Sourcing Equity and Debt Globally

Sourcing Equity Globally

To implement the goal of gaining access to global capital markets a firm must begin by designing a strategy that will ultimately attract international investors. This would mean identifying and choosing alternative paths to access global markets. This would also require some restructuring of the firm, improving the quality and level of its disclosure, and making its accounting and reporting standards more transparent to potential foreign investors.

Designing a Strategy to Source Equity Globally

Designing a capital sourcing strategy requires that management agree upon a long-run financial objective and then choose among the various alternative paths to get there. Often, this decision making process is aided by an early appointment of an investment bank as an official advisor to the firm. Investment bankers are in touch with potential foreign investors and know what they currently require, and can also help navigate the numerous institutional and regulatory barriers in place.

Designing a Strategy to Source Equity Globally

Most firms raise their initial capital in their own domestic market. However, most firms that have only raised capital in their domestic market are not well known enough to attract foreign investors. Incremental steps to bridge this gap include conducting an international bond offering and/or cross-listing equity shares on more highly liquid foreign stock exchanges.

Foreign Equity Listing and Issuance

A firm must choose one or more stock markets on which to cross-list its shares and sell new equity. Just where to go depends mainly on the firms specific motives and the willingness of the host stock market to accept the firm.

Foreign Equity Listing and Issuance

Cross-listing attempts to accomplish one or more of many objectives: Improve the liquidity of its existing shares and support a liquid secondary market for new equity issues in foreign markets Increase its share price by overcoming mis-pricing in a segmented and illiquid home capital market Increase the firms visibility Establish a secondary market for shares used to acquire other firms Create a secondary market for shares that can be used to compensate local management and employees in foreign subsidiaries

Effect of Cross-Listing and Equity Issuance on Share Price

Cross-listing may have a favorable impact on share price if the new market values the firm or its industry more than the home market does. It is well known that the combined impact of a new equity issue undertaken simultaneously with a cross-listing has a more favorable impact on stock price than cross-listing alone. Even US firms can benefit by issuing equity abroad as increased investor recognition and participation in the primary and secondary markets results.

Barriers to Cross-Listing and Selling Equity Abroad

There are certainly barriers to cross-listing and/or selling equity abroad. The most serious of these includes the future commitment to providing full and transparent disclosure of operating results and balance sheets as well as a continuous program of investor relations. The US school of thought is that the worldwide trend toward requiring fuller, more transparent, and more standardized financial disclosure of operating results and balance sheet positions may have the desirable effect of lowering the cost of equity capital.

Alternative Instruments to Source Equity in Global Markets

Alternative instruments to source equity in global markets include the following:
Sale of a directed public share issue to investors in a target market Sale of a Euroequity public issue to investors in more than one market (foreign and domestic markets) Private placements under SEC Rule 144A Sale of shares to private equity funds Sale of shares to a foreign firm as part of a strategic alliance

Alternative Instruments to Source Equity in Global Markets

A directed public share issue is defined as one that is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country. The issue might or might not be denominated in the currency of the target market. The shares might or might not be cross-listed on a stock exchange in the target market.

Alternative Instruments to Source Equity in Global Markets

The gradual integration of the worlds capital markets and increased international portfolio investment has spawned the emergence of a very viable Euroequity market. A firm can now issue equity underwritten and distributed in multiple foreign equity markets, sometimes simultaneously with distribution in the domestic market. The Euro market (a generic term for international securities issues originating and being sold anywhere in the world), was created by the same financial institutions that had previously created an infrastructure for the Euronote and Eurobond markets.

Alternative Instruments to Source Equity in Global Markets

One type of directed issue with a long history as a source of both equity and debt is the private placement market. A private placement is the sale of a security to a small set of qualified institutional buyers under SEC Rule 144A.

Since the securities are not registered for sale to the public, investors have typically followed a buy and hold policy.
Private placement markets now exist in most countries.

Alternative Instruments to Source Equity in Global Markets

Private equity funds are usually limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets. These investors then invest the private equity fund in mature, family-owned firms located in emerging markets. The investment objective is to help these firms to restructure and modernize in order to face increasing competition and the growth of new technologies. Private equity funds differ from traditional venture capital funds as private equity funds operate in many countries, fund companies in many industry sectors and have often have a longer time horizon for exiting.

Alternative Instruments to Source Equity in Global Markets

Strategic alliances are normally formed by firms that expect to gain synergies from one or more of the following joint efforts: Sharing the cost of developing technology Gaining economies of scale or scope Financial assistance (lowering of cost of capital through attractively priced debt or equity financing)

Sourcing Debt

Optimal Financial Structure

The domestic theory of optimal financial structure must be modified considerably to encompass the multinational firm. Most finance theorists are now in agreement about whether an optimal financial structure exists for a firm, and if so, how it can be determined. When taxes and bankruptcy costs are considered, a firm has an optimal financial structure determined by that particular mix of debt and equity that minimizes the firms cost of capital for a given level of business risk. As the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize tradeoffs between business and financial risks.

Optimal Financial Structure

The following exhibit illustrates how the cost of capital varies with the amount of debt employed. As the debt ratio increases, the overall cost of capital (kWACC) decreases because of the heavier weight of low-cost (due to taxdeductibility) debt ([kd(1-t)] compared to high cost equity (ke).

Exhibit 16.1 The Cost of Capital and Financial Structure

Optimal Financial Structure and the MNE

The domestic theory of optimal financial structures needs to be modified by four more variables in order to accommodate the case of the MNE.

These variables include:

Availability of capital Diversification of cash flows

Foreign exchange risk

Expectations of international portfolio investors

Optimal Financial Structure and the MNE

Availability of capital:
A multinational firms marginal cost of capital is constant for considerable ranges of its capital budget
This statement is not true for most small domestic firms (as they do not have equal access to capital markets), nor for MNEs located in countries that have illiquid capital markets (unless they have gained a global cost and availability of capital)

Optimal Financial Structure and the MNE

Diversification of cash flows:
The theoretical possibility exists that multinational firms are in a better position than domestic firms to support higher debt ratios because their cash flows are diversified internationally
As returns are not perfectly correlated between countries, an MNE might be able to achieve a reduction in cash flow variability (much in the same way as portfolio investors who diversify their security holdings globally)

Optimal Financial Structure and the MNE

Foreign exchange risk:
When a firm issues foreign currency denominated debt, its effective cost equals the after-tax cost of repaying the principal and interest in terms of the firms own currency
This amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses

Optimal Financial Structure and the MNE

Expectations of International Portfolio Investors:
The key to gaining a global cost and availability of capital is attracting and retaining international portfolio investors If a firm wants to raise capital in global markets, it must adopt global norms that are close to the US and UK norms as these markets represent the most liquid and unsegmented markets

Financial Structure of Foreign Subsidiaries

If the theory that minimizing the cost of capital for a given level of business risk and capital budget is an objective that should be implemented from the perspective of the consolidated MNE, then the financial structure of each subsidiary is relevant only to the extent that it affects this overall goal.

In other words, an individual subsidiary does not really have an independent cost of capital; therefore its financial structure should not be based on an objective of minimizing it.

Financial Structure of Foreign Subsidiaries

Advantages to implementing a financing structure that conforms to local norms: Reduction in criticisms Improvement in the ability of management to evaluate ROE relative to local competitors Determination as to whether or not resources are being misallocated (cost of local debt financing versus returns generated by the assets financed)

Financial Structure of Foreign Subsidiaries

Disadvantages to localization:
MNEs are expected to have a competitive advantage over local firms in overcoming imperfections in national capital markets; there would then be no need to dispose of this competitive advantage and conform
Consolidated balance sheet structure may not conform t any countrys norm (increasing perceived financial risk and cost of capital to the parent) Local debt ratios are really only cosmetic as lenders will ultimately look to the parent, and its consolidated worldwide cash flow as the source of debt repayment

Financial Structure of Foreign Subsidiaries

In addition to choosing an appropriate financial structure for foreign subsidiaries, financial managers of MNEs must choose among alternative sources of funds to finance the foreign subsidiary. These funds can be either internal to the MNE or external to the MNE. Ideally the choice should minimize the cost of external funds (after adjusting for foreign exchange risk) and should choose internal sources in order to minimize worldwide taxes and political risk.

Simultaneously, the firm should ensure that managerial motivation in the foreign subsidiaries is geared toward minimizing the firms worldwide cost of capital

International Debt Markets

The international debt market offers the borrower a wide variety of different maturities, repayment structures, and currencies of denomination. The markets and their many different instruments vary by source of funding, pricing structure, maturity, and subordination or linkage to other debt and equity instruments. The three major sources of debt funding on the international markets are depicted in the following exhibit.

International Debt Markets

Bank loans and syndications:
International bank loans have traditionally been sourced in the Eurocurrency markets, there is a narrow interest rate spread between deposit and loan rates of less than 1%.
Eurocredits are bank loans to MNEs, sovereign governments, international institutions, and banks denominated in Eurocurrencies and extended by banks in countries other than the country in whose currency the loan is denominated. The syndication of loans has enabled banks to spread the risk of very large loans among a number of banks (this is significant for MNEs as they usually need credit in an amount larger than a single banks loan limit).

International Debt Markets

The Euronote market:
Euronotes and Euronote facilities are short to medium in term and are either underwritten and non-underwritten
Euro-commercial paper is a short-term debt obligation of a corporation or bank (usually denominated in US dollars) Euro medium-term notes is a new entrant to the worlds debt markets, which bridges the gap between Euro-commercial paper and a longerterm and less flexible international bond

International Debt Markets

The International Bond Market:
A Eurobond is underwritten by an international syndicate of banks and other securities firms and is sold exclusively in countries other than the country in whose currency the issue is denominated A foreign bond is underwritten by a syndicate composed of members from a single country, sold principally within that country, and denominated in the currency of that country The Eurobond markets differ from the Eurodollar markets in that there is an absence of regulatory interference, less stringent disclosure rules and favorable tax treatments for these bonds

International Debt Markets

Unique Characteristics of Eurobond Markets:
Absence of regulatory interference
National governments often impose tight controls on foreign issuers of securities denominated in local currencies. However, governments in general have less stringent limitations for securities denominated in foreign currencies and sold within their markets

Less stringent disclosure

Disclosure requirements less stringent than those of the SEC

Favorable tax status

Eurobonds offer tax anonymity and flexibility. Interest paid on Eurobonds is generally not subject to an income withholding tax