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 The nine different ways that alliances create value for firms and how these nine sources of value can be grouped
Objective 2 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 Helping firms improve the performance of their current operations

ƒ Creating a competitive environment favorable to superior performance
ƒ 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 non-
exclusive 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 How adverse selection, moral hazard, and hold-up can threaten the ability of alliances to generate value.
Objective 3
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 mid-
range 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 The Rarity of Strategic Alliances

Objective 4
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.