Foreign Direct Investment or FDI is any capital investment a company in one country makes in another, explains Kevwe Yerifor, the Chief Investment Officer of CAPITAL INTELL and a member of the Investment and Wealth Institute USA.
For example, when a corporation in the United States purchases a controlling stake in a company in Canada, this is considered foreign direct investment.
Kevwe Yeriforholds an MBA from the University of Bradford, UK and certifications in Investment Management from the Yale School of Management and he recently took some time to explain FDI and what types of FDI corporations can participate in.
FDI can be broken down into two approaches, says Kevwe Yerifor: greenfield FDI and brownfield FDI.
- Greenfield FDI refers to instances where a corporation venturing into a new country begins operations from scratch.
- Brownfield FDI, on the other hand, involves a corporation partnering with another company in the target country.
At a lower level, Kevwe Yerifor explains, FDI can further be broken down into horizontal, vertical, and conglomerate investments.
- Horizontal FDI are investments in businesses like those the investing company runs. For example, Starbucks opening a new outlet in a foreign country.
- Vertical FDI refers to any investments into businesses that fit somewhere in the investing company’s value chain. For instance, BMW investing in a parts manufacturer in Poland.
- Conglomerate FDI refers to investments in businesses unrelated to the investing company’s core business. For example, a real estate company opening a restaurant chain in another country.
Kevwe Yerifor says these definitions identify broad patterns in FDI. From an internal perspective within a corporation considering FDI, he says, some additional questions need to be addressed when it comes to defining FDI.
Specifically, what resources does the corporation have at its disposal to channel into an FDI initiative? Here, Kevwe Yerifor highlights three types of resources that can be utilized for FDI: equity capital, profits converted to investments, and internal debts within the corporation.
Equity capital is the most basic form of equity any corporation has. This equity is represented by the value held in the company’s common stock. For instance, says Kevwe Yerifor of CAPITAL INTELL, Apple’s equity capital is vested in the sum of all its listed shares as well as all assets, less total liabilities.
If Apple sought to participate in FDI using its equity capital, it would be able to do so through one of two ways, mergers or acquisitions.
Mergers are takeover scenarios where the investing company merges its ownership with that of another company. In this case, Apple would go into another country and merge its ownership with that of the company it is targeting. This is often accomplished through a share swap where each company swaps an equal number of shares to create a merged entity.
Acquisitions, on the other hand, are all-out purchases of the target company using equity capital. That is, Apple offers the owners of the target company Apple stock equivalent to the value of the target company. In such a scenario, Apple takes full ownership of the target company.
One major requirement for this type of FDI, says Kevwe Yerifor, is that the investing company must be valuable enough to absorb the cost of the investment through its equity capital without changing its ownership structure.
Profits Converted to New Investments
If a corporation is sufficiently profitable, it may opt to convert some of its profits into FDI. In most cases, Kevwe Yerifor says, this can be done as a way of avoiding paying additional taxes on the profits earned as investments made can be earmarked as tax-deductible capital expenditure.
Using profits for new investments is especially useful when a corporation wants to expand into new markets. For instance, if Apple wants to build a supply chain in a new country, it can use some of its profits to either set up a greenfield operation in the new country or acquire an existing company.
Although using profits for FDI is a good way to invest excess cash, it does bear some risks. For instance, if later the FDI venture requires additional capital, and the home company is not making as much profit, this may starve the venture of much-needed capital.
In such a case, it is prudent for the investing company to augment profit led FDI with other capital sources such as equity, as discussed earlier, or through corporate debt, as discussed next.
Internal Debts in Corporations
If a corporation lacks both the equity capital and the profits to invest in an FDI venture, it may opt to tap into a corporate debt vehicle to raise the capital. Although not always the best option due to interest rates and other requirements, Kevwe Yerifor of CAPITAL INTELLsays, debt can be the fastest way to move quickly on an FDI opportunity.
To qualify for such a facility, a corporation must have a strong balance sheet that demonstrates a strong positive cash flow. An even better position will be if the balance sheet shows a strong free cash flow.
In such a scenario, a corporation can acquire a facility that enables it to pursue an FDI opportunity. However, in such a case, the question that arises is who will own the debt – the parent company or the target company?
As a tax avoidance device, many corporations opt to saddle the new subsidiary with the debt, allowing the target company to add the loan payments to the liability side of its balance sheet. For the parent company, these payments, in some cases called interest income, can then be added to the asset’s column of its balance sheet, giving it a stronger overall position.
FDI is a useful tool for any corporation seeking to expand beyond its current geographical confines. However, cautions Kevwe Yerifor, there are numerous cautionary tales of FDI gone wrong, where corporations make investments only for the venture to falter.
Factors a corporation must consider besides internal fund-raising efforts include the business environment in the target country, politics, tax regime, and other factors that could threaten the investment in the near, mid or long term.