Joint Ventures and Risk Sharing

By Blenman, Lloyd P.; Xu, Mingxin | Journal of Business and Entrepreneurship, March 2009 | Go to article overview

Joint Ventures and Risk Sharing


Blenman, Lloyd P., Xu, Mingxin, Journal of Business and Entrepreneurship


ABSTRACT

We analyzed the problem of optimal risk sharing in a new joint venture, in a two-entity framework, where the new venture's products are sold in a competitive market environment. The two parties to the joint venture each have pre-existing risky projects, and the profit potential of the new venture is random. Risk is driven by Brownian motion processes; there is no debt, and the two entities act cooperatively. In this setting, optimal risk-sharing can be determined ex-ante, with a sure expectation of no ex-post negotiation, and the resulting solution will be stable. We found the square root sharing rule can be optimal and depends on the risk preferences of the venture partners, the time horizon of the joint venture, and the complementarity and substitutability of the new venture cash flows with those of existing projects owned by each partner.

(ProQuest: ... denotes formulae omitted.)

INTRODUCTION

There are several types of cooperative governance structures, production, and risk sharing mechanisms. Of these, the most prominent are strategic alliances, partnerships, and joint venture agreements. These types of agreements are typically drawn up for sharing technical information, undertaking joint research and development projects, sharing production costs, and interlocking equity stake holdings and joint ventures, either of the horizontal or vertical type.1

Joint ventures result from sharing the assets of two or more cooperating entities to create a new entity that may or may not have an independent management structure. In most cases, the amount of managerial control exerted over the new entity is a function of the relative bargaining strengths of the parties, as well as their respective capital contributions, equity stakes, and shares of the start-up costs of the venture.

Chan, Kensinger, Keown, and Martin (1997) found that strategic alliances, like joint ventures, generate positive mean share price reactions when announced. McConnell and Nantell (1985) found that joint ventures are wealth-increasing and attribute the share price gains to synergies. Chen and Ross (2003) analyzed the pricing strategy of joint ventures, where the venture cooperates in the production of a common input, and showed that a joint venture can replicate the effects of a full-scale merger of the parents. Chan et al. (1997) studied strategic alliances and found that there is a positive response to such announcements and there is no wealth transfer among the alliance partners. For horizontal alliances, which may include joint ventures, more value accrues to the partners when they pool and share technical information.

Some of the other reasons advanced for the rise of joint ventures include the avoidance of holdup problems (Williamson, 1979, 1983); transaction specificity, transaction uncertainty, and use as financing vehicles (Cai, 2003). The deterioration of the finances of an entity might propel a firm to seek a partner. Another possible motive is that joint ventures allow suppliers to share risks with buyers. Joint ventures reduce the size of the investment a supplier makes to fill an order, which puts less of its resources at risk and allows it to invest in a greater number of projects for a given amount of capital. If financial distress is costly, then risk sharing can increase value. Thus, risk sharing should be particularly important for risky suppliers and/or suppliers that are less diversified.

Johnson and Houston (2000) investigated firms and their suppliers in vertical joint ventures and found no evidence of risk sharing motives as drivers of joint ventures. However, they found synergistic gains for suppliers in vertical joint ventures and gains for joint partners in horizontal joint ventures. Reynolds and Snapp (1986), Kwoka (1989), and Chen and Ross (2000) studied the impact of joint ventures on competition. Chen and Ross (2000) showed that joint ventures could be used as a deterrent to the market entry of a rival and those joint ventures could be anticompetitive. …

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