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How foreign acquisitions lower the debt level of domestic firms

 New research suggests foreign investment opportunities benefit domestic firms and should be welcomed by national governments

Georgios Efthyvoulou, Associate Fellow, SPERI, and Lecturer in Economics, University of Sheffield

Georgios EfthyvoulouThe impact of foreign ownership on firm performance has been at the forefront of the international business and finance literature for several decades.  However, the impact of foreign ownership on acquired firms’ debt levels is less well known.  Our new research sheds lights on this issue.

From a resource based view, foreign ownership has been associated with positive performance, as a result of ownership-specific advantages bestowed to foreign owners.  Technological expertise and specialized production processes, superior management and marketing capabilities, and access to financial and human capital are just some of these key advantages identified.  When effectively deployed in a foreign market, these advantages can help their proprietors to exploit host market imperfections, and overcome transaction costs, the liability of foreignness and other barriers of internationalization.  Indeed, several empirical studies have provided evidence for the superiority of foreign-owned firms over their domestic counterparts.  Moreover, foreign ownership has been associated with higher overall productivity, and greater firm resistance to domestic demand contractions.

From an agency point of view, foreign corporate ownership has been associated with both positive and negative effects.  Foreign ownership has been known to enhance managerial control, and hence shareholder protection, especially in the presence of institutional voids.  By exhibiting higher concentration of share ownership, corporate foreign owners, such as large multinationals, can set and effectively impose control mechanisms that maximize performance, leading to dominance over domestically-owned companies.  Yet, the imposition of high control mechanisms has been known to increase transaction costs, which, coupled with minority shareholder expropriation (through the transfer of assets and profits of firms for the benefit of those in control), can lead to serious negative performance effects.

With the seventh global Merger Wave well under way (starting in 2011, as a consequence of the rise of the big emerging countries), it is imperative to better understand not only the direct but also the indirect implications of foreign acquisitions on firm performance, and particularly with regards to firms’ debt levels.  So far we know that a reduction in debt levels minimizes the risk of failure and thus enhances the chances for a positive post-acquisition performance and survival.  Yet, we are still unclear on whether foreign ownership has in fact a direct impact on the debt levels of acquired companies.

In a recently published study in the journal ‘International Business Review’, Vassiliki Bamiatzi, Liza Jabbour and I explicitly factor in the impact of foreign ownership on debt reduction.  Using a very large dataset of firms operating in Italy and Spain over the period 2002 to 2010 (around 120,000 firms per year for each country), we particularly examine the causal effect of foreign and domestic acquisitions on two firm-level debt measures: gearing (the ratio between short and long term debt to shareholders’ funds) and short-term leverage (the ratio between short term debt to total assets).

Our results show that a change from domestic to foreign ownership leads to a lower reliance on short and long term debt.  In fact, our findings indicate a significant and steady reduction in both the gearing and short-term leverage ratios for both Italian and Spanish firms.  Specifically, during the year of acquisition, foreign-acquired Italian firms have a 49% lower gearing ratio (for foreign-acquired Spanish firms the figure is 40%) compared to their matched control observations; that is, non-acquired domestic firms with similar observable characteristics as the foreign-acquired firms.  The reduction in the gearing ratio increases to 62% and 54% for Italian and Spanish firms, respectively, in the first year following the foreign acquisition, reaches its peak at 67% (Italian firms) and 81% (Spanish firms) in the second year, and declines moderately to 57% (Italian firms) and  78% (Spanish firms) in the third year.

The reduction in debt is not associated with a change of ownership per se, but only when the ownership is transferred to foreign investors.  As such, an acquisition by domestic investors offers no significant reduction in debt.  Thus, foreign ownership not only yields higher profitability and productivity for the target firms, but can further act as a deterrent against debt over-exposure, leading as such to more financially healthy target firms.

Acknowledging the important role of banks in Italy and Spain (which makes domestically-owned firms particularly vulnerable to macro-economic shocks and changes in bank credit), our findings come to validate Desai et al. who argue that parent companies would be inclined to reduce external influences on their affiliates when faced with highly regulated and uncertain institutions.  Nevertheless, we find that the reduction in the short-term leverage is much larger in total.  This might be further explained by the predominance of small-sized companies within the two examined countries, which use significantly more short-term debt to finance their operations.  Therefore, it could be expected that foreign acquirers – out of prudency – will reduce the target’s short-term over-exposure, minimizing as such the associated default risks and their overall external control.

The above findings have important policy implications that may contradict the old conservative European agendas in encouraging the emergence of ‘national champions’.  It is clearly showcased here that foreign acquisitions can benefit significantly acquired domestic firms, offering consequently important overall contributions to the domestic economy in which they operate.  Taxation and financial benefits, but also spillover effects, sharing new competencies, resources and developing stronger networking alliances with the domestic market are only some of the associated benefits.

Our research suggests that foreign investment opportunities should be welcomed and supported by national governments, especially in less-efficient bank-based economies.  Implementing policies aimed at attracting foreign investment can also be particularly beneficial for countries like Italy and Spain, which are characterized by underdeveloped private equity markets and an overwhelming large share of small-sized companies, and thus an overreliance on bank credit and restricted financing availability for domestic firms.

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