Rewriting the Playbook for Corporate Partnerships

In fast-changing markets, some companies are developing more flexible, adaptive strategic partnerships to leverage the resources and capabilities of both customers and suppliers.

Today’s business environment is unforgiving of companies that are slow to adapt. To extend their capabilities and facilitate change, many organizations have experimented with different types of strategic partnerships with suppliers and customers that help them design and deliver products and services efficiently. But some innovative companies are attempting to redefine the parameters of strategic partnerships as we know them, navigating between the risk of being exploited by an opportunistic partner and the risk of being trapped in the rigidities of vertical integration. These organizations have initiated multileveled relationships with customers and suppliers that leverage the resources and capabilities of the respective parties in an effort to create superior products and services.

What makes such partnerships — which I call adaptive strategic partnerships — counter-intuitive is that they are being formed in situations where the two most relevant streams of organizational economics would predict vertical integration.1 Moreover, managerial literature cautions against establishing customer-supplier agreements that, like those contemplated here, lack conditions of specifiability, verifiability and predictability.2

Bharti Airtel Ltd., a telecommunications services company based in New Delhi, India, is among a growing group of companies that have nevertheless elected to take a different path. Back in 2004, Bharti Airtel, currently the world’s third largest wireless telecom service provider, with more than 275 million subscribers in 20 countries, was struggling to keep up with the growth of India’s wireless telecom market while also competing for broadband and landline telephone customers. Increasingly, Bharti Airtel managers found that negotiating and updating contracts with vendors interfered with their ability to focus on satisfying customers and outsmarting the company’s competition. Contrary to what other telecom operators have done, Bharti Airtel negotiated unconventional relationships with some of its leading vendors, including Nokia Siemens Networks (now Nokia Solutions and Networks), Ericsson and IBM — vendors whose interests at times have collided with its own.

Typically, companies with outside partners rely on simple tools such as service-level agreements, which specify what is expected from each party and provide for performance standards to assess compliance. But in rapidly changing business environments where companies are making decisions every day about how to evolve their products and services to surpass their customers’ expectations, such agreements can have limited effect. They can also lead to problems down the line, because they call for levels of service that are meaningful at the time of the negotiation but less so as service needs change. Bharti Airtel wanted to have a greater level of coordination to facilitate its contemplated expansion in India’s (and later, the emerging world’s) wireless communications market.

Bharti Airtel’s relationships with partners Ericsson, Nokia Siemens and IBM were fundamentally different from the more traditional business partnerships other telecom companies favored. Instead of expanding network infrastructure by purchasing increasing amounts of equipment (such as exchanges and cellular antennas), which often results in unused capacity, Bharti Airtel pays the vendors to operate the network; it compensates them based on telecom volume (measured in “erlangs”), paying only when equipment is in use. In addition to rethinking the approach to network capacity, vendors take responsibility for network performance and troubleshooting. To facilitate this transfer, Bharti Airtel gives vendors access not just to data on usage but also to sensitive strategic information, such as demand forecasts and expansion plans. By having a more open information exchange, Bharti Airtel’s suppliers can optimize their delivery schedules and leverage their knowledge of building capacity with less equipment; Bharti, in the meantime, avoids the cost of having to buffer excess capacity and frees management to focus on developing the relationships with the company’s own customers. Without being solely responsible for the equipment risk, it can invest more heavily in capacity, which, in turn, benefits the suppliers through higher upfront equipment sales and fewer rush orders.

In managing its partnerships with vendors, Bharti Airtel uses a joint governing structure that encourages people at different levels of the organizations to communicate and address problems as they arise (for example, restoring service after a severe storm). In some cases, such interactions have led the company and its partners to redraw the scope of their collaborations (for example, assign responsibility for building and maintaining the cell towers to a new company), something that would be more difficult to do in a more traditional partnership. With flexible contracts, the companies can adapt to shifts in the competitive environment and implementation challenges. The incentive system rewards vendors for efficient network management. By sharing information, Bharti Airtel and its telecom equipment providers are incentivized to develop processes that advance learning, innovation and mutual trust.

Since implementing its contracts with its strategic vendors, Bharti Airtel’s total customer base has grown at an annual rate of more than 35%,3 and the company has maintained its leadership position in the Indian wireless market. Much of Bharti Airtel’s growth and success can be attributed to the way it has structured its relationships with vendors. Its adaptive strategic partnerships break some traditional rules of business relationships by outsourcing core capabilities to partners and being somewhat loose in specifying what the partners are expected to do. As a result, building such partnerships can be more easily said than done. But for companies in fluid environments, these partnerships offer opportunities for strategic leadership and adaptability.

The examples in this article involve a customer and a supplier uniting their efforts to navigate in an uncertain world. However, most of the insights presented here could also apply to other types of strategic alliances (such as horizontal alliances between different businesses in the same part of the value chain).4 (See “About the Research.”)

A New Framework for Adaptive Strategic Partnering

The traditional relationship framework for governing interactions between two or more organizations assumes that the different parties act in their own self-interest. Whether a company sells a machine tool to a customer (a transaction) or buys a maintenance contract for a piece of equipment from a service provider (a relationship), the ultimate objective for each side is to get a larger share of the overall value. Companies, therefore, try to curb opportunistic behavior by other players that deprives them of potential benefits.5

Although it is impossible to anticipate all possible contingencies, customer relationships have traditionally been defined by contracts that include detailed service-level agreements and rewards and penalties linked to performance specifications. In this context, parties share information on an event-driven, need-to-know basis in order to measure performance or to indicate a need to renegotiate terms based on unexpected events.

Traditionally, parties not satisfied by this type of institutional framework have opted for vertical integration. However, the cost of vertical integration is often considered too high in light of the technology and business risks. What’s more, changes in the talent market have shifted the balance toward flexible partnerships; many high-caliber professionals prefer environments in which they can learn and grow by working with leaders in their field. Many analytics specialists, for example, might prefer working for IBM doing big data analytics to working in the information technology department of a less analytically sophisticated company. The result: Many organizations outsource functions that were formerly considered core to their business.

When outside entities control core business functions, the traditional relationship framework — which includes setting detailed specifications, pursuing costly renegotiations and participating in limited information exchanges — is not consistent with the conditions necessary for successful adaptive strategic partnerships; traditional contracts discourage flexibility, stifle innovation and erode trust. A new institutional framework is required.

Adaptive strategic partnerships can provide an effective vehicle under three conditions: (1) The product or service in question is of strategic importance to the customer; (2) the vendor or service provider has more domain expertise than the customer; and (3) the evolution, outcome and purpose of the relationship are fairly uncertain.

If (2) and (3) are present but (1) is not, then it’s usually adequate to pursue short-term contracts and to renegotiate them as necessary. If (1) and (3) are present but (2) is not, it is more efficient for the customer to perform the function internally. Finally, if (1) and (2) are present but (3) is not, the traditional contracting environment, with detailed service-level agreements specifying the supplier outputs, is usually the best choice. Although adaptive strategic partnerships are by no means a universal solution, the range of circumstances where they are worth consideration is increasing, particularly in emerging markets and rapidly changing industries such as telecommunications and information technology. (See “When to Consider Adaptive Strategic Partnering.”)

Companies like Bharti Airtel that are moving away from traditional customer-supplier relationships toward adaptive strategic partnerships are shifting the institutional framework on three dimensions: (1) incentives, (2) information and (3) collaboration mechanisms. By managing across these dimensions, they are paving the way for a new level of collaboration. (See “Changing the Relationship Framework.”

Incentives

Relationships between companies and their suppliers and customers frequently break down, not because they don’t create value but because of disputes over what is seen as an attempt by the other side to capture an unfair share of value. Innovation suffers as well; no one wants to innovate for fear of not being rewarded. The road to success in adaptive strategic partnering needs to start with incentive arrangements that focus partners on joint value creation rather than on value distribution.

Detailed service-level agreements with steep financial rewards and penalties linked to prespecified performance parameters often lead to opportunistic behavior. Incentives often encourage parties to focus on the things that entitle them to receive rewards, and performance indicators are selected to encourage parties to produce what the other side wants. Unfortunately, the performance indicators are almost never perfect proxies for true value. In complying with the letter of the contract, parties may violate the spirit of the relationship.6 For example, the service agreements for call center operators sometimes specify the amount of time service reps can spend talking with a customer, with little flexibility for the cases that require extra time. The result: Some customers end up being treated rudely.

Adaptive strategic partnerships, by contrast, encourage incentive systems that support innovation and the partnership’s success. The incentives tend to be “flatter” and more linked to the totality of the relationship and the value and profits the relationship generates. While there is a risk that suppliers will become complacent as they gain familiarity with the client and as the cost of switching to other suppliers increases, that risk is relatively minor compared with the potential benefits.

As the supplier internalizes the client’s problems, there’s an opportunity to refocus the incentive system from the individual inputs/actions of the exchange (time and materials) to more comprehensive aspects of the collaboration (the project or set of projects). That is essentially what Carrefour S.A., the French retail chain, did several years ago when it decided to redesign its purchasing function. Under the old system, Carrefour set an annual list price and negotiated individual promotions with consumer packaged goods manufacturers. However, that approach prevented the retailer and its suppliers from collaborating on market intelligence and created an adversarial dynamic. Carrefour pushed to get as many promotional dollars as possible from the manufacturers; the manufacturers, in turn, aimed to minimize that amount while keeping Carrefour happy. Under the new arrangement, Carrefour awards decision rights typically assumed by the retailer to one supplier (or “category captain”) in each product category. That supplier has access to sales information for the category and decides which products and formats Carrefour will carry, as well as the shelf space and location of each product. In exchange, the suppliers commit to an annual target for the total margin generated by the category.

Of course, the ultimate mechanism for aligning incentives is revenue or profit sharing. To compensate IBM for managing its IT system, for example, Bharti Airtel provides IBM with a percentage of its revenues. That gives IBM a vested stake in the outcome of its own innovations. Normally, revenue sharing in such situations is regarded as inappropriate — after all, the link between IBM’s actions and Bharti Airtel’s revenues is fairly remote. However, the decision to share revenue has positive overall effects in terms of building trust and supporting innovation and flexibility.7 Because IBM has much to gain in the future, it is less tempted to emphasize short-term performance.

It’s no accident, then, that telecom companies located in emerging markets are among the leaders in the development of innovative partnerships and revenue-sharing agreements. However, some of the same principles are being used at other rapidly growing companies in young industries. Sanjay Purohit, senior vice president responsible for products, platforms and solutions at Infosys, a major provider of business, consulting, information technology, software engineering and outsourcing services that is based in Bangalore, notes that “an openness to innovative arrangements such as revenue sharing is being shaped by three factors: (1) a cultural aversion to risk, (2) an orientation toward growth and impatience with inaction, and (3) a competitive environment, which makes people more open to trying new things that will allow them to stay ahead of the curve.”8

The spirit of revenue sharing and risk sharing underlines the sense that partnering is a “joint and several” venture. Both partners should be rewarded for the success of the venture, and both partners should take responsibility for its setbacks. The surest way to undermine the spirit of such a relationship is to point the finger of blame at the other party. A classic example of this danger can be found in the very public clash between Ford Motor Co. and Firestone in 2000, which came to a head following press reports about rollovers, injuries and deaths from the failure of Firestone tires on Ford Explorer SUVs. Ford publicly stated that the problem was the tires, and Firestone responded by contending that the Explorer’s design contributed to the problem.9 The accusations destroyed the trust the companies had built during almost a century of collaboration.

In working out the terms of their business relationship, Seattle’s Virginia Mason Medical Center and Owens & Minor, a distributor of medical and surgical supplies based in Mechanicsville, Virginia, were well aware of the risks of adversarial customer-supplier relationships and took conscious steps to create a different kind of partnership. Traditionally, the fee structure in the medical and surgical supplies distribution industry is based on cost-plus pricing — adding a fixed percentage of the cost of the products delivered. However, this pricing structure can create perverse incentives for hospitals to cherry-pick which items to buy directly from the manufacturer, as well as careless planning that results in too many rush orders. For Owens & Minor, the traditional pricing structure led to high costs and low margins, hurting its profitability. Therefore, it proposed a more efficient supply chain and offered to share whatever savings it created with the medical center. In working out the agreement, the two parties anticipated that there would be process failures (for example, out-of-stock surgical rooms), but they didn’t establish any penalties. Instead, they agreed to share the cost of all errors and defects equally.10 As a result, the emphasis shifted away from who caused the problems to resolving them.

Information

Another important tenet of effective partnerships is open and extensive information sharing. The information environment in traditional customer relationships is often characterized by detailed definitions of the data to be measured and the targeted performance levels for each metric. Service-level agreements are based on a philosophy of compliance and designed so that predetermined triggers result in price adjustments, contract extensions or new orders.

In adaptive strategic partnering, the purpose of information exchange goes far beyond compliance; having common information allows partners to solve problems together and allows suppliers to anticipate and define customer needs. Although compliance is still important, the number of metrics linked to rewards and penalties is fewer, and the most helpful ones are those that reflect the performance of the partners vis-à-vis their end customers.11 Having just a few metrics can result in fewer arguments and greater emphasis on the outcomes that are important to the success of the partnership. In Infosys’s partnership with a major U.S. retailer, for example, one of the most important performance measures is the number of out-of-stock items at the client’s stores. This metric is far more relevant to the retailer than the number of bugs in the company’s stock-replenishment software.

Organizations that want to achieve success with adaptive strategic partnering give less weight to compensation linked to metrics and more weight to building a common understanding of opportunities to create value. In fact, contracts are often longer and the number of operating indicators exchanged larger as partnerships evolve and as clients and suppliers get to know each other better.12 That’s because contracts fulfill two distinct roles: (1) the traditional role of formalizing the rights and obligations of the parties to it and (2) helping customers and suppliers identify and communicate their expectations about their contributions to and benefits from the relationship, which can be more important in this context.13

Monitoring delivery on preconceived expectations is not enough to build superior competitive strength. Infosys, for example, uses what it calls a “relationship scorecard” (a type of balanced scorecard) to support information exchange with key customers. The scorecard includes metrics representing current developments in the relationship (such as the number of improvement suggestions approved by the client), each party’s business performance and the alliance’s future potential.14 Infosys managers say that sharing such information helps maintain a holistic view of the partnership and how it fits within the bigger picture of the client’s strategic priorities. Given that the purpose of the exchange is problem solving rather than performance evaluation, it is more flexible than a set of operational metrics would be.

Successful collaborations recognize that reliable information is essential to establishing trust with suppliers, and the absence of credible information can erode trust and destroy opportunities for collaboration. The experience of Metalcraft15 (a pseudonym for an actual auto supplier) underlines this principle. Metalcraft’s supplier scorecard, which it used to rate and classify suppliers, produced detailed supplier performance reports that were designed to promote continuous improvement. In an effort to build flexible and constructive relationships with its suppliers, the company gave its own sourcing managers the authority to “adjust” the measurements when they felt that circumstances warranted it. The intent was to avoid situations in which a strict application of a sourcing agreement would lead to an unfair result — for example, the placement of a good supplier on the no-order list. However, some suppliers cried foul; they considered the adjustments to be arbitrary and blatantly unfair. They lost faith in the fairness of Metalcraft’s decisions and in the scorecard system itself.

Information mistrust can be the result of widespread practices in certain industries. For example, a McKinsey & Co. study documented that in high-tech supply chains, clients’ fear that common suppliers may leak confidential information to their competitors leads them to share projections that are inaccurate. Suppliers interpret this information with clients’ biases in mind, thus further undermining the efficiency of the supply chain.16

Collaboration Mechanisms

Although establishing incentives for value creation and generating information exchanges are extremely important, they are not enough. Partnerships also need mechanisms that allow partners to join forces in generating value. The best partnerships create processes that promote learning, trust and adaptability to a changing competitive environment. (See “New Mechanisms for Collaboration.”)

One of the virtues of traditional service-level agreements was clarity. When circumstances changed (for example, the price of oil increased), there were specified consequences and remedies. Of course, anticipating every contingency is difficult, even impossible. Still, when unforeseen events do occur, organizations need mechanisms for renegotiating their agreements.

The new paradigm for adaptive strategic partnering does not completely eliminate the need for contracts. However, so that the organizations involved can adapt to changing circumstances, contracts are no longer the law governing the parties’ actions. In practice, the negotiation process (during which both parties discuss what they expect and the value that they aim to create) is more important than the contract itself.17 As observed by Akhil Gupta, deputy group CEO and managing director of Bharti Enterprises, Bharti Airtel’s parent company, “The key to minimizing conflict between partners is to write contracts that are simple enough so they leave room to the pragmatism of the parties to make things work.… If circumstances show us that things are not working, then, together with our partners, we have no problem in reinterpreting or redefining the contract.”18

In adaptive strategic partnering, the driving principle is problem solving, and the institutional center of gravity is a decision-making body (often a steering committee) charged with surveying the progress of the relationship and maintaining a big-picture perspective. Traditionally, a committee with representatives from different sides would be a clear acknowledgment that the relationship is financially significant. In adaptive strategic partnering, however, the committee plays a more comprehensive role. Customers use such a forum to learn how the relationship is helping (or has the potential to help) their competitive position. For suppliers, committee meetings can provide information on new skills they might acquire in order to work more effectively with the client. Having senior leadership involved in the committees can be a huge plus: It can help in securing critical resources and magnifies the potential impact. Infosys, for example, assigns a member of its management committee (its top executive body) to the steering committee of each of its major clients.

Regular and open communication between the operating levels of the organization is essential. Scheduling periodic performance reviews at the operating level and knowing who to go to when problems occur are two mechanisms that facilitate day-to-day communication. The goal is to solve problems as opposed to assigning blame. At Bharti Airtel, for example, dispute resolution mechanisms have been created but are rarely used; typically, managers step in to solve the operating problems before formal intervention is necessary.

No governance framework is complete without highlighting three types of agreements that are typical in adaptive strategic partnering: exit agreements, noncompete clauses and rights of first refusal. These mechanisms contribute to flexibility, innovation and trust, providing opportunities on both sides to improve the partnership.

1. Exit Options

Bharti Airtel had a well-defined exit option with its network management companies, facilitated by the fact that the standard equipment it used could easily be redeployed by another company. In cases where the assets are more specific, a detailed plan is necessary for transitioning assets, personnel and knowledge. Exit options in partnerships are similar to prenuptial agreements: The parties enter the agreements hoping that they will not need to terminate them. Rather than being a symptom of a lack of trust, they enable partners to commit more fully to the relationship by controlling the damage in case of failure.19

2. Noncompete Clauses

There are conflicting views about noncompete clauses as well. If a supplier cannot apply the knowledge developed in a partnership to other client situations, it will be cut off from one of the major sources of value and lose some of its incentive to innovate.20 Moreover, sharing knowledge across different customers advances the supplier’s learning curve and generates operating scale, which can directly benefit clients. But clients may be reluctant to collaborate with suppliers that can transfer the competitive advantage developed in the partnership to competitors. My research suggests that absolute prohibitions on working for or extending innovations to other organizations — even competitors — are rare in adaptive strategic partnerships.

3. Rights of First Refusal

Partnership contracts and memoranda of understanding often give suppliers an explicit right of first refusal in areas close to the current scope of collaboration. For instance, Infosys’s customers that build relationship scorecards typically promise Infosys the opportunity to bid on new projects before opening the process to other suppliers. Such agreements symbolically reinforce the trust necessary to sustain the partnership.

Managers are exploring new structures for relationships between vendors and customers to address today’s circumstances. Companies are learning to respond to the changing market requirements, and the relationships they develop will continue to evolve to meet the challenges of innovation, flexibility and trust. Although the specific elements of the relationships will differ, the basic principles presented in this article could help companies navigate the uncertain future.

References

1. Those two streams of organizational economics are Williamson’s transaction cost economics and Hart’s property rights theory. See O.E. Williamson, “Transaction-Cost Economics: The Governance of Contractual Relations,” Journal of Law and Economics 22, no. 2 (October 1979): 233-262; and O. Hart, “Firms, Contracts and Financial Structure” (Oxford, United Kingdom: Oxford University Press, 1995).

2. C.M. Christensen and M.E. Raynor, “The Innovator’s Solution: Creating and Sustaining Successful Growth” (Boston: Harvard Business School Press, 2003), 137.

3. The compound annual growth rate of Bharti Airtel’s revenues in Indian rupees for the 2004-2013 period was 36%. The growth rate in U.S. dollars for the same period was 33%, reflecting a 20% devaluation of the Indian rupee against the U.S. dollar in 2013.

4. An excellent overview of the related organizational economics literature is R. Gibbons and J. Roberts, eds., “The Handbook of Organizational Economics” (Princeton, New Jersey: Princeton University Press, 2012). See also J. Oxley, “Appropriability Hazards and Governance in Strategic Alliances: A Transaction Cost Approach,” Journal of Law, Economics & Organization 13, no. 2 (October 1997): 387-409, which discusses how the degree of appropriability hazard leads to a continuum of relationships that go from the arms-length transaction to vertical integration; J.H. Dyer and H. Singh, “The Relational View: Cooperative Strategy and Sources of Interorganizational Competitive Advantage,” Academy of Management Review 23, no. 4 (October 1998): 660-679; and J.H. Dyer, P. Kale and H. Singh, “How to Make Strategic Alliances Work,” MIT Sloan Management Review 42, no. 4 (summer 2001): 37-43. The latter articles view the capability to develop strategic alliances as a difficult-to-replicate core competency and a main source of competitive advantage. Finally, R. Gulati, “Social Structure and Alliance Formation Patterns: A Longitudinal Analysis,” Administrative Science Quarterly 40, no. 4 (December 1995): 619-652, presents the sociological view of strategic alliances.

5. O.E. Williamson, “The Economic Institutions of Capitalism: Firms, Markets, Relational Contracting” (New York: Free Press, 1985).

6. S. Kerr, “On the Folly of Rewarding A, While Hoping for B,” Academy of Management Journal 18, no. 4 (December 1975): 769-783.

7. P. Casas-Arce and T. Kittsteiner, “Opportunism and Incomplete Contracts,” working paper, Arizona State University, 2010.

8. S. Purohit, interview with author, July 21, 2010.

9. T. Aeppel, C. Ansberry, M. Geyelin and R.L. Simison, “Road Signs: How Ford, Firestone Let the Warnings Slide by as Debacle Developed,” Wall Street Journal, Sept. 6, 2000.

10. V.G. Narayanan and L. Brem, “Supply Chain Partners: Virginia Mason and Owens & Minor (A),” Harvard Business School case no. 109-076 (Boston: Harvard Business School Publishing, 2009).

11. D. Boskovic and S. Hariramasamy, “Next Generation IT ADM O&O” (presented at the Seventh Annual Conference on Outsourcing and Offshoring, McKinsey & Co., New York, Nov. 13, 2008). In a comparative study of two application-development relationships in the financial services sector that had met with widely different success, Boskovic and Hariramasamy found that one of the critical differences between successful and unsuccessful relationships was the concentration of quality assurance on only four points of the life cycle versus in all the deliverables.

12. M.D. Ryall and R.C. Sampson, “Formal Contracts in the Presence of Relational Enforcement Mechanisms: Evidence from Technology Development Projects,” Management Science 55, no. 6 (June 2009): 906-925.

13. O. Hart and J. Moore, “Contracts as Reference Points,” Quarterly Journal of Economics 123, no. 1 (February 2008): 1-48; and E. Fehr, O. Hart and C. Zehnder, “Contracts as Reference Points — Experimental Evidence,” American Economic Review 101, no. 2 (April 2011): 493-525.

14. K. Miller, R.S. Kaplan and F.A. Martínez-Jerez, “Infosys’ Relationship Scorecard: Measuring Transformational Partnerships,” Harvard Business School case no. 109-006 (Boston: Harvard Business School Publishing, 2008).

15. V.G. Narayanan, S. Kulp and R.L. Verkleeren, “Metalcraft Supplier Scorecard,” Harvard Business School case no. 102-047 (Boston: Harvard Business School Publishing, 2002).

16. G. Grover, E. Lau and V. Sharma, “Building Better Links in High-Tech Supply Chains,” McKinsey Quarterly 14 (winter 2008): 14-19.

17. Hart and Moore, “Contracts as Reference Points.”

18. A. Gupta, interview with author, Jan. 2, 2009.

19. B.R. Klein, G. Crawford and A.A. Alchian, “Vertical Integration, Appropriable Rents, and the Competitive Contracting Process,” Journal of Law and Economics 21, no. 2 (October 1978): 297-326.

20. S. Samila and O. Sorenson, “Noncompete Covenants: Incentives to Innovate or Impediments to Growth,” Management Science 57, no. 3 (March 2011): 425-438. Samila and Sorenson show that in states where noncompete clauses are enforced, there is less innovation, as well as fewer startups and lower employment growth.