When are international joint ventures too inflexible to exit?

Author:Hong, Sungjin J.


For a firm to employ some logic in its strategic decision making process, it needs to identify conditions under which the firm can apply that logic to a particular decision. From institutional legitimacy and experiential learning perspectives, this paper identifies the boundary conditions of real options theory as strategic decision making logic within the context of the divestment flexibility of international joint ventures (IJVs).

In recent decades, real options theory has been suggested as an important form of strategic decision making logic because it explicitly considers the value of future flexibility (Bowman & Moskowitz, 2001). That is, flexibility and uncertainty explain the core themes of real options theory (Dixit & Pindyck, 1994). The rationale behind real options theory is that possessing flexibility provides decision makers with greater value when the future state is unpredictable. In other words, when the future is fairly predictable, flexibility is not valuable.

The conventional wisdom in the real options literature posits that the value of flexibility stemming from IJVs is greater in a host country with a volatile environment (Reuer & Tong, 2005). At the same time, however, empirical studies have indicated that high economic volatility in emerging economies may not contribute to the option value of having IJVs (Reuer & Leiblein, 2000; Tong, Reuer, & Peng, 2008). Given this seemingly contradictory empirical puzzle, this paper raises the question of under what circumstances, does high uncertainty not increase the options value of an IJV. This paper focuses on the option value of divestment flexibility because divestment flexibility has received little attention in the IJV literature (Zardkoohi, 2004). Only a few studies have examined the effects of divestment flexibility at the parent firm level instead of at the subsidiary level (Chung, Lee, Beamish, & Isobe, 2010). In this regard, the focal question is, when an IJV is not a real option in terms of divestment flexibility.

Before addressing this research question, there is a need to define the option value of IJVs. According to Chi and Seth (2002), one can classify types of flexibility that an IJV creates into three categories: an option to expand/contract, an option to acquire/divest, and an option to use knowledge learned by IJV. This paper focuses mainly on divestment flexibility because the difficulty in terminating sequentially committed investments is one of the most understudied domains in the real options literature (Zardkoohi, 2004).

Then what does divestment flexibility mean? IJV divestment flexibility is the option value that the option holder (foreign parent firm in this case) has in terms of the right to sell its equity stake to a local partner or the third party when the option holder expects the economic payoff for maintaining the IJV is less than divesting it (Chi & Seth, 2002). Because all options are not obligations but rights, divestment flexibility provides a foreign parent firm with a safeguard that prevents further losses in case the focal IJV faces an unfavorable local economic condition.

In terms of the original research question, what factors make IJVs operating in volatile local environments not as valuable as the conventional wisdom of real options theory predicts? This paper argues that institutional pressures and behavioral uncertainty offset the positive effect of environmental volatility on IJV divestment flexibility. In this sense, this research implicitly assumes that foreign parent firms as multinational corporations (MNCs) are willing to invest in building host-country-specific capabilities (Song, 2002). That is, only those parent firms with economic incentives to maximize long-term benefits from the host country are posited to concern about local legitimacy in the country. Therefore, if an IJV investment has been made to serve as an export platform, then the parent firm of the IJV is less concern about gaining and maintaining local legitimacy. This paper also posits that the level of prior experience that each MNC gains affects the level of uncertainty and legitimacy pressures as an antecedent of uncertainty and legitimacy pressures.

From institutional and experiential learning perspectives, this paper evaluates the boundary conditions for applying real options logic to IJV divestment decisions. In doing so, this paper seeks to shed new light on the real options literature and the sequential decision making literature in the sense that an IJV may not be a valuable option when environmental uncertainty itself cannot ensure flexibility to divest.


Real options logic, which addresses the question of why an MNC chooses JV over a wholly owned subsidiary in a host country, posits that forming an IJV in the host country enables the MNC to reduce downside risks while claiming upside opportunities (Reuer & Tong, 2005). Kogut (1991) explicitly illustrated this option-like characteristic of joint ventures. When there are market, technological, and other economic uncertainties, firms with JVs can limit their downside risks to the initial investment because they only have to treat this initial investment as a sunk cost if future conditions for expected returns are not favorable (Kogut, 1991). At the same time, if circumstances become favorable, firms with JVs can expand by acquiring equity stakes from their JV partners (Reuer & Tong, 2005). In a similar vein, Folta and Miller (2002) argued that when there is no uncertainty surrounding alliances, firms are likely to acquire an additional equity stake from their alliance partners.

Kogut (1991) and Folta and Miller (2002) focused mainly on the option value of flexibility to acquire and expand. The option value in terms of flexibility to divest and contract has received relatively little research attention. As an exceptin, Reuer (2000) examined the stock market performance of parent firms when their investment in IJVs is terminated. Reuer (2000) distinguished five modes of IJV termination: the focal parent firm (1) acquires the IJV, (2) sells it to the partner, (3) sells the equity stake to an outsider, (4) joins the partner in selling the IJV in its entirety to an outsider, and (5) liquidates the IJV. When IJVs lead to a negative stock market valuation during their formation, these ex ante unattractive IJVs tend to generate a positive stock market valuation when they are sold to outside parties. This implies that divestment flexibility is an important element of the option value created from forming IJVs. Unless the parent firm has the flexibility to divest, the reduction of downside risks, which is a fundamental assumption in real options logic, does not hold. In this sense, it is noteworthy that having IJVs in emerging economies do not actually contribute to the reduction of the MNC's downside risks, as suggested by Reuer and Leiblein (2000). Does this imply that real options logic is not useful for predicting the value of having IJVs in volatile environments? One cannot conclude this without robust evidence. Instead this seemingly contradictory empirical puzzle provides a promising research opportunity to better understand why environmental volatility does not make IJVs flexible in certain circumstances. The next two sections revisit the main assumptions of real options logic in terms of path dependency and the type of uncertainty. In this way, the departure point at which real options logic can reconcile with institutional and experiential learning logic is identified.


In the real options world, decision makers want to make incremental resource investment decisions to reduce the potential cost in times of uncertainty. The central role...

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