( CHOOSE : JP Morgan & Chase as my chosen comapny, so this assignment suppose to fit JP Morgan & chase comapny.) Forums / Week 6 Forum / Financing the MNC
Requirements: Based on the company that you will review in your final paper, identify examples of concepts and issues presented in Chapters 14 (optimal financial structure) and 18 (project finance), and discuss how these are involved or addressed.
Instructions: Your initial response should be no less than 450-words with at least one scholarly journal reference (dictionary-type websites are excluded)**.
Enclosed please find a soft copy of the chapters 14 and 18 of this book ( Eiteman, D. Stonehill,A. & Moffett, M(2016). Multinational Business Finance, 14th Edition. Pearson Learning Solutions. VitalBook file.)- course FINC620. Use them when necessary
CHAPTER 14 Raising Equity and Debt Globally
Do what you will, the capital is at hazard. All that can be required of a trustee to invest, is, that he shall conduct himself faithfully and exercise a sound discretion. He is to observe how men of prudence, discretion, and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.
—Prudent Man Rule, Justice Samuel Putnam, 1830.
¦ Design a strategy to source capital equity globally
¦ Examine the potential differences in the optimal financial structure of the multinational firm compared to that of the domestic firm
¦ Describe the various financial instruments that can be used to source equity in the global equity markets
¦ Understand the different forms of foreign listings—depositary receipts—in U.S. markets
¦ Analyze the unique role private placement enjoys in raising global capital
¦ Evaluate the different goals and considerations relevant to a firm pursuing foreign equity listing and issuance
¦ Explore the different structures that can be used to source debt globally
Chapter 13 analyzed why gaining access to global capital markets should lower a firm’s cost of capital, increase its access to capital, and improve the liquidity of its shares by overcoming market segmentation. A firm pursuing this lofty goal, particularly a firm from a segmented or emerging market, must first design a financial strategy that will attract international investors. This involves choosing among alternative paths to access global capital markets.
This chapter focuses on firms that reside in less liquid, segmented, or emerging markets. They are the ones that need to tap liquid and unsegmented markets in order to attain the global cost and availability of capital. Firms resident in large and highly industrialized countries already have access to their own domestic, liquid, and unsegmented markets. Although they too source equity and debt abroad, it is unlikely to have as significant an impact on their cost and availability of capital. In fact, for these firms, sourcing funds abroad is often motivated solely by the need to fund large foreign acquisitions rather than to fund existing operations.
This chapter begins with the design of a financial strategy to source both equity and debt globally. It then analyzes the optimal financial structure for an MNE and its subsidiaries, one that minimizes its cost of capital. We then explore the alternative paths that a firm may follow in raising capital in global markets. The chapter concludes with the Mini-Case, Petrobrás of Brazil and the Cost of Capital, which examines how the international markets discriminate in their treatment of multinational firms by home and industry.
Designing a Strategy to Source Capital Globally
Designing a capital sourcing strategy requires management to agree upon a long-run financial objective and then choose among the various alternative paths to get there. Exhibit 14.1 is a visual presentation of alternative paths to the ultimate objective of attaining a global cost and availability of capital.
EXHIBIT 14.1 Alternative Paths to Globalize the Cost and Availability of Capital
Source: Oxelhiem, Stonehill, Randøy, Vikkula, Dullum, and Modén, Corporate Strategies in Internationalizing the Cost of Capital, Copenhagen: Copenhagen Business School Press, 1998, p. 119.
Normally, the choice of paths and implementation is aided by an early appointment of an investment bank as official advisor to the firm. Investment bankers are in touch with the potential foreign investors and their current requirements. They can also help navigate the various institutional requirements and barriers that must be satisfied. Their services include advising if, when, and where a cross-listing should be initiated. They usually prepare the required prospectus if an equity or debt issue is desired, help to price the issue, and maintain an aftermarket to prevent the share price from falling below its initial price.
Most firms raise their initial capital in their own domestic market (see Exhibit 14.1). Next, they are tempted to skip all the intermediate steps and drop to the bottom line, a euroequity issue in global markets. This is the time when a good investment bank advisor will offer a “reality check.” Most firms that have only raised capital in their own domestic market are not sufficiently well known to attract foreign investors. Remember from Chapter 12 that Novo was advised by its investment bankers to start with a convertible eurobond issue and simultaneously cross-list their shares and their bonds in London. This was despite the fact that Novo had an outstanding track record of financial and business performance.
Exhibit 14.1 shows that most firms should start sourcing abroad with an international bond issue. It could be placed on a less prestigious foreign market. This could be followed by an international bond issue in a target market or in the eurobond market. The next step might be to cross-list and issue equity in one of the less prestigious markets in order to attract the attention of international investors. The next step could then be to cross-list shares on a highly liquid prestigious foreign stock exchange such as London (LSE), NYSE, Euronext, or NASDAQ. The ultimate step would be to place a directed equity issue in a prestigious target market or a euroequity issue in global equity markets.
Optimal Financial Structure
After many years of debate, finance theorists now agree that there is an optimal financial structure for a firm, and practically, they agree on how it is determined. The great debate between the so-called traditionalists and the Modigliani and Miller school of thought has ended in compromise:
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 firm’s cost of capital for a given level of business risk.
If the business risk of new projects differs from the risk of existing projects, the optimal mix of debt and equity would change to recognize trade-offs between business and financial risks.
Exhibit 14.2 illustrates how the cost of capital varies with the amount of debt employed. As the debt ratio, defined as total debt divided by total assets at market values, increases, the after-tax weighted average cost of capital (kWACC) decreases because of the heavier weight of low-cost debt [kd (1 – t)] compared to high-cost equity (ke). The low cost of debt is, of course, due to the tax deductibility of interest shown by the term (1 – t).
Partly offsetting the favorable effect of more debt, is an increase in the cost of equity (ke), because investors perceive greater financial risk. Nevertheless, the after-tax weighted average cost of capital (kWACC) continues to decline as the debt ratio increases, until financial risk becomes so serious that investors and management alike perceive a real danger of insolvency. This result causes a sharp increase in the cost of new debt and equity, thereby increasing the weighted average cost of capital. The low point on the resulting U-shaped cost of capital curve, 14% in Exhibit 14.2, defines the debt ratio range in which the cost of capital is minimized.
Most theorists believe that the low point is actually a rather broad flat area encompassing a wide range of debt ratios, 30% to 60% in Exhibit 14.2, where little difference exists in the cost of capital. They also generally agree that, at least in the United States, the range of the flat area and the location of a particular firm’s debt ratio within that range are determined by such variables as (1) the industry in which it competes; (2) volatility of its sales and operating income; and (3) the collateral value of its assets.
EXHIBIT 14.2 The Cost of Capital and Financial Structure
Optimal Financial Structure and the Multinational
The domestic theory of optimal financial structures needs to be modified by four more variables in order to accommodate the case of the multinational enterprise. These variables are (1) availability of capital; (2) diversification of cash flows; (3) foreign exchange risk; and (4) expectations of international portfolio investors.1
Availability of Capital
Chapter 13 demonstrated that access to capital in global markets allows an MNE to lower its cost of equity and debt compared with most domestic firms. It also permits an MNE to maintain its desired debt ratio, even when significant amounts of new funds must be raised. In other words, a multinational firm’s marginal cost of capital is constant for considerable ranges of its capital budget. This statement is not true for most small domestic firms because they do not have access to the national equity or debt markets. They must either rely on internally generated funds or borrow for the short and medium terms from commercial banks.
Multinational firms domiciled in countries that have illiquid capital markets are in almost the same situation as small domestic firms unless they have gained a global cost and availability of capital. They must rely on internally generated funds and bank borrowing. If they need to raise significant amounts of new funds to finance growth opportunities, they may need to borrow more than would be optimal from the viewpoint of minimizing their cost of capital. This is equivalent to saying that their marginal cost of capital is increasing at higher budget levels.
1An excellent recent study on the practical dimensions of optimal capital structure can be found in “An Empirical Model of Optimal Capital Structure,” Jules H. Binsbergen, John R. Graham, and Jie Yang, Journal of Applied Corporate Finance, Vol. 23, No. 4, Fall 2011, pp. 34–59.
Diversification of Cash Flows
As explained in Chapter 13, 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. The probability of a firm’s covering fixed charges under varying conditions in product, financial, and foreign exchange markets should increase if the variability of its cash flows is minimized.
By diversifying cash flows internationally, the MNE might be able to achieve the same kind of reduction in cash flow variability as portfolio investors receive from diversifying their security holdings internationally. Returns are not perfectly correlated between countries. In contrast, a domestic German firm, for example, would not enjoy the benefit of international cash flow diversification. Instead, it would need to rely entirely on its own net cash inflow from domestic operations. Perceived financial risk for the German firm would be greater than for a multinational firm because the variability of its German domestic cash flows could not be offset by positive cash flows elsewhere in the world.
As discussed in Chapter 13, the diversification argument has been challenged by empirical research findings that MNEs in the United States actually have lower debt ratios than their domestic counterparts. The agency costs of debt were higher for the MNEs, as were political risks, foreign exchange risks, and asymmetric information.
Foreign Exchange Risk and the Cost of Debt
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 firm’s own currency. This amount includes the nominal cost of principal and interest in foreign currency terms, adjusted for any foreign exchange gains or losses.
For example, if a U.S.-based firm borrows SF1,500,000 for one year at 5.00% interest, and during the year the Swiss franc appreciates from an initial rate of SF1.5000/$ to SF1.4400/$, what is the dollar cost of this debt ? The dollar proceeds of the initial borrowing are calculated at the current spot rate of SF1.5000/$:
At the end of one year the U.S.-based firm is responsible for repaying the SF1,500,000 principal plus 5.00% interest, or a total of SF1,575,000. This repayment, however, must be made at an ending spot rate of SF1.4400/$:
The actual dollar cost of the loan’s repayment is not the nominal 5.00% paid in Swiss franc interest, but 9.375%:
The dollar cost is higher than expected due to appreciation of the Swiss franc against the U.S. dollar. This total home-currency cost is actually the result of the combined percentage cost of debt and percentage change in the foreign currency’s value. We can find the total cost of borrowing Swiss francs by a U.S.-dollar based firm, , by multiplying one plus the Swiss franc interest expense, , by one plus the percentage change in the SF/$ exchange rate, s:
where = 5.00% and s = 4.1667%. The percentage change in the value of the Swiss franc versus the U.S. dollar, when the home currency is the U.S. dollar, is
The total expense, combining the nominal interest rate and the percentage change in the exchange rate, is
The total percentage cost of capital is 9.375%, not simply the foreign currency interest payment of 5%. The after-tax cost of this Swiss franc denominated debt, when the U.S. income tax rate is 34%, is
The firm would report the added 4.1667% cost of this debt in terms of U.S. dollars as a foreign exchange transaction loss, and it would be deductible for tax purposes.
Expectations of International Portfolio Investors
Chapter 13 highlighted the fact that the key to gaining a global cost and availability of capital is attracting and retaining international portfolio investors. Those investors’ expectations for a firm’s debt ratio and overall financial structures are based on global norms that have developed over the past 30 years. Because a large proportion of international portfolio investors and based in the most liquid and unsegmented capital markets, such as the United States and the United Kingdom, their expectations tend to predominate and override individual national norms. Therefore, regardless of other factors, if a firm wants to raise capital in global markets, it must adopt global norms that are close to the U.S. and U.K. norms. Debt ratios up to 60% appear to be acceptable. Higher debt ratios are more difficult to sell to international portfolio investors.
Raising Equity Globally
Once a multinational firm has established its financial strategy and considered its desired and target capital structure, it then proceeds to raise capital outside of its domestic market—both debt and equity—using a variety of capital raising paths and instruments.
Exhibit 14.3 describes three key critical elements to understanding the issues that any firm must confront when seeking to raise equity capital. Although the business press does not often make a clear distinction, there is a fundamental distinction between an equity issuance and an equity listing. A firm seeking to raise equity capital is ultimately in search of an issuance—the IPO or SPO described in Exhibit 14.3. This generates cash proceeds to be used for funding and executing the business. But often issuances must be preceded by listings, in which the shares are traded on an exchange and, therefore, in a specific country market, gaining name recognition, visibility, and hopefully preparing the market for an issuance.
That said, an issuance need not be public. A firm, public or private, can place an issue with private investors, a private placement. (Note that private placement may refer to either equity or debt.) Private placements can take a variety of different forms, and the intent of investors may be passive (e.g., Rule 144A investors) or active (e.g., private equity, where the investor intends to control and change the firm).
EXHIBIT 14.3 Equity Avenues, Activities, and Attributes
Publicly traded companies, in addition to raising equity capital, are also in pursuit of greater market visibility and reaching ever-larger potential investor audiences. The expectation is that the growing investor audience will result in higher share prices over time—increasing the returns to owners. Privately held companies are more singular in their objective: to raise greater quantities of equity at the lowest possible cost—privately. As discussed in Chapter 4, ownership trends in the industrialized markets have tended toward more private ownership, while many multinational firms from emerging market countries have shown growing interest in going public.
Exhibit 14.4 provides an overview of the four major equity alternatives available to multinational firms today. A firm wishing to raise equity capital outside of its home market may take a public pathway or a private one. The public pathway includes a directed public share issue or a euroequity issue. Alternatively, and one that has been used with greater frequency over the past decade, is a private pathway—private placements, private equity, or a private share sale under strategic alliance.
Initial Public Offering (IPO)
A private firm initiates public ownership of the company through an initial public offering, or IPO. Most IPOs begin with the organization of an underwriting and syndication group comprised of investment banking service providers. This group then assists the company in preparing the regulatory filings and disclosures required, depending on the country and stock exchange the firm is using. The firm will, in the months preceding the IPO date, publish a prospectus. The prospectus will provide a description of the company’s history, business, operating and financing results, associated business, financial or political risks, and the company’s business plan for the future, all to aid prospective buyers in their assessment of the firm.
EXHIBIT 14.4 Equity Alternatives in the Global Market
The initial issuance of shares by a company typically represents somewhere between 15% and 25% of the ownership in the firm (although a number in recent years have been as little as 6% to 8%). The company may follow the IPO with additional share sales called seasoned offerings or follow-on offerings (FOs) in which more of the firm’s ownership is sold in the public market. The total shares or proportion of shares traded in the public market is often referred to as the public float or free float.
Once a firm has “gone public,” it is open to a considerably higher level of public scrutiny. This scrutiny arises from the detailed public disclosures and financial filings it must make periodically as required by government security regulators and individual stock exchanges. This continuous disclosure is not trivial in either cost or competitive implications. Public firm financial disclosures can be seen as divulging a tremendous amount of information that customers, suppliers, partners, and competitors may use in their relationship with the firm. Private firms have a distinct competitive advantage in this arena.2
An added distinction about the publicly traded firm’s shares is that they only raise capital for the firm upon issuance. Although the daily rise and fall of share prices drives the returns to the owners of those shares, that daily price movement does not change the capital of the company.
2A publicly traded firm like Walmart will produce hundreds of pages of operational details, financial results, and management discussion on a quarterly basis. That is in comparison to large private firms like Cargill or Koch, where finding a full single page of financial results would be an achievement.
A euroequity or euroequity issue is an initial public offering on multiple exchanges in multiple countries at the same time. Almost all euroequity issues are underwritten by an international syndicate. The term “euro” in this context does not imply that the issuers or investors are located in Europe, nor does it mean the shares are denominated in euros. It is a generic term for international securities issues originating and being sold anywhere in the world. The euroequity seeks to raise more capital in its issuance by reaching as many different investors as possible. Two examples of high-profile euroequity issues would be those of British Telecommunications and the famous Italian luxury goods producer, Gucci.
The largest and most spectacular issues have been made in conjunction with a wave of privatizations of state-owned enterprises (SOEs). The Thatcher government in the United Kingdom created the model when it privatized British Telecom in December 1984. That issue was so large that it was necessary and desirable to sell tranches to foreign investors in addition to the sale to domestic investors. (A tranche is an allocation of shares, typically to underwriters that are expected to sell to investors in their designated geographic markets.) The objective is both to raise the funds and to ensure post-issue worldwide liquidity.
Euroequity privatization issues have been particularly popular with international portfolio investors because most of the firms are very large, with excellent credit ratings and profitable quasi-government monopolies at the time of privatization. The British privatization model has been so successful that numerous others have followed like the Deutsche Telecom initial public offering of $13 billion in 1996.
State-owned enterprises (SOEs)—government-owned firms from emerging markets—have successfully implemented large-scale privatization programs with these foreign tranches. Telefonos de Mexico, the giant Mexican telephone company, completed a $2 billion euroequity issue in 1991 and has continued to have an extremely liquid listing on the NYSE.
One of the largest euroequity offerings by a firm resident in an illiquid market was the 1993 sale of $3 billion in shares by YPF Sociedad Anónima, Argentina’s state-owned oil company. About 75% of its shares were placed in tranches outside of Argentina, with 46% in the United States alone. Its underwriting syndicate represented a virtual “who’s who” of the world’s leading investment banks.
Directed Public Share Issues
A directed public share issue or directed 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 may or may not be denominated in the currency of the target market and is typically combined with a cross-listing on a stock exchange in the target market.3
A directed issue might be motivated by a need to fund acquisitions or major capital investments in a target foreign market. This is an especially important source of equity for firms that reside in smaller capital markets and that have outgrown that market.
Nycomed, a small but well-respected Norwegian pharmaceutical firm, was an example of this type of motivation for a directed issue combined with cross-listing. Its commercial strategy for growth was to leverage its sophisticated knowledge of certain market niches and technologies within the pharmaceutical field by acquiring other promising firms—primarily firms in Europe and the United States—that possessed relevant technologies, personnel, or market niches. The acquisitions were paid for partly with cash and partly with shares. The company funded its acquisition strategy by selling two directed issues abroad. In 1989 it cross-listed on the London Stock Exchange (LSE) and raised $100 million in equity from foreign investors. Nycomed followed its LSE listing and issuance with a cross-listing and issuance on the NYSE, raising another $75 million from U.S. investors. Global Finance in Practice 14.1 offers another example of a directed issue, in this case, a publicly traded firm in Sweden and Norway issuing a euroequity to partially fund the development of a recent oil property acquisition.
3The share issue by Novo in 1981 (Chapter 12) was a good example of a successful directed share issue that both improved the liquidity of Novo’s shares and lowered its cost of capital.
GLOBAL FINANCE IN PRACTICE 14.1 The Planned Directed Equity Issue of PA Resources of Sweden
One example of the use of directed public share issues was the 2005 issuance of PA Resources (PAR.ST), a Swedish oil and gas reserve acquisition and development firm. First listed on the Oslo, Norway, stock exchange in 2001, PAR announced in 2005 a potential private placement of up to 7 million shares that were specifically directed at Norwegian and international investors (non-U.S. investors). The proceeds of the issuance were expected to partially fund the development of recent oil and gas reserve acquisitions made by the company in the North Sea and Tunisia.
The directed issue was reportedly heavily oversubscribed following the announcement. Like many directed issuances outside the United States the offer expressly stated that the securities would not be offered or sold in the U.S., as the issue had not and would not be registered in the U.S. under the U.S. Securities Act of 1933.
Depositary receipts (DRs) are negotiable certificates issued by a bank to represent the underlying shares of stock that are held in trust at a foreign custodian bank. Global depositary receipts (GDRs) refer to certificates traded outside of the United States, and American depositary receipts (ADRs) refer to certificates traded in the United States and denominated in U.S. dollars. For a company that is incorporated outside the United States and that wants to be listed on a U.S. stock exchange, the primary way of doing so is through an ADR program. For a company incorporated anywhere in the world that wants to be listed in any foreign market, this is done via a GDR program.
ADRs are sold, registered, and transferred in the U.S. in the same manner as any share of stock, with each ADR representing either a multiple or portion of the underlying foreign share. This multiple/portion allows ADRs to carry a price per share appropriate for the U.S. market (typically under $20 per share), even if the price of the foreign share is inappropriate when converted to U.S. dollars directly. A number of ADRs, like the ADR of Telefonos de Mexico (TelMex) of Mexico shown in Exhibit 14.5, have been some of the most active shares on U.S. exchanges for many years.
The first ADR program was created for a British company, Selfridges Provincial Stores Limited, a famous British retailer, in 1927. Created by J.P. Morgan, the shares were listed on the New York Curb Exchange, which in later years was transformed into the American Stock Exchange. As with many financial innovations, depositary receipts were created to defeat a regulatory restriction. In this case, the British government had prohibited British companies from registering their shares on foreign markets without British transfer agents. Depositary receipts, in essence, create a synthetic share abroad, and therefore do not require actual registration of shares outside Britain.
EXHIBIT 14.5 TelMex’s American Depositary Receipt (Sample)
Exhibit 14.6 illustrates the issuance process of a DR program, in this case a U.S.-based investor purchasing shares in a publicly traded Brazilian company—an American depositary receipt or ADR program:
1. The U.S. investor instructs his broker to make a purchase of shares in the publicly traded Brazilian company.
2. The U.S. broker contacts a local broker in Brazil (either through the broker’s international offices or directly), placing the order.
3. The Brazilian broker purchases the desired ordinary shares and delivers them to a custodian bank in Brazil.
4. The U.S. broker converts the U.S. dollars received from the investor into Brazilian reais to pay the Brazilian broker for the shares purchased.
5. On the same day that the shares are delivered to the Brazilian custodian bank, the custodian notifies the U.S. depositary bank of their deposit.
6. Upon notification, the U.S. depositary bank issues and delivers DRs for the Brazilian company shares to the U.S. broker.
7. The U.S. broker then delivers the DRs to the U.S. investor.
EXHIBIT 14.6 The Structural Execution of ADRs
Source: Based on Depositary Receipts Reference Guide, JPMorgan, 2005, p. 33.
The DRs are now held and tradable like any other common stock in the United States. In addition to the process just described, it is possible for the U.S. broker to obtain the DRs for the U.S. investor by purchasing existing DRs, not requiring a new issuance. Exhibit 14.6 also describes the alternative process mechanics of a sale or cancellation of ADRs.
Once the ADRs are created, they are tradable in the U.S. market like any other U.S. security. ADRs can be sold to other U.S. investors by simply transferring them from the existing ADR holder (the seller) to another DR holder (the buyer). This is termed intra-market trading. This transaction would be settled in the same manner as any other U.S. transaction, with settlement in U.S. dollars on the third business day after the trade date and typically using the depository trust company (DTC). Intra-market trading accounts for nearly 95% of all DR trading today.
ADRs can be exchanged for the underlying foreign shares, or vice versa, so arbitrage keeps foreign and U.S. prices of any given share the same after adjusting for transfer costs. For example, investor demand in one market will cause a price rise there, which will cause an arbitrage rise in the price on the other market even when investors there are not as bullish on the stock.
ADRs convey certain technical advantages to U.S. shareholders. Dividends paid by a foreign firm are passed to its custodial bank and then to the bank that issued the ADR. The issuing bank exchanges the foreign currency dividends for U.S. dollars and sends the dollar dividend to the ADR holders. ADRs are in registered form, rather than in bearer form. Transfer of ownership occurs in the United States in accordance with U.S. laws and procedures. Normally, trading costs are lower than when buying or selling the underlying shares in their home market, and settlement is faster. Withholding taxes is simpler because it is handled by the depositary bank.
ADR Program Structures
The previous section described the issuance of a DR (an ADR in this case) on a Brazilian company’s shares resulting from the desire of a U.S.-based investor to buy shares in a Brazilian company. But DR programs can also be viewed from the perspective of the Brazilian company—as part of its financial strategy to reach investors in the United States.
ADR programs differ in whether they are sponsored and in their certification level. Sponsored ADRs are created at the request of a foreign firm wanting its shares listed or traded in the United States. The firm applies to the U.S. SEC and a U.S. bank for registration and issuance of ADRs. The foreign firm pays all costs of creating such sponsored ADRs. If a foreign firm does not seek to have its shares listed in the United States but U.S. investors are interested, a U.S. securities firm may initiate creation of the ADRs—an unsponsored ADR program. Unsponsored ADRs are still required by the SEC to obtain approval of the firms whose shares are to be listed. Unsponsored programs represent a relatively small portion of all DR programs.
The second dimension of ADR differentiation is certification level, described in detail in Exhibit 14.7. The three general levels of commitment are distinguished by degree of disclosure, listing alternatives, whether they may be used to raise capital (issue new shares), and the time typically taken to implement the programs. (SEC Rule 144A programs are described in detail later in this chapter.)
Level I (over-the-counter or pink sheets) DR Programs.
Level I programs are the easiest and fastest programs to execute. A Level I program allows the foreign securities to be purchased and held by U.S. investors without being registered with the SEC. It is the least costly approach but might have a minimal favorable impact on liquidity.
Level II DR Programs.
Level II applies to firms that want to list existing shares on a U.S. stock exchange. They must meet the full registration requirements of the SEC and the rules of the specific exchange. This also means reconciling their financial accounts with those used under U.S. GAAP, raising the cost considerably.
EXHIBIT 14.7 American Depositary Receipt (ADR) Programs by Level
Level III DR Programs.
Level III applies to the sale of a new equity issued in the United States—raising equity capital. It requires full registration with the SEC and an elaborate stock prospectus. This is the most expensive alternative, but is the most fruitful for foreign firms wishing to raise capital in the world’s largest capital markets and possibly generate greater returns for all shareholders.
DR Markets Today: Who, What, and Where
The rapid growth in emerging markets in recent years has been partly a result of the ability of companies from these countries to both list their shares and issue new shares on global equity markets. Their desire to access greater pools of affordable capital, as well as the desire for many of their owners to monetize existing value, has led to an influx of emerging market companies into the DR market.
The Who of global DR programs today is a mix of major multinationals from all over the world, but in recent years participation has shifted back toward industrial country companies. For example, in 2013 the largest issues came from established multinationals like BP, Vodafone, Royal Dutch Shell, and Nestlé, but also included Lukoil and Gazprom of Russia and Taiwan Semiconductor Manufacturing of Taiwan. The oil and gas sector was clearly the largest in both 2012 and 2013, but followed closely by pharmaceutical and telecommunications firms. It’s also important to note that in recent years, as illustrated by Exhibit 14.8, the market has clearly been in decline.
The What of the global DR market today is a fairly even split between IPO and follow-on offerings or FOs (additional offerings of equity shares post-IPO). It does appear that IPOs continue to make up the majority of DR equity-raising activity.
EXHIBIT 14.8 Equity Capital Raised Through Depositary Receipts
Source: “Depositary Receipts, Year in Review 2013,” JPMorgan, p. 5. Data derived by JPMorgan from other depositary banks, Bloomberg, and stock exchanges, 2014.
Given the dominance of emerging market companies in DR markets today, it is not surprising that the Where of the DR market is dominated by New York and London. By the end of 2013 there were more than 2,300 sponsored DR programs from more than 86 countries. Of those 2,300, just over half were U.S. programs (ADRs), with the remainder being GDR programs split between the London and Luxembourg stock exchanges.
Even more important than the number of programs participating in the DR markets is the capital that has been raised by companies via DR programs globally. Exhibit 14.8 distinguishes between equity capital raised through initial equity share offerings (IPOs) and seasoned offerings (follow-on). The DR market has periodically proved very fruitful as an avenue for raising capital. It is also obvious which years have been better for equity issuances—years like 2000 and 2006–2007.
Global Registered Shares (GRS)
A global registered share (GRS) is a share of equity that is traded across borders and markets without conversion, where one share on the home exchange equals one share on the foreign exchange. The identical share is listed on different stock exchanges, but listed in the currency of the exchange. GRSs can theoretically be traded “with the sun”—following markets as they open and close around the globe and around the clock. The shares are traded electronically, eliminating the specialized forms and depositaries required by share issuances like DRs.
The differences between GRSs and GDRs can be seen in the following example. Assume a German multinational has shares listed on the Frankfurt Stock Exchange, and those shares are currently trading at €4.00 per share. If the current spot rate is $1.20/€, those same shares would be listed on the NYSE at $4.80 per share.
€4.00 × $1.20/€ = $4.80
This would be a standard GRS. But $4.80 per share is an extremely low share price for the NYSE and the U.S. equity market.
If, however, the German firm’s shares were listed in New York as ADRs, they would be converted to a value that was strategically priced for the target market—the United States. Strategic pricing in the U.S. means having share prices that are generally between $10 and $20 per share, a price range long-thought to maximize buyer interest and liquidity. The ADR would then be constructed so that each ADR represented four shares in the company on the home market, or:
$4.80 × 4 = $19.20 per share
Does this distinction matter? Clearly the GRS is much more similar to ordinary shares than depositary receipts, and it allows easier comparison and analysis. But if target pricing is important in key markets like that of the U.S., then the ADR offers better opportunities for a foreign firm to gain greater presence and activity.4
There are two fundamental arguments used by proponents of GRSs over ADRs, both based on pure forces of globalization:
1. Investors and markets alike will continue to grow in their desire for securities, which are increasingly identical across markets—taking on the characteristics of commodity—like securities, changing only by the currency of denomination of the local exchange.
4GRSs are not a new innovation, as they are identical to the structure used for cross-border trading of Canadian equities in the United States for many years. More than 70 Canadian firms are listed on the NYSE-Euronext. Of course, one could argue that has been facilitated by near-parity of the U.S. and Canadian dollar for years as well.
2. Regulations governing security trading across country markets will continue to converge toward a common set of global principles, eliminating the need for securities customized for local market attributes or requirements.
Other potential distinctions include the possibility of retaining all voting rights (GRSs do, by definition, while some ADRs may not) and the general principle that ADRs are designed for one singular cultural and legal environment—the United States. All argument aside, at least to date, the GRS has not replaced the ADR or GDR.
Raising equity through private placement is increasingly common across the globe. Publicly traded and private firms alike raise private equity capital on occasion. A private placement is the sale of a security to a small set of qualified institutional buyers. The investors are traditionally insurance companies and investment companies. Since the securities are not registered for sale to the public, investors have typically followed a “buy and hold” policy. In the case of debt, terms are often custom designed on a negotiated basis. Private placement markets now exist in most countries.
SEC Rule 144A
In 1990, the SEC approved Rule 144A. It permits qualified institutional buyers (QIBs) to trade privately placed securities without the previous holding period restrictions and without requiring SEC registration.
A QIB is an entity (except a bank or a savings and loan) that owns and invests on a discretionary basis $100 million in securities of non-affiliates. Banks and savings and loans must meet this test but also must have a minimum net worth of $25 million. The SEC has estimated that about 4,000 QIBs exist, mainly investment advisors, investment companies, insurance companies, pension funds, and charitable institutions. Simultaneously, the SEC modified its regulations to permit foreign issuers to tap the U.S. private placement market through an SEC Rule 144A issue, also without SEC registration. A trading system called PORTAL was established to support the distribution of primary issues and to create a liquid secondary market for these issues.
Since SEC registration has been identified as the main barrier to foreign firms wishing to raise funds in the United States, SEC Rule 144A placements are proving attractive to foreign issuers of both equity and debt securities. Atlas Copco, the Swedish multinational engineering firm, was the first foreign firm to take advantage of SEC Rule 144A. It raised $49 million in the United States through an ADR equity placement as part of its larger $214 million euroequity issue in 1990. Since then, several billion dollars have been raised each year by foreign issuers with private equity placements in the United States. However, it does not appear that such placements have a favorable effect on either liquidity or stock price.
Private Equity Funds
Private equity funds are usually limited partnerships of institutional and wealthy investors, such as college endowment funds, that raise capital in the most liquid capital markets. They are best known for buying control of publicly owned firms, taking them private, improving management, and then reselling them after one to three years. They are resold in a variety of ways including selling the firms to other firms, to other private equity funds, or by taking them public once again. The private equity funds themselves are frequently very large, but may also utilize a large amount of debt to fund their takeovers. These “alternatives” as they are called, demand fees of 2% of assets plus 20% of profits. Equity funds have had some highly visible successes.
Many mature family-owned firms resident in emerging markets are unlikely to qualify for a global cost and availability of capital even if they follow the strategy suggested in this chapter. Although they might be consistently profitable and growing, they are still too small, too invisible to foreign investors, lacking in managerial depth, and unable to fund the up-front costs of a globalization strategy. For these firms, private equity funds may be a solution.
Private equity funds differ from traditional venture capital funds. The latter usually operate mainly in highly developed countries. They typically invest in start-up firms with the goal of exiting the investment with an initial public offering (IPO) placed in those same highly liquid markets. Very little venture capital is available in emerging markets, partly because it would be difficult to exit with an IPO in an illiquid market. The same exiting problem faces the private equity funds, but they appear to have a longer time horizon. They invest in already mature and profitable companies. They are content with growing companies through better management and mergers with other firms.
Foreign Equity Listing and Issuance
According to the alternative equity pathways in the global market illustrated earlier in Exhibit 14.1, a firm needs to choose one or more stock market on which to cross-list its shares and sell new equity. Just where to go depends mainly on the firm’s specific motives and the willingness of the host stock market to accept the firm. By cross-listing and selling its shares on a foreign exchange, a firm typically tries to accomplish one or more of the following objectives:
¦ Improve the liquidity of its shares and support a liquid secondary market for new equity issues in foreign markets
¦ Increase its share price by overcoming mispricing in a segmented and illiquid home capital market
¦ Increase the firm’s visibility and acceptance to its customers, suppliers, creditors, and host governments
¦ Establish a liquid secondary market for shares used to acquire other firms in the host market and to compensate local management and employees of foreign subsidiaries5
Quite often foreign investors have acquired a firm’s shares through normal brokerage channels, even though the shares are not listed in the investor’s home market or are not traded in the investor’s preferred currency. Cross-listing is a way to encourage such investors to continue to hold and trade these shares, thus marginally improving secondary market liquidity. This is usually done through ADRs.
Firms domiciled in countries with small illiquid capital markets often outgrow those markets and are forced to raise new equity abroad. Listing on a stock exchange in the market in which these funds are to be raised is typically required by the underwriters to ensure post-issue liquidity in the shares.
The first section of this chapter suggested that firms start by cross-listing in a less liquid market, followed by an equity issue in that market (see Exhibit 14.1). In order to maximize liquidity, however, the firm ideally should cross-list and issue equity in a more liquid market and eventually offer a global equity issue.
5A recent example of this trading expansion opportunity is Kosmos Energy. Following the company’s IPO in the United States in May 2011 (NYSE: KOS), the company listed its shares on the Ghanaian Stock Exchange. Ghana was the country in which the oil company had made its major discoveries and generated nearly all of its income.
In order to maximize liquidity, it is desirable to cross-list and/or sell equity in the most liquid markets. Stock markets have, however, been subject to two major forces in recent years, which are changing their very behavior and liquidity—demutualization and diversification.
Demutualization is the ongoing process by which the small controlling seat owners on a number of exchanges have been giving up their exclusive powers. As a result, the actual ownership of the exchanges has become increasingly public. Diversification represents the growing diversity of both products (derivatives, currencies, etc.) and foreign companies/shares being listed. This has increased the activities and profitability of many exchanges while simultaneously offering a more global mix for reduced cost and increased service.
With respect to stock exchanges, New York and London are clearly the most liquid. The recent merger of the New York Stock Exchange (NYSE) and Euronext, which itself was a merger of stock exchanges in Amsterdam, Brussels, and Paris, has extended the NYSE’s lead over both the NASDAQ (New York) and the London Stock Exchange (LSE). Tokyo has declined a bit over the past 20 years in terms of trading value globally, as many foreign firms chose to delist from the Tokyo exchange. Few foreign firms remain cross-listed now in Tokyo. Deutsche Börse (Germany) has a fairly liquid market for domestic shares but a much lower level of liquidity for trading foreign shares. On the other hand, it is an appropriate target market for firms resident in the European Union, especially those that have adopted the euro. It is also used as a supplementary cross-listing location for firms that are already cross-listed on the LSE, NYSE, or NASDAQ.
Why are New York and London so dominant? They offer what global financial firms are looking for: plenty of skilled people, ready access to capital, good infrastructure, attractive regulatory and tax environments, and low levels of corruption. Location and the use of English, increasingly acknowledged as the language of global finance, are also important factors.
Most exchanges have moved heavily into electronic trading in recent years. In fact, the U.S. stock market is now a network of 50 different venues connected by an electronic system of published quotes and sales prices. This shift to electronic trading has had broad-reaching effects. For example, the role of the specialist on the floor of the NYSE has been greatly reduced with a corresponding reduction in employment by specialist firms. Specialists are no longer responsible for ensuring an orderly movement for their stocks, but they are still important in making more liquid markets for the less-traded shares. The same fate has reduced the importance of market makers on the London Stock Exchange (LSE).
Electronic trading has allowed hedge funds and other high-frequency traders to dominate the market. High-frequency traders now account for 60% of daily volumes. Conversely, volume controlled by the NYSE fell from 80% in 2005 to 25% in 2010. Trades are executed immediately by computer. Spreads between buy and sell orders are now in decimal points as low as a penny a share instead of an eighth of a point. Liquidity has greatly increased but so has the risk of unexpected swings in prices. For example, on May 6, 2010, the Dow Jones Average fell 9.2% at one point but eventually recovered by the end of the day. During that single day of trading, nineteen billion shares were bought and sold.
Promoting Shares and Share Prices
Although cross-listing and equity issuance can occur together, their impacts are separable and significant in and of themselves.
Does merely cross-listing on a foreign stock exchange have a favorable impact on share prices? It depends on the degree to which markets are segmented.
If a firm’s home capital market is segmented, the firm could theoretically benefit by cross-listing in a foreign market if that market values the firm or its industry more than does the home market. This was certainly the situation experienced by Novo when it listed on the NYSE in 1981 (see Chapter 12). However, most capital markets are becoming more integrated with global markets. Even emerging markets are less segmented than they were just a few years ago.
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. This occurs because the new issue creates an instantly enlarged shareholder base. Marketing efforts by the underwriters prior to the issue engender higher levels of visibility. Post-issue efforts by the underwriters to support at least the initial offering price also reduce investor risk.
Increasing Visibility and Political Acceptance
MNEs list in markets where they have substantial physical operations. Commercial objectives are to enhance corporate image, advertise trademarks and products, get better local press coverage, and become more familiar with the local financial community in order to raise working capital locally.
Political objectives might include the need to meet local ownership requirements for a multinational firm’s foreign joint venture. Local ownership of the parent firm’s shares might provide a forum for publicizing the firm’s activities and how they support the host country.
Establish Liquid Secondary Markets
The establishment of a local liquid market for the firm’s equity may aid in financing acquisitions and in the creation of stock-based management compensation programs for subsidiaries.
Funding Growth by Acquisitions.
Firms that follow a strategy of growth by acquisition are always looking for creative alternatives to cash for funding these acquisitions. Offering their shares as partial payment is considerably more attractive if those shares have a liquid secondary market. In that case, the target’s shareholders have an easy way to convert their acquired shares to cash if they prefer cash to a share swap. However, a share swap is often attractive as a tax-free exchange.
Compensating Management and Employees.
If an MNE wishes to use stock options and share purchase compensation plans as a component of the compensation scheme for local management and employees, local listing on a liquid secondary market would enhance the perceived value of such plans. It should reduce transaction and foreign exchange costs for the local beneficiaries.
Barriers to Cross-Listing and Selling Equity Abroad
Although a firm may decide to cross-list and/or sell equity abroad, certain barriers exist. The most serious barriers are 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 Commitment to Disclosure and Investor Relations.
A decision to cross-list must be balanced against the implied increased commitment to full disclosure and a con