Strategic Alliances

Strategic Alliances INTRODUCTION Accompanying the release of every Disney movie is an avalanche of commercials by McDonalds promoting characters from the movie in its “Happy Meals.” Why does McDonalds do this? The two companies entered into a strategic marketing partnership in 1996 for 10 years that was valued at $10 billion. The two companies agreed to promote Disney movies using a marketing campaign featuring television and radio spots and in-store giveaways. Both companies benefit from this arrangement. Disney gets to create awareness for its movies and McDonalds uses recognizable characters to draw customers (particularly kids) to their restaurants. What McDonalds and Disney have is a strategic alliance. Strategic alliances are a means of vertical integration and/or diversification and hence are part of corporate-level strategy. In this sense, they are a mode of entry once a firm has made the decision to enter a new business.

WHAT IS A STRATEGIC ALLIANCE? It is important to define strategic alliances clearly at the outset. The term “strategic alliances” is a broad one and includes any kind of cooperative effort between two or more independent organizations. The effort may revolve around manufacturing or marketing or both.

It is important to point out that the definition is broad enough to include all kinds of cooperative relationships between organizations. This sets the stage for the three categories of strategic alliances discussion that comes later. Why would firms enter into strategic alliances? Firms enter into strategic alliances because of two important motivations: to access complementary resources and capabilities (that they do not have) and/or to leverage existing resources and capabilities. Thus, Disney has the capability to produce movies with compelling characters that children can identify with while McDonalds provides grassroots marketing. The notion of comparative advantage from international trade can be used here to explain the motivation for strategic alliances. Take the case of two countries, Canada and Mexico. Assume that Canada has an advantage in the production of wheat while Mexico has the advantage in bananas. Each country can independently produce both wheat and bananas. But if the countries form a strategic alliance, they can become more efficient in the production of the two products. Canada can export wheat to Mexico and import bananas from Mexico. Each country saves time and increases productivity.

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When firms agree to work together to develop, manufacture, or sell products or services, they are engaged in a nonequity alliance. The Disney-McDonalds alliance alluded to earlier is an example of a nonequity alliance. Neither McDonalds nor Disney invested in the equity of the other – rather the two agreed to work with each other for a certain period of time. Such agreements could involving licensing (where one firm allows the use of its design or brand name to another), supply agreements (agreeing to supply inputs), or distribution agreements (agreeing to sell another company’s goods). When agreements to work with one another are supplemented with equity investments, equity alliances are formed. The Disney-Pixar alliance is an example. Back in 1986, Disney took a small equity position in Pixar as part of the terms of the strategic alliance. A special form of equity alliance is a joint venture. Here, the cooperating companies (the “parents”) create a legally independent firm in which they invest and from which they share any profits created. For example, the two pharmaceutical companies, Johnson and Johnson and Merck created a joint venture (called Johnson and Johnson Merck Consumer Pharmaceuticals) to market over-the-counter pharmaceuticals such as Mylanta. / Important point: Although the strategic alliance partners own the joint venture, courts have ruled that the joint venture is a separate legal entity. When lawsuits were filed against Dow Corning in the silicone gel implant controversy, courts held that claimants cannot include the parent companies in the lawsuit.

HOW DO STRATEGIC ALLIANCES CREATE VALUE? Learning Objective 2

The nine different ways that alliances create value for firms and how these nine sources of value can be grouped into three large categories. The motivation to enter into a strategic alliance is value creation for the partners. How is value created in an alliance? Value is created in three broad ways: ƒ ƒ ƒ

Helping firms improve the performance of their current operations Creating a competitive environment favorable to superior performance Facilitating entry and exit

Strategic Alliance Opportunities Alliances present great opportunities to benefit from economies of scale. Economies of scale exist when per unit cost of production falls as the volume of production increases. A single firm, for various reasons, may not have the scale to benefit from these economies. By combining with another firm, the efficient scale can be reached. Alliances may help improve operations because of learning opportunities. When firms work together, they can observe each other and transfer skills across firms. Such interactions help in learning. As the example of the NUMI alliance between General Motors and Toyota points out, both firms wanted to learn from each other. General Motors wanted to learn lean production techniques. Toyota, on the other hand, wanted to learn to operate manufacturing plants in the U.S., particularly to adapt their famed production technology to U.S. workers.

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Alliances are attractive when firms engage in projects that are expensive and where the risks are high. By combining forces, each firm reduces the downside risk if the project fails. Of course, this also means that the firms have to share the profits generated by the project. ► Example: Dreamworks SKG Dreamworks SKG is the movie company formed by the trio of Stephen Spielberg, Jeffrey Katzenberg and David Geffen. From early on, the company decided to protect itself from the risk of a big budget movie failing at the box office. Established movie companies typically had a number of movies in various stages of production. Failure of one movie could be offset by succeeding releases. Also, old movies could be reissued in DVDs to provide a steady revenue stream. Since Dreamworks did not have a “library” of old movies nor a stream of movies under production, every big budget movie was a make or break event for the young company. The company decided to partner with other studios for such movies. By partnering, Dreamworks was able to reduce its exposure to the ups and downs of the movie business. Movies produced by Dreamworks under such alliances include The Gladiator, War of the Worlds, and Munich. Interestingly, this phenomenon is not limited to Dreamworks. The box office smash Titanic that cost more than $200 million was co-produced by 20th Century Fox and Paramount. (Variety, various issues). The second category of value creation within strategic alliances is improvement of the competitive environment for the alliance partners. This can be done in two ways: setting technology standards and facilitating tacit collusion. Standards are very important in certain industries, particularly in those where technology plays a key part. Technology-based industries are typically network industries. Network industries exhibit an important phenomenon called “increasing returns to scale.” This term was used frequently in the Justice Department’s case against Microsoft. Certain products are more valuable to a buyer if a network of owners exist for that product. This is because the product is used for communication (exchanging message, data files, etc.) or the product requires a complementary product (such as DVDs for a DVD player). When competing formats emerge for a particularly technology, customers may be unwilling to invest in that product for fear of being left out of the network if an alternate standard becomes more popular. How should the firm developing the new technology approach this problem? A good way is to form a strategic alliance with other players (competitors and producers of complementary products) to establish its technology as the widely accepted standard. Sony’s Betamax lost out to Matsushita’s VHS primarily because Matsushita was willing to forgo some of its profits to its alliance partners while Sony decided to go solo. VHS became the industry standard while Betamax became a cautionary tale and the butt of jokes on late night TV!

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► Example: Blu-ray Disc There is a standards war in progress for the next generation storage medium for video and data. One format is HD-DVD, led by Toshiba and NEC Corporation. The competing format is Blu-ray disc, led by a strategic alliance consisting of Sony, Sharp, Apple, TDK and a host of others. As compared to the HD-DVD format, Blu-ray has more information capacity but a higher initial cost. To avoid the example of Betamax, Sony, the leader of the Blu-ray format, formed the Blu-ray Disc Association (BDA). BDA was a strategic alliance of hardware producers such as Sony and Sharp, computer companies such as Apple and Dell, and content providers such as Disney and 20th Century Fox. The race between the two competing formats was to sign up as many content providers as they could to get the critical mass necessary to become the dominant standard. At present, Paramount, Universal, and Warner have signed non-exclusive agreements to support HD-DVD, while Disney and Columbia supported the Blu-ray format. Each format is trying to woo content providers who are either undecided or have signed nonexclusive contracts with the other format. The race is still too close to call! (Blue-ray Disc from http://en.wikipedia.org) When firms talk to each other to coordinate their strategic actions, they engage in collusion. Explicit collusion is when they communicate directly with each other about their competitive intentions. Explicit collusion is illegal in most countries. The choice available to managers, then, is tacit collusion – colluding indirectly by exchanging signals about intentions to cooperate. Strategic alliances help in tacit collusion because the alliance partners work closely with each other. This constant interaction allows for many opportunities to indirectly communicate their strategic intentions. A third category of motivation for forming strategic alliances is its role in facilitating market entry and exit. Alliances facilitate low cost/low risk entry into a new market or industry. By partnering with a firm that has complementary skills, the chances of success in the new market/industry go up. ► Example: Smart Money When Dow Jones & Company (the publisher of The Wall Street Journal) wanted to enter the magazine market, it realized that its skills in producing a daily newspaper were not adequate to succeed in the monthly magazine market. It formed an alliance with the Hearst company (a successful publisher of magazines such as Cosmopolitan, Good Housekeeping, etc.) to pool the skills of the two organizations. The alliance partners developed a personal finance magazine called Smart Money that was one of the most successful magazine launches ever. (websites of Hearst and Dow Jones & Co.) Alliances also help in exiting industries and markets. By forming a strategic alliance, the company that desires to exit has allowed another player (a potential buyer) to examine closely how valuable the seller’s assets are. Such information may not be fully available to

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the market and therefore the seller may believe that it is not going to get full value for its assets. By operating a strategic alliance, the seller can hope to sell its business to the alliance partner at the market price. Alliances help in managing uncertainty. Back in 1986, when George Lucas (of Star Wars fame) formed a small company, Pixar, to experiment making animated movies using computer technology, the future of this technology was unknown. Disney managed this uncertainty by forming an equity alliance with Pixar. For a small investment, Disney got the option to benefit from this technology if it became popular. It stood to lose its small investment if the technology did not pan out. The success of Pixar’s movies from Toy Story to The Incredibles made Disney’s decision a profitable one. In this sense, strategic alliances allow a firm to use the real options approach to managing uncertainty. Real options are options embedded in decisions. Firms can exercise these embedded options if it is to their benefit.

ALLIANCE THREATS: INCENTIVES TO CHEAT ON STRATEGIC ALLIANCES Learning Objective 3

How adverse selection, moral hazard, and hold-up can threaten the ability of alliances to generate value. Given the enormous benefits that firms can get by forming strategic alliances, as discussed in the previous section, why do a large number of alliances fail? Clearly, alliances may fail because the value creating potential may have been overestimated to begin with. However, there is also a second possibility. Alliances may fail because an alliance partner cheats – that is, not cooperate in a way that maximizes the value of the alliance. One of the key challenges to a successful strategic alliance strategy is that partners often face strong incentives to misappropriate the value created within an alliance. These challenges arise primarily because of the difficulties of monitoring the actions of other partners. Partners may take advantage of other partners at several points in an alliance relationship: in contributions to the alliance, in performance within the alliance, and in allocating the value created in the alliance. OPEC is an alliance of oil producing nations. Partners in this alliance have a history of cheating on one another. OPEC meets and decides to limit output by a certain number of barrels of production. OPEC members understand that if they limit output prices will rise and benefit all the members simultaneously. However, as prices rise each member has a strong incentive to cheat by increasing output and selling more oil at the higher prices. There is no mechanism in OPEC to closely monitor the sales of any one country in a timely way. The cheating on quotas becomes apparent in time, but the individual cheaters are usually able to profit for awhile. This is a common problem in alliances. Collective action taken to improve the market for all members may be exploited (misappropriated) by individual members who take the opposite action. Adverse Selection Firms enter into alliances to pool resources and skills. What happens when a firm promises certain resources to the alliance partner but does not deliver? This situation is called adverse selection. In many cases, particularly involving tangible resources, an alliance partner can determine exactly what its partner is bringing to the table. In such “observable” resource pooling, the possibility of adverse selection is minimized. If the resources that a potential

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partner has are not attractive, then the firm seeking a partner can look for other partners that have these resources. But the problem becomes much more challenging when the resources are intangible – knowledge of markets, human capital, contacts, etc. These are difficult to observe and so firms enter into the alliance hoping that the partner indeed has these resources. When this is not true, the value creation potential of the alliance is constrained. Moral Hazard In the case of adverse selection, the partner does not have the resources that it promised to contribute to the alliance. Moral hazard is when the partner has these resources but fails to make any or most of these resources available to the alliance partners. A partner may promise to send the best and brightest engineers to work in an alliance and then choose to actually send only mediocre engineers to work in the alliance. In a sense, the difference between adverse selection and moral hazard is this: adverse selection in an alliance is akin to an employee getting a job by falsely stating that he/she has certain skills important to the job. Moral hazard is when the person has these skills but chooses not to use them in the job. Holdup The concept of transaction-specific investments was introduced in chapter 6 in the context of vertical integration. This concept also plays an important role in strategic alliances. Sometimes, the strategic alliance may call for one partner to make a transaction-specific investment. Transaction-specific investments introduce the possibility of holdup. Holdup occurs when a firm takes advantage of another’s transaction-specific investment to appropriate a large share of the value created. Holdup was seen as one of the instances where the market mechanism is likely to fail and make vertical integration the better option. Strategic alliances may be viewed as midrange alternatives to market transactions and hierarchies. The partners in the alliance can anticipate the possibility of holdup by explicitly stating the terms in the alliance contract. Furthermore, equity holdings and trust may help to prevent holdup as well. Slide 9-13 Make sure that students understand the difference among adverse selection, moral hazard, and holdup. While all three result in one firm gaining an unfair advantage over another in the context of a strategic alliance, they are not the same. Point out that these forms of cheating usually end up hurting the alliance as a whole and in turn, the cheating partner. Once the three ways to cheat in an alliance are discussed, it is important for the instructor to summarize the conclusion of the “Ethics and Strategy” box on page 293. While cheating may help an alliance partner appropriate a larger share of the value created in an alliance, it reduces the possibility of the “cheater” finding a company to partner with it in any future alliance. Its reputation as a “cheater” will likely make other firms wary of partnering with it.

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STRATEGIC ALLIANCES AND SUSTAINED COMPETITIVE ADVANTAGE Learning Objective 4

The Rarity of Strategic Alliances Given the vast number of strategic alliances announced on a regular basis in the business press, it is clear that alliances per se are not rare, even within an industry. However, it is not the creation of strategic alliances that should be looked at. Rather, what makes an alliance rare is the motivation to form the alliance and the type of resources that partners pool to form the alliance. Look at this example: Let’s say that several firms in an industry enter into independent strategic alliances. Imagine that only one firm enters into an alliance for learning purposes. It cooperates with another firm that has valuable resources to offer in the area of learning. This would make this alliance rare. In those cases where there are only a few companies that have certain resources, firms that partner with such organizations create a rare alliance. The Johnson and Johnson-Merck alliance described earlier is a good example. Johnson & Johnson is arguably the leader in marketing health care products directly to the end user, while Merck has an enviable track record in developing new drugs. This combination is rare in that it combines the skills of two industry leaders. The Imitability of Strategic Alliances Strategic alliances can be imitated by direct duplication or by substitution. When these avenues are not possible (in that they don’t create the same value), the alliance passes the costly-to-imitate test. Once again, alliances can be imitated by direct duplication. If Firm A in an industry can form a marketing alliance, its competitor, Firm B can form a similar alliance. The test, though, is in combining the partners’ resources in such a way that value creation is maximized. Successful alliances are typically characterized by complex social relationships between the partners. There is usually a great amount of trust and information exchange among the partners. This may be difficult to imitate by others. Some firms may have tremendous expertise in forming and managing alliances and may benefit from the learning curve. This may be difficult for others to imitate. Internal development (“go it alone”) and acquisitions may be viable substitutes for strategic alliances. Instead of forming a strategic alliance, a firm may “go it alone,” in other words, vertically integrate into that activity. Conditions that favored vertical integration need to be revisited in this context. While the market mechanism is favored when there is no need for transaction-specific investment and vertical integration when the other extreme is present, alliances are the better option when moderate levels of transaction-specific investments need to be made. Alliances are preferred over “going it alone” when the exchange partner has valuable resources that are costly to acquire. Finally, alliances offer a great deal more flexibility as compared to “going it alone.” Acquisitions can be compared to strategic alliances. Certain conditions favor strategic alliances over acquisitions. One is when there are legal (antitrust) constraints on acquisitions. The second is that acquisitions allow for less flexibility under conditions of uncertainty. The third is that an acquisition may bring “unwanted” parts of the acquired firm to the acquiring firm. This “baggage” may make the acquisition less valuable. Finally, in

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some cases, the value of a firm is maximized when it is an independent entity. This value may be reduced when it is owned by another firm. Since strategic alliances allow the firm to retain its independent status, they may be preferred over acquisitions.

ORGANIZING TO IMPLEMENT STRATEGIC ALLIANCES How contracts, equity investments, firm reputations, joint ventures, and trust can all reduce the threat of cheating in strategic alliances. Many alliances fail because of governance problems. It is a good idea for the instructor to first of all list the organizing options by dividing them into formal and informal categories. Formal options are: explicit contracts and legal sanctions; equity investments, and joint ventures. The informal ones are: trust and firm reputation. Explicit Contracts and Legal Sanctions The threats that adversely affect the success of an alliance (adverse selection, moral hazard, and holdup) can be anticipated and the alliance contract can explicitly provide remedies for them. The contract can include legal sanctions for breach of these provisions. Equity Investments Equity investments increase the stake for firms involved in the alliance. Because Firm A has invested in the equity of Firm B as part of the alliance (called equity alliances), Firm A is not likely to cheat Firm B. If it does, then its equity in Firm B loses value. Equity arrangements are particularly common among Japanese companies. These cross holdings (the network is called a keiretsu) reduce the incentives for one firm to cheat the other for short-term gains. Joint Ventures Just as equity alliances minimize the possibility of cheating because of the financial impact to both firms, joint ventures are a good organizational option for the same reason. Both firms have a financial interest in the joint venture. If one cheats the other, the joint venture suffers. Losses incurred by the joint venture affects the financials of both firms. Joint ventures are the preferred mode of alliances when the possibility of cheating is high. Firm Reputations If a firm seeks to use strategic alliances as a means to compete in its industry, needless to say, it should maintain a reputation as a reliable partner. If it maximizes its value in a specific alliance through cheating, it is unlikely to find companies willing to partner with it in the future. It behooves a firm to maintain its reputation so as to not preclude the possibility of forming alliances in the future. This threat, that of a smeared reputation, is likely to have a greater effect, in some cases, that what is contractually written. However, the possibility of a tarnished reputation may not work to prevent opportunistic behavior in some cases. Obviously, subtle cheating is less likely to draw the

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same attention as overt cheating. Also, the information about a firm cheating must be made public in order for it to be a threat. Some firms may not be well connected in a network to enable this. Finally, tarnished reputation (or the fear of it) may not help the affected partner in the current alliance. In short, this is not a panacea for alliance problems. Trust Examining the issue of trust is a good way for the instructor to complete the discussion on organizing the alliance. This is because research has indicated that the one characteristic that is common in most successful alliances appears to be a significant amount of trust placed by the partners in each other. Beyond contractual provisions, trust is what is likely to bind the two firms in a cooperative relationship and take care of everyday problems that may surface. Firms that have a successful track record of alliances seem to excel in this area. Research suggests that trust in an alliance can serve as a substitute for more formal governance mechanisms like contracts. Even though almost every alliance has a contract the role of the contract in the alliance can vary a great deal—from being relied upon almost daily to never being referenced once it is signed. In those alliances where the contract is seldom looked to after the creation of the alliance, trusting relationships are relied upon to guide the behavior of partners. One of the greatest benefits of trust in an alliance is that it may allow alliance partners to pursue opportunities that would be economically infeasible in the absence of trust. Suppose two partners, one based in the U.S. and the other based in Bolivia, recognize an opportunity in developing a new drug based on a rare plant found only in remote areas of the Amazon River Basin. One partner has the capability to find and harvest the plant and the other partner has the capability to manufacture and market the drug. Neither partner can successfully develop the new drug without the other partner. In the absence of trust, these partners would have to rely on contracts and monitoring that would be expensive due to the geographic distance between operations. Careful analysis shows that if the partners have to incur these costs of governance the alliance is unlikely to be profitable. The partners would rationally choose not to pursue the alliance. However, if the partners can rely on trust between them the alliance is likely to be profitable.

STRATEGIC ALLIANCES IN AN INTERNATIONAL CONTEXT The role of strategic alliances in an international context: Strategic alliances are a popular way to access international markets. Microsoft has formed strategic alliances with local companies in many Asian markets such as India. The attraction for a firm such as Microsoft in such arrangements is that the local partner has sound knowledge of market conditions in that country, in addition to governmental and business contacts. In the case of some countries (e.g., Nigeria and China) for specific industries (such as telecommunications) strategic alliances may be the only possible mode of entry. In many ways the threats associated with strategic alliances – adverse selection, moral hazard, and holdup – are accentuated when the alliance involves foreign partners. There is tremendous information asymmetry in such dealings that may lead to cheating. However, the flexibility that alliances give and the fact that this is a relatively low cost/low risk mode of entry makes this a popular choice.

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SUMMARY Alliances are becoming increasingly popular as vehicles for a variety of strategic purposes. There are a number of ways by which alliances create value. Alliances have to create value, be rare and costly-to-imitate, and be organized in such a way that it achieves its purpose. The economic exchanges should produce gains from trade.