Controlling Joint Venture Risk

Internal Auditor, June, 2001 by Dennis B. Applegate

With the proliferation of strategic alliances in the corporate business world, internal auditors are being challenged to use innovative audit techniques to assist management in planning, controlling, and monitoring these newly created business opportunities.

OVER THE LAST DECADE, JOINT VENTURES HAVE gained renewed prominence as companies seek to expand their business base without incurring the high cost of merging or restructuring. Joint ventures offer companies potential revenue growth that is usually achieved using one of two approaches: the historical approach, which involves a constant stream of innovative products and services or the modern approach, which leverages innovation through business alliances into new markets. According to research by Deloitte & Touche LLP, 25 of the most active alliance companies generate returns 50 percent greater than the Fortune 500, on average. In 2000 alone, nearly 20 percent of all corporate revenue was estimated to be derived from strategic business alliances, primarily joint ventures.

Yet, next to mergers and acquisitions, joint ventures are considered the highest risk and most problematic of all strategic alliances. According to the Deloitte & Touche research, over half of joint ventures survive less than four years because of poor planning, including overestimated market demand, undetected changes in the business environment, and weak leadership structures that lead to poor partner-company integration. Inadequate due diligence is another reason they sometimes fail. Companies often do not properly screen their potential partners, resulting in unexpected cultural differences or the wrong partner being selected for the intended business purpose.

Clearly companies that properly implement joint ventures stand to gain much. But there are inherent risks in joint venture planning, due diligence, operations, and divestiture that can destroy value creation. Internal auditors can employ their control assurance knowledge and skill to assist management in creating value for investors through joint ventures.

PROCESS CONTROLS

Because internal auditors assist management in assessing risk and ensuring that controls are working as intended, it is imperative that they become involved in all phases of joint venture formation and operation. A well-designed and controlled joint venture planning process contains four phases: concept, analytic, development, and pre-operation. The business development department -- strategic planning and marketing -- controls the first three phases of the process, while the operating business division takes responsibility for the last phase. The business resources department -- mainly finance and contracts -- owns the planning process and monitors compliance with established procedures. By taking someone outside the process to monitor the adequacy of internal controls, these procedures become a unique segregation of duties, consistent with the Committee of Sponsoring Organizations (COSO) of the Treadway Commissions Internal Control -- Integrated Framework.

CONCEPT PHASE In the concept phase, aventure idea surfaces, usually from someone outside the company who is looking for finding (see "Concept Phase -- Business Development," page 46). The organization then assigns an opportunity manager and prepares a summary of the idea, which is routed for review and comment. Based on feedback received, the business development department determines whether the idea is worthy of further analysis. If not, lessons learned are prepared and stored to prevent wasting time and effort should the idea resurface -- a good feedforward control.

There are two important control areas in this phase of the process. The first, strategic and technical fit, considers whether there is a business concept and strategy in place that provides a choice among potential partners. Many large companies with excess cash merely react to ideas from potential partners, rather than initiating the ideas themselves. Companies should look for value as a leader and not get drawn into a deal with the first potential partner who has an idea for a market that matches the company's current interest. Knowing a potential partner's business plan and core competencies will help direct a company to a wider array of would-be partners of potentially greater compatibility.

The second control area pertains to partner assessment: The wrong partner can doom a venture. Assume, for instance, that market access is the goal. Even though the market may be right, the potential partners may not be good "market access" partners that can provide the necessary entree to new customers. Thus, potential partners are continuously assessed at each phase of the planning process -- even as early as the concept phase -- to ensure they meet the comany's joint venture objectives.

ALNALYTIC PHASE In this phase, the business development department forms a deal team, led by the opportunity manager, and appropriate market, financing, and cost studies are conducted, possibly with consulting support (see "Analytic Phase -- Business Development," page 47). The company then defines its objectives and prepares a tentative venture plan. If appropriate the business development department may authorize due diligence of potential partners. However, the business resources department actually conducts he due diligence to ensure objectivity--a good segregation of duties.