Financial foreign direct investment: the role of private equity investments in the globalization of firms from emerging markets.
| Verfasser | Agmon, Tamir |
| Posten | RESEARCH ARTICLE |
Abstract and Key Results:
* One major change in the world of international business and finance is the growing role of private equity investments in firms in emerging markets. In little more then four years, since 2003, the money raised by international, primarily American private equity funds for investment in emerging markets went up about ten times, from $3.5B to $35B.
* This paper provides a multidimensional analysis and discussion on the role of private equity funds in the globalization process of firms from emerging markets. The discussion begins with development economics, focusing on financial markets development and sector specific capital, proceeds to a discussion of local comparative advantage and intangible trade costs in the process of globalization, and continues with a discussion of imperfect contracts and financial contracting based on recent research in financial economics.
* The multidimensional character of the research is congruent with the nature of globalization and international business. Investment of private equity funds in emerging markets is shown as a new form of foreign direct investment dubbed FFDI (financial foreign direct investment).
Keywords: Emerging Markets * Financial Markets Development * FDI * Globalization
Introduction
International business and economic development are closely related. When applying to emerging markets, foreign direct investment (FDI) and development economics are two sides of the same coin. In terms of the classical OLI model of the economics of international business, the multinational enterprises (MNE) brings into play the ownership advantage while the governments of emerging markets bring into play the location advantage (Dunning 2000). For most part, the economics and the strategy of international business focused on the MNE while economic geography from Koopman (1957) to Krugman (1991) and later (as well as development economics) have focused on the country in which the investment takes place.
This paper brings together international business development economics and international trade to gain better insights into an important and fascinating phenomenon in the arena of international business--the recent growth of private equity investments in emerging markets. The tremendous growth of private equity investments in emerging markets is evident from the data presented in Table 1. The total went up almost ten times, from about $3.5B to more than $33B in the period 2003-2006. Emerging Asia led the emerging markets with $19.4B raised in 2006 by 93 funds; about a third of the money that was raised by these funds went to China and India.
The main argument that is presented and discussed in this paper is that private equity investments in emerging markets is another expression of foreign direct investment (FDI) where firms from the developed countries export specific factors of production (their ownership advantage) to small countries and emerging markets (new locations) as a way to generate value to all stakeholders. The firms in the developed countries in this case are specialized financial institutions (private equity funds) (Yoshikawa et al. 2006) and the factor of production that they export is high-risk sector specific capital. We dubbed this form of FDI as financial foreign direct investment (FFDI), but the process and the rational are the same as in the classical FDI analysis. FFDI (synonymous--but not restricted to--for private equity throughout this paper) is a subset of FDI that is solely devoted--as the name implies--for investments in private firms in purpose of generating high return-on-investment over a relatively short period (5-7 years). The term "short" is relative and in comparison with the typical investment periods of the investors of private equity funds (e.g., pension funds, endowment funds and the like). At the extreme, i.e., in venture capital investments, investors take into account upfront that some of their investments will be written off at the prospects that few will generate return that will more than compensate those sunk investments (hence the "high-risk" referral). Sector specific capital is a general phenomenon. In many industries such investment is more than mere financial investment and is augmented by specific information that the investor may posses in the form of managerial expertise, deal structuring specialty, networking capabilities and the like. In the case of the high-risk capital industry there is a need to bridge the gap between the risk perception of the investment project by the entrepreneurs or the "insiders" and the investors (most often risk-averse investors), the "outsiders". This is accomplished by a combination of validation processes and screening mechanisms that are engaged by the private equity funds. In this regard they act as financial and risk intermediaries (Coval/Thakor 2005, provide an analytical framework for this approach). The value of the general partners of private equity funds depends on the quality of the risk intermediation that they perform for their investors. This makes them credible and reliable processors of information.
The discussion and the analysis presented in this paper draw on three different bodies of literature; the literature of finance and growth from development economics, (Levine 1997, 2004), the literature on comparative advantage in the discussion of patterns of trade (Deardorff 2004) and the literature of imperfect contracts in micro economics and in financial economics (Hart 2001, Zingales 2000).
Financial foreign direct investment as practiced by private equity funds can be a powerful contributor to economic and business growth in emerging markets. FFDI changes the scene of international business as it contributes to a change in the relations between firms in developed countries and firms in the emerging markets. The unique relatively short term nature of a private equity investment makes it an appropriate instrument for the transition period that the world of international business is experiencing regarding the role of emerging markets and the role of China and India in particular. This is so because the short term nature of private equity investments allows firms in emerging markets for sufficient time for transfer of information and learning and yet allow the local stakeholders to resume full ownership once the process is completed.
The relations between the development economics literature on finance and growth and the international business literature is presented and discussed in the next section of the paper. It is shown that the two bodies of literatures are quite related once one penetrates the specific lingo employed by each one of them. The problems in the institutional setting and the lack of sufficient development of the capital markets in most emerging markets are overcome by creating specific international alliances that generate local comparative advantage. In section three, the concept of local comparative advantage (Deardorff 2004) is used for better understanding of FFDI. The perfect and efficient financial market of the Modern Theory of Finance is replaced by a set of imperfect contracts negotiated and renegotiated between domestic firms in emerging markets and private equity funds from the US and other major capital markets. This issue is discussed and analyzed in section four of the paper. Private equity funds drew a fair amount of criticism lately. The potential of private equity investment in emerging markets is discussed in section five of the paper. The conclusions of the study are briefly discussed in section six, the last section of the paper.
Finance, Growth and International Business
In a survey paper on the relations between financial development and economic growth Levine (1997) states that: "... the development of financial markets and institutions are critical and inextricable part of the growth process". He continues and says that: "... financial development is a good predictor of future rates of economic growth, capital accumulation and technological change. Moreover, cross-country, case study, industry- and firm- level analyses document extensive periods when financial development-or the lack thereof-crucially affect the speed and the pattern of economic development", (Levine 1997, p. 689). Levine makes two other important points; first that the discussion of finance and developments takes place outside the state-contingent world of Arrow (1964) and Debreu (1959) and the discussion takes place in an incomplete world with imperfect (monopolistic) competition. The second point is that there are three main research questions in the field of finance and development that needs more attention. (1) Why does financial structure change as countries grow? (2) Why do countries at similar stages of economic development have different looking financial systems? and (3) are there long-term economic growth advantages to adopting legal and policy changes that create one type of financial system vis-a-vis another?
The three research questions raised by Levine deal with different aspects of the location of foreign direct investment. In particular, the three research questions deal with the gap between the potential of a certain country, or countries, as a site for an international oriented investment and the actual investment that has taken place. This is particularly true where the investment from the developed countries is in the form of high-risk sector specific capital such as provided by private equity funds. The potential of some countries in attracting private equity funds is not being fully realized due to the absence of an appropriate financial system. A well developed financial system is necessary to enhance the import of sector specific (high-risk) capital, a necessary condition for FFDI.
As the financial structure of a country changes (as the country grows), it is suggested by Levine in his first question that...
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