International venture capital portfolio diversification & ag
Meyer, James E
With the development of international trade and the integration of capital markets, the flow of funds from one country to another to seek higher investment returns has become more and more prevalent. One striking trend is the flow of funds from the newly-developed countries such as Taiwan, Hong Kong, Singapore. and some other southeast Asian countries to the developed countries. This reverse in the direction of the flow of funds has created unique opportunities for many entrepreneurs in the U.S. to seek international venture capital for funding of their investment projects. Several reasons tend to encourage international investors to participate in risky projects in the U.S.. These reasons include diversification, lower expected returns in the domestic markets, and hedging local economies. The concept of international diversification and returns will be examined in the next section of this paper.
The sale of part of the equity ownership by the entrepreneur to international investors may give rise to a conflict of interests between the investor and the entrepreneur. The conflict can occur due to the difficulties in monitoring the entrepreneur-manager, This situation is particularly evident in the case of international investors where cultural differences and physical distance between the two parties come into play. The potential agency costs resulting from the conflict of interests are anticipated by the investor and consequently will be born by the original owner. The role of the agency problem in an international venture capital setting will be investigated in the third section.
The desire of international investors to gain the benefits of international diversification may tend to be offset by the higher agency costs involved with international ventures. Simply put, international investors will seek to diversify their investments up to the point where the marginal benefit from the investment is equal to the marginal cost of the investment. An approach to reduce agency costs and improve the attractiveness of U.S. venture capital investments will be presented in the fourth section.
Venture Capital & International Portfolio Diversification
The nature of the venture capital industry began to solidify soon after the Second World War as investors began to search for investments that would allow them to increase their returns. These investors formed venture capital companies to invest in special situations. These investors usually had an ultimate objective of earning returns in excess of 20 percent per year over the life of the investment (which in many cases may be 10 or more years).
For the international investor, there is an opportunity to diversify one’s portfolio to reduce risk while at the same time potentially increase the portfolio return. This change in portfolio holdings creates a marginal benefit for the investor. A reduction in risk will occur if the diversification takes place in a country whose economy and markets are not perfectly correlated with the investor’s domestic markets.
The total risk (SD sub f ) to a foreign investor of the investor’s portfolio in the investor’s domestic currency, given it contains only domestic securities and a U.S. investment, can be given by (equation 1):
SD sub f = (SD sub d sup 2 W sub d sup 2 + SD sub u sup 2 W sub u sup 2 + 2SD sub d SD sub u W sub d W sub u P) sup 1/2
SD sub d = the standard deviation of returns from the domestic portfolio,
SD sub u = the standard deviation of returns from the U.S. venture capital investment adjusted for changes in the exchange rate risk, and
P = the correlation of returns between the domestic portfolio and the U.S. venture capital investment adjusted for the change in exchange rates such that
w sub d + w sub u = 1, 0
The covariance factor in equation (1) will depend upon the relationship between the distribution of returns in the domestic securities market and the distribution of returns of the U.S. venture capital investment. While the expected return and risk from a venture capital investment depend upon each situation, if it is assumed that these returns act in the same manner as the returns in the U.S. securities markets, it is possible to make some observations with regards to the total risk. Several empirical studies have been conducted examining the correlation between different countries stock markets. Solnik found that there was an average correlation of 0.35 between 1971 and 1985 between different countries’ stock markets. The results of this study were supported by research by Kaplanis and Schaefer which found an average correlation of 0.32 between 1978 and 1987. It is interesting to notice that the correction between U.S. indices is usually higher than 0.90. This indicates that incorporating foreign investments will lower average correlation of portfolios.
Given the above correlations, it is reasonable for an international investor to assume that such a situation may exist for a venture capital investment in the U.S.. Since the foreign investor’s risk is lower, the investor could then be willing to accept lower returns relative to a given amount of risk. Assuming that the investor will offset risk and return and attempt to maximize the return per unit of risk on the investment, a foreign investor will be willing to invest in the U.S. whenever the investor expects (equation 2),
(Equation 2 omitted)
R sub r = the risk free interest rate,
R sub u = the return of the foreign investor’s U. S. venture capital portfolio in U.S. dollars, and
R sub d = the return of the foreign investor’s domestic Portfolio in the investor’s own currency.
Or, alternatively solving for the breakeven or indifference point, the minimum expected return required in the U.S. in order for the foreign investor to be interested in diversification can he given as (equation 3):
(Equation 3 omitted)
Using a Singapore investor as an example and assuming the standard deviation of the Singapore stock market is 23.3% (the standard deviation of annual returns from 1999-1992), the risk of the U.S. venture capital investment of 45% (assumed), a correlation between these two markets of 0.59 (the correlation from 1988-1992), a required rate of return by the Singapore investor of 15.9% (the average annual return from 1988-1992), and a risk free interest rate of 8%, then a return of 15% from a U.S. venture capital investment would be equivalent to a 15.9% domestic return in Singapore. Applying this analysis to venture capital projects where the expected returns are higher than the returns for the stock market, it is evident that a foreign investor can be more risk tolerant than a U.S. investor for the same expected returns.
A potential problem that a foreign venture capital investor must face is exchange rate risk. Hedging strategies using currency futures and/or options contracts are usually not available because the duration of the investment is not not and is usually very long. From a theoretical aspect it might be argued that in a perfect market system changes in exchange rates are unimportant due to the concept of purchasing power parity. If purchasing power parity holds, the real return to the foreign investor in his currency will equal the real return in the U.S. market. In practice there is a negative correlation between the within country rate of return and the end of the period exchange rate. This is an expected result, but the correlation is not perfect which indicates that the returns are not identical. Hence, a foreign investor who invests in the U.S. may not be able to completely offset returns with the changes in the exchange rate. Since inflation has historically been low in the U.S. the inability to totally offset exchange rate risk may not be very important for the foreign investor, especially investors from third world or developing countries whose currency has historically depreciated against the U.S. dollar.
In addition to diversifying the investor’s portfolio, a foreign investor may have other motivations for considering an investment in the U.S.. First, there may be a desire by the investor to remove capital from possible control or restriction by the investor’s government. In this case, once the investor’s capital is “offshore” it will be very difficult for the investor’s government to apply any restrictions. Since the U.S. has essentially no restrictions on the inflow or outflow of capital, an investment in the U.S. can become attractive from this standpoint.
Second, if the investor’s country is heavily dependent upon exports, foreign investment may act as a hedge to protect against several possible situations. The economies of countries that are heavily dependent upon exports can be very volatile, as recessions in the countries to which their country exports can also cause a downturn in the local economy. As wage rates rise in these exporting countries in relation to slower gains in productivity, the competitive advantage of these countries starts to decline and further domestic investments are less attractive. Therefore, international diversification can be a hedge for a foreign investor against lower future returns on domestic markets.
Third, in the case of some foreign investors their returns are decreasing because of high domestic savings rates leading to excess capital availability. In this case in order to increase their potential returns investors will have to internationally diversity their asset portfolios.
Fourth, since many third world countries suffer from continued high inflation and investors can not earn sufficient real returns on their savings, they prefer to exchange their “soft” currency for “hard” currency. In this case an investment in the U.S. provides protection against further devaluation of the investor’s domestic currency and will help maintain the real wealth of the investor.
Agency Costs and International Venture Capital
The agency relationship is often defined as a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent. Wherever an agency relationship is created, the conflict of interests among the principal and the agent is unavoidable since both parties are utility maximizers, and the agent will not always act in the best interests of the principal.
Agency costs are created from the conflict of interests among the principal and the agent. Jensen and Meckling define agency costs as the sum of: (1) the monitoring expenditures by the principal, (2) the bonding expenditures by the agent, and (3) the residual loss. The monitoring cost refers to the expenditures the principal expends to limit the aberrant activities of the agent. The bonding costs are resources the agent commits to guarantee that it will not take certain actions which could harm the principal or to ensure that the principal will be compensated if the agent does take such actions. Given the optimal monitoring and bonding activities by the principal and the agent, there will still be some divergence between the agent’s decisions and those decisions which would maximize the welfare of the principal. The dollar amount of the reduction in welfare experienced by the principal due to this divergence is referred to as the “residual loss”.
A typical case of agency relationship occurs when a entrepreneur who owns 100 percent of the residual claims on a firm sells a portion of those claims to venture capital investors. When the entrepreneur owns 100 percent of the firm’s equity, the optimum mix of the various pecuniary and non-pecuniary benefits is achieved when the marginal utility derived from an additional dollar of expenditures (measured net of any productive effects) is equal for each non-pecuniary item and equal to the marginal utility derived from an additional dollar of wealth. After the owner-manager sells equity claims on the firm, agency costs will be generated by the divergence between the owner-manager’s interests and those of the outside shareholders. The owner-manager will then bear only a fraction of the costs of any non-pecuniary benefits that are taken out of the firm. For example, if the owner-manager owns only 80 percent of the stock, the owner-manager will expend resources to the point where the marginal utility derived from a dollar’s expenditure of the firm’s resources on such items equal the marginal utility of an additional 80 cents in general purchasing power (i.e., the owner-manager’s share of the wealth reduction).
Such activities create a marginal cost to the venture capital investor. The marginal cost may be small or large depending upon a variety of factors, such as percent of ownership by the venture capital investors, how active a position the venture capitalists take in the management of the firm, the physical distance between the parties, etc.. The activities by the manager that are not in the best interests of the venture capital investors can be limited (but probably not eliminated) by the expenditure of resources on monitoring activities. It is the owner/manager, not the outside stockholders, who will ultimately bear the entire wealth effects of these costs so long as the equity market anticipates these effects. Prospective minority shareholders will realize that the owner-manager’s interest and theirs may not be the same. Therefore, it is in the manager’s interest to incur certain bonding expenditures to align the interests of the owner-manager and the outside shareholders. The bonding expenditures will create an additional marginal cost to the prospective investors.
The implication is that the lower the percentage of ownership the manager keeps, the larger the agency costs that are borne. The owner-manager is willing to hear all the agency costs if the benefits from selling equity to outside parties is greater than the costs involved. It is in the owner-manager’s best interest to minimize the agency costs since the owner-manager captures the benefits from their reduction.
Unlike established public corporations, a new enterprise probably has no active market for its equity. In other words, the exit cost for outside investors in a new venture is usually much higher than shareholders of a public corporation. Hence, the negative wealth effects of the agency relationship on the owner-manager is even more severe. It follows that the owner-manager will get a lower price from the sale of a portion of the equity claim on the new venture, given the same risk characteristics.
When a U.S. entrepreneur seeks international venture capital to help finance the firm, the agency costs associated with it will be higher than that associated with a domestic venture capital investment. The longer distance, differences in legal environment, cultural traditions, and business norms all make the monitoring and bonding activities more difficult and more expensive. The difference in the goals pursued by the entrepreneur and the international venture capitalists may also contribute to the increase in the agency costs (or the marginal cost of the investment).
Although developments in communication and transportation have made the world a global village, the long distance that sets apart the entrepreneur and the international venture capitalists will probably increase the costs of communicating among the parties. In addition, a difference in languages also contributes to the difficulties of communication. In sum, the effectivity of monitoring and bonding activities by the international venture capitalists and the entrepreneur will probably be diminished, making higher monitoring and bonding costs unavoidable.
Cultural differences between East and West have been one of the major issues studied in international marketing simply because they have profound implications concerning product design and promotion. Since the formation and success of a joint venture requires cooperative joint efforts of both the entrepreneur and the international investor, cultural difference may reduce the likelihood of successful cooperation.
For example, American businessmen attach great importance to formal written contracts. However, in many Asian countries, business traditionally relies on personal relationships and hence, a verbal agreement among the parties is their form of “contract”. Their approach to discussing and carrying on business is much more subtle than their American counterparts. A written contract is just an extension of the verbal agreement and could be disregarded if the circumstances change. Consequently, in an East/West joint venture each party may be uncomfortable with the other party’s approach of doing business, resulting in misunderstandings and distrust of the other party. Naturally, the effectivity of ordinary monitoring and bonding activities is diminished.
Differences in the legal environment and the system of taxation may also contribute to potential conflicts and restrictions between the entrepreneur and the international investor. A country’s legal environment and tax system provide a framework within which business activities are conducted. Individual businessmen have no direct control over the system. All these businessmen can do is to adapt themselves to the environment. For example, double taxation and restrictions on capital movement across borders may increase opportunity costs of international investors, which will be transferred to the entrepreneur in the form of a higher required rate of return to compensate the international investor. Due to the above reasons, the agency costs on international capital will be higher, compared with the agency costs associated with raising domestic venture capital.
A Proposal to Encourage Venture Capital Investment and Reduce Agency Costs
The marginal benefits and the marginal costs to international venture capitalists have been considered in the past two sections. Since a potential investor will invest up to the point where marginal benefits equal marginal costs, if agency costs can be reduced without affecting marginal benefits then international investors will find U.S. venture capital proposals more attractive.
High expected agency costs incurred by international investors appear to arise from several sources. First, because of the distance, differences in doing business, and availability of information the international investor may initially be unable or less able to identify and evaluate potentially good venture capital investments. Second, even if good investments are located, the investor will need to invest time and funds to become familiar with (in effect “trust”) the U.S. owner-manager. Also, the U.S. entrepreneur will have similar problems, in locating potential investors and insuring that they have similar goals and objectives.
Developing a method by which to assist in bringing together the international venture capitalist and the U.S. entrepreneur can bring about advantages to both sides. First, for the venture capitalist, a more formal procedure will make it easier to identify and evaluate potential investments. If the situation is properly structured, the marginal costs that are incurred due to increased agency costs can he decreased. Second, with regards to the U.S. entrepreneur, such a system will make it easier to find capital while retaining control of the firm.
The authors propose a two pronged attack on this problem. First, for the international investor, a venture fund (or funds) could be established which could be jointly controlled by foreign and U.S. investors. The purpose of this fund is to locate, evaluate, invest in, and to the extent necessary manage venture capital investments. The creation of this fund will provide several advantages. First, it allows the investor diversification with regards to venture capital investments. Second, it will provide an experienced staff of intermediaries which can help reduce certain agency costs and management expenses which will benefit both parties. However, one problem that these funds cannot directly address is the “trust” or “bonding” factors that must occur between the two parties so that perceived agency costs can be reduced to a manageable level. Since an investor will invest up to the point where marginal benefits equal marginal costs, if the investor perceives high marginal costs, the investment will be attractive only as long as the return is very high. From the U.S. entrepreneur’s standpoint, a very high return to an investor may be unattractive and thus no “deal” will be made.
The second prong of the author’s proposal involves either or both of the following ideas: (1) the creation of private insurance that can provide insurance on the debt portion of a venture capitalist’s investment and/or (2) the creation of a U.S. government corporation with responsibility for lending and/or guaranteeing a portion of the loans to a U.S. business. The purpose of private insurance would be to allow the foreign venture capitalist to insure for a premium a portion of their investment. Since many venture capital investments are made by providing the entrepreneur part debt capital and part equity capital the insurance could be written for part or all of the debt capital portion. The premium would depend upon the expected risk of the covered portion of the investment. The advantage of insurance would be that the international venture capitalists would not be risking their entire investment. The disadvantage, of course, is that the insurance premium may be so high as to make the investment unattractive. This insurance alternative could be similar to mortgage protection insurance which is written on some residential mortgages in the United States.
An alternative, would be the creation of a U.S. Government sponsored corporation somewhat like a combination of the Small Business Administration (SBA) and the Federal National Mortgage Corporation (Fannie Mae). The purpose of this corporation (primarily privately owned) would be to loan and/or guarantee portions of loans made at market rates for venture capital and small business investments. For political reasons, it would not guarantee equity or quasi-equity investments provided by private investors, but could guarantee debt financing by domestic and foreign investors. The purpose of this arrangement is simply that if the U.S. entrepreneur were able to secure financing that was partially guaranteed by a quasi-government corporation then this should increase the “trust” of a foreign investor. This government sponsored corporation, like Fannie Mae, would be self-financing and self-sustaining and the debt of the corporation would be like Fannie Mae’s debt, similar to Government Agency debt, but not explicitly guaranteed by the U.S. Government. Also, this corporation should be allowed to take small minority equity positions in addition to its debt positions.
The advantages of a government sponsored corporation for promoting and financing venture capital and small business investments over the present system is that; it is self-funding rather than government funded like the SBA (the corporation will make a profit from the interest rate differentials on funds it loans and/or fees from guaranteeing loans). It should be noted that the purpose of this corporation is to provide or guarantee market rate financing to potentially good investments, not subsidized financing for these investments. The major problem with this proposal is that since most investments will have high risk, the risk factor will have to be aggressively managed so that the business itself will not be endangered by potential loan losses. By packaging many investments together and reselling these investments the risk can be diversified. Also, by making it a private government sponsored corporation it should be able to borrow at attractive rates. Finally, with private ownership, the management will have the flexibility to manage for a profit.
From the viewpoint of a foreign investor, the participation of a U.S. government sponsored corporation in the venture capital investment should reduce the perceived risk and the associated agency costs. This should reduce the marginal cost of the investment and lower the return requited by a foreign investor.
Because of problems of both international investors and U.S. entrepreneurs locating each other and the attendant agency problems, it would seem that the best was to match these investors and owner-managers is through an indirect approach. In effect, a joint venture should be formed consisting of international venture capitalists (who have capital or access to capital in their domestic of regional markets) and U.S. investor/managers. These investor/managers should be professionals who then can specialize in locating, analyzing, negotiating, investing, and if necessary managing (or assisting in managing) the venture capital situations. In this case some of the bonding and monitoring costs could be absorbed by the joint venture because of an existing relationship between the international and U.S. principals.
Jensen, M. and Meckling, W., Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, Journal of Financial Economics 3, (1976): 305-360.
Kaplanis, C. and Schaefer, S., Exchange Risk and International Diversification in Bond and Equity Portfolios, unpublished manuscript, London Business School.
Mantell, E., How to Measure Expected Returns on Foreign Investments, Journal of Portfolio Management 10, no. 2 (Winter 1984): 38-45.
Patricoff, A. appears as Chapter 20 in, How to Make Your Money Make Money, ed. by A. Levitt (Dow Jones-Irwin) 1981.
Solnik, B., The Advantages of Domestic and International Diversification, in Elton and Gruber, International Capital Markets, (Amsterdam: North-Holland), 1975.
Copyright College of Business Administration. University of Detroit Mercy Spring 1995
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