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Real options and foreign affiliate divestments: A portfolio perspective

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Abstract

This paper develops a real options portfolio perspective on foreign affiliate divestments. Affiliates are less likely to be divested in response to adverse environmental change if they represent growth or switch option value to the multinational firm under conditions of macroeconomic uncertainty. However, the affiliate is partially redundant to the option value of the multinational firm's affiliate portfolio if the affiliate shares the manufacturing platform role in the host country with other affiliates, or if macroeconomic conditions of the host country are highly correlated with those of other countries in which the multinational firm operates affiliates. We find strong support for these arguments in tests on a comprehensive sample of 1078 Asian manufacturing affiliates of Japanese electronics multinationals.

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Notes

  1. Contributions to the literature on survival of foreign affiliates include Boddewyn (1979), Delios and Beamish (2001), Li (1995), Mata and Portugal (2000), Pennings and Sleuwaegen (2000), Shaver (1998), Shaver et al. (1997), and Zaheer and Mosakowski (1997). These studies have not examined divestments from a real options perspective, and have tended to pay less attention to the potential impact of the multinational plant configurations, often because of the single-country setting of the empirical analysis. Belderbos and Sleuwaegen (2005) examined the determinants of global plant configurations, but not the role of real options logic. The industrial organization literature has a longer history of examining exit decisions of domestic firms (e.g., Caves, 1998; Dunne et al., 1989; Jovanovic, 1982).

  2. Chang (1995) finds that such follow-up investments tend to be more diversified in nature, whereas the initial investments are more strongly based on core competitive advantages exploited in greenfield affiliates of the investing firms. Other contributions (e.g., Kogut, 1991) emphasize the role of international joint ventures as growth platforms.

  3. Recent studies have explored the application of the real options approach to international joint ventures in particular, suggesting that the type of uncertainty (exogenous vs endogenous to the venture) is an important moderator of the impact of the option value of joint ventures on multinational firms' entry mode decisions (Cuypers & Martin, 2006; Li & Rugman, 2005). In this paper we deal with exogenous (macroeconomic) uncertainty, which has a straightforward interpretation in real options valuation (Adner & Levinthal, 2004). We also abstract from the threat of pre-emption of the exercise of real options by rival firms (Folta & O'Brien, 2004; Kulatilaka & Perotti, 1998).

  4. Folta, Johnson, and O'Brien (2006) analyze the role of irreversibility and uncertainty in detail in the context of entry decisions.

  5. The formal valuation of correlated options in a portfolio is highly complex (e.g., Trigeorgis, 1993).

  6. Milgrom and Roberts (1990) use the terms “submodularity (sub-additivity)” and “supermodularity (super-additivity)” in the context of combinations of organizational practices affecting organizational objective functions. For recent applications to R&D (collaboration) strategies and their impact on innovative performance, see for instance Cassiman and Veugelers (2006) and Belderbos, Lokshin, and Carree (2006).

  7. Real option redundancy in a portfolio perspective bears some resemblance to the redundancy concept in social network theory (Burt, 1992, 2004), which has been applied in the context of technology alliances (e.g., Baum et al., 2000). Here the value of a specific alliance in the firm's network is smaller (the alliance is redundant) if the knowledge obtained through the alliance is also (partly) available through the firm's other alliances. Whereas within the social network perspective the informational ties and flows between alliance partners are essential, the options portfolio perspective does not presume that affiliates have concurrent ties within a network structure. An operational tie between any two affiliates will only potentially arise if the multinational firm decides to exercise the switch options within the portfolio and transfer manufacturing activities between countries. Both redundancy concepts suggest that it is the variety within the portfolio or network that underlies their valuation.

  8. The coverage is much broader, in particular for smaller and privately held firms, than the coverage of the often-used directory compiled by Toyo Keizai Inc. (e.g., Delios & Beamish, 2001).

  9. We find highly consistent results for the hazard model with a more limited number of divestments. This is in line with Shaver and Flyer (2000), who also report very comparable results of duration and probit models in their analysis of divestments by foreign affiliates in the US.

  10. Another candidate for adverse macroeconomic circumstances, decline in host-country market demand, is less relevant in export-oriented industries such as the electronics sector. We experimented with a hybrid measure of adverse circumstances by combining the impact of labor cost growth and market demand, and found qualitatively similar but statistically weaker results.

  11. This compares to the approach in Vassolo et al. (2004), where portfolio redundancy is measured as the degree of overlap in technology profiles between the alliances in the firm's portfolio.

  12. The exchange rate policies and movements have varied considerably across countries during the period. The Philippine currency has been freely floating, and the Singaporean dollar has been on a free float under a “monitoring” regime (with undisclosed band). Several other currencies (those of South Korea, Indonesia, Thailand, and Taiwan) were subject to a managed float up to the financial crisis in 1997, after which a free float was adopted by the first three countries. Malaysia, in contrast, pegged its currency to the dollar in 1998 after experiencing difficulties managing the float of the ringgit. Hong Kong and China are the only countries that maintained a peg to the dollar throughout the period.

  13. No negative correlations over the period 1995–1998 were observed among the nine Asian countries. In the yearly analysis of the duration model (Appendix B) negative correlations are observed; results are highly consistent with the results of the probit model.

  14. Different definitions of multinational portfolio redundancy (e.g., splitting at the mean) gave similar results. A split around the median has the advantage that empirical results are less likely to be affected by different sample sizes (e.g., Hoetker, 2007).

  15. Since acquisitions are almost absent in the sample (five affiliates), we group these together with the reference category of greenfield affiliates.

  16. We also attempted to control for demand factors by including a measure of host-country electronics market growth, but this variable was not significant in any model, probably because of the export orientation of electronics plants in Asia.

  17. Cross derivatives were estimated with the inteff command in STATA due to Ai et al. (2004). The cross derivative is [β 12−(β 1+β 12 x 2)(β 2+β 12 x 12)Xβ]φ, where φ is the normal density function.

  18. Taking the year of affiliate establishment as the onset of risk does not change the empirical results in an appreciable manner. The divestments included in the sample took place in 1995 (4), 1996 (10), 1997 (9), 1998 (22) and 1999 (3). We cannot determine whether the larger number of divestments included in 1998 is a fully representative feature of the sample: since our main source of information on divestments is a survey in 1999, the precise year of recent divestments is more likely to be reported than the year of divestments early in the period.

  19. Coefficients and standard errors were calculated with the predictnl command in STATA as 1/p[pβ 12−p(β 1+β 12 x 2)(β 2+β 12 x 1)], with p (exp(x b )) the predicted hazard.

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Acknowledgements

This paper benefited from helpful comments by Sea-Jin Chang, three anonymous referees, Ilja Cuypers, Koen De Backer, Victor Gilsing, Jean Francois Hennart, Xavier Martin, Leo Sleuwaegen, Reinhilde Veugelers, and participants at the Korea and World Economy Conference in Seoul, the Ninth International Convention of the East Asian Economic Association in Hong Kong, the Annual Conference on Corporate Strategy at WHU-Vallendar, the Annual Conference of the Academy of International Business (AIB), and seminars at the Katholieke Universiteit Leuven, Tilburg University and Keio University.

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Authors and Affiliations

  1. Department of Managerial Economics, Strategy and Innovation, Katholieke Universiteit Leuven, Belgium

    René Belderbos

  2. Fortis Bank N.V., Brussels, Belgium

    Jianglei Zou

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  1. René Belderbos
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Accepted by Lorraine Eden, Editor-in-Chief, 24 April 2008. This paper has been with the authors for one revision.

Appendices

APPENDIX A

6

Table a1 Correlation Table
Full size table

APPENDIX B

COX PROPORTIONAL HAZARD MODEL OF AFFILIATE DIVESTMENTS, 1995–1999

We used the semi-parametric Cox proportional hazard model to examine the impact of hysteresis and redundancy on the timing of divestments. We have 1027 affiliates in early 1995 (the year we take as the onset of risk), of which 48 are divested in the period up to March 1999. The dependent variable is the duration of the spell until divestment, and takes values between 1 (for divestments in 1995) and 4.3 (divestments within the first 3 months of 1999).Footnote 18 As divestments can occur early or late in a year, we relate the hazard of divestment in a year to average labor cost growth and macroeconomic uncertainty in that year and the preceding year. Platform affiliate status and multinational portfolio correlation values for affiliate are also time-varying, as they may change during the period owing to new affiliate investments and divestments.

The empirical results of a full sample hazard model, and split sample models with respect to affiliate platform status (host-country redundancy, Models 2 and 3) and multinational portfolio correlation (low vs high network redundancy, Models 4 and 5) are presented in Table B1. Model 1 (full sample) reconfirms the presence of hysteresis: the interaction effect between uncertainty and labor cost growth is significantly negative. Since the coefficients of the Cox model show the effect of a unit changes in independent variables on the proportional change in the single period divestment hazard (exp(x b )) and lend themselves to a direct interpretation as an elasticity (e.g., Cleves et al., 2004; Wooldridge, 2002), we also calculated the cross effect of uncertainty on the elasticity of the hazard with respect to labor cost growth.Footnote 19 Analysis of this cross derivative expressed as an elasticity shows that the moderating impact is negative for all observations and significant for 46% of the observations. Splitting the sample between host-country non-redundant (platform) affiliates (Model 2) and host-country redundant (non-platform) affiliates (Model 3) shows a significant hysteresis effect for non-redundant affiliates, but no such significant effect for redundant affiliates. The estimated cross-derivative for the non-redundant sample is negative for 78% of observations and significant for 46% of observations, while the cases of positive cross derivatives are never statistically significant. For redundant affiliates, the cross derivative is never significant. This provides confirmation for the presence of a hysteresis effect among non-redundant affiliates. Similar results are obtained for the subsample of affiliates that are non-redundant from a multinational portfolio perspective (affiliates with a multinational portfolio correlation below the median of 0.38, in Model 4): a significant interaction term and a negative cross derivative (throughout), which is significant for 70% of observations. For multinational portfolio redundant affiliates (Model 5), no significant hysteresis effect is found. (Table B1)

Table b1 Cox proportional hazard model of Japanese affiliate divestment in Asia, 1995–1998
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Belderbos, R., Zou, J. Real options and foreign affiliate divestments: A portfolio perspective. J Int Bus Stud 40, 600–620 (2009). https://doi.org/10.1057/jibs.2008.108

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