Perfect partners

Foreign investment in China used to be restricted largely to alliances with struggling state-owned companies. The results were mixed, and some high profile failures gave alliances a bad name. Recently, however, foreign companies have been allowed to run their own enterprises in certain sectors, and they will soon be able to do so in several others as well.

For both foreign and Chinese investors, wholly owned ventures are, on average, more profitable than alliances. Yet in 2002, alliances attracted roughly half of China's record US$55bn in new foreign direct investment, and many companies expect to pursue more alliances. How come? It's not just because they remain the sole way to invest in the life insurance, securities and telecommunications sectors. Our research shows that, in many cases, they perform quite well. Indeed, if alliances are carefully chosen and skillfully run, they can be just as financially rewarding as wholly owned businesses.

In the six months to March 2003, we surveyed 31 companies in five industry sectors – automotive, basic materials, consumer goods and pharmaceuticals, energy, and high-tech and telecommunications – to learn about the goals, partnership structures and past performance of the 400-odd alliances these companies have undertaken in China. A majority were foreign-owned, the remainder Chinese. All expect to enter into more alliances in China during the next five years.

Upward of 90 per cent of the multinationals surveyed believe that their alliances in China perform at least as well as those in other emerging markets. Most foreign investors now judge the success of an alliance by its current profitability instead of by the longer-term strategic gains they used to pursue, such as learning how to operate in China, gaining access to its regulators, building market share or brand awareness and developing an export-manufacturing base. By contrast, the Chinese partners often place greater emphasis on acquiring Western management skills and production technologies and on the secure employment that comes with foreign joint ventures. However, among the 31 companies in our survey, we found big differences separating the strong and weak performers, which we identified by the proportion of their alliances that met or exceeded expectations (financial and strategic) and the proportion that operated in the black.

Whatever the sector, companies with the strongest alliance portfolios focus on three elements: choosing a Chinese partner that can add value to a business, keeping a close eye on the financial and operational progress of joint ventures, and restructuring them quickly if necessary. In years past, when multinational companies were typically willing to settle for long-term strategic benefits from their alliances, the competitive calibre of their Chinese partners didn't matter very much. Recently, however, many sectors in China's vast domestic market have become potentially profitable for international investors, and a number of local private companies have reached world-class levels of competitiveness.

Our research suggests that in this more attractive but more crowded market, a venture's profitability increasingly depends on the Chinese partner's ability to provide an immediate competitive advantage – for example, by helping to find low-cost workers and providing access to privileged assets such as distribution networks in growing markets, operating licenses, factories and land. High performers are almost four times likelier than poor ones to team up with the leading Chinese company in their sectors; a case in point is GM's alliance with Shanghai Automotive Industry Corporation – an alliance now into the partners' fourth successful venture producing cars, minibuses and trucks. But as many of China's industries mature and consolidate, strong partners are harder to find.

The second critical factor for foreign investors is the way they monitor their ventures. Because some Chinese companies are interested primarily in the skills and technologies that outsiders bring to an alliance, foreign partners need to formulate and convey their financial targets clearly at the outset and to demand from their alliances the same depth and types of information they demand from their own businesses. About 80 per cent of the top players feel that they have an extremely good sense of the performance of their Chinese alliances, as compared with only 20 per cent of the weaker performers. Companies with successful ventures are more likely to give them informal lines of communication – for example, by scheduling regular gatherings to assess their operational performance and by resolving issues outside of board meetings.

Last, leading companies give partnerships time to develop but act quickly to restructure those that are not meeting their targets – for example, by adjusting the ownership split and each partner's contributions of capital, changing the composition of the board and management, buying or selling assets, reviewing third-party contracts and adjusting operational targets. Every company we surveyed found these actions difficult to undertake for several reasons, including regulatory restrictions, fear of harming the partner relationship and the high cost of restructuring. Yet businesses that overcome such obstacles generally reap the rewards: strong performers have restructured 35 per cent of their alliances, on average, and 88 per cent of their alliances now meet objectives. By contrast, though only 14 per cent of the laggards' ventures do so, only about 15 per cent of them have been restructured. China's market is growing and changing so quickly that the stronger performers now assume that even their most successful joint ventures may require restructuring at some point.

Peter Kenevan is a principal in McKinsey's Tokyo office, and Xi Pei is a consultant in the Shanghai office. This article was originally published in The McKinsey Quarterly , 2003 Number 3, and can be found on http://www.mckinseyquarterly.com. Copyright . 2003 McKinsey & Co. All rights reserved. Reprinted by permission.