locked out. But vertical integration also has potential disadvantages: Locking in suppliers and customers makes your firm an equity participant in their fortunes; if they fail to remain competitive, their problems can harm your core business. Furthermore, the creation of internal markets can lead to the loss of economic discipline and a distancing from the information conveyed by external markets.
ACQUISITION OF UNIQUE RESOURCES AND CAPABILITIES In some situations, it may be impossible to create internally those resources that are vital to the continued success of the firm. In fields such as biotechnology, computer software, defense electronics, and filmed entertainment, large corporations regularly reach beyond their internal operations to acquire intellectual property, patents, creative talent, and managerial know-how.
VALUE CREATION THROUGH DIVERSIFICATION The classic motive for diversification is to create a portfolio of businesses whose cash flows are imperfectly correlated, and therefore might be able to sustain one another through episodes of adversity—this is a straightforward application of the theory of portfolio diversification that Levy and Sarnat (1970) explored at the corporate level. It is not clear what value this kind of portfolio management adds to shareholders’ wealth—couldn’t shareholders build these portfolios on their own? If so, why should they pay managers to do this for them? Salter and Weinhold (1979) argued that corporate diversification could do things that shareholder portfolio formation cannot. Thus, diversification might pay if it:
Promotes knowledge transfer across divisions. This might lift the productivity of weak divisions. For instance, General Electric practices Total Quality Management and extends its productivity-enhancing techniques to new businesses that it acquires.
Reduces costs. Where the diversification is into related fields, it may be possible for the diversified firm to reduce costs through improved bargaining power with suppliers. Also, the cost of financing may be lower thanks to the portfolio diversification effect. Lewellen (1971) suggested that combining two unrelated businesses whose cash flows are imperfectly correlated can reduce the risk of default of the entire enterprise, and therefore expand debt capacity and reduce interest rates.4
Creates critical mass for facing the competition. Diversification may bring an aggregation of resources that can be shaped into core competencies that create competitive advantage.
Exploits better transparency and monitoring through internal capital markets. Internal markets might function better than external markets. First, there may be lower transaction costs: shifting funds from cash cows to cash users may not entail the contracting costs associated with loan agreements or equity underwritings. Coase (1932) argued that the chief explanation of why some firms internalize activities that could, in theory, be conducted among independent firms was that high transaction costs made it cheaper for the firm to do so. Weston (1970), Alchian (1969), and Williamson (1975) offered supporting arguments that internal markets may be more efficient in some circumstances than external markets; Stein (1997) highlights one of these circumstances to be where the corporate headquarters is competent in “winner-picking,” the shifting of funds to the best projects. Second, disclosure is probably greater: within the confines of the diversified firm, senior executives can obtain sensitive information that might not be available to outside sources of funds. Chandler (1977) documented the rise of the modern corporation and showed that enhanced methods of monitoring and information transfer enabled senior executives to manage larger and more diverse operations effectively. But the evidence about the effectiveness of internal capital markets is mixed. For instance, Lamont (1997) studied the behavior of oil companies during the oil price collapse of the mid-1980s and found evidence consistent with the story that “large diversified companies overinvest in and subsidize underperforming segments.” (Page 106)
Transactions for Inorganic Growth
Executives enjoy a wide range of tactical alternatives for inorganic growth. Mergers and acquisitions are often the focus of financial advisers seeking to generate fee income by assisting firms on M&A. But the executive should consider at least four other avenues before embarking on an M&A effort. These include contractual relationships, strategic alliances, joint ventures, and minority investments.
CONTRACTUAL RELATIONSHIPS This is the simplest of all inorganic expansions; it may assume strategic significance if the relationship extends over the long term, if there is a two-way exchange of information; if the two firms are linked into each other’s business processes (e.g., inventory management systems), and/or if it entails an exchange of managers. These relationships can take many forms. Several classic arrangements are these:
Licensing agreements. Your firm simply “rents” the technology, brand name, or other assets that are the focus of your interest.
Co-marketing agreements. Your firm and the partner each agree to sell the products of the other party. The owner of the product permits another firm to make and market the product under a different brand name in return for a fee and profits on ingredients sold to the partner.
Co-development agreements. Your firm and the partner each agree to share the costs of R&D or creative work necessary to develop a new product or process.
Joint purchasing agreements. Your firm and the partner each agree to combine purchase orders for raw materials or other resources, to exploit economies of scale in purchasing.
Franchising. Your firm grants an exclusive market territory to the partner in return for a one-time payment or annual fee.
Long-term supply or toll agreement. Your firm commits to a predictable volume of unit purchases over the long term, in return for advantageous pricing.
These kinds of agreements are widespread in business. For instance, Glaxo Holdings, a pharmaceutical company established a co-marketing agreement with Hoffmann–La Roche to market its best-selling product, Zantac, an antiulcer drug. Bruner et al. (1992) detail the economics of these agreements: The trade-off for Glaxo was between lost direct sales versus fee income, profits on ingredients, and faster time to market within a limited period of patent protection.
STRATEGIC ALLIANCE In comparison with a contractual relationship, an alliance is typically more complicated and expresses a more serious commitment between the parties. A contract may formalize the alliance. But it is the exchange of managerial talent, resources, capabilities, and possibly even equity investment that elevates the alliance beyond a mere contractual agreement. An equity investment under the alliance may be structured across a range of possible deals, including a joint venture or minority investment.
JOINT VENTURE A joint venture (JV) creates a separate entity in which your firm and the counterparty will invest. The JV agreement between the venture partners specifies investment rights, operational responsibilities, voting control, exit alternatives, and generally the allocation of risks and rewards. The entity could be a division carved out of one of the venture partners, or an entirely new business established for the venture. The agreement for large JVs may be as complicated as for an acquisition.
MINORITY INVESTMENT Here, your firm invests directly in the counterparty firm, rather than in an intermediate firm (like the joint venture). Sometimes firms take mutual minority interests in each other; this is called a cross-shareholding arrangement and is common among large Japanese and Continental European firms. Taking a direct equity interest in another firm is a strong signal of commitment and participation in the fortunes of that firm.
Research
