Motives for Collaborative Arrangements

Companies collaborate with other firms in their foreign operations in order to gain

location-specific assets, overcome legal constraints, diversify geographically, and

minimize their exposure in high-risk environments.

1. To Gain Location-Specific Assets. Cultural, political, competitive, and

economic differences among countries create challenges for companies that

operate abroad. To overcome such barriers and gain access to location-specific

assets (e.g., distribution access or a competent workforce), firms may pursue

collaborative arrangements with local companies.

2. To Overcome Governmental Constraints. Countries may prohibit or limit

the participation of foreign firms in certain industries, or discriminate against

foreign firms via tax rates and profit repatriation. Firms may be able to overcome

such barriers via collaboration with a local partner. It is also helpful to have a

collaborative relationship with a local firm to protect assets. Some countries

provide protection only if intellectual property is exploited locally within a

specified time period. Local partners can monitor the illegal usage of the firm’s

intellectual property.

3. To Diversify Geographically. By operating in a variety of countries, a firm can

smooth its sales and earnings; collaborative arrangements may also offer a faster

initial means of entering multiple markets or establishing multiple sources of

supply.

4. To Minimize Risk Exposure. The higher the risk managers perceive with

respect to a foreign operation, the greater their desire to form a collaborative

arrangement.

V. FORMS OF AND CHOICE OF COLLABORATIVE ARRANGEMENTS

A. Some Considerations in Choosing a Form

1. Trade-offs and Limitations. Operating modes for foreign operations differ in

the amount of resources a company commits and the proportion of the resources

it locates abroad. In this respect, there are trade-offs. Furthermore, a company

may be limited in entering a market with its preferred operating mode.

2. What’s the Purpose? Alliance Types. Alliances vary by objective and by place

in the value chain. These variances have led to terms that describe different

types. Scale alliances aim to provide efficiency for partners by pooling similar

operations; such as airlines have done by combining their lounges. In a link

alliance, firms use their partners’ complementary resources to expand into a new

business. A vertical alliance connects firms in different links of their value

chains, such as a food franchiser with a franchisee. A horizontal alliance, such

as the Mexican joint venture between Mercedes and Infiniti, enables each

partner to extend its product offerings (in this case, a new compact car) on the

same level of the value chain. Coopetition, such as the Mercedes-Infiniti

example, refers to collaboration while competing.

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3. Prior Company Expansion. Companies’ experience and assets in a foreign

country influence their choices of operating mode when introducing new

products or businesses.

4. Compensation. Collaboration also implies sharing revenues and knowledge.

How to divide revenue is not clear-cut because many variables influence the

outcome. Factors such as government mandates, partners’ perception of risk, and

competitive constraints are all important in the agreement.

POINT-COUNTERPOINT:

Should Countries Limit Foreign Control of Key Industries?

POINT: Countries should limit foreign control of key industries in order to protect their

economic and security interests, especially in key industries such as transportation, mass media,

and energy. History has shown that home governments have used powerful foreign companies to

influence policies in the countries where they operate, and that foreign companies have used their

home governments as instruments to improve their interests in a country. Whenever a company is

controlled from abroad, decisions about that company can be made abroad, possibly to the

detriment of the host country.

COUNTERPOINT: Decisions made by foreign companies are not likely to be much different

than decisions made by local companies. MNEs staff their foreign subsidiaries mainly with

nationals of the countries where they operate, and make decisions based on a good deal of local

advice. Their decisions have to adhere to local laws and consider the views of suppliers and

customers. Protection of certain industries from foreign control could reduce competitiveness in

those industries and harm, rather than help, the local people. Those who argue for limits are

relying on the outdated dependencia theory, which holds that emerging economies have

practically no power in their dealings with MNEs. More recent bargaining school theory states

that the terms for a foreign investor’s operations depend on how much the investor and host

country need the other’s assets. Countries and foreign companies need each other, and both will

lose if limitations are placed on foreign control.

B. Licensing

Under a licensing agreement, a firm (the licensor) grants rights to intangible property to

another company (the licensee) to use in a specified geographic area for a specified

period of time; in exchange, the licensee ordinarily pays a royalty to the licensor. Such

rights may be exclusive or nonexclusive. Usually, the licensor is obliged to furnish

technical information and assistance, while the licensee is obliged to exploit the rights

effectively and pay compensation to the licensor. Intangible property may be classified

as:

• Patents, inventions, formulas, processes, designs, patterns

• Copyrights for literary, musical, or artistic compositions

• Trademarks, trade names, brand names

• Franchises, licenses, contracts

• Methods, programs, procedures, systems

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1. Major Motives for Licensing. Licensing often has an economic motive, such as

the desire for faster start-up, lower costs, or access to additional resources (e.g.,

technology). For the licensor, the risks and costs of a given venture are lessened;

for the licensee, costs are less than if it had to develop a product or process on its

own. Cross-licensing represents the situation in which companies in various

countries exchange technology rather than compete with each other with every

product in every market.

2. Payment Considerations. The amount and type of payment for licensing

arrangements may vary. Each contract tends to be negotiated on its own merits; the

bargaining range is based on dual expectations. Both agreement-specific and

environment-specific factors may affect the value of a license. Companies

commonly negotiate a “front-end” payment to cover transfer costs when

technology is involved. In addition, they usually charge fees based on actual usage.

Licensors of technology do this because it usually takes more than simply

transferring explicit knowledge, such as through reports. The move requires the

transfer of tacit knowledge as well, such as engineering.

3. Licensing to Subsidiaries. Many licenses are given to firms owned in part or

in whole by the licensor. From a legal standpoint, subsidiaries are separate

companies; thus, a license may be required in order to transfer intangible property.

C. Franchising

Franchising represents a specialized form of licensing in which the franchisor not only

sells an independent franchisee the use of the intangible property essential to the

franchisee’s business, but also operationally assists the business on a continuing basis.

In a sense, the two partners act like a vertically integrated firm because they are

interdependent and each produces a part of the product that ultimately reaches the

customer.

1. Franchise Organization. A franchisor may penetrate a foreign country by

dealing directly with its foreign franchisees, or by setting up a master franchise

and giving that organization the right to open outlets on its own or to develop

subfranchises in the country or region.

2. Operational Modifications. Franchise success is derived from three factors:

product standardization, effective cost control, and high identification through

promotion. Nonetheless, franchisors face a classic dilemma: the more they

standardize on a global basis, the lower the potential for product acceptance in a

given country; the more they permit adaptation to local conditions, the less the

franchisor can offer the franchisee, the higher the costs and the less the control by

the franchisor.

D. Management Contracts

A management contract represents an arrangement in which one firm provides

management personnel to perform general or specialized functions to another firm for a

fee. A firm usually pursues such contracts when it believes a partner can manage certain

operations more efficiently and effectively than it can itself.

E. Turnkey Operations

Turnkey operations represent a type of collaborative arrangement in which one firm

contracts with another to build complete, ready-to-operate facilities. Usually, suppliers

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of turnkey facilities are industrial-equipment and construction companies; projects may

cost billions of dollars; customers most often are government agencies or large MNEs.

1. Contracting to Scale. One characteristic that sets the turnkey business apart

from most other international business operations is size of the contract.

2. Making Contacts. The nature of the business requires executives with top-level

contacts abroad.

3. Marshaling Resources. Many turnkey operations are in remote areas and

necessitate massive housing construction and the importation of personnel.

F. Joint Ventures (JVs)

Although usually thought of as 50/50 companies, JVs may nonetheless involve more

than two companies and ones in which a partner owns more than 50 percent. When

more than two organizations participate, the venture is sometimes called a consortium.

JVs may also involve a partner owning over 50 percent, such as ANA’s ownership of 67

percent in Air Asia Japan. [see Figure 15.4].

1. Possible Combinations. Examples of the many combinations of JV

partnerships include:

Two companies from the same country joining together in a foreign market

(e.g., NEC and Mitsubishi [Japan] in the United Kingdom)

A foreign company joining with a local company (e.g., Barrick [Canada] and

Zijin Mining Group in China)

Companies from two or more countries establishing a joint venture in a third

country (e.g., Mercedes-Benz [Germany] and Nissan [Japan] in Mexico)

A private company and a local government forming a joint venture, or mixed

venture (e.g., Mitsubishi [Japan] with the government-owned Exportadora de

Sal in Mexico)

A private company joining a government-owned company in a third country

(e.g., BP Amoco [private British-U.S.] and Eni [government-owned Italian] in

Egypt)

G. Equity Alliances

An equity alliance represents a collaborative arrangement in which at least one of the

collaborating firms takes an ownership position (usually a minority) in the other(s). The

purpose of an equity alliance is to solidify a collaborating contract, thus making it more

difficult to break.

VI. WHY COLLABORATIVE ARRANGEMENTS FAIL OR SUCCEED

All collaborative arrangement parties must be satisfied with performance; otherwise, the

arrangement may fail.

A. Reasons for Failure

The major strains on collaborative arrangements are due to five factors:

• Relative importance to partners

• Divergent objectives

• Control problems

• Comparative contributions and appropriations

• Differences in culture

1. Relative Importance

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One partner may give more attention to the collaboration than the other—often because

of a difference in size. An active partner will blame the less active partner for its lack of

attention, while the less active partner will blame the other for poor decisions.

1. Divergent Objectives

Although firms may enter into collaborative arrangements with complementary

capabilities and objectives, their views regarding such things as reinvestment vs. profit

repatriation and desirable performance standards may evolve quite differently over

time.

2. Questions of Control

When no single party has control of a collaborative arrangement, the venture may lack

direction; if one party dominates, it must still consider the interests of the other. By

sharing assets with another firm, a company may lose some control over the extent

and/or quality of the assets’ use. Further, even when control is ceded to one of the

partners, both may be held responsible for problems.

3. Comparative Contributions and Appropriations

One partner’s ability to contribute technology, capital, and other assets may diminish (at

least on a relative basis) over time. Further, in almost all collaborations the danger

exists that one partner will use the other’s contributed assets, or take more than its fair

share from the operation, thus enabling it to become a direct competitor. Such

weaknesses may cause a drag on a venture and even lead to the dissolution of the

agreement.

4. Culture Clashes

Differences in both national and corporate cultures may cause problems with

collaborative arrangements, especially joint ventures.

a. Differences in Country Cultures. Firms differ by nationality in terms of how

they evaluate the success of an operation (e.g., profitability, strategic market

position, and/or social objectives). Nonetheless, joint ventures from culturally

distant countries tend to survive at least as well as those between partners from

similar cultures.

b. Differences in Corporate Cultures. In addition to national culture, differences

in corporate culture may create problems for joint ventures. For example, some

firms may have an entrepreneurial culture and others are risk averse. Compatibility

of corporate cultures is important to the success of joint venture projects.

B. Helping Collaborative Operations Succeed

Aside from awareness of and adjustment to the pitfalls we have discussed, the following

considerations help assure success when choosing among and managing operating forms:

Fitting modes to country differences

Finding and evaluating partners

Negotiating agreements: The question of secrecy

Controlling through contracts and trust

Evaluating continually

Adjusting the internal organization

1. Fitting Modes to Country Differences. A company should ordinarily commit more

of its IB resources to those markets that are most attractive and fit best with its

strategies and competence. The choice of operating mode directly affects this

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resource allocation inasmuch as different modes commit different levels of resources

and different portions of those resources abroad. Figure 15.5 illustrates a matrix

relating country attractiveness, a company’s competitive strength per country, and

operating forms.

2. Finding and Evaluating Potential Partners. Partner pairing should depend on

mutual assessment of each other’s resources, motivation, and compatibility.

3. Negotiating the Arrangement: The Question of Secrecy. Numerous collaborative

arrangements involve technology transfers. Because the value of many technologies

would diminish if they were widely used or understood, technology owners have

historically insisted on including contract provisions whereby recipients will not

divulge such information.

4. Controlling Through Contracts and Trust. Although both trust and contracts have

control limitations, there are provisions that should be included in any collaborative

agreement.

5. Evaluating Continually. Contracting with a capable and compatible partner is

necessary but insufficient to ensure success. A company must continually assess

partners’ performance and periodically assess the need for change in the type of

collaboration.

6. Adjusting Within the Internal Organization. As companies change operating

modes, they encounter pressures necessitating organizational adjustments. These

include organizational application of what they have learned and the need to alter

group and individual evaluations as operating forms change.

a. Learning and Its Applications. Evidence suggests that companies’

collaborative performance improves with experience. However, improvement

is most associated with similar types of collaborations, such as applying what a

firm has learned from JV operations in one country to JVs in another country.

b. Pressures from Switching Collaborative Modes. Changes in operating

mode, such as from exporting to foreign production to serve a market, cause

some individuals to gain and others to lose responsibilities.

LOOKING TO THE FUTURE:

Growth in Project Size and Complexity

More than a half-century ago, John Kenneth Galbraith postulates that because the cost of

development is often so high, it can only be carried out with firms of considerable size.

Galbraith’s conclusion overlooks several factors. Although firms can become ever larger through

mergers and acquisitions, collaborative arrangements are likely to be increasingly important in the

future as governments opt to restrict such activities because of antitrust concerns. At the same

time, companies might not be able to internalize the breadth of technology necessary to solve

these big problems. Also, most product development is much more modest than required to

unravel the gigantic projects. Collaborative arrangements will bring forth both opportunities and

problems as firms move simultaneously into new countries and to new types of contractual

arrangements with new partners. The more partners in a given alliance, the more strained the

decision- making and control processes will likely be.

CLOSING CASE: The Oneworld Airline Alliance

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[see Map 15.2]

The airline industry is almost unique in that its need to form collaborative arrangements has been

important almost from the start of international air travel because of cost, regulatory, and

competitive factors. In recent years, this need has accelerated because of airlines’ difficult profit

performance. No single airline has the capacity to serve the whole world, yet passengers want to

travel the whole world with a seamless experience. Thus, airlines have increasingly worked

together to provide more seamless experiences for passengers and to cut costs. Several notable

regulatory changes have occurred in

recent years. First, the U.S. domestic market has been deregulated. Once deregulation was

instituted, many U.S. airlines were competitively forced out of business. Second, similar

deregulation within Europe influenced the demise of some airlines. The high cost of maintenance

and reservations systems and the need to spread costs have led to cooperation involving multiple

airlines from multiple countries in the form of JVs and alliances such as the oneworld Alliance

which comprises 15 airlines. These alliances allow for considerable cooperation, such as

code-sharing; however, antitrust regulations (unless given immunity) prohibit their members from

coordinating routes, schedules, and prices.

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