Financial Globalization and the ‘Locust’ Myth

Foreign Investors: Bane or Boon?

In a world of increased financial globalization, foreign investors have a bad reputation in some circles, sometimes being labeled “locusts” for what’s been seen as their plaguing effect on local companies and economies. But new research by Darden School of Business Professor Pedro Matos and three colleagues may soon turn that idea on its head.

The “Locust” Hypothesis

Let’s start with a little background. Since ancient times, those short-horned grasshoppers known as “locusts” have been known to shift — under certain circumstances — from a solitary and harmless state to an abundant, “gregarious” state. In the latter situation, destructive swarms swoop in, eat all the crops such that nothing can grow back, and then move on to the next field.

The comparison of the rise of global capital flows to an invasion of locusts was first made during the German federal election in 2005, in which a prominent leader of one campaigning party called foreign private equity and activist hedge fund investors “locusts,” who were “stripping companies bare.”[1] The label stuck.

Those who take this locust viewpoint argue that foreign money managers deprive companies of long-term success. This “locust hypothesis” contends that foreign investors usually push companies to focus on short-term profits and:

• Delocalize production and stop investing in new plants and equipment.
• Adopt unfriendly labor policies, including layoffs.
• Underinvest in R&D and innovation.

This view is part of a broader sentiment of protectionism taken by some people. The question is, is this hypothesis actually true? Are locusts a fair comparison with regard to foreign capital flows?

As the economy has grown increasingly globalized and complex, it’s not obvious whether investors from abroad — say, Chinese investors in an American company or American investors in a British company — are indeed harmful. Is it possible these foreign investors are pools of capital that firms can tap into and produce stronger companies, which make better products and services? Do these investors from afar monitor firms — for example, keeping managers from becoming too entrenched? Should continental Europe be fearful of U.K. investment, or Asian countries fear European capital, and so on? Or are these fears, at least in some cases, stunting potential corporate growth?

Or, on the flip side, are companies better off as “national champions” — owned by local investors who tend to have a vested, personal interest in the firm both long- and short-term?

Our goal was to stand back from prevailing assumptions and investigate these questions using empirical data from a comprehensive sample of companies from across the globe.

Results on the Impact of Foreign Capital

Our study was more comprehensive than those executed to date. Specifically, we examined the impact of foreign institutional investors on 30,952 publicly listed firms across 30 countries for the 2001–10 period.[2] We excluded utilities and financial firms because of their tendency to be regulated businesses. We used new data on equity holdings by institutional money managers that include mutual funds, hedge funds, investment advisers, bank trusts, insurance companies, pension funds and endowments.

To determine the impact of foreign institutional ownership, we looked at three variables related to a company’s long-term health:

1. Long-term investment: Do foreign investors push companies to distribute their shot-term gains, or instead reinvest it in the form of capital expenditures and R&D?
2. Employment: What’s the effect of foreign investors on the workforce in terms of number of workers and wages?
3. Innovation: What’s the effect of foreign capital on innovation output in terms of new technologies, new patents, and better products and services?

Our study documents a positive relationship between foreign investors and all three factors above.[3] In other words, foreign capital is generally good for public firms in terms of spurring long-term investment, employment and innovation. We also show that higher foreign institutional ownership leads to increases in total factor productivity, internationalization of firms’ operations and shareholder value. So companies, on the whole, benefit from having investors who are “at arm’s length,” rather than consisting solely of local investors whose decision-making about a firm’s future and leadership may suffer from entrenchment (e.g., promoting a family-line successor to CEO instead of the best person for the job) or home bias.

We conclude that the globalization of a firm’s shareholder base is a positive force for capital formation, which makes firms more productive and competitive in the global economy. Of course, not every firm benefits from foreign capital in every instance. But on average, these foreign investors do not seem to deserve the epithet they’ve been assigned (“locusts”) and deserve at least a careful look before being shown the door.

Takeaways for Managers

Our study has wide policy implications, but here we will focus on two immediate implications for current managers and executives.

First, managers should recognize the value of global capital and be willing to welcome foreign shareholders. Avoid letting instinctual fear to take over, and give these investors a good, hard look. Not every foreign investor is going to benefit you, just like not every local one will. But companies will overall benefit by not discriminating against shareholders purely based on their nationalities.

Anecdotally, Asia is a major region where we’ve seen evidence of the negative effects of a protectionist mindset against foreign capital. As discussed in a 2014 article in The Economist (“Avoiding the Dinosaur Trap”), “state firms and family conglomerates are Asia’s favourite kinds of companies.”[4] A refusal to let go of local control is hampering many companies’ potential. It means products that could today be household names around the world are still unknown to anyone beyond Asia.

Second, managers should prioritize investor relations. Nurturing relationships with shareholders becomes all the more critical when those shareholders are dispersed around the globe. Getting to know your investors means an investment of company time and resources, but in the end, they’re resources well spent. Doing so helps weed out true “locusts.” It builds trust and a shared vision, which, in turn, encourages longer-term investment and greater profits.

A change in attitude toward foreign investment will be difficult and uncomfortable, but in the long run, our analysis shows that it’s to firms’ advantages to take a more welcoming approach toward it.

Pedro Matos co-authored “Are Foreign Investors Locusts? The Long-Term Effects of Foreign Institutional Ownership,” forthcoming in the Journal of Financial Economics, with Jan Bena of the University of British Columbia Sauder School of Business and Miguel A. Ferreira and Pedro Pires, both of the Nova School of Business and Economics.

[1] The (in-)famous statement by Franz Müntefering, German SPD chairman was: “We support those companies, who act in interest of their future and in the interest of their employees against irresponsible locust swarms, who measure success in quarterly intervals, suck off substance and let companies die once they have eaten them away.” See also “Locust, Pocus,” The Economist (5 May 2005). Accessed 15 November 2016, at http://www.economist.com/node/3935994

[2] We looked at only public firms because, by their very nature, theirs is the only data readily available. Also, we ended at 2010 because this gave time to see the success (or failure) of patents, which take several years to be approved and were how we measured one outcome variable.

[3] We made allowances in our model to ensure that the results weren’t simply reflective of “selection bias” — i.e., that these investors were investing in firms that already showed a better growth prospect or expected a surge in investment and innovation.

[4] “Avoiding the Dinosaur Trap,” The Economist (31 May 2014). Accessed 15 November 2016, at http://www.economist.com/news/special-report/21602829-state-firms-and-family-conglomerates-are-asias-favourite-kinds-companies-both-must.