by The increasing integration of global capital markets now makes it easier for firms to access capital outside of their home countries. Firms access international capital markets through a variety of means such as initial public offerings (IPO), seasoned equity offerings (SEO), cross-listings, depository receipts, special purpose acquisition companies (SPACS), shelf offerings, private equity and other informal equity capital channels. Firms can also access debt resources outside their market through bank loans, and foreign bond issues. Finally, cross border flows of venture capital (VC) continue to increase rapidly. The objective of this Special Issue will be to explore the challenges firms face in capital markets beyond their domestic boundaries, be it equity, debt, or VC markets.
While IB research continues to evaluate the challenges facing firms in foreign product markets, IB scholars have yet to adequately address the underlying reasons why firms face challenges in foreign equity markets. These include underpricing, higher underwriting and professional fees, higher listing fees, audit fees, and greater risk of lawsuits, and home bias on the part of investors (French and Poterba, 1991). Further, research suggests the existence of a “foreign firm discount” relative to host market firms.
Venture capital and private equity have truly become global phenomena and take many forms such as cross-border investment, foreign acquisitions, VC firms opening offices overseas, and influencing their portfolio firms to enter and exit international stock exchanges. Foreign firms raise significantly more debt than equity in the U.S. Indeed, the largest component of the international capital market is the bond market.
Research on the motivation, the processes, the supporting mechanisms, and the range of outcomes that firms experience as a result of entering international capital markets is extremely limited so far. We believe such research can draw from a variety of theoretical perspectives and research traditions in international business. The choice of whether to access financial resources outside of the firm’s home market, how to select the appropriate foreign market, and the manner in which to raise resources are all relevant questions that parallel prior IB research market and entry mode choice. IB scholars consider LOF as the “fundamental assumption driving theories of the multinational enterprise”. Yet, the conceptualization and research on LOF solely based upon product market may be inadequate today given the increasing integration of capital markets.
The Functions of a Generic Capital Market
Commercial banks perform an indirect connection function. They take cash deposits from corporations and individuals and pay them a rate of interest in return. They then lend that money to borrowers at a higher rate of interest, making a profit from the difference in interest rates .Investment banks perform a direct connection function. They bring investors and borrowers together and charge commissions for doing so.
Capital market loans to corporations are either equity loans or debt loans. An equity loan is made when a corporation sells stock to investors. The money the corporation receives in return for its stock can be used to purchase plants and equipment, fund R&D projects, pay wages, and so on. A share of stock gives its holder a claim to a firm’s profit stream. The corporation honors this claim by paying dividends to the stockholders. The amount of the dividends is not fixed in advance. Rather, it is determined by management based on how much profit the corporation is making. Investors purchase stock both for their dividend yield and in anticipation of gains in the price of the stock. Stock prices increase when a corporation is projected to have greater earnings in the future, which increases the probability that it will raise future dividend payments.
Attractions of the Global Capital Market
The Borrower’s Perspective: A Lower Cost of Capital
In a purely domestic capital market, the pool of investors is limited to residents of the country. This places an upper limit on the supply of funds available to borrowers. In other words, the liquidity of the market is limited. A global capital market, with its much larger pool of investors, provides a larger supply of funds for borrowers to draw on.
Perhaps the most important drawback of the limited liquidity of a purely domestic capital market is that the cost of capital tends to be higher than it is in an international market. The cost of capital is the rate of return that borrowers must pay investors. This is the interest rate on debt loans and the dividend yield and expected capital gains on equity loans. In a purely domestic market, the limited pool of investors implies that borrowers must pay more to persuade investors to lend them their money. The larger pool of investors in an international market implies that borrowers will be able to pay less.
Problems of limited liquidity are not restricted to less developed nations, which naturally tend to have smaller domestic capital markets. As illustrated in the opening case and discussed in the introduction, in recent years even very large enterprises based in some of the world’s most advanced industrialized nations have tapped the international capital markets in their search for greater liquidity and a lower cost of capital.
The Investor’s Perspective: Portfolio Diversification
By using the global capital market, investors have a much wider range of investment opportunities than in a purely domestic capital market. The most significant consequence of this choice is that investors can diversify their portfolios internationally, thereby reducing their risk to below what could be achieved in a purely domestic capital market. We will consider how this works in the case of stock holdings, although the same argument could be made for bond holdings.
Consider an investor who buys stock in a biotech firm that has not yet produced a new product. Imagine the price of the stock is very volatile–investors are buying and selling the stock in large numbers in response to information about the firm’s prospects. Such stocks are risky investments; investors may win big if the firm produces a marketable product, but investors may also lose all their money if the firm fails to come up with a product that sells. Investors can guard against the risk associated with holding this stock by buying other firms’ stocks, particularly those weakly or negatively correlated with the biotech stock. By holding a variety of stocks in a diversified portfolio, the losses incurred when some stocks fail to live up to their promises are offset by the gains enjoyed when other stocks exceed their promise.
As an investor increases the number of stocks in her portfolio, the portfolio’s risk declines. At first this decline is rapid. Soon, however, the rate of decline falls off and asymptotically approaches the systematic risk of the market. Systematic risk refers to movements in a stock portfolio’s value that are attributable to macroeconomic forces affecting all firms in an economy, rather than factors specific to an individual firm. The systematic risk is the level of nondiversifiable risk in an economye.
Information Technology
Financial services is an information-intensive industry. It draws on large volumes of information about markets, risks, exchange rates, interest rates, creditworthiness, and so on. It uses this information to make decisions about what to invest where, how much to charge borrowers, how much interest to pay to depositors, and the value and riskiness of a range of financial assets including corporate bonds, stocks, government securities, and currencies.
Such developments have facilitated the emergence of an integrated international capital market. It is now technologically possible for financial services companies to engage in 24-hour-a-day trading, whether it is in stocks, bonds, foreign exchange, or any other financial asset. Due to advances in communications and data processing technology, the international capital market never sleeps. The integration facilitated by technology has a dark side. “Shocks” that occur in one financial center now spread around the globe very quickly.
Deregulation
In country after country, financial services have been the most tightly regulated of all industries. Governments around the world have traditionally kept other countries’ financial service firms from entering their capital markets. In some cases, they have also restricted the overseas expansion of their domestic financial services firms. In many countries, the law has also segmented the domestic financial services industry. It has also been a response to pressure from financial services companies, which have long wanted to operate in a less regulated environment. Increasing acceptance of the free market ideology associated with an individualistic political philosophy also has a lot to do with the global trend toward the deregulation of financial markets.
Global Capital Market Risks
Some analysts are concerned that due to deregulation and reduced controls on cross-border capital flows, individual nations are becoming more vulnerable to speculative capital flows. They see this as having a destabilizing effect on national economies.14 Harvard economist Martin Feldstein, for example, has argued that most of the capital that moves internationally is pursuing temporary gains, and it shifts in and out of countries as quickly as conditions change. He distinguishes between this short-term capital, or “hot money,” and “patient money” that would support long-term cross-border capital flows. To Feldstein, patient money is still relatively rare, primarily because although capital is free to move internationally, its owners and managers still prefer to keep most of it at home.
A lack of information about the fundamental quality of foreign investments may encourage speculative flows in the global capital market. Faced with a lack of quality information, investors may react to dramatic news events in foreign nations and pull their money out too quickly. Despite advances in information technology, it is still difficult for an investor to get access to the same quantity and quality of information about foreign investment opportunities that he can get about domestic investment opportunities. This information gap is exacerbated by different accounting conventions in different countries, which makes the direct comparison of cross-border investment opportunities difficult for all but the most sophisticated investor.
