Formal Institutions and the Governance of Equity-Based Subsidiary Investments Established by Foreign-Investing SMEs in Emerging Markets

Prior research pertaining to the relationship between formal institutions and the governance of equity-based subsidiary investments (wholly-owned subsidiary or joint venture (JV) partnership) established by foreign-investing small-to-medium-sized enterprises (SMEs) in overseas markets has generated equivocal results. To reconcile these disparate findings, we propose a more fine-grained conceptualization of the formal institutions construct. More specifically, we employ an uncertainty-grounded lens to categorize formal institutions in terms of the distinct varieties of uncertainty (environmental versus behavioral) and transaction costs (information costs versus monitoring and enforcement costs) that they foster. We theorize that formal institutions can be categorized into environmentally oriented formal institutions (EOFI) and behaviorally oriented formal institutions (BOFI). We detail the distinct transaction cost-reduction mechanisms through which these two different types of formal institutions impact the equity-based governance choices of foreign-investing SMEs in emerging markets. In brief, we propose that weaker BOFI foster both greater behavioral uncertainty and heightened monitoring and enforcement costs for these investors, which will precipitate a preference for full ownership. Conversely, weaker EOFI induces greater environmental uncertainty and more pronounced information costs, which will motivate these firms to engage in a JV with a local partner. The results of our tests of these hypotheses provide empirical support for the main effects of EOFI and BOFI, as well as partial support for our hypothesis pertaining to the interaction effect between these two categories of formal institutions.