Relationship with headquarters and divestments of foreign subsidiaries: The hysteresis perspective.

Author:Song, Sangcheol
Position:RESEARCH ARTICLE - Report

Abstract This paper examines the conditions under which foreign subsidiaries of multinational corporations (MNCs) are less prone to divestments. In the study, we examine the importance of foreign subsidiaries to MNCs based upon (1) product-level vertical integration, (2) human capital investments, and (3) technological investments in the subsidiaries. Given that we examine the probability that a subsidiary divestment will occur under the condition that all other subsidiaries are also at risk during the same time period, we employ a Cox proportional hazard rate model as a commonly used statistical method in the event history analysis. For empirical testing, we utilized a sample of Korean 439 MNCs and its 5306 foreign subsidiaries over a period of 1990-2011. We find that even under hostile host market demand conditions, MNCs are less likely to divest their foreign subsidiaries when those subsidiaries are vertically integrated with their headquarters, benefiting from a top management team dispatched from their headquarters or other affiliates, or possessing technological knowledge shared by their headquarters. These findings imply that relationship-specific investments with headquarters cause a hysteresis effect that deters these subsidiaries from being divested, even during times when divestments seem most likely because of unfriendly economic conditions in their host countries.

Keywords Vertical integration * Human capital investment * Technological investment * Hysteresis effect * Multinational corporation * Foriegn subsidiary divestment

1 Introduction

Divestments of the foreign subsidiaries of multinational corporations (MNCs) have long been of interest to international business researchers. MNCs' sales or closures of their foreign businesses reflects the level of MNC performance (Bauer 2006; Lee and Madhavan 2010; Yan and Zeng 1999), changes in their global strategies, and changes to their cross-country management of foreign asset portfolios (Bauer 2006; Chow and Hamilton 1993; Kumar 2005). For this reason, subsidiary divestment decisions are at least as important as subsidiary establishment decisions. Given that foreign subsidiaries are exposed to a variety of macroeconomic uncertainties (e.g., adverse macroeconomic conditions in host countries), not all subsidiaries survive and thus MNCs have to be strategic in their subsidiary divestment decisions (Benito 2005; Hennart et al. 1998; Kumar 2005; Mata and Portugal 2000).

However, not all foreign subsidiaries are uniformly divested under the same host market conditions; some subsidiaries are long lived even in hostile host country situations. In particular, the literature on hysteresis argues that some environmental and organizational factors induce the hysteresis effect and thus retard MNCs' divestment decisions. The notion of hysteresis indicates that certain deterrents make a firm less motivated to change its established choices even when situations change (Belderbos and Zou 2009; Bragger et al. 2003; Christophe 1997; Dixit 1989, 1992). The literature adopting this notion finds that certain environmental and organizational factors trigger a firm's counterintuitive behavior to stick to its established investment even though changes in underlying causes for the past choice have invalidated it (Belderbos and Zou 2009; Christophe 1997; Dixit 1992; O'Brien and Folta 2009). Hence, in terms of subsidiary divestments, the hysteresis effect, heightened by certain environmental and organizational factors, increases organizational inertia and deters MNCs from abandoning their foreign subsidiaries even when they are exposed to hostile host market conditions.

The purposes of this study are twofold. First, taking the hysteresis perspective as a point of departure, we examine why MNCs do not abandon their foreign subsidiaries under hostile market conditions. Second, we investigate the organizational factors that explain subsidiary divestments. Compared with environmental and investment factors which are frequently examined in real options and/or sunk cost studies, organizational factors are under-researched. Further, the hysteresis effect, owing to the specific relationship between headquarters and their foreign subsidiaries, is a crucial but rarely examined phenomenon. Given that certain investments in foreign subsidiaries by parent MNCs reflects the strategic importance of those subsidiaries, it is thus important to examine whether the hysteresis effect reduces the divestment rates of MNC subsidiaries facing unfavorable market conditions in their host countries.

By using a dataset of Korean MNCs' foreign subsidiaries, we examine both the environmental conditions of host countries and the nature of intra-firm connectedness between subsidiaries and their headquarters, the latter of which indicates each subsidiary's level of strategic importance. Since the hysteresis perspective focuses on continued commitment to a current strategic position even under new hostile conditions, we first assess the impact of unfavorable economic conditions in the host country that trigger a subsidiary's divestment. We next examine three contingent factors that reflect the level of importance of subsidiaries to their headquarters: (1) product-level vertical integration, (2) human capital investment, and (3) technological investment. We find that all independent variables show the expected impact on foreign subsidiaries' divestments when exposed to declining market demand in their host countries, thereby supporting the hysteresis perspective.

2 Theory and Hypothesis Development

2.1 Subsidiary Divestments: The Hysteresis Effects of Relationship to Headquarters

For MNCs, foreign divestments are a challenging managerial issue given the decision requires the reversal of past diversification (Benito and Welch 1997; Haynes et al. 2003; Madura and Whyte 1990; Madura and Murdock 2012) and thus careful adjustments to international portfolios (Bauer 2006; Chow and Hamilton 1993; Kumar 2005). Aligning a firm's international portfolio with its new asset and resource allocations can lead to increased firm performance and longevity. The foreign divestment literature finds that divestments of MNC foreign subsidiaries are caused by several internal and external factors. In particular, MNCs are exposed to a variety of external uncertainties including changes in exchange rates, demand, and institutions (Cuypers and Martin 2010). Unpredictable and uncontrollable changes in macroeconomic factors within and across countries incur a large cost burden, leading to low performance and eventually divetment (Belderbos and Zou 2009; Buckley and Casson 1998; Chung et al. 2010; Huchzermeier and Cohen 1996). If an MNC cannot either overcome these cost pressures or find new business opportunities from its foreign subsidiary exposed to hostile host market conditions, the firm is more likely to abandon the subsidiary of concern (Benito 2005; Hennart et al. 1998; Mata and Portugal 2000).

Contrary to the traditional perspective on subsidiary exits, however, foreign subsidiaries exposed to unfriendly host market conditions are not necessarily exited. As noted in the Introduction, the literature adopting the notion of hysteresis argues that certain environmental and organizational factors widen the "hysteresis band" in which a firm neither increases nor decreases its established investment (Bowman and Hurry 1993; Christophe 1997; Dixit 1992; O'Brien and Folta 2009). In other words, a firm delays its response to changes in the underlying cause and maintains its initial choice considering that the effects of a current input (or stimulus) persist (Dixit 1989, 1992; Oliva et al. 1988). The hysteresis effect indicates that certain conditions increase organizational inertia; therefore, firms will engage in counterintuitive behavior such as continued investment following negative feedback (Bragger et al. 2003; Dixit 1989, 1992; Oliva et al. 1988). Relevantly, Gaur and Lu (2007) argue that institutional unfamiliarity may give MNCs arbitrage benefits. Once a subsidiary is divested, the arbitrage benefits and learning attached to these benefits also dissipate, giving another reason for slow responses.

A common argument of hysteresis-based research in the area of divestment is that the specificity of an investment increases organizational inertia, thereby maintaining the investment in the longer run without divestment decisions changing significantly. In the international business context, considering that foreign subsidiaries' operations are heavily dependent upon their headquarters' support, relationship-specific investment between foreign subsidiaries and their headquarters is thus expected to affect hysteresis-driven organizational inertia. Such relationship-specific investment is affected by the governance structure related to the headquarters-subsidiary relationship. The specificity of foreign direct investment is more salient when foreign subsidiaries are controlled and managed by the headquarters. The greater the strategic importance of certain subsidiaries from the headquarters' standpoints, the more they receive special care and a favorable allocation of physical, human, and intangible resources. Hence, foreign subsidiaries' close ties with their headquarters can provide organizational slack and thus help them buffer against the environmental challenges associated with adverse host market conditions.

This close relationship between headquarters and foreign subsidiaries is observed among emerging market MNCs. Compared with MNCs from developed countries, MNCs from emerging markets or newly industrialized economies have a more headquarters-centered strategy based around vertical integration. Further, these MNCs have unique organizational cultures, which are embedded in business groups to address institutional voids. For example, compared with their counterparts in Japan, Samsung Electronics and LG Electronics, as two...

To continue reading