Experience, equity and foreign investment risk: a PIC perspective.

VerfasserJames, Barclay E.
PostenRESEARCH ARTICLE - Abstract

Abstract We analyze foreign investment risk-mitigating effects of host-country policy stability, firm experience and equity stakes using an empirical context largely ignored by international business (IB) research: project investment companies (PICs). PICs permit cleaner separation of individual investment project risk from the parent firm, which may otherwise pool risk characteristics from managing multiple projects across different industries and countries. PICs also permit potentially unbiased, prospective risk assessment at the time of a project's initial announcement based on the mix of debt and equity funding the project. Consistent with previous IB research, our analyses of 396 PICs announced in 53 countries from 1990-2006 indicate that investment risk measured as the percentage of equity-to-total capital funding a PIC decreases with greater host-country policy stability, lead-investor experience in the host country, and lead-investor equity stakes. But contrary to previous IB research, we find that lead-sponsor experience and equity stakes reduce investment risk less as host-country policy stability decreases. From a PIC perspective, investor experience and equity stakes are complements to (not substitutes for) host-country policy stability. Our PIC-based evidence re-invigorates research and related practice and policy debates about how investor experience and equity holdings affect foreign project decisions and suggests new avenues for future work.

Keywords Foreign investment risk * Project investment companies * Experience * Equity * Policy stability

1 Introduction

International business (IB) research has investigated the effectiveness of different strategies multinational enterprises (MNEs) use to mitigate foreign investment risk often heightened in host countries with unevenly-enforced laws (North 1990) and broader policies subject to frequent change (Henisz 2000; Makhija 1993). MNEs may simply avoid such countries (Henisz and Macher 2004). If they do invest, MNEs may do so with more flexible ownership modes like joint ventures (JVs) (Gatignon and Anderson 1988) or with smaller equity stakes (Delios and Beamish 1999). Another set of risk-mitigating strategies prompts MNEs to invest despite host-country instability so that they might build political knowledge allowing them to anticipate and adjust to novel circumstances (Johanson and Vahlne 1977). This host-country investment experience has been shown to increase the likelihood of project survival (Delios and Beamish 2001) and make follow-on projects in the same country more likely (Chang 1995).

Such strategies may, in fact, be effective, but their evidentiary bases strike us as problematic. First, IB empirical research to date indicating the effectiveness of these strategies is based on observation and analysis of surviving foreign investment projects--ones that survived initial planning, construction and operational stages. Arguably, many more projects aborted before any of those stages are censored from researcher view, thus rendering observation and analysis of a potentially different project investment risk pool problematic. Second, IB empirical research to date is based largely on foreign subsidiaries that typically operate with the parent MNE's implicit or explicit guarantee of financial backing if subsidiary operations become distressed. This conflates the risk profiles of MNE parent and foreign subsidiary, thus rendering observation and analysis of individual project investment risk problematic. We are not aware of any IB empirical research investigating investment risk trends admitting and addressing these two problems.

We do, by resorting to a different and understudied context in IB empirical research: project investment companies (PICs). PICs are legally-separate and bankruptcy-remote, single-business organizations that, when initially announced, yield a potentially-unbiased, forward-looking indicator of risk of project failure (Esty 2004). Consistent with the idea that risky firms can borrow less (Myers 1984), higher percentages of capital in the form of equity rather than debt to fund PIC operations imply greater PIC risk. Thus, we have a risk indicator for an individual project, available at the time of its announcement. In this PIC context, we can observe the risk level for projects ultimately financed, constructed and initially put into operation or not. And because PICs are bankruptcy remote from the MNEs that fund them, we can address the second problem with previous IB empirical research. This PIC risk indicator does not conflate individual investment project risk with risks relate to other MNE investment projects around the world.

With this new, novel and arguably less problematic empirical context, we can re-examine "accepted wisdom" about how MNEs mitigate investment risk. To do that, we develop a theoretical framework of investment risk integrating host country-, MNE- and foreign investment-level factors. Our framework integrates transaction cost economics (TCE) factors assuming greater risk due to opportunistic renegotiation of initial investment agreements by host-country governments with lower policy stability (e.g., Henisz 2000; Levy and Spiller 1994). Our framework integrates organizational learning factors assuming less risk where investing MNEs have more experience and, thus, knowledge letting them quickly adapt to host-country policies (e.g., Johanson and Vahlne 1977). Our framework integrates principal-agent factors assuming less risk when MNEs have more incentives to manage an investment, that is, when they have larger equity stakes in the investment (e.g., Jensen and Meckling 1976). Our framework integrates such factors individually and in combination, thus letting us also predict not only how changes in policy stability, experience and equity stakes matter for investment risk on their own, but also how those factors differ in effect as, say, host-country policy stability decreases. Thus, we can ask, for example, whether country experience substitutes for policy stability as a means to reduce investment risk.

Analyses of capital structure-based investment risk in 396 foreign PICs announced in 53 countries from 1990-2006 both confirms and questions previous IB empirical research findings. Consistent with previous IB research, we find investment risk to be lower for PICs announced for construction and or operation in host countries with higher policy stability. We also find investment risk to be lower for announced PICs to be led by MNEs (i.e., largest equity investor) with previous host-country experience, and for PICs with greater equity stakes to be taken by the lead MNE. But we uncover patterns inconsistent with previous IB empirical research. We expect to find that MNE host-country experience and larger equity stakes will have magnified risk-reducing effects when host-country policy stability is low. We find the opposite. Their risk-reducing effects are stronger when policy stability is high. This means that experience and equity stakes are complements to (rather than substitutes for) policy stability as a means to reduce investment risk.

Our PIC-based study makes at least three contributions to IB research. First, we think our study will prompt new and useful debate about how foreign investment risk is affected by MNE host-country experience and equity stakes at varying levels of host-country policy stability. For example, previous IB research (e.g., Delios and Henisz 2003) suggests that MNE host-country experience can mitigate the risk-increasing effects of low policy stability. Our PIC-based results indicate the opposite effect. Host-country experience reduces risk more when MNEs announce projects in host countries with higher policy stability, thus indicating a complementary relationship between host-country experience and policy stability in affecting investment risk.

Second, our study contributes new approaches for identifying and analyzing foreign investment risk by exploiting unique characteristics of PICs at the time of their initial announcement. Empirical study of foreign investment using PICs thus represents a methodological advance for IB research on this topic. PICs render individual foreign investment risk less elusive to observe, measure and correlate with country-, industry-, project-, and MNE-specific factors attracting IB research interest.

Third, our study contributes to IB practice and public policy. For practice, we highlight for foreign project managers when host-country policy stability increases or decreases with investment risk. We highlight when their previous experience and equity stakes are more likely to mitigate the increased investment risk brought on by low policy stability. For public policy, we demonstrate the crucial importance of political regimes providing consistent regulatory policies to foreign investors. Managerial experience and equity-based commitment do not substitute for strong policy stability in lowering investment risk.

2 Empirical Context

Additional explanation of the PIC context provides helpful background for the theoretical framework and empirical methods used to arrive at our findings and make our research contributions. This explanation relies primarily on Vaaler et al. (2008) and Sawant (2010a, b) from management and Esty (2002, 2004) from finance. Esty (2004) provides a useful overview of PIC characteristics. PICs are large, stand-alone single business organizations costing hundreds of millions of dollars to construct and operate, most often in infrastructure industries such as power generation, water- and sewage-related services, telecommunications, transportation, and in mining and energy (e.g., oil and gas) exploration and refining industries. Typically, from one to four sponsoring firms own a PIC, with the lead sponsor holding the largest equity share and having the greatest involvement in PIC structure and supervision. Sponsors are...

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