Contemporary Concerns Study
Determining Mode of Entry of Multinationals: An Analytical Framework
Under the guidance of
Prof. V. Ravi Anshuman
By
Hemant Chandrasekaran(0511088)
Dharini Kannan(0511013)
Submitted On
29th August, 2006
Indian Institute of Management, Bangalore
TABLE OF CONTENTS
EXECUTIVE SUMMARY
Emerging Markets- Epicentre of growth
India- an attractive destination for MNCs
Modes of Entry of Multinationals
EXPORT
LICENSING
JOINT VENTURE
WHOLLY OWNED SUBSIDIARY
ACQUISITION
GREENFIELD VENTURES
LITERATURE SURVEY
RISK VS CONTROL ISSUES2
RESOURCE BASED VIEW FOR ENTRY MODE ISSUES
PRINCIPAL-AGENT THEORY IMPLICATIONS3
LOGISTIC REGRESSION
STUDIES OF EARLIER DEVELOPED LOGISTIC REGRESSION MODELS
1.Model 15
2.Model 24
3.Model 3
4.Model 4
BUILDING A LOGISTIC REGRESSION MODEL
DATA COLLECTION
CASE STUDY ANALYSES
QUANTITATIVE ANALYSIS
STEP 1: Correlation between independent variables
STEP 2: DATA REDUCTION USING PRINCIPAL COMPONENT ANALYSIS
STEP 3: MUTLINOMIAL LOGISTIC REGRESSION ON REDUCED DATA SET
OUTPUT INTERPRETATION:
TEST RESULTS
MODEL 1: WITH LOCATION OF ORIGIN VARIABLE U/E/J
MODEL 2: WITHOUT LOCATION OF ORIGIN VARIABLE U/E/J
STEP 4: DISCRIMINANT ANALYSIS
WHY DISCRIMINANT?
OUTPUT INTERPRETATION:
TEST RESULTS
MODEL 1: WITH INCLUSION OF VARIABLE U/E/J
MODEL 2: DISCRIMINANT ANALYSIS WITHOUT THE U/E/J VARIABLE
PERCEPTUAL MAP
DEVELOPMENT OF AN ANALYTICAL FRAMEWORK
CONCLUSION
ADDITIONAL REFERENCES
APPENDIX
EXECUTIVE SUMMARY
In recent years, several developing economies have seen a burst in growth, partly fuelled by Foreign Direct Investment or FDI flows. Post liberalization, several MNCs have been entering India. An MNC may enter through one of several modes of entry available to them, including Joint Ventures, Acquisitions, Wholly Owned Subsidiaries, Licensing route, etc. The decision of entry mode is governed by several factors.
This paper looks at several strategic theories governing entry modes and a few models developed in the past. Based on these, the paper attempts to develop a statistical model for predicting the entry mode of an MNC into India. A unique set of variables is identified on the basis of these, including a new variable, namely the country of origin (USA/Europe/Japan-Asia). These have been used in further statistical analysis.
Factor analysis using Principal Component Analysis has been done to reduce the variable set and combine certain relevant variables. This was then used to prediction models using Multinomial Logistic regression. Another statistical model, using Discriminant analysis, to classify a particular entry as one of the entry modes, has also been developed. This approach has not been attempted before in previous literature. The model was found to have a good predictive power compared to random selection. The model was also validated by applying it to a holdout sample. The prediction of the holdout sample was also found to be significant.
The results of the discriminant analysis, have been used to develop a 2-by-2 framework, which captures the entry mode decision of a multinational based on 2 fundamental factors. These have been identified to be the Risk-Return balance and the amount of Local Resources needed (alternately, the amount of resources needed to be brought in by the MNC). Though these two factors have never been combined before in previous literature, it matches with earlier findings well.
Emerging Markets- Epicentre of growth
As the markets in developed countries gradually mature, companies in these countries are looking for new avenues of growth. Emerging markets, particularly the BRIC block (Brazil, Russia, India, and China) offer huge potential for growth. The rapid globalization has triggered most of the companies in developed nations to look at these countries seriously.
Source: JP Morgan Asia Pacific Equity Research Report, 07 March 2006, Adrian Mowat, Joanne Goh, Steve Malin
Other factors in these emerging markets like availability of cheap labour, huge size of potential market and the urge to catch up with the developed world are conducive to the entry of foreign multinationals into these countries.
India- an attractive destination for MNCs
India in particular offers a huge target market owing to the rising middle class and has posted a GDP growth rate of 6.5% p.a.[1]CAGR over the last decade. This makes it an attractive destination for multinational companies. Until 1991, the stiff regulatory framework, government imposed restrictions in favour of local companies, etc made it virtually impossible for MNCs to set shop in India. Following the liberalization of the economy, the markets have opened up for the MNCs. Most of the restrictions have been relaxed and the market as a whole has moved more towards free market economics. While this has spelled doom for some of the local companies, overall the competitiveness in the market has improved.
MNCs often tend to leverage on the technical expertise and brand value they are able to bring in. But several industries often require local support infrastructures. A combination of all these factors and many more ultimately determines the mode of entry of a multinational into India.
Modes of Entry of Multinationals
Mode of entry is the way in which a multinational decides to start its business in India. Selecting this institutional arrangement is one of the most crucial decisions for an MNC. An MNC has to ensure that its mode of entry is in line with its long term strategies and enables it to gain a competitive advantage in the target country by leveraging on its strengths. There are several modes of entry by which an MNC may enter India, as discussed below[2]:
EXPORT
In export oriented entry, the manufacturing of the final product is done outside the destination country and finished goods are transported to the country. Indirect exports via intermediaries may also be done.
E.g.: Boeing is a prime example of a major exporter. While the aeroplanes are manufactured in USA, most of is flights are sold to other countries.
LICENSING
This mode of entry is based on a contractual agreement and does not involve equity investment. The MNC transfers the right to use its patents, intellectual property, trademarks, technology, business methods, etc to a local company in the destination country for a fee. This fee could include an initial payment and subsequent payments based on annual earnings. (Actual structuring of the contract could vary from one company to another)
E.g. Most MNCs entering the retail segment have entered through the licensing route.
JOINT VENTURE
This involves collaboration with a local partner to share ownership, resources, business risks, management techniques, etc. Each partner brings in unique capabilities into the business, which together gives the joint venture the ability to build on these synergies and develop a competitive advantage. A company maybe forced to enter through this mode if the industry is not foully liberalized and the MNC has to have an Indian partner.
E.g. Allianz insurance formed a joint venture with Bajaj to form Bajaj-Allianz insurance, in which it has a 26% equity stake.
WHOLLY OWNED SUBSIDIARY
These are subsidiary of the parent company in the destination company, of which they have complete ownership. Thus the parent company has sole responsibility of the risks and returns associated with the business.
E.g.: When the electronics manufacturer Samsung entered India, it did so by setting up a wholly owned subsidiary, Samsung India Pvt. Ltd.
ACQUISITION
In this mode of entry, the parent company acquires an existing company in the destination country. This provides it access to all the local resources that a local company might enjoy, while reducing the hassles and time involved in setting up a WOS. The downside could be that government regulations might be very stringent in approving acquisitions, but this has been declining with increasing liberalization.
GREENFIELD VENTURES
This involves an investment by a multinational in a project in the destination country. As in the case of a WOS, all the resources are invested by the parent company. This is particularly common in case of highly explorative R&D as in the case of oil drilling, etc. The disadvantage with this mode of entry is that it might take a long time to develop all the resources, both tangible and intangible.
LITERATURE SURVEY
The motivation for our study comes from the quest for an answer to the question to the factors determining entry modes of an MNC into an emerging market, particularly India, and developing an empirical model to predict the same. Several papers have attempted to identify these factors. The essence derived from these papers and their implications for developing a prediction model are discussed below.
RISK VS CONTROL ISSUES2
This paper discusses the differences in modes of entry between countries based in US and Japan. As identified from previous research (Maignan and Lukas, 1997; Woodstock et al 1994) mode of entry is believed to be governed by three factors:
- quantity of resource commitment required
- amount of control
- level of risk
Resource commitments are investments in dedicated assets which cannot be put to alternative use. These may be tangibles, like machinery, plants, distribution infrastructure, etc. or intangibles in the form of managerial skill, distribution network and contacts, etc.
Figure 1
Source:Selecting international modes of entry and expansion, Gregory E Osland, Charles R Taylor, Shaoming Zou
As seen from the illustration above, export involves very little resource commitment while WOS require a high level of resource commitment.
The level of control is the extent to which the parent company wants to be involved in the day-to-day decisions and long term strategies of the operations in destination country. While a license agreement often relinquishes most of the control to the local licensee, control is shared in a JV based on the extent of equity investment. A WOS retains all the control with the parent company itself as seen in figure 1.
Technology risk refers to the possibility that the parent company’s knowledge may be transferred to a local firm. These are often referred to as “bleedthroughs”. In a license agreement, the risk that the licensee may end the contract and reproduce the technology on its own is fairly high. WOS has the least technology risk, as no external partners are involved.
Figure 2
Source:Selecting international modes of entry and expansion, Gregory E Osland, Charles R Taylor, Shaoming Zou
Some of the additional factors could include target market issues- competition, host government involvement, culture, partner availability, etc, company level issues- organization experience, resource needs, strategy. JVs offer some advantages over a WOS:
- greater freedom for promotional activities
- lower taxes
- fewer government inspections
- more infrastructure support
- easier access to local government and institutions
While the other modes of entry involve lower levels of risk, the level of risk associated with WOS is very high, but the level of control that can be realised is also the highest. Hence a choice of entry mode is determined by the parent company’s risk appetite vs. need for control.
RESOURCE BASED VIEW FOR ENTRY MODE ISSUES[3]
The paper deals with the analysis of entry modes from a resource based view and developing an empirical model. The resource based view is based on the premise that entry strategies are dominated by the need of the foreign entrant to exploit the locally available resources in the destination country and to augment them with new resources available elsewhere. This is gradually being accepted as an alternative to the transaction theory based view to entry modes. In emerging economies, the markets are not as well developed and institutional frameworks not well established, due to which a large proportion of the local resources are often embedded in existing firms. Ability to work with the institutions like the government is valuable resources which could take a long time for a foreign entrant to develop on its own. Foreign investors could look at JVs (or acquisitions) for two reasons:
- To gain experience in the new country before starting on their own
- To circumvent institutional blocks which might otherwise be hard to work with
Emerging economies have been identified to have the following characteristics with regards to availability of resources:
- Less sophisticated institutional framework
- Weaker endowments of resources in the form of intellectual capital and infrastructure. Often, they are endowed with natural resources, low skilled cheap labour, etc.
- Tangible and intangible assets could provide an important source of competitive advantage, such as control over natural resources, access to low skilled labour, etc.
Thus the choice of entry mode is based on an evaluation of the resources that can be acquired locally, resources that the MNC can bring in, and the ability to combine and exploit these in a way so as to obtain a competitive advantage.
Factors that favour entry to a JV or acquisition are identified to be:
- inefficient markets that make it more difficult to contract or outsource
- weaker institutional framework
- lack of specialised intermediaries
- bureaucracy and corruption
- formal constraints like caps on FDI %
Factors that could work against in investment decision to enter through a JV include:
- need to invest significantly to restructure the local organization
The paper goes on to build several hypotheses on entry strategies which are test based on empirically collected data. Need for local assets, prior experience in emerging markets, institutional support systems, etc are found to have an impact on entry mode decisions.
PRINCIPAL-AGENT THEORY IMPLICATIONSError! Bookmark not defined.
The subsidiary- headquarters relationship involves control issues and can be modelled along the lines of the classic principal-agent problem, as developed by SumantraGhosal in one of his papers. This can be seen particularly in WOS and acquisitions. The principal- namely the headquarters cannot make all the decisions as they don’t possess specialized local information, neither can they leave all the decision making to the subsidiary as the interests of the local management might differ from that of the parent. The parent company tries to develop a host of control mechanisms to work around this problem. The paper tests this hypothesis based on data collected from a range of companies in the manufacturing sector. This is done by developing a logistic regression model which predicts the mode of entry- Greenfield or acquisition.
Another view of the agency theory and its implications is in the case of a JV. The principal, namely the foreign entrant will need to monitor the activities of the agent, or the joint venture partner to ensure he acts in the best interests of the parent[4]. This entails a transactional cost of monitoring. Inability to resolve this conflict results in eventual dissolution of the JV. In the event of an acquisition, the transaction cost is in the form of restructuring of the organization to match the culture of the parent company.
LOGISTIC REGRESSION
Logistic regression is a linear regression model which is used when the dependent variable is a categorical variable. In this model, the coefficients can be used to estimate the odds ratio for each of the variables in the model.
E.g.the preference of consumers between 3 brands of health drinks may be identified to be a function of several variables like taste, health consciousness, energy, colour, etc.
Logistic data does not rely on any distributional assumptions, but usually the solution is likely to be more stable if the predictors have a multivariate normal distribution. Additionally, a low level of multi collinearity among predictors is desirable as it could lead to distortion and biases in the prediction. If all the predictors are categorical in nature, a log linear logit model may be used.
Predicting the mode of entry using a quantitative model is amenable to analysis by means of logistic regression. This is because the dependent variable, namely the mode of entry, is a categorical variable (JV/acquisition/WOS, etc). This has been explored in the past, and some important papers that attempted to develop a logit model have been identified. Developing a logistic regression model requires us to first identify the most important factors, collect necessary data and use this to build a model.
STUDIES OF EARLIER DEVELOPED LOGISTIC REGRESSION MODELS
1.Model 13
This paper identifies several variables that might impact the entry mode decision and builds a logit model to test the significance of these variables in predicting the entry mode. The paper identifies variables on a resource based view of the strategy. The variables identified include:
- Need for local resources, both in the form of tangible and intangible assets. This test the fundamental premise of the resources based view on entry mode strategy.
- Investment motive, as resource seeking or otherwise
- Experience in the destination country
- Quality of local firms, taken as a rating on a five point scale
- Quality of local institutions
- Relative size of MNC, conglomerate or not
- Geographic distance, CDP per capita of MNCs home country
The model predicts whether the entry mode will be a Greenfield venture or not. Thus the model suggests that the most important local resource sought by MNCs is in the form of human capital which is usually embedded in existing organizations. In addition to these the paper identifies the strategy of the parent firm- global/ multinational/ multi domestic as another factor.
Source:Acquisition vs.Greenfield investment: International strategy and management of entry modes, Anne-Wil Harzing, Strategic Management Journal
2.Model 24
This paper again explores the various factors determining modes of entry by developing and empirical model. The paper has a common author as the previous paper, Mr. Sumon Bhaumik. The variables used in the study include:
- Growth of local industry
- Technology intensiveness of product
- Competition in local market
- Resource needs of MNC
- Local institutions
- Governance and business regulations
- Prior operating experience in developing country markets
- Cultural distance between home country and host country
- Extent of liberalization
- Industry specific regulations
- Perceptions of quality of host country’s managerial labour
- Sector of operation
The paper tries to predict the mode of entry to be JV, acquisition or a Greenfield venture. The data set used in this mode is based on companies in South Africa and Egypt. An additional variable predicted in the model was by making a distinction between two types of acquisitions: acquisitions with total control and acquisition with less than total control. The paper tries to contrast results between two countries, one being far more developed that the other. The model aims to validate the theoretical factors guiding entry mode and attempts to find deviations to the same if possible.