America the Difficult
Thursday, May 29, 2008
Why the United States should put out the welcome mat to foreign direct investors.
Foreign investors increased their acquisition of corporate assets in the United States last year by 90 percent, setting new records for foreign investment. And 2008 began with nearly daily stories of American financial executives courting foreign investors, particularly sovereign wealth funds, for new investments. Citigroup raised more than $7.5 billion from Abu Dhabi, and Merrill Lynch raised more than $5 billion from South Korea and Kuwait.
All this foreign interest in American firms and assets raised eyebrows in Washington. Calls for increased government oversight of such investments have already begun to percolate, and discussion of a “grand bargain” or new institutional framework for governing these transactions has emerged.
Indeed, several American lawmakers have suggested that the federal law that provides for review of acquisitions involving national security through the Committee on Foreign Investment in the United States (CFIUS) should be expanded. Specifically, these lawmakers suggest that the U.S. government should be able to block foreign acquisition of companies in “economically strategic areas,” especially when the investors are foreign governments.
Are these concerns warranted, and should domestic regulators begin to expand their purview in this manner?
If history is any guide, foreign investors in the United States have more to worry about than domestic regulators do. The singular fact about such investing is just how unsuccessful it is—foreign direct investments appear systematically to earn low returns. The recent decision by Daimler to pay a private equity firm to take Chrysler off their hands after paying $37 billion for the company eight years ago appears to be more representative than not of the experience of foreign investors in the United States.
Foreign investors increased their acquisition of corporate assets in the United States last year by 90 percent.
Consider the accounting returns for both American outbound foreign direct investment (FDI) and for FDI inbound to the United States over the last 25 years. FDI is classified as positions that exceed 10 percent of the ownership of a corporation (below 10 percent is called foreign portfolio investment, or FPI). This effectively compares the experiences of major American multinational firms like General Electric when they invest abroad with the experiences of foreign firms like Siemens when they invest in the United States.
As it turns out, American inbound FDI has underperformed American outbound FDI consistently for the last 25 years and usually by a wide margin. Over that period, the rate of return on inbound FDI has averaged 4.3 percent; while outbound has been 12.1 percent.
Moreover, this underperformance happened during a time when no such persistent return differential existed for FPI. Indeed, a simple comparison of S&P 500 returns to the returns of a broad foreign stock index such as MSCI EAFE for the same period reveals that U.S. capital markets outperformed non-U.S. capital markets for the vast majority of those same years. America is a beautiful country for portfolio investors. But it is a very difficult one for direct investors.
Of course, this differential on FDI returns could reflect nothing real and may just show the ability of multinational firms to relocate profits in response to tax differences. Perhaps non-U.S. firms are particularly adept at shielding profits from U.S. tax authorities. Or perhaps tax rate differentials make the United States a particularly unattractive place to report profits. This explanation would appear lacking, however, given that this underperformance spans periods when U.S. tax rates were not high relative to other countries. And, if anything, the United States has greater relative expertise in guarding against transfer-pricing abuses.
Foreign investors have more to worry about than domestic regulators do. Foreign direct investments appear systematically to earn low returns.
So why is it so difficult to make money as a direct investor in the United States? Indeed, much of the rhetoric on investing environments argues that the major destinations for U.S. out- bound FDI—such as the developed markets of Europe and Japan and the emerging markets of China and India—are filled with obstacles to American direct investors, including burdensome regulatory regimes, capital controls, and ownership restrictions. With a relative absence of this litany of investment obstacles, how can the United States be so much less attractive to investors?
Part of the answer may lie precisely in how these obstacles tilt the playing field between local firms and multinational firms. In a series of papers, C. Fritz Foley of the Harvard Business School, James R. Hines Jr. of the University of Michigan Law School, and I have shown that distorted environments are precisely where multinational firms have an advantage relative to local firms. In countries with weak capital markets and burdensome regulatory regimes, multinational firms can use their internal capital and product markets to access global resources while local firms cannot. In effect, these distorted environments burden local firms. But for multinational firms, they create opportunities for institutional arbitrage and can lead to a very successful set of foreign activities.
The United States, in contrast, creates few such opportunities for low-hanging fruit for foreign multinational firms relative to local firms. Thus, the conditions that may underpin the profitable experience of U.S. firms as they expand abroad do not exist for foreign firms investing in the United States. More generally, the presence of highly competitive American local firms undercuts efforts by foreign multinationals that lack truly differentiated capabilities. Simply replicating strategies that were successful at home is likely to be insufficient in the United States. Similarly, American multinational firms have proven very successful in timing their investments to take advantage of periods when local firms are most handicapped, such as currency crises, but when investment opportunities remain solid. Such opportunistic periods are less likely to occur for foreign firms entering the United States.
The real lesson of this experience is that investing directly in corporate assets in an economy is a very different experience, and creates a distinct return profile, than investing as a portfolio investor. In the absence of a unique capability that is a source of value-added expertise, direct investing is very difficult. The presence of such a capability is all the more important in the relatively unfettered U.S. market, and recent experience suggests that foreigners on average do not possess that advantage.
For sovereign funds eager to deploy capital, the experience of the last two decades of investing in the United States is a cautionary tale. While firms and countries can be tempted to think that they have a unique capability that will allow them to generate returns through direct investment, most such arguments are founded on hubris rather than solid advantages or capabilities.
Indeed, Norway, the country with the most experience in investing national wealth, has developed an endowment model that eschews direct investments. Instead, Norway has evolved into a world-class portfolio investor that predominantly makes asset allocation decisions rather than direct investments. While such an approach leads to fewer headlines and a lower profile, it might actually make the most money for their citizens, particularly when considering investments in the United States.
These patterns should also give pause to U.S. legislators and regulators considering the expansion of the review authority of CFIUS. While national security is a relevant concern for some foreign acquisitions in certain sectors, expanding that authority in ambiguous ways will only engender retaliatory responses. Protectionist tendencies in trade can easily ripple over to policies regarding investment. The irony of this brand of protectionism is that it can potentially reduce investment and job creation in the United States.
Indeed, perhaps America should be rolling out the welcome mat and thanking foreign direct investors. On average, these investments appear to transfer wealth from abroad to the United States. What’s not to like about that?
Mihir Desai is a professor of business administration at Harvard Business School and a research associate at the National Bureau of Economic Research. In another short piece, Mr. Desai and Nihar Shah examine the Committee on Foreign Direct Investment in the United States.
Illustration by John Yeo.