When Do Alliances Make Sense?

Image: {Shutterstock}

To answer one of the oldest business quandaries—is it better to partner or go solo on a project—John Beshears looked for answers in an unusual place: the oil and gas drilling industry in the Gulf of Mexico.

But instead of mining for energy sources, Beshears dug for data. And what he found was a treasure trove that could help businesses plan their alliance strategy.

Firms often ask this question when considering a large project. It can be advantageous to partner with another company, pooling resources, sharing expertise, and spreading out risk. On the other hand, forming alliances also requires coordinating tasks and merging cultures, which can often be difficult and costly to achieve.

Business theorists have long pursued this question in an effort to determine the best and most efficient organizational form for a business. "There has been a lot of fascinating and important literature on this topic," says Beshears, Harvard Business School assistant professor, "but for the most part, it doesn't get beyond anecdotal evidence."

That's because it can be extremely difficult to compare solo firms and alliances head-to-head in a meaningful way, which requires measuring their performance in similar situations. "When you see an alliance over here, and a solo firm over there, there's a good reason for that," says Beshears. "That's because the alliance is probably particularly good for the investment projects it is pursuing, and the solo firm is probably particularly good for its projects."

But just because a firm decides to form an alliance in one case and not in another doesn't mean it's making the most efficient choice, says Beshears, an empirical researcher who has been interested in this age-old question since graduate school. In order to answer it, he looked around for some kind of hard data that would allow him to make an apples-to-apples comparison of which form was better—and under what circumstances an alliance might make more sense than operating solo.

He found it in a unique set of data: leases for oil and gas drilling in the Gulf of Mexico. Firms competing to drill in the region have historically bid on 5,000-acre tracts, submitting sealed bids with lease rights awarded to the highest bidder.

"I stumbled across this data set, which other people had been using to look at auction bidding behavior," says Beshears. "When I saw it I realized that it was a wonderful place to go beyond the anecdotal evidence to look at organizational performance."

That's because firms bid for contracts both as single entities and in alliances with other firms. By looking at cases in which a solo firm narrowly outbid an alliance—or vice versa—Beshears could be confident he was looking at situations in which both types of business organizations were developing comparable tracts. In other words, because only the luck of having a slightly higher bid determined the winner, neither firm had an inherent advantage.

That gave Beshears the apples-to-apples comparison of performance that had long been sought by researchers looking to answer this question of organizational form. In order to judge that performance, Beshears waded through thousands of public documents from the Department of the Interior that detailed bid price and profits from 1954 to 1975. He reported his findings in a paper published in the Journal of Financial Economics last year, The Performance of Corporate Alliances: Evidence from Oil and Gas Drilling in the Gulf of Mexico .

Examining the net profits of those leases for which solo firms and alliances narrowly outbid one another, Beshears concludes that alliances are in fact more efficient than solo firms, earning an average of $31 million more over the life of a lease.

Of course, that number doesn't answer why or under what circumstances alliances excel. In order to examine that question further, Beshears looked at various firms' experiences drilling in particular areas in the Gulf. The underwater topography of the region is varied—with tracts having different depths and types of rock or soil that present unique drilling challenges.

Beshears found that alliances produce more profit when at least two firms in the partnership had experience drilling in that particular area. In areas where that wasn't the case, the profit difference between alliances and solo firms was practically zero.

"What that suggests to me is that the members of an alliance were able to learn something from their past experience and contribute that to achieve a better outcome," he says.

That lesson could be applied more broadly to other industries, says Beshears, suggesting that an alliance makes sense where firms have complementary knowledge. If that knowledge differential isn't present, an alliance may not make sense due to increased coordination costs.

"If an alliance is so much better, why isn't everything done by alliance?" asks Beshears. "The reason is that it can sometimes be very costly."

Those costs are incurred in two ways. First, there is the logistical expense of setting up communication between firms—which can be particularly difficult with companies separated by distance or technology. Second, an alliance can be hampered when the two companies involved don't agree on the goal they are trying to achieve, leading to time delays or other costs.

"When there's no clear objective, that's when alliances can get into trouble—they spend all of their time arguing about what they are trying to accomplish."

In other words, Beshears's findings show that in business, as in life, two heads are often better than one. But only if they know different things—and agree on what is to be done.

[This article was provided with permission from Harvard Business School Working Knowledge.]