America the Difficult
Sovereign Wealth Funds Should Expect Low Returns
Last year, foreign investors set new records for their acquisition activity in the United States. And 2008 began with nearly daily stories of American financial executives courting foreign direct investors, particularly sovereign wealth funds, for new investments. Calls for increased oversight of such investments have already begun to percolate. Are these concerns warranted?
If history is any guide, foreign investors in the United States have more to worry about than domestic regulators do. The singular fact about foreign direct investors in the United States is just how unsuccessful they are. They appear to systematically earn low returns on their investments in American corporate assets.
The returns on American inbound foreign direct investment (FDI) are highly distinctive for two reasons. First, they are systematically lower than the returns of American outbound FDI. By way of example, the data indicate that GE earns a much higher return on overseas activities than Siemens does in the United States. Indeed, over the last 25 years, the accounting rate of return on inbound FDI to the United States has averaged 4.3 percent while the average for outbound FDI from the United States has been 12.1 percent.
Second, this remarkable return differential doesn’t reflect a more general differential in investment returns. During this same period, the equity markets in the United States outperformed the rest of the world in the majority of years. As such, there is something particularly bad about the return experience of foreign investors taking a controlling position in American companies. In short, America is a beautiful country for stock portfolio investors and a very difficult one for direct investors.
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. outbound FDI — the developed markets of Europe and Japan and the emerging markets of China and India — are filled with capital controls and ownership restrictions. How can the United States as a destination end up being so much less attractive despite the relative absence of this usual litany of investment obstacles?
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, [HBS associate professor] C. Fritz Foley, [University of Michigan professor] James R. Hines Jr., 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 can’t. In effect, these distorted environments burden local firms, create opportunities for institutional arbitrage for multinational firms, and can lead to a successful set of foreign activities for multinational firms.
The United States, in contrast, creates few such opportunities for low-hanging fruit for foreign multinational firms relative to local firms. As such, the conditions that may underpin the profitable experience of U.S. firms as they expand abroad are not there for foreign firms investing in the United States. More generally, the presence of highly competitive local firms in the United States undercuts efforts by foreign multinationals that don’t have truly differentiated capabilities. Simply replicating strategies that were successful at home is likely to be insufficient in the United States.
The real lesson of this experience is that investing directly in corporate assets 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 on some dimension, making money on direct investing is very difficult. In a relatively unfettered market like the United States, the presence of such a capability is all the more important, and recent experience suggests that direct foreign investors on average do not possess that advantage when entering the United States.
For sovereign wealth 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 on 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, the Norwegians have evolved into a world-class portfolio investor that predominantly makes asset allocation decisions.
For U.S. regulators, these patterns do not recommend increasing barriers to foreign investment. Indeed, America should be rolling out the welcome mat and thanking foreign direct investors for investments that appear to be, on average, transferring wealth from abroad to the United States.
— Mihir A. Desai is a professor at HBS and a research associate at the National Bureau of Economic Research. Reprinted with permission from The American.
