There are many ways that an enterprise can enter a market abroad. It can take an indirect approach, like buying stocks and bonds from a foreign business, or it can invest in an economy directly by setting up subsidiaries or creating joint ventures. The direct approach to foreign investment is called foreign direct investment (FDI). Read on to discover what direct investment means, how it differs from other foreign investment methods, and what benefits/challenges it brings corporations.
Direct Investment Definition
Direct investment is the shorter term for foreign direct investment (FDI).
Foreign direct investment (FDI) involves an individual or organization investing in a business abroad.
But FDI is more than just transferring funds. It also provides the investor significant control over the business's management. Foreign direct investors can take up a large percentage of a company's equity. In extreme cases, they might purchase the entire business and start new operations from scratch.
A key feature of direct investment is lasting interest, meaning the investors are going for the long haul. While some believe long-term investment enhances the local economy and creates more jobs, others see it as a cause of interdependency and inequality.
Direct Investment Market Entry Strategy
Direct investment market entry strategy refers to how an investor can invest in a business abroad. The three direct investment methods include: setting up a subsidiary in another economy, acquiring or merging with an existing foreign business, and initiating a joint venture with a foreign firm.
Direct investment: Subsidiaries
A subsidiary is a firm that belongs to a parent firm in another country. The parent firm can own over 50% to 100% of the subsidiary's equity. When the ownership is 100%, the subsidiary is called a wholly owned subsidiary.
A subsidiary is a business operation purchased or set up by a parent company abroad.
Companies set up subsidiaries to create synergy (combining the value of two or more firms to benefit from their capabilities, making them stronger), diversify risk, avoid tariffs and improve their earnings. While the parent has significant control over its subsidiary, the subsidiary is still a separate legal entity and is liable for its tax and governance.
Direct investment: Mergers and Acquisitions (M&A)
Mergers and Acquisitions (M&A) means buying the entire business or merging with it to create a new business. The terms mergers and acquisitions are often used interchangeably, though they are slightly different.
Mergers are the combination of two businesses to create a new business entity.
An acquisition involves one firm taking over another firm and establishing itself as the new owner.
In addition to pure mergers and acquisitions, there are also:
Consolidations - combining two firms' core businesses and abandoning the old structure.
Tender offers - buying another firm's stock at a specific price rather than the market price.
Acquisition of assets - the direct acquisition of another firm's assets (for example, before it goes bankrupt).
Management acquisitions - also called management-led buyout (MBO), is when a company's management team purchases the majority or all stakes of a business.
Direct investment: Joint Ventures (JV)
The final type of direct investment market entry strategy is a joint venture.
A joint venture is a partnership of two firms for mutual benefit.
Joint ventures help firms leverage each others' resources (including local workforce, expertise, and infrastructure) and achieve economies of scale. JVs are also a common way for businesses to enter a new market. Suppose a firm wants to expand to another economy; it can partner with a local company to benefit from local experience and existing distribution networks.
Types of Foreign Direct Investment
There are three main ways a foreign investor can invest in a business abroad.
Vertical direct investment
Vertical direct investment is a common type of investment by advanced economies to developing ones.
Vertical direct investment means funding or acquiring firms that operate in the same supply chain.
The invested business will either become a supplier or distributor of the investing company. When the foreign operation becomes a Supplier, the process is called backward vertical FDI. The process is known as forward vertical FDI when the foreign operation becomes a distributor.
Backward vertical FDI can help companies reduce production costs by relocating production to low-wage countries, whereas forward vertical FDI helps to resolve distribution challenges.
Horizontal direct investment
Another type of direct investment is horizontal direct investment.
Horizontal direct investment means funding or acquiring businesses in the same industry as the parent company.
Horizontal FDI is done to avoid tariffs and trade barriers to selling goods more efficiently in the foreign market. It also allows the investing firm to access local resources such as skilled workers and technology.
Conglomerate direct investment
Finally, there is a conglomerate investment.
Conglomerate investment occurs when a company invests or takes over unrelated businesses in other countries.
The term "conglomerate" refers to a corporation that comprises several independent businesses. Conglomerate FDI is carried out to diversify business risks, expand into new areas, and reduce total operating costs.
Direct Investment vs. Indirect Investment
There are two ways to classify foreign investment: direct and indirect. Foreign direct investment (FDI) is a firm's physical investment or acquisition of businesses abroad. It may involve setting up buildings, equipment, and elements in another economy. This kind of investment has a long-term effect on the host country.
Foreign indirect investment refers to buying the stocks and bonds of a foreign business as listed on a foreign stock exchange. It is also called Foreign Portfolio Investment (FPI). We will look more into FPI in the next section.
Direct Investment vs. Portfolio Investment
Both direct investment and portfolio investment are methods of foreign investment. They involve a company investing in another company in exchange for ownership and economic gains. However, they differ in a number of ways.
Foreign direct investment (FDI) involves an investor investing in a business in another country to obtain a degree of control over its management. FDI methods may include establishing a subsidiary in the host country, merging or acquiring a foreign operation, or initiating a joint venture with a firm abroad.
Foreign portfolio investment (FPI) involves investors buying financial assets from another country. For example, investors can purchase bonds, stocks, mutual funds, exchange-traded funds, etc.
An important thing to note here is that FPI does not give the investor control over the business management as FDI.
Another critical difference between FDI and FPI is that while FDI is seen as a long-term investment, FPI is a short-term attempt to make quick money. In addition, FDI is more likely pursued by large and well-established corporations.
Direct Investment Advantages and Disadvantages
So, what are direct investment advantages? Here are the main benefits that FDI can bring to a business:
Fosters global trade - FDI is the flow of capital from one country to another; in addition to the economic benefit, it also assists the production of multinational firms. For example, Nike has suppliers in many countries, like China, Vietnam, Thailand, etc., to manufacture its footwear and apparel.
Share resources - FDI allows one firm to share its technology, know-how, and culture with another. This not only improves its own operations but also strengthens the links between economies.
Diversify risks - It is risky to be in one market since if customers are no longer interested in a company's product, it will have to close down. Having operations broad or investing in another economy is a way for businesses to spread risk and stay in the market longer.
Lower production costs - Multinational companies can invest in countries where wages are lower to reduce their production costs and achieve economies of scale.
Tax incentives - Finally, FDI can have tax incentives if the company sets up subsidiaries in tax havens (regions with very low tax rates for foreign investors).
However, foreign direct investment is not risk-free. Here are some disadvantages that might come with FDI:
- Loss of independence - Economies that depend on FDI risk losing their independence. When investors withdraw their funds, the economy might be left with a hard time. This is why some countries place strict policies on FDI.
- Loss of jobs - Shifting production to other economies means local employees will lose their jobs. This is a compromise when multinational firms want to make cheaper products for customers.
- Risk of economic or political changes - Many events like wars, political power shifts, and inflation can affect foreign capital flows and put investors at risk.
Direct investment - Key takeaways
- Foreign direct investment (FDI) involves an individual or organization investing in a business abroad in exchange for significant control over the business.
- There are three types of foreign direct investment: vertical, horizontal, and conglomerate.
- The difference between direct and indirect investment is that while the former is a long-term investment in a foreign business to gain control over it, the latter is a short-term attempt to make quick money.
- Indirect investment is also called portfolio investment. It is the buying of foreign stocks and bonds.
- Direct investment advantages include more efficient global trade, shared resources, lower risks, lower production costs, and tax incentives.
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