ownership and control in multinational joint ventures
TRANSCRIPT
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structural component of the JV experience. Within the frame of political economy, De
la Torre (1981) discusses several of these elements, including the crucial aspects related
to capital restrictions. The factors determining why a multinational enterprise (MNE)
and a local government, or a domestic firm embedded in a foreign legal environment,
decide to enter in a JV seem to vary from country to country (Contractor 1990). This
fact presents the challenge to build a theoretical frame that helps to account for at least
some of the basic observations. Kogut (1988) classifies theories as belonging to one of
two main streams: explanations based on transaction costs as derived from the work
given by Williamson (1975, 1985), or strategic. The transaction costs approach benefits
from a wide range of perspectives, going from the costs of technology transfer (e.g.
Teece 1977) to costs related to inefficient internal markets (Hennart 1988). The strategic
frame is more a collection of approaches that share a common preoccupation with
competitive positioning and its impact on profitability (e.g. Lecraw 1984). Harrigan
(1988) proposes a general frame for competitive strategies through the use of joint
ventures and similar business arrangements. More recently there is a stream of literature
that systematizes many of the separate streams coming from both the transaction cost
approach as well as some of the ideas in the strategic approach, though still clinging
closer to the ideas in I/O (see Markusen, 2002).
Ownership structure can depend on many factors, which have been qualitatively
studied by a number of authors (e.g. Fagre and Wells 1982; Sercu and Uppal 1995).
Gomes-Casseres (1990) makes a statistical study comparing predictions from both the
transaction costs and strategic perspectives in their predictions about ownership
structure. At least some of these factors can be explained by the existence of capital
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restriction rules. These may explain, for example, why it is that many JVs have minority
participation by the MNE (Hladik 1985).
International ventures are a fertile ground where to investigate the effects of
different arrangements of bargaining power and of private information between the
partner firms. These effects will reflect on different types of contracts, structured
according to an optimization program that incorporates all constraints resulting from
limited liability, reservation value constraints, participation constraints and varied
assortments of incentive constraints. This line of research into the structure of joint
ventures is relatively less explored1
1See the observations to this point made by D. Yoffie, 1993.
than has been the motivations for the formation of
joint ventures (Gomes-Casseres 1990). In a recent paper (Noe, Rebello and Shrikhande
2002, from now on NRS) the authors build the problem of structuring international
ventures along four separate instances, depending on who has the information and who
the bargaining power. In their work the basic scenario consists of a multinational that
enters a joint venture with a foreign domestic firm. Different investment strategies result
from each of the four possible combinations. Overinvestment occurs when the
multinational has both the bargaining power and the information about the true
prospects of the venture; this outcome assumes that there are no legal rules imposing a
capital participation restriction on the multinational. If the equity participation of the
multinational is restricted, then depending on the stringency of this constraint, the
investment level that optimizes the utility of the multinational varies considerably. The
main aim of this paper is to find out the effects of capital restriction policies for this
particular case. A second issue that is addressed in both NRS and the present work
concerns the quality of the private information possessed by the informed party. With
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some frequency venture contracts between heterogeneous partners attempt to specify an
optimal schedule of transfer payments (Darrough and Stoughton 1989 and also
Stoughton and Talmor 1994). This kind of solution may indeed be optimal only if there
is no residual uncertainty left on the future cash flows, conditional on private
information. In Stoughton and Talmor (1994) the informed party has perfect
information and they focus on a mechanism for the transfer of payments, with the
multinational facing differential income taxes. Imperfect information begets the
necessity for contract design. Given limited liability, contracts have to be state
dependent if private information is imperfect, this mechanism solves for the optimal
contract form, instead of the mechanism of a simple transfer payment used if all
information were known to the informed part. NRS suggest that this reasoning follows
the same intuition underlying the models for takeover when the shareholders of the
target firm have private information (Eckbo, Giammarino and Heinkel, 1990; Fishman
1989; Hansen, 1987). This gives the problem characteristics similar to those found in
optimal security design and optimal mechanism design under asymmetric information,
when investment policy is the main issue (see, for instance, Green 1984). Income tax
considerations are left out of the present work, since the purpose of this work is to focus
on the effect of capital restrictions on the structuring of the venture contract. Indeed,
capital participation constraints can be seen as a form of regulatory taxation in the
classic sense.
A review of previous work
Fagre and Wells (1982) report results from an empirical study made using
information on the experiences of several U.S.-based MNEs in Latin American
countries on the relationship between certain qualities of an MNE and its ability to
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obtain a certain level of ownership in a JV. This paper makes the central assumption
that the determinants of the percentage of equity participation in a JV are best explained
by the concept of relative bargaining power. Relative bargaining power is defined in
terms of a set of characteristics that distinguish both the MNE and the host country. The
authors propose that much of the relative bargaining power that a MNE musters reflects
in the proportion of ownership struck in the bargain with the local government.
Therefore, they see ownership as an important measure of the MNE's bargaining power.
They duly observe that there are other measures, such as control and allocation of
economic benefits that might be of importance. Economically, they point out, there are
some ways in which one could see ownership as the least important of the measures that
have been mentioned, due to the existence of other mechanisms, such as taxation and
rights to name board members, in which governments can have effective control and
redistribute allocations. ''Nevertheless, many governments have generally considered
local ownership as an important goal when they negotiate with foreign investors. Their
concerns presumably arise from political motivations;...Whatever the facts about the
relationship of ownership to control and economic benefits, both parties to negotiations
seem to view the distribution of shares as an important outcome in it own right.''2
In
brief, the authors see ownership linked in practice, though in an imperfect way, to
control. The paper devotes its main efforts to investigate how some of the MNE
resources relate to its overall bargaining power, as measured by equity participation,
vis--vis the foreign government.
Three different measures of ownership are introduced in the paper, each at an
increasing degree of refinement. Measure I takes the naive approach of assuming that a
2 Op. cit. page 10.
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larger equity participation by the MNE corresponds to a larger measure of bargaining
power. The second measure recognizes the fact that there is no such thing as a universal
attitude toward ownership that all multinational enterprises follow faithfully. Some may
voluntarily place limits to their share of ownership, even in the absence of external
pressures from any particular government. Measure II therefore is constructed in order
to account for such idiosyncratic differences among MNEs. First, for each MNE in the
sample an average value for ownership was calculated for its holdings in its subsidiaries
in Europe. This geographical area was chosen because there ownership participation by
the MNEs in their subsidiaries is largely left to their own reckoning. Therefore, the
proposed average is considered to be a true measure of attitude of the MNE toward
ownership. Measure II is then defined as the difference between the ownership share in
the Latin American subsidiary and its European average. The third measure tries to
account for differences in attitude toward ownership adopted by the different countries
in Latin America. The third measure is defined as the difference between the parent's
ownership share in the subsidiary and the average U.S. ownership of subsidiaries for the
particular country.
The model proposed in the paper attempts to establish the effect of five
economic characteristics of the MNE on each of the measures defined above. According
to the authors, these measures are meant to represent the impact of these economic
characteristics on the outcome of negotiations as a whole, though they concede that to a
more skeptical reader those measures only represent the impact on equity alone. These
characteristics are: the level of technology, the degree of product differentiation through
advertising, to access provided to export markets, the amount of capital, and the
diversity of the firm's product line. These five characteristics act as independent
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variables and each separate measure of ownership as defined earlier act as the
dependent variable.
The level of technology is proxied by the percentage of sales revenues spent by
the parent on R&D during 1974. This choice is open to some criticism, since not all
firms are equally efficient at making the R&D budget to translate into tangible results.
The justification for this choice resides in the fact that R&D expenditures are an
imperfect measure of the rate of technological innovation produced and put into practice
by the MNE. The higher the R&D expenditures as a percentage of sales, the more likely
is that innovation and technological uniqueness are at the heart of the strategic
commitments of the firm. Most developing countries are at a considerable disadvantage
when negotiating with a firm that deals in markets with participants that compete
through a fast paced product improvement race. These conditions will not be met by
those countries without the involvement of a foreign investor that has the necessary
R&D experience and the required material and human resources. By comparing studies
where each of the three measures of ownership is taken as dependent of this single
variable, the results are all consistent with each other, and point to a not too simple
dependence: If the percentage of R&D expenditures is less than about 5%, then there is
no clear effect, as seen through any of the alternative dependent variables. However, if
it is higher than 5%, then all of the measures show a strong effect, where all MNEs
within this category take on average nearly 100% of ownership, regardless of industry,
number of competitors in the particular industry, or other similar criteria.
Fagre and Wells suggest that product differentiation seems to be one of the main
bargaining advantages for those MNEs that have strong marketing skills. ''Product
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differentiation by multinational enterprises presents a formidable barrier to potential
local enterprises in developing countries. Although the production technology needed to
manufacture satisfactory ball point pens and carbonated beverages is hardly secret,
Parker pens and Coca Cola are still the preferred products in many developing
countries.''3
This independent variable is proxied by the percentage of sales that the
MNE spends on advertising. Advertising technology is also a rather perfected art;
therefore, in this case, there is a much higher confidence that the proxy represents more
closely the associated concept than in the case for the level of technology. The authors
find that advertising seems to be related to bargaining power at nearly all levels of
expenditure. As with the previous criterion, they seem to distinguish a threshold value
of about 7% of total sales revenues, above which MNEs in this group attain on average
a level of ownership of 98% (see their TABLE 3.) The measures corrected for firm
attitude toward ownership and for country attitude show this same tendency as well.
This result must be taken with some caution, since the mix of MNEs at the top of the
scale are to some extend of the same characteristics as those that have a strong
technological background, therefore there is the possibility for confounding effects. The
authors argue that since expenditures in advertising show significance for nearly the
entire range of analysis, this variable is important on its own. To strengthen this
argument, they point out that no other variable nearly approaches the power to explain
the bargaining success of pharmaceutical and cosmetics multinational enterprises.
A high capacity for exporting the product of the subsidiary is found by the
authors to be another important factor in the bargaining power of a MNE. ''Fundamental
to the strategy of some multinational enterprises is an ability to rationalize production
3 Op. cit. page 12
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on a global scale and a capacity to acquire and utilize sophisticated knowledge of
foreign markets.''4
In particular, if a large portion of the product from the subsidiary is
for export to another affiliate of the same multinational, this will result in considerable
negotiating strength for the MNE, although in general if the greatest part of production
is for exports, then Fagre and Wells find that this translates into high relative bargaining
power. The proxy variables for these concepts are the percent of total production
transferred and the percent of total production exported, respectively. They find that
especially the third measure: the country corrected ownership, shows a significant
increase when the proportion of exports in either category are in excess of 50% of the
total product. Again there is here the ever present risk of confounding, caused by the
fact that the multinational enterprises used in the sample may be also either strong in
technological level or marketing. The authors justify the independent relevance of this
variable by looking at MNEs in the electronic part sector, where product differentiation
or technology are not of particular importance, and find a marked difference between
the ownership measures for those subsidiaries that export most of its product, and those
that do not.
The case for capital as a source of bargaining power is less clear. From the
sample used to make this particular study, there is no clear evidence for this to be a
factor that favors the MNE. Only when the 1975 investments involved assets over 100
million, there was a visible effect in equity participation. But then, the authors disclose
the fact that subsidiaries with assets of this size were usually located in countries that
have lenient policies toward foreign ownership.
4 Op. cit. page 13
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The last of the independent variables, product diversity, is an additional factor
not found, according to the authors, in the previous literature on the subject. ''When
subsidiaries are classified by the number of products (3-digit SIC) they produce, a quite
strong relationship to ownership appears. The greater the number of products, the
greater the apparent bargaining of the firm...''5
They find somewhat puzzling though
why this variable turns out to be very significant in their study. This is more striking
after they confirm the fact that variable is not correlated to any of the others already
discussed that are of particular interest to the host country. Differently from the other
four variables, there doesn't seem to be a straightforward reason as to why this one
seems to weaken the relative bargaining position of the host country in Latin America.
To be sure this is not a general sort of happening, the authors check the European case,
and find that the effect there is almost the opposite. The authors attempt to understand
the reasons by concentrating in the single case of Mexico, where the numbers are large
enough to produce some significant statistics. When parent firms are classified
according to the number of affiliates, and each affiliate is associated to a certain group,
the authors find the following effect: ''Enterprises that have only one affiliate in Mexico
use it as a base for several product lines in 55 percent of the cases, roughly double the
similar figure for corporations owning 5 or more affiliates in Mexico. Parent firms using
a single affiliate strategy also wholly owned their affiliate in 64 percent of the cases,
again roughly double the similar figure for corporations having 5 or more affiliates.''6
5 Op. cit. page 17.
The possible reasons that they conjecture for these observations relate to higher
management skills, preferences by the host country of larger, multi-product,
investments over those for a single product, there may be a concentration of specially
sensitive industries which use a single affiliate with several products, and the one
6 Op. cit. page 18.
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favored by the authors, that the observed relationship is the consequence of government
regulations in the host country.
Fagre and Wells not only consider enterprise related factors in order to measure
its relative bargaining power, they also looked at the degree of competition that the
multinational could face within its industry. They classified the parents into industrial
sectors, using the 3-digit SIC classification and within each industry counted the
number of MNEs acting in each country. As it turns out, the number of competitors has
a very significant effect on bargaining power, as measured by the average level of
ownership, using any of the three measures. The authors report that ''16 of the 18
industries in which all foreign investment were wholly owned contained only one
corporation, and the average parent ownership of subsidiaries for the 24 single-
corporation industries was 95 percent.''7
They obtain a consistently negative relationship
between ownership and degree of competition, as long as they exclude from the study
three industries that have a special meaning to most governments in Latin America:
Pharmaceuticals (SIC 283), petroleum refining (SIC 291) and office machinery (SIC
357); they discuss in some detail why these three are to be left out of the study. The
reasons they offer for the case of office machinery are a bit dated, and it might be worth
to repeat this same study with modern data.
The paper closes with a brief discussion of multivariate analysis, where the
different measures of equity participation are modeled using linear regression taking all
five independent variables at once. Their results show all coefficients but the one for
size (assets) of affiliate to be significant at least to the 0.05 level. The R2s are for all
7 Op. cit. page 19.
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three measures in the neighborhood of 13%, with a total of 648 degrees of freedom.
These results point to problems due to imperfection in the measures defined for both
dependent and independent variables, as well a to inadequacies due to the application of
a linear model.
The main general concern left unanswered by this study is whether actually the
main assumption made in the study; that equity participation is a sufficient measure of
bargaining power, can survive further inspection. This is one of the central
considerations, and the starting point, for some of the more recent studies.
In LeCraw (1984) the problem posed by the relationship between bargaining
power and ownership in the JV is further analyzed, beyond the findings already
discussed by Fagre and Wells (1982). In Fagre and Wells (1982) the driving concept is
to define relative bargaining power through a set of five characteristics of the MNE, and
then to measure it via the MNE's percent of equity ownership participation. While
recognizing the important contribution of the bargaining power framework provided in
their paper, LeCraw, as well as others, is skeptical of the assumption made there that
equity participation alone is enough measure. LeCraw (1984) is a paper mostly
empirical in its content. It has three distinguishable components. In the first, LeCraw
extends the study of Fagre and Wells (1982) to include countries in the ASEAN group:
Thailand, Malaysia, Singapore, Indonesia and the Philippines. The second part studies
the connection between the relative bargaining powers of a MNE vis--vis the local
government, as proxied by a chosen set of characteristics, to the degree of control the
MNE exercises over its subsidiary in the host country. This particular dimension of
bargaining power is missing in Fagre and Wells (1982). Quoting from LeCraw (1984, p.
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27): ''Poynter [1982] has shown that a TNC [MNE] may find it advantageous to bargain
not for increased equity ownership, but for control over the variables critical to the
success of the subsidiary from the TNC's point of view.'' Control provides means other
than equity participation by which the MNE may appropriate the return on its
investment: ''...licensing and management fees paid by the subsidiary, sale of inputs to
the subsidiary, sale of outputs to other units of the TNC [MNE] or on world markets,
and interest on intra-company debt. The TNC may use its bargaining power not to
increase its equity ownership, but to secure some other means by which to appropriate
this return, possibly by manipulating the transfer price of these other payments.''8 In the
third part of the study, LeCraw explores how the exertion of control over a specific list
of important operations and functions in the MNE's subsidiary (marketing, finance,
technology, production, imports, exports, etc.) affects the overall success of the JV, as
perceived by the sampled MNEs. The paper draws its conclusions from a sample of 153
subsidiaries operating in the five countries of the ASEAN community. These countries
differ widely in the characteristics of their respective policies toward foreign direct
investment. The MNEs operated in six different manufacturing sectors. The MNEs
subject of the study were based in the United States, Europe, Japan, and several LDCs.
The care in the construction of the sample encourages the author to believe that ''the
sample then may give a good basis on which to reach generalizations concerning the
determinants of ownership and control of the subsidiaries of TNCs [MNEs] in LDCs,
and concerning the effects of ownership and control on the success of these
investments.''9
8 LeCraw (1984) page 30.9 Op. cit. page 28.
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The study proceeds along methodological lines that are similar to those
discussed above for Fagre and Wells (1982). This work concentrates its attention in
three dependent variables: Actual equity ownership, MNE bargaining success, and
effective control. These measures are related through multivariate linear regression to
the following set of independent variables: Technological leadership, Advertising
intensity, Subsidiary assets, Capital/output, Export/sales, MNE assets, MNE-subsidiary
linkages, Host-country attractiveness, Potential MNE investors, Time (1960=1),
Dummy-Japanese MNE, Dummy-LDC MNE, and European MNE.
The measure of actual equity participation is immediate. What the author calls
bargaining success is defined thus
EODE
DEEOS
MNE
HCMNE
=
Where EO is the actual equity ownership,DEHC
is the resulting equity
ownership of the MNE, if the host country gets its desired level of equity ownership,
andDEMNE
is the desired level of equity ownership of the MNE. This measure is
approximately equivalent to the ratio of the country-corrected to the company-corrected
measures devised by Fagre and Wells. There are three observations that come to mind
about the introduction and intended use of this measure. First, the author does not state
all the arguments for why this particular construct is a good representative of bargaining
success. Second, inspecting the regression results that he presents in TABLE 2 of the
paper, there doesn't seem to be any new insight gained from this variable that it is not
already included in the results for actual equity ownership. Third, if the idea is that the
measure is an increasing function of bargaining power, then it is worth noticing that for
fixed values ofDEHC
andDEMNE
, the measure is monotonically increasing with actual
equity ownership. This seems, at least superficially, somewhat at odds with the J-shaped
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relationship between equity ownership and the company and country corrected success
presented in Figure 3 of the same paper.
The third measure is effective control. This measure is constructed using
managerial evaluations. Each manager of the 153 subsidiaries rated the importance of
control over each of a list of 18 factors: output pricing, output volume, output quality,
technology transfer, technology control, capital expenditures, financing source,
financing cost, financing amount, dividends timing, dividends amount, fees paid to the
MNE, advertising and marketing expenditures, channels of distribution, import price,
import source, import volume, export price, export destination, export volume and
overall management. The rating system used a scale from 1(none) to 10(critical). The
managers were also asked to rate the degree of control that the MNE had over each
factor from 1(no control) to 10(complete control). These data were then used to
construct the measure of effective control by averaging the scores for the degree of
control over the 18 factors, weighed with the scores for the importance. The author
interprets this measure by stating that ''...Effective Control measured the degree of
control over the critical success variables retained within the TNC [MNE] compared to
the control lost to those outside the TNC, such as, local partners or the host
government.''10
He finds the correlation between effective control and equity ownership
to be 0.57, much less than a 1 to 1 correspondence.
Next, using multiple regression, the connection is established between the three
dependent variables and the set of factors associated with relative bargaining strength.
The independent variables used to describe bargaining power were: technological
10 Op. cit. page 37.
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leadership, advertising intensity, subsidiary assets, capital/output, export/sales, MNE
assets, MNE-subsidiary linkages, host country attractiveness, potential MNE investors
(this refers to the number of potential competitors), time (1960=1), dummy for Japanese
MNE, dummy for LDC-based MNE and dummy for European MNE. Now we provide a
brief description of the measures for each independent variable, and place in
parentheses the respective sign for each dependent measure (Actual equity, Bargaining
success and Effective control) in the results for the regression. The measure of
technological leadership (intensity) (+ all)11
11 This means that all signs in the regression positive. The same interpretation applies if the sign inparentheses is negative.
was made by asking the managers of the
153 subsidiaries to rate from 1 to 10 some aspects that are usually associated with this
characteristic. The measure includes ratings for the technology that was initially
transferred and the potential for further transfers in the future. Advertising intensity (+
all) was represented with the advertising to sales ratio of the subsidiary relative to other
firms in the industry; capital intensity (+ all) and capital requirements (+ all) were
measured using total assets/output and total assets of the subsidiary, respectively, but
since these two are correlated, when put together in the regression the first shows
significance below the ten percent level and the second is significant to only ten percent
level. Export intensity (+ all) was measured as exports/sales; this was significant at the
one percent level in all three regressions. The total assets of the parent MNE (+ all)
relative to others in the same industry were included to test the hypothesis that smaller
MNEs would take a minority equity position, this variable showed high significance in
both the first and third dependent measures, it was not significant for Bargaining
success. The Linkage effects (-, -, +) is proxied by the ratio of total flow of resources
between the parent and the subsidiary over sales, the flows considered included ''inputs,
interests on loans and intrafirm suppliers' credit, intrafirm sales, management and
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technical service fees, and imputed rental value on machinery and equipment supplied
by the MNE.''12
12 Op. cit. page 35.
Notice the opposite sign between Actual equity and Effective
control, this confirms the hypothesis that if linkages are strong, then the MNE will be
less interested in equity and more interested in having control over critical operations
and functions; the coefficients for these two measures were significant at least at the
five percent level, the coefficient for Bargaining success was not significant. For
attractiveness of the host country (- all), the managers of the subsidiaries in the sample
were asked to rank the country on a 1 to 10 scale; the results show that the more
attractive the country the lower the relative bargaining power of the MNE vis--vis the
host country, the coefficient for Effective control was not significant. Potential MNE
investors (- all) represents the degree of competition found by the MNE at its arrival.
The number of MNEs that had already undertaken FDI in the same industry in the
particular country was used as the measure; all coefficients for the three regressions are
significant to the five percent level or better. An absolute reference for Time (1960=1)
(- all) was introduced to show the learning effect of the host countries, which got better
in their bargaining ability over time; all coefficients are significant at the five percent
level. The coefficient of the dummy for a Japanese MNE showed a somewhat
unexpected result, it was negative for Actual equity and positive for effective control,
with both significant to the five percent level. The apparent interpretation is that the
Japanese bargain less for equity participation while keeping a relatively higher degree of
control over operations. The LDC dummy (-, +, -) shows that these MNEs have
relatively less bargaining power; this is stressed by the fact that the coefficient for
Bargaining success is not significant. The European dummy was not significant to any
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of the dependent measures. The2
R for each of the three regressions were 0.63 for
Actual equity, 0.47 for Bargaining success and 0.55 for Effective control.
LeCraw also analyses in more direct ways the relationship between equity
ownership, effective control and the overall success of the JV, from the MNE's point of
view. ''...TNCs [MNEs] may bargain for increased equity participation in order to
increase their control over the operations of their subsidiary, to try to ensure that the
internalization advantages are in fact realized. The link between the level of equity
participation and the TNCs control over its subsidiary, however, may not be
straightforward. Depending on type of technology transferred, the capabilities of the
local partners, and the host government policies, a TNC may be able to control the
operations of its subsidiary that are critical from its viewpoint without a majority
ownership, or, conversely, may have little control over these operations despite majority
(or even complete) ownership. A TNC may therefore be willing to trade reduced equity
ownership for increased control of variables crucial to the success of the venture from
its point of view...The link, therefore, between the bargaining power of the TNC, the
level of its equity participation, its control of the subsidiary, and its perception of the
success of the investment is complex and may be difficult to trace.''13
13 Op. cit. pages 30-31.
In an attempt to
map the relationships among these factors introduces three measures of success: the
profitability of the subsidiary, the success of the subsidiary as rated by the MNE (on a
scale from 1 to 10); and a ''country and industry corrected'' success (CICS) measure.
This way of measuring success was introduced to account for the perception that
profitability was not the only measure of success and for the fact that profitability
reports from subsidiaries of MNEs have sometimes been found to differ from actual
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profitability. The CICS was plotted against Effective control, using the latter as
independent variable. The plot is shown as FIGURE 2 in the paper, and it displays a
strong linear dependence. In FIGURE 3 CICS is plotted against the percent of actual
equity ownership; it shows a J-shaped diagram, with its lowest points drawn around the
equity region where ownership is roughly equally distributed between the partners.
Meaning that in the sample studied, ventures were the least successful when ownership
was split roughly equally between the partners, condition that possibly reflects a hard
bargaining process where both parties saw a close tie between ownership and control,
resulting in a poor managerial structure. This result is consistent with the findings in
Killing (1982).
On relative bargaining power and project control
There are several reasons given by different governments for the existence of
equity participation restrictions: better access to information, control of payments for
technology transfer and management fees, control of pricing of output and intra-
company trade, reinvestment and remittance of capital. These reasons sometimes do not
provide a coherent information set on which to draw conclusions, much less to predict
the outcome of a particular negotiation. Also, it is common to find equity participation
restrictions related to politically sensitive issues to the host government, quite apart
from economic considerations.
The main purpose of this section is to propose a starting point for the
formalization of the ideas contained in Poynter (1982) and LeCraw (1984). It may be
useful first to summarize briefly the relevant aspects of what has been found and
presented in the previous section. In Fagre and Wells (1982) the plausible assumption is
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made that there is a close relationship between the bargaining power of the MNE and
the level of equity participation that it can negotiate with local firms and governments.
Their study shows results where this assumption finds empirical support. Nevertheless,
Poynter (1982) makes the observation that such bargaining power will not necessarily
be focused on equity participation alone, but that often it is used in order for the MNE
to keep decision control over operations that are critical to the success of the venture,
even if the MNE has minority participation. After additional empirical research LeCraw
(1984) finds that the implied additional assumption made by in Fagre and Wells (1982):
that increased equity participation goes hand in hand with increased control of critical
functions, is not necessarily true. Control of critical operations and percentage of equity
participation are not, in general, perfectly correlated. These empirical results have a
bearing on the theoretical side of JV studies. If an important part of the contribution
from the MNE to the JV is related to managerial skills, then it is not adequate to
describe models for JV only in terms of equity participation, but control must also be
included as part of the model. In terms of bargaining power, it is difficult not to see as
somewhat odd the fact that the MNE has the bargaining power, and yet it has no say in a
negotiation process with a local government which is perhaps acting under its own
pressures to seek outside investment, especially for the increase of the nation's export
capacity. The main items over which there is something to bargain for are equity
participation and project control, therefore, if such power is on the side of the MNE, it
would have to reflect in at least the second of these two components. A more careful
inspection of this argument though would hint at a stronger characterization of the
concept of bargaining power itself. The standing literature limits its scope of bargaining
power to setting the bargaining problem such that the party having the power maximizes
its own utility, subject to some rationality constraint given by the counterpart. This
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maximization is done with respect to a set of variables that specify the terms of the
problem; these variables represent the main items that are subject to negotiation at the
''bargaining table''. However, in order for this maximization exercise to make sense,
there are sometimes conditionality restrictions that the set of variables most satisfy. In
the present literature, the treatment of ownership and governance variables, even when
the latter is directly treated at all, does not seem to follow clear rules of conditionality.
This does not seem to be an entirely satisfactory scheme. Consider an MNE that does
indeed wield a ''big stick'' in terms of, for instance, marketing power. If it faces a
negotiation process with a government that is lenient in its capital participation policy,
then it is to be expected that the MNE will must certainly have full control of the main
components of the project as well. Assume on the other hand that the same MNE faces
negotiations in a country with tough policies regarding foreign investment in certain
industries. Then it may be the case that capital participation restrictions could act as a
barrier for the MNE to have access to majority participation. However, if it is true that
the MNE carries weight in the negotiation, it still should be able to keep the full control
of critical parts of the project. This can always be the case, since project control is not
an aspect that is easily visible to outsiders, as opposed to what happens with equity
participation. On the other hand, it is not easy to conceive of a situation in which the
result of negotiations between a local government and an MNE were that the latter gets
to keep, say, 95% of equity, but it has no effective control of operations. In other words,
a clear sign that the MNE has any true bargaining power is that it keeps control of at
least those components of the project that are critical for a successful outcome, from the
MNE's point of view. We will refer to having control, or having effective control to a
situation in which managerial control is not shared to the extend where decisions result
in actions that are inconsistent among each other, and with the well being of the project.
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Some arrangements of shared management in JVs result in each of the parties
controlling some vital components of the project, leading almost always to conflicts that
cause the JV to fail (Killing, 1982).
An example may help to clarify the arguments given above. Consider the
following simple model: suppose that a JV project produces a certain amount L if things
do not turn out well. This amount can be seen as a riskless cash flow that the partners
get for the very fact of undertaking the project. If all comes out perfect, then the final
cash flow for the project isL+ , where is a ''premium'' that defines the degree of
success over failure. Suppose moreover that the probability of success for the project is
some concave, increasing function of initial investmentI , and that it also depends on
the degree of control c exerted by the MNE over critical parts of the project. Let's
denote this probability by ( )Icp ,| . Then the expected utility for a risk-neutral MNE
will be given by ( ) ( ) IIcpLIcU+=
,|,,, . Here corresponds to the share the
MNE gets of the riskless part of the cash flow contributed by the mere undertaking of
the project, and is its equity participation. This formula assumes that all initial
investment comes from the MNE. This assumption makes sense at least in the scenario
when the MNE has both the bargaining power and privileged information, because then
one can not expect the local firm to have an incentive to put cash up front as part of the
initial investment in the project. To simplify matters, let's assume that { }1,0c , where
0=c if the MNE has no control and 1=c if it has total control. The probability function
is assumed to be such that ( ) ( )IcpIcp ,0|,1| == and
( ) ( )IcpDIcpD II ,0|,1| == for all feasibleI . In what follows we shall incur in a
small abuse of notation and rename these two probabilities simply as ( )Ip1
and ( )Ip0 ,
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respectively. The stated conditions are meant to ensure that the project with full control
will be comparatively more successful than the project with no control. Let's analyze a
hypothetical situation in which the MNE has to choose between having a higher than
50% equity participation H , but with little or no control, and having a minority
participation L , but with the possibility of having full control of critical operations.
Then, all else been equal, the MNE will have to decide the best use of its bargaining
power on the basis of which of the two products, ( )IpH 0 or ( )IpL 1 is higher. Given
that there exist some indifference point of investment level between these two options,
then the MNE will have an incentive to put a larger investment I into the second case14
,
if constraints so allow it. Therefore, it won't choose the first case.
Another issue that goes to the heart of the benefits of control to the MNE is the
one related to transfer prices and fees. Clearly, the more economically significant is the
internal transactions between a parent and its subsidiary, the greater the total size of
such fees. These cash movements can be seen as riskless rents that the MNE derive
from the JV. If the MNE exerts no control over the critical decisions of the venture, the
transfer of these riskless cash flows is not likely. Another scenario could be that the JV
does not come with the convenience of frequent internal transactions, leaving the MNE
with the need to obtain maximum results out of the risky part of the cash flow, plus any
riskless part that has to be shared with the subsidiary. Assuming that the MNE will
prefer riskless gains to risky ones, it is useful to recognize the importance of any
riskless cash flow that results from internal pricing and fees, as opposed to any riskless
cash flow that is shared by the partners. In other words, instead of writing L , the shared
riskless cash flow, we should write Llc + as the complete expression for the riskless
14 This is so because the second term eventually has a higher slope than the first, for I large enough.
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component, where l represents the amount stemming from internal pricing and fees.
Observe that if the MNE has no actual control, then the additional profits arising from
pricing and fees vanishes.
Realizing that the description of bargaining power may be a more complex
matter than it is usually taken for in much of the present literature; it is worth to
consider a more direct representation of this concept. It is possible to picture the
bargaining process between the MNE and the local firm/government with a dynamics
where the final outcome in terms of control and equity participation is uncertain to some
degree. At an early stage, when the MNE is considering whether or not to enter a JV, it
will have to decide on the convenience of the proposed JV pretty much based on
expectations of some kind. The setup of the problem for the MNE must consider this
ex-ante expectation. There is then the matter of how to make operational this
expectation. Clearly what is meant by bargaining power is a relative notion. It is not
reasonable in general to suppose that the MNE can exert it equally well with different
companies spread across different countries. In the case of Latin-American countries, as
is remarked in Fagre and Wells (1982), there are obvious differences in negotiating
with, say the Dominican Republic, than doing so with Mexico. The lesson that we can
extract from these considerations is that we can talk only of relative bargaining power,
and that if this power is to be measured in terms of the more or less uncertain outcome
of some negotiation, then a likely candidate to represent it in a formal way is a
conditional probability. This probability should meet at least three criteria: First, we
assume that the most relevant element in the negotiation is the extent to which the MNE
can gain control of critical parts of the project. Second, the extent to which it is able to
keep such control at a given level of equity participation. Third, once the first two issues
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have been settled, there are no other significant elements left that can characterize the
outcome of the bargaining process. This is not to say that in order to reach a final state
in terms of control and equity participation there might not be other factors that weigh
in as chips used in the bargaining game. This could be the case, for instance, of the size
of the investment.
Given the above criteria, we propose ( ) ( ) |1Pr == c as a direct measure of
the true relative bargaining power of the MNE. We argue that this conditional
probability summarizes the conditions that best reflect the findings in the empirical
literature, in particular those in LeCraw (1984) and Fagre and Wells (1982). It is
necessary to carefully state the interpretation given to this choice for the bargaining
power of the MNE. First, it means that if the MNE is not able to retain control of critical
parts of the project, then this outcome is a strong indicator of a relatively low bargaining
power with respect the local firm/government. Second, the ''given '' part of the
formula must be read as ''given that it is able to get at least in the bargaining process''.
Much too often reaching agreements for carrying out a JV between a MNE and a local
firm, with the local government as a third interested party, brings the spotlight on the
issue of ownership, as represented by equity participation. Arrangements that may lead
to successful outcomes - or possible equilibrium solutions if we see it as a bargaining
game - include either having a majority participation, up to 100%, by the MNE, as well
as having full control, or alternatively they may lead to the MNE settling for a minority
participation, so that it can have full control. A different sort of outcome results if equity
considerations are closely tied to the issue of control of critical operations. This may be
the case if the local government is, for example, a strong advocate that the JV must also
be a learning process that contributes to increase local managerial skills. Assume that
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the informational advantage possessed by the MNE truly represents a superior
organizational and technical know-how. If the MNE gets into a situation in which both
sides of the table see more equity as more control, then this may result in a mixed
governing body, quite possibly in the neighborhood of a fifty-fifty composition. Then
its knowledge advantage may be seriously diluted (i.e. 0c = ) by a hampered and
somewhat unpredictable decision making process. The resulting inefficiencies are likely
to have bad consequences for the project. From these considerations we can gather that
the particular shape of ( ) is not necessarily simple; this function is somehow
summarizing all the essentials of what the MNE and the locals can achieve, or are
willing to concede, in the negotiation. Further discussion of this model is deferred to
section 1.7.
Structuring international cooperative ventures
Noe, Rebello and Shrikhande (2002) explore the relationship between
bargaining power, regulations, information asymmetry and financing policies in
international joint ventures. They consider a cooperative arrangement between a
multinational and a local firm; the partners determine the scale of the venture and its
financial structure. This scenario assumes that the local firm is capital constrained, and
it will not undertake direct investment unless circumstances, in terms of its own private
information, would indicate otherwise. The multinational may find legal barriers
established by the host government for it to realize its desired equity ownership
participation in the venture. Either one or both of the parties may face competition and
may hold private information about the venture's prospects. The approach in NRS
consists of studying four different allocations of information and bargaining power:
First, the multinational has the bargaining power and also has the information
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advantage; this could be the case, for instance, if the local firm faces competition and
the main product from the venture is marketed outside the host country. Second, the
multinational has a bargaining advantage, but the local firm has more information about
the venture's prospects; this may happen, for instance, when the multinational has a
recognized brand name, but the product of the venture is directed toward the host
country's market, where the local firm has better knowledge of market's conditions.
Third, the local firm finds several multinationals competing to enter the local market; in
this case the local firm has both the bargaining power and the information advantage.
Fourth, bargaining power rests with the local firm, but the multinational has an
informational advantage. In the four cases mentioned, the authors stress the importance
of contract structures that favor firm-value contingent payments over simple transfer
payments for the firm with the information advantage. This is in line with the literature
on takeover bids, when the target firm has private positive information (Eckbo,
Giammarino and Heinkel (1990), Fishman (1989), and Hansen (1987)). This intuition
about the optimal contract is not fully in line though with actual JV experience15
, where
an important part of the motivations underlying the interest of a multinational enterprise
in entering a JV is related to riskless transfer payments.
In the first case, when the multinational has both the bargaining power and an
informational advantage, the multinational has to make sure that the local firm values
highly its participation in the venture. The multinational may achieve this goal by
signaling the goodness of the project through taking as much equity as possible.
Government regulations on capital participation restrictions can prevent this form of
signaling and then the multinational will be forced to use a costlier form of signaling via
15 See, for instance, the account in Killing (1982).
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overinvestment. Overinvestment caused by capital regulations will have a positive
impact on the level of local employment and on the possible rents that the local firm
could derive from this situation. Therefore, in the present case of bargaining power and
information allocation, the local firm and government stand to benefit from capital
restrictions16
.
In the second case, when the MNE holds the bargaining power, but the local
firm has an informational advantage, as it might be the case when the end product of the
JV is directed to the local market. In this case, the local firm has an incentive to declare
the state to be B. With this news the local firm is interested in convincing the MNE that
it needs a larger share of the profits (i.e., a larger) in order to meet its opportunity
costs. The right response of the MNE, should the local firm declare B, is to offer a
contract that ''severely restricts project investment, reduces to a minimum domestic firm
investment participation, and deprives the domestic firm of upside cash flows''17
. The
way in which the MNE limits upside the upside cash flows to the local firm is by
maximizing its own equity participation, and therefore capital restriction rules are
relevant, as in the first case.
The third case is when the local firm has both the bargaining power and an
informational advantage; this might be exemplified by an arrangement where the MNE
acts as a simple financier of the venture. In this case the local firm is the one interested
in taking an all equity position, as a signal of the project's good prospects. This measure
alone might not be enough, and a degree of overinvestment might still be a necessary
signal. The local firm will indicate in this way that it can bear the costs of
16
As noted earlier, this sort of reasoning makes strict sense only in the total absence of the possibility ofinternal transfer payments.17 Noe, Rebello and Shrikahnde (2002), page 3.
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overinvestment. In this case any rule restricting the capital participation of the local firm
would benefit the MNE.
The fourth case considered in NRS occurs when bargaining power rests with the
local firm, but the MNE has the informational advantage, situation that may arise if the
local is in a monopoly position, but the end product is directed to the MNE's home
market. The MNE may have an incentive to report bad news, in which case the response
from the local firm must be to offer a contract were investment is restricted to a
minimum and it will take a100% equity participation. Again, any rule restricting the
capital participation of the local will go in favor of the MNE.
In conclusion, capital participation restrictions on FDI have an effect on the
MNE mainly when it has the bargaining advantage, while any rule restricting
investment participation by the local firm affects it mainly if it has the bargaining
power. Investment distortions result from asymmetry of information between the
partners, with overinvestment occurring when the partner having the bargaining power
also possesses an informational advantage, and underinvestment occurring when the
partner that has the bargaining power is at an informational disadvantage. In what
follows, we shall explore the combined effects of capital restrictions and information
asymmetry in the first case, when the MNE has both the bargaining power and an
informational advantage. The main question to be addressed is whether capital
restrictions can eliminate the effects due to asymmetric information, restoring
investment to its Pareto efficient level, or even inverting the original effect and creating
underinvestment.
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The model
The project requires of a total investment I that is bounded by exogenous
conditions, so that [ ]min max, I I I . Throughout this work we assume that the
multinational (from now on the MNE) makes all the necessary investment and its
partner - from now on the domestic firm - doesn't have to put any cash up front. This
assumption, as explained earlier, is consistent with the case when the multinational has
the bargaining power, which is the main focus of the subsequent analysis. The project's
future cash flow can only be one out of two possible outcomes, either H or L , where
0H L> > . The probability for realizing the high cash flow H depends on the value of
the information signal. The information types are either G , for good news, or B for bad
prospects. These states determine probabilities ( )t tP I for cash flowH , with { },t G B .
These probabilities are assumed to be common knowledge, and are such that
( ) 0I tD P I > and ( ) ( )G BP I P I > , for [ ]min max, I I I , and they are strictly concave over the
same interval. In order to ensure that there is a solution to the optimal investment
problem we assume
( ) IPD tIII minlim
Since information in the G state is more valuable than in the B state, we also
require (Reily, 1979)
( )( )
( )( )IP
IPD
IP
IPD
B
BI
G
GI >
This will ensure that there is no more than a single crossing in the iso-utility
diagrams in the plane of investment-equity participation, condition that then guarantees
the existence of a separating equilibrium for the adverse selection problem.
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The domestic firm incurs in an irreversible costmin
V if it undertakes the project;
this will constitute its reservation value. The MNE's reservation value will be taken to
be zero, and all its initial sunk costs are included inmin
I ; this simplification helps to
produce more transparent expressions, without any loss of generality18
minIL
just defines the lowest utility acceptable for theMNE to be willing to undertake the project in association with the domestic firm. It would act asthe equivalent of an opportunity cost.
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represented bytL . The full specification of the contract is contained in the triad
( ): , ,t t t t S I = ; the set of all feasible contracts in state t will be denoted t . From these
definitions we can construct the expected utility of the multinational, which will be
( ) ( ) ( ) ttttttt IIPLHLSU += :
From this expression is not difficult to see that the MNE will have an incentive
to seek an equity participation as long as the risk-free component of the project does not
become important compared with the risky part, i.e., as long as ( ) ( )ttt IPLHL < for
all t tS
. If this were not the case, the riskless cash flows would generate a tension
with the signaling purpose for the MNE to take a large portion of equity in the venture.
Such tension will indeed be present for any amountL , and there is an inverse
relationship between the maximum portion of equity that the MNE is interested in
taking and the size ofL . From now on we shall assume that the above mentioned
inequality applies.
The expected utility for the domestic firm is given by
( ) ( ) ( ) ( ) ( )( ) ( )tttttttttt IPLHLSUINSV +== 11:
As will be stated in the next section, this expected value needs to be at least the
reservation value minV . This condition would turn equality, if it werent for the effect of
the capital restriction rules. The constraint on capital participation is taken to be a state
independent rule that puts an upper bound to the equity portion of the multinational.
This rule is formally expressed as
t
.
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Where (1) is the capital participation constraint. As discussed below, this constraint
will have the effect of substituting investment distortion for equity participation as a
signaling mechanism for the multinational.
The optimization problem
We address the case when the multinational has the bargaining power and also
the informational advantage. In the G state of the world the optimization problem is
(MB/MI-G):
( ) ( ) GGGGGGGS IIPLSU += max
s.t. ( ) ( ) 0 BBGB SUSU
( ) 0min GG SVV
With
[ ]maxmin ,IIIG , [ ] ,0G , [ ]1,0G .
The notation : H L = will be used throughout the rest of the paper. The first
constraint is the incentive compatibility, or ''no-mimicry'' constraint, which prevents the
multinational with B B information to mimic the strategy of the one with G
information. ( )B BU S is the optimal solution to the maximization problem if the signal is
B . The second constraint is the reservation value constraint for the domestic firm. The
problem when the MNE has information B is stated as (MB/MI-B):
( ) ( ) BBBBBBBS IIPLSU += :max
s.t. ( ) 0min BB SVV
With
[ ]maxmin ,IIIB , [ ] ,0B , [ ]1,0B .
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The optimal solution to MB/MI-B is then used as the constraint for no mimicry
in the G problem. How this constraint acts on the problem with good information
depends in general on the level of the capital participation restriction and on the
domestic firm's reservation value minV . In Appendix A we show the precise form of this
dependence. The main facts about the solution can be intuited from the situation faced
by the multinational when its information isB . Under this condition the multinational
will not use costly overinvestment to signal its type, instead, it will keep all equity
participation compatible with constraints. If the value ofis so high as to be too
lenient, then we may expect that the MNE will proceed to take an all equity position19
,
up to a maximum such that ( ) ( )min
1 VIPL POBBB =+ , wherePO
BI is the Pareto
optimal investment level. The multinational, having the bargaining power, will structure
a contract that keep the domestic's rationality constraint binding, if this is possible.
Under informational disadvantage, the domestic firm will be more interested in the
riskless cash flow componentL , in order to cover as much as possible of its reservation
costs. A second regime comes if the capital restriction rule is such that B < . If the
reservation value is high, and by this we mean ( ) min1 VIPLPO
BB + , the
multinational will invest at the Pareto optimal level, but no more than that. This requires
that the multinational take some share 0B > of the riskless cash flowL . If the
reservation cost is not so high, such as when ( ) ( ) FBBPO
BB IPVIP >> 11 min ,
where FBI is the full information investment, the multinational will take all the share of
debt ( 1B = ) and will invest at a lower level ( )POBFB III ,* in order to just meet the
reservation constraint. If the reservation value is too low, that is if( ) ( ) min1 VIP FBB > ,
19See the observation made about the value of L in the previous section.
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then the reservation constraint will not bind and the multinational will choose the full
information level of investment FBI . Since this level of investment corresponds to the
global maximum of the multinational's utility, we can not expect it to lower it even
further, no matter how smallmin
V may become, therefore the domestic will derive
forced rents in the B state for any FBB
IPV < /1 min .
If the multinational type is G then it will need to convince the domestic firm of
its goodness through signaling. This means taking as much equity as allowed by the
imposed capital constraint and the reservation value of the domestic firm. NRS show
that as long as the reservation value constraint remains active, signaling will take the
form of overinvestment, and the contract structure will be such that either *G = or
*0G = .
20
The way investment strategy changes with can be depicted as follows: if is
too high, then the capital restriction constraint will not be binding, and overinvestment
will come solely as a consequence of the no-mimicry constraint. As grows smaller,
the effect is to suppress the signaling value of equity participation, which will further
distort the investment policy, and from that point on we get *G = and
*0
G > . The
reservation value constraint remains active provided is not too low. In other words, it
depends on the truth value of the inequality
( ) ( ) min*1 VIP GG
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other form of signaling. As diminishes further, the no mimicry constraint will stop
being binding, since paying rents for the G MNE is costlier than for the B type. Since at
this point both constraints have become non-binding, the MNE's investment level will
reach the full information, unconstrained value FBI . Therefore, for a range of values of
the investment policy will have gone from overinvestment to underinvestment.
Consequently we can state the following proposition
Proposition 1:When the multinational has both bargaining power and the
information, there is a degree of capital restriction for which the investment level will
be the Pareto efficient level.
The proof is left to Appendix B.
Continuity arguments indicate that there must be some value c for which the
multinational will invest at the Pareto optimal level POBI . In Appendix B we show that
this value is given by the equation
( ) ( )min
VIIPIIPPO
B
PO
BB
PO
G
PO
GBc += .
Notice that this formula only involves quantities related to general structural and
technological aspects of the project, meaning that c can serve as an objective reference
for any negotiation process.
Proposition 2:When the multinational has both bargaining power and the
information, capital participation restrictions can be Pareto improving even when the
information is G. The level of the Pareto optimizing restriction depends only on the
structural characteristics of the project and not on any particular strategic variable.
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The specific form for the probabilities is
( )( )
100
min0tc
t
ttt
IIPIP
+= .
With [ ]33,25tI , and 75.00=GP , 5.0
0 =BP , 4.0=Gc , 001.0=Bc .
For the cash flows we choose 20L = and 300H = .
The specific value of minV that is used to produce the output graphs is min 29V = .
This particular value has no special significance, it was chosen only for illustration
purposes.
The best way to see all the features described in the previous section is through a
graphic representation of some of the more significant variables as a function of.
Figure 1.1 illustrates the changes undergone by the optimal investment as descends
from 100% down to 70% of maximum participation. This graph is a plot of the
parameter versus, where is a more easily readable measure of*
GI , defined by the
relation ( )minmin
*IIII
PO
GG += . In terms of this measure 1 = is the Pareto optimal
investment level, 1 > means overinvestment and 1 < corresponds to
underinvestment. Figure 2 shows the comparative evolution of the utilities for the
multinational and the domestic firm in the G state across the same range of values of
as in Figure 1.1.
Reading the graph in Figure 1.1 from right to left we can see that very loose
levels of capital restriction have no effect on the multinational's level of investment,
which corresponds to a degree of overinvestment ( 2.5 = ) that is just the necessary to
meet the reservation value constraint, and avoids imitation by a B copycat. How this
reflects in both partners' utilities is shown in Figure 2. As the restriction tightens,
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additional overinvestment, up to 8.2 = , substitutes for lost equity participation as a
signal. At this point the domestic firm starts getting more utility than its reservation
value and the multinational's starts to decline in the same amount. As the maximum
participation goes on reducing, it reaches the point where the multinational starts paying
forced rents to the domestic firm in the G state. At this point signaling through
overinvestment is no longer meaningful, because the B copycat would start having
even a more difficult time sustaining any attempts at mimicry. The investment level
plummets quickly across a very narrow range of values of, until it reaches the value
FGI , the unconstrained level of investment. At this value of the mimicry constraint
ceases to be binding, the multinational with B information no longer capable of
reaching the necessary contract structure.
Further considerations on the relation between effective control and bargaining
power
In several respects, the treatment of the problem as presented in NRS presumes
circumstances and attitudes toward equity ownership in JVs that are at variance to those
known to the author, at least in the Latin American context. It is not frequent the case
that, even in the presence of adverse selection problems, the locals will simply seat
waiting for the MNE to choose its most convenient level of equity as a signal. It is not
in general the case either that governmental restrictions on equity participation act as
sort of ''stone wall'', against which the MNE has no negotiating power. The statements
in LeCraw (1984) are a more realistic guide. There, equity ownership is the result of a
negotiation process in which there are no firmly defined stop points, and this result is
seen as a relatively complex conjunction of four basic conditions21
1) The desired ownership level of the MNE.
:
21LeCraw (1984), p. 28. See also Vernon (1971), Stopford and Wells (1972) and Franko (1971).
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2) The bargaining power of the MNE.
3) The desired level of local equity participation of the host country.
4) The bargaining power of the host government (including the bargaining
power of locally-owned firms in the host country).
The combination of these four factors brings about the immediate consequence
that for MNEs operating within the same industry actual ownership participation varies
within the same country. No such thing as a constant, repetitive top ownership share is
observed. The observed distribution of actual ownership is more the ''equilibrium'' result
of the negotiation process, where the above mentioned factors act as forces. Being this
the case, a MNE seeking to establish a JV in any given country has to consider at least
three variables: its desired equity level, the equity level that is most likely to achieve
after negotiations, and the degree of effective control attained after negotiations. Other
considerations, such as the degree of competition that is likely to find may be seen as
part of the bargaining power that MNE has.
This part of the essay is mostly concerned with the explicit introduction of the
concept of effective control in the description of the bargaining process. One of the
simplifications made in NRS is the implicit assumption that control of critical
operations within the project is not relevant. Whichever of the partners that carries
through the project, or whatever the composition of governance, will have no effects on
either total welfare or the efficacy to get results. However, it can easily be argued on the
basis of the available empirical evidence that this assumption is not justified. In
particular, the ''J'' shaped form in FIGURE 3 of LeCraw (1984) would become hard to
explain within the NRS model, not to mention that it would not be able to say anything
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at all about the results presented in FIGURE 2 of the same reference. The present
treatment is an attempt at including these components missing in NRS, so that with a
minimum of additional complications, the expanded model becomes rich enough to deal
with the above mentioned facts.
It is important to clarify from the outset that the maximization problem faced by
the MNE is ex-ante. Therefore, it does not know before hand the results of negotiations
with the local firm/government. In what follows we will voluntarily limit our analysis to
the case of no adverse selection problems, when there is no need for the MNE to be
constrained by an incentive compatibility condition. This is done only for the sake of
transparency of the arguments that follow. Full treatment in the case with adverse
selection will be done elsewhere.
If the MNE has the bargaining power, then when considering the bargaining
process with the local firm/government there are at least two possibilities for the role
that the size of the investment can play: either it is part of the bargaining or it is not. In
case the size of the investment does matter, the ex-ante problem that the MNE must
solve is given by22
( ) ( ) ( ) ( )( ) ( )IUIUIUI
,,1,,,,max01
,,
+=
.
22Note that this treatment is simplified. The fact that the MNE has no control does not meanautomatically that the local firm has the control. It may be the case that none of the parties haseffective control, situation that seems to happen often enough. In this case the analysis wouldentail a third term. The only change with respect to the formulas given in the text is that wewould have
( ) ( ) ( ) ( ) ( ) ( ) ( ).:, IpIpIpIP NONENONE
LOC
LOC
MNE
MNE ++=
Where we must have
( ) ( ) ( ) 1=++ NONELOCMNE
,with all terms being non-negative. But at this stage we choose to keep matters as simple aspossible.
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Where ( )IU ,,1
and ( )IU ,,0 are the utilities for the MNE in case of full control or
no control, respectively. Expressions for each are
( ) ( ) IIpLIU +=00
,,
and
( ) ( ) IIpLlIU ++= 11 :,,
In these expressions all symbols used are as they are explained in other parts of
this essay. If we substitute the above equations back into the maximization problem
we get
( ) ( ) ( ) IIPLlIUI
++= ,,,max,,
.
Where
( ) ( ) ( ) ( )( ) ( )IpIpIP 01 1, += [1.1]
Notice that if the site of control is irrelevant, i.e., if ( ) ( )IpIp 01 = and 0=l , then
the above expressions are indistinguishable from those found in Section 1.5 of this
essay, where we discuss the model in NRS. Under the present formulation, the
effective conditional probability for project success ( )IP , incorporates all the risk
structure associated with the possible outcomes from negotiations. This function
represents the best information that the MNE can count on in order to make its own
estimates for the prospects of success of the JV.
The absence of adverse selection in this problem is not tantamount to an absence
of information asymmetry. The information asymmetry of the problem resides in the
fact that the MNE has no credible way to pass on the knowledge contained in the
effective conditional probability function to the local firm/government. The knowledge
condensed in ( )IP , is the product of a long process of organizational learning, and
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there is simply no way in which this can be meaningfully revealed to an external party
over a short period of time. It is telling how is it likely that project's success prospects
are going to be influenced by ownership structure, since ownership structure will most
likely have a bearing on how decisions are made and implemented. This knowledge-trap
brings us to the matter of the rationality constraint imposed by the local firm. First,
consider the not unlikely case where the MNE is seeking an already established firm to
serve as a service provider for a line of products for the MNE's home market. The local
firm/government does not have information about the prospects for success of the
project, beyond that contained in some ''average'' conditional probability ( )Ip . This
probability function does not contemplate the effects of the structure of governance,
because the locals may not believe the MNE's claims to the contrary. From such claims
they may construe that the ''true'' conditional probability ( )Ip is somewhere between
( )Ip1
and ( )Ip0
, but no more and no less. For the sake of this discussion we shall
assume that ( ) ( ) ( ) ( )( )IpIpIp 0121 += . This understanding of the problem by the locals
is fully known to the MNE. Under these circumstances, if the local firm/government is
assumed to be risk neutral, the rationality constraint takes the form
( ) ( ) ( )min
2
111 VIIpL ++ .
Wheremin
V corresponds to the reservation value of the local firm. It is important to
realize at this point that this value may not, in general, be invariant with respect to the
condition of which of the parties - if any - does exert effective control of the JV.
Continuing with our simplified scenario of either/or for the possession of effective
control, let's call 0minV to the reservation value if the local firm exerts effective control,
and 1minV when the MNE has the control. Then, on general grounds related to the
structure of costs, one might expect these two values to differ. If we can attribute these
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reservation values as due mostly to operating costs, then the main cost factors are those
related to managerial compensation. Certainly, the costs associated with a local
managerial team, assuming control rests with the local firm, are going to differ
significantly from those caused by managerial fees coming from the MNE, if it has
control. Call 0C the managerial costs in the first case, and let them be 1C in the second
case. Then in general we must assume 10 CC (and in the Latin American context, we
can assume that most likely it is 10 CC < .) With this notation, if the described factors
make the only important difference between the two circumstances, then we could write
0
0
min
1
minCVV = as the connection between the two values, while 1C (or at least an
important part of it) would become a part ofI . In all likelihood, there are other reasons
why the two reservation values will be different; for example, the reservation value may
be altered by the efficiencies that one style of management may bring over the other,
independent from the changes in the risk structure represented by the ( )Ipi . In the
reservation value constraint given above, the right hand side could be seen only as some
expectedreservation value.
Another feature of the rationality constraint is the presence of the internal
transfer value l . The concept that it represents may not be assimilated to that ofL . One
has to keep in mind that, contrary toL , which acts as value added by the project to total
welfare, l is an internal - forced - type of payment, and therefore it adds nothing to total
welfare. It would not be adequate to absorb l into a redefinition ofmin
V either, because
the presence of l is conditioned by the access to control by the MNE, and includes rents
due to internal pricing, whilemin
V is mainly related to operating costs. Finally, and
perhaps most important, the constrained quantity is not the result of the remaining
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welfare, once the MNE has taken its share; rather, it is the result of what the locals are
expected to believe about the value of such residual claim. Therefore, it will have a
distortionary effect over the investment policy. Obviously, the extend of the distortion
will depend on how misaligned are the beliefs of the locals with respect to the
knowledge contained in ( )IP , .
The particular role played by l becomes even more significant if in order to
solve its optimization problem the MNE must assume that the locals are risk averse.
Then, instead of the single constraint above we must write
( ) ( ) ( ) 1min111 VlIpL ++ [1.2a]
and
( ) ( ) ( ) 0min0
11 VIpL + [1.2b]
It must be remarked that, depending on the value of l , these two constraints do
not necessarily produce feasibility sets such that, for instance, the one for the first
constraint would be a subset of the one for the second constraint. This could be the case
perhaps if 0=l , but in general for 0>l this will not be the case.
Second, consider the case when the MNE wants to set up a subsidiary from
scratch in the foreign country, because of labor and/or tax advantages, or perhaps
because of the existence there of natural resources that represent interesting potential
profits. Ideally the MNE would wish to fully own its subsidiary, if it weren't because of
governmental restrictions that may be negotiated within limits dictated in part by the
degree of relative bargaining strength of the MNE. In this case, the proposed firm would
share the full know-how of its parent, and it would be willing to share as well the
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associated risks resulting from negotiation. Therefore we would expect the following
rationality constraint to apply:
( ) ( ) ( ) ( )min,11 VlIPL ++ [1.3]
We may see the two cases presented above as opposite corners in the space of
possible JV scenarios. The latter case will in general preserve the Pareto optimal level
of investment, while the former will in general distort investment and produce
inefficiencies. These scenarios are depicted by the specifics of the constraints and by the
shape of ( ) . The solution set to the optimization problem composed of (D1) plus any
of the appropriate constraints will be characterized by a triplet *** ,, lS = .
The conception of relative bargaining