SMEs, FDI and Financial Constraints

1. SMEs, FDI and Financial Constraints Wouter De Maeseneire Erasmus University Rotterdam – School of Economics Tine Claeys Vlerick Leuven Gent Management School Small Business Banking and Financing: a Global Perspective May 25-26 2007, Cagliari, Italy

2. Summary of the paper Introduction Contribution Literature review Hypothesis development Method Sample description Results Discussion and conclusion Avenues for further research Agenda

3. Explorative research on FDI financing issues faced by small firms Develop theoretical hypotheses + empirical testing We find severe capital market imperfections for many SMEs due to Information problems Home bias of financiers Lack of collateral, banks’ use of capital gearing method FDI finance gap hinders internationalization strategy and negatively affects firms’ economic performance 1. Summary of the paper

4. Internationalization: important business phenomenon of the 20th century Both large and small firms Impressive rise in FDI SMEs face financial constraints Do SMEs face more severe financing constraints for FDI projects? Many countries provide FDI credits for SMEs; however, only anecdotal evidence FDI huge economic importance, though there is gap in the literature on (SME)FDI financing 2. Introduction

5. Potential lack of finance impediment for SMEs’ performance? Relevant since financial constraints have real impact Entrepreneurial initiatives Firm growth Economic viability Most internationalization literature focuses on Large firms, export, specific firms We develop hypotheses and empirical evidence 32 Belgian SMEs 5 banks and 5 VCs Belgium provides an interesting setting (typical Cont. Europe – many firms internationalize) 2. Introduction

6. First academic article on SME-FDI finance Insight in financing of SME-FDI Hypothesis development for SME-FDI finance issues Document existence of SME-FDI financial constraints Explore nature of those constraints Examine impact of constraints on firm performance Finding empirical evidence on finance constraints is inherently difficult, little is known about their significance and effects 3. Contribution

7. SMEs frequently face a lack of capital to finance exports No single study investigated financing constraints SMEs experience when pursuing FDI Survey by European Commission: SMEs that engage in outward internationalization activities may confront shortage of capital 4. Literature review

8. Internationalization-FDI and firm performance Advantages of internationalization Economies of scale and scope Spreading investment risks Increasing market power Exploit market imperfections Learning Advantages of FDI Tax rate arbitrage, innovation transfer, cheaper input factors Leverage of ownership or location based advantages Reduce transaction costs Vs. market-based transactions: reputation concerns, technology transfer and moral hazard problems Enjoy FDI credits offered by several foreign countries 4. Literature review

9. Internationalization-FDI and firm performance Yet, internationalization may be risky Governmentally instituted barriers to trade Incomplete understanding of local laws, culture and business practice Greater agency and information problems Monitoring managers is more difficult Geographical constraints, multi-country financial statements,.. Liability of foreignness and newness FDI entails greater resource commitment than export, is more difficult to reverse and less flexible in dealing with investment risks 4. Literature review

10. Strong predisposition of equity investors towards geographically and culturally proximate investments “Home bias”, cognitive bias towards the familiar and lower information costs Similarly, VC firms/banks rather invest/lend close to their home base. As distance rises, reducing information asymmetries becomes challenging. We argue that many issues firms face in attracting capital for FDI are equivalent to those for financing R&D Returns are volatile and skewed: creditors only care about the downside/left tail Higher information asymmetries: foreign investments are hard to evaluate, insiders have better information Limited collateral value: sunk costs such as expenses of foreign market analysis, translation of documents, adapting products, travel expenses; FDI frequently involves intangible assets or firm specific assets Thus, the limited collateralizability of FDI assets restrains access to debt 5. Hypothesis development

11. SMEs face greater challenges: internal shortages of information, finance, management time and experience, resulting in higher vulnerability, inflate liabilities of foreignness Credit rationing for FDI: likely worse for small firms Home bias is due to information costs; to some extent fixed Methods of evaluation to assess loans; income gearing (large firms) is preferable to traditional capital gearing (small firms), relies on future performance rather than on collateral. However, requires bank to understand how firm operates; assessment of FDI often unfeasible. High tech SMEs complain of banks’ limited competency in evaluating their potential and about excessive warranties; smaller firms suffer most Financing constraints for FDI may hurt survival and growth potential; SMEs rather internationalize in less capital intensive ways, and opt for export 5. Hypothesis development

12. H1: SMEs experience more severe financing constraints for their FDI than for their domestic projects H2: The financing constraints SMEs face for their FDI projects have a detrimental impact on their performance and growth 5. Hypothesis development

13. Interviewed demand and supply side of SME FDI finance in Belgium 32 SMEs that are involved in FDI projects 5 banks and 5 venture capitalists: check on validity Impossbile to find a listing of all SMEs that pursue productive FDI (e.g. set up a new plant) Several sources Belgian Corporation for International Investment (BCCI), Entrepreneurship, Governance and Strategy Competence Centre at Vlerick Leuven Gent Management School, Cabinet of Economic Affairs, sector federations like Agoria and Febeltex Flanders Investments & Trade (FIT): list of seminar (on financing and insurance of foreign investments) particpants SMEs interviewed Hard to identify SMEs suitable for our research Smaller firms are notably less internationalized, particularly for more complex forms of internationalization like FDI Second, a large part of FDI does not involve productive investments 6. Method

14. Group of 130 firms considered to be SMEs carrying out productive FDI Email was sent informing them about our research project, then contacted by phone, meet sample criteria? 32 SMEs met requirements and cooperated Semi-structured interviews were conducted with owner-manager (1-1.5 hours) Develop questionnaire, pretested and sent to all SME owners previously interviewed General information about SME, FDI, financing of FDI, score broad range of statements on a 5 point Likert scale (1, totally disagree - 5, totally agree) 23 questionnaires have been filled out 6. Method

15. 7. Sample description

16. 42.9%: most recent FDI project entirely funded by internal cash flows 50.0% mainly finance their latest foreign investment with internal funds Hints to financing constraints… NOTE: simply focusing on mean score might be misleading: score of around 3 may be the result of averaging out. Thus, we also examine the percentage that reports fully agreeing with a statement Many respondents would have trouble financing FDI project in case of insufficient internal finance They more strongly depend on internal financing for foreign than for domestic projects Larger wedge between cost of external-internal financing for FDI Finally, 28.6% totally agree that raising equity from new stockholders is the last financing option they would consider 8. Results – Internal financing

17. 78.3% of the SMEs uses external financing for its FDI projects Bank financing is most popular source of funds: 39.1% obtain local bank finance in foreign country Many SMEs consider local bank financing but High interest charges and collateral requirements Sometimes, local banks refuse to accept domestic guarantees Bank regulation quite restrictive, or bank sector not well developed. For instance, only short or medium term loans offered; leasing does not exist;… Obtaining local bank financing is time consuming 8. Results – Local bank financing

18. 65.2% attract domestic bank finance Major impediments Assets cannot serve as collateral, partly due to their specificity Repeatedly require (further) personal collateral, limited by nature Usually lends to parent, thereby shifting credit risk Not really interested in FDI, specific domestic focus, reluctant because of monitoring issues, not always capable of accurately assessing risks. Frequently only consider lending for acquiring fixed assets, not for required start up costs, market studies, business trips During interviews, not only refusal of loan request was mentioned by some SMEs, but also long search for financing and period of time before approval While searching for funds, SMEs cannot focus on core business activities and optimal timing-implementation of FDI may be jeopardized 8. Results – Domestic bank financing

19. Credit decision for foreign projects based to higher degree on collateral, and not on projects' profitability, than for domestic projects For small SMEs, banks require more collateral If banks judge FDI's risk is excessive, rather ration credit than raise interest For large firms, banks tend to base credit decision on FDI profitability; larger firms have possibilities to collateralize FDI assets Attracting bank finance for FDI projects difficult, some countries even impossible More willing to provide funds for FDI projects in geographically proximate countries. Preference for East Europe over Asia Africa-based projects: next to impossible, straightforward for US Interestingly, 31.3% admit sometimes not even apply for bank credit for valuable though complex FDI project, convinced will not be granted 8. Results – Domestic bank financing

20. 50.0% of respondents make use of new equity raised with existing shareholders Existing shareholders are claimed to be capable and willing to provide new equity financing However, respondents may in some cases be reluctant to raise equity from new shareholders 8. Results – New equity

21. SMEs may try to attract business angel (BA) or venture capital (VC) finance Not a single respondent makes use of BA funds, two ever applied for it Major obstacles: lack of knowledge about this source of finance, perceived high levels of control and monitoring, cost of BA finance, requested amounts sometimes too large Numerous SMEs are reluctant to attract BA finance 8. Results – Business angels

22. 2 SMEs attracted venture capital for FDI; half of sample ever applied Rather than not being capable of raising VC, some unwillingness to attract VC Substantial preference for industrial partner over VC, VC to some extent considered as a last resort SMEs do not feel VCs are not open to investing. By contrast, VC more interested in SMEs with FDI due to enhanced exit opportunities In contrast to bank results, firms do not think VCs lack skills to assess projects Major obstacles: Too expensive, especially given low risk VC's option to sell off stake in case of bad results SME's fear of not being able to buy back VC's shares VCs are reported To desire too quick exit Employ aggressive investment contracts Require much control/monitoring 8. Results – Venture capital

23. 30.4%: government subsidies in host country, while all firms use grants in domestic country Financial government support: most welcome Several firms: without government support, very doubtful FDI projects could be executed Obtaining government grants facilitates private financing Improved solvency position More significantly: positive signal, e.g., to banks 1 SME mentioned: next to impossible to obtain bank credit, but attracting grants enabled this Obtaining FDI government grants/support is harder for Small SMEs, limited amounts required, certain industries, like services Government must create environment that facilitates- stimulates international trade, e.g., through provision of information and promotion of domestic firms 8. Results – Government grants

24. In addition to providing additional resources and expertise, domestic partner may support FDI projects financially 21.7% has partnered up with domestic firm for (some of) foreign projects Domestic partner slightly eases access to domestic financing For FDI projects, partnering up with host country firm is quite common (43.5%) Allows benefiting from local partner's legal, cultural and administrative knowledge Additionally, facilitates access to local finance and local government support 8. Results – Partnerships

25. Severe financing constraints for FDI for many SMEs Due to volatile returns, information problems and lack of collateral Home bias of financiers and capital gearing method used by banks further reinforce problems Findings support theoretical hypotheses, provide an exploration into nature of capital market imperfections and document negative effects of finance gaps When internal finance is insufficient for FDI, lot of SMEs have a hard time attracting funds Excessive collateral requirements, high interest rates or an underdeveloped banking system may preclude local bank finance Domestic banks often not well capable of evaluating FDI and suffer from home bias. Furthermore, frequently only willing to finance fixed assets and base credit decisions on capital gearing approach. Typically, FDI assets cannot serve as collateral Attracting external equity not available, too expensive/unattractive SMEs often rely on government grants to alleviate the private market's failure: direct positive effect + positive signal to private financiers Partnerships, both domestic and local firms: repeatedly utilized, facilitate access to finance Supply side interviews fully confirm our findings 9. Discussion and conclusion

26. Capital market imperfections found suggest further need to find ways of alleviating barriers to entry to stock market for SMEs Government should remove any lack of equity stemming from tax and regulatory frameworks Financial institutions are required to develop creative solutions to information problems involved in SMEs' FDI projects, rather than relying on collateral For instance, relationship-based lending. Establishing close and long-standing relationships reduces information asymmetries, provides bank with clearer understanding of business' prospects and better picture of managerial capabilities Government grants or other forms of support may mitigate effects of private market's failure; especially, government's lack of demand for collateral or its guaranteeing of SME commitments are crucial. Besides financial help, government should create framework that facilitates internationalization 9. Discussion and conclusion

27. Examine impact of SMEs’ financial constraints for FDI on Internationalization strategy, mode of internationalization,… Which variables drive constraints? Human capital; owner education; stage of internationalization;… Collected data about owner-managers' characteristics and SME ('s FDI), like founding date, industry, size,… . We find (statistically insignificant) negative relationship between proxies for firm size and FDI financing difficulties, and mitigating effect of previous experience with foreign investment Next, local bank finance deserves attention. Important source of financing, void in literature Our research is subject to limitations Lack of public data required to rely on self-reported data; risk of bias Focus on single country, Belgium. Still, no reason why theoretical foundations for our work should obtain more fully in Belgium Sample mainly composed of firms that succeeded in FDI plans  true financing gaps faced by SMEs considering international investment might be more substantial Sample size; given paper's explorative nature and small population of SMEs involved in productive FDI, sample cannot be considered small  resolve these limitations 10. Avenues for future research

28. Q and A