Multinational Ownership and Subsidiary Investment

1. Multinational Ownership and Subsidiary Investment Wendy Carlin, UCL & CEPR Andrew Charlton, LSE Colin Mayer, Oxford & CEPR June 2009

2. How does foreign ownership affect investment in host economies? Specific question: How does shock to parent company�s investment opportunities affect fixed investment of subsidiary? Motivating example: Impact of Asian crisis on investment of foreign subsidiaries cf. domestic firms? Innovation of this paper: Use sample of listed subsidiaries as well as listed owners ? measure of investment opportunities using Tobin�s Q for both subsidiaries & parents

3. Some Facts about Listed Firms In 2005 there were 28,915 listed firms in the world Of those 7,751 were in the US, 3,598 in Japan, 1,316 in China and 1,869 in the UK Of the 28,915, 74% were standalone, 23% were owned by another firm and 3% were owners of another firm Ownership is defined as a stake of >50%

4. Foreign Ownership & Listed Firms Of the 23% that were owned, one-third were foreign owned Of the 3% that were owners, almost all were owners of foreign firms In the US, 3% were foreign owned and 4% owners of foreign firms In the UK, 9% foreign owned and 9% owners of foreign firms In China, 14% foreign owned and <1% owners of foreign firms In Croatia, 17% foreign owned and 0% owners of foreign firms Foreign ownership is substantial Some countries are much more open and dependent on foreign ownership than others

5. Implications of Foreign Ownership Subsidiaries have access to internal as well as external capital markets Subsidiaries of multinationals have indirect access to parent and as well as domestic capital markets Multinationals allocate resources across as well as within countries

6. Allocation of Resources: comparing stand-alones with MNE subsidiaries Descriptive statistics (Sample: 22,176 firms in 69 countries, 1994-2004) In firms with above average investment opportunities and below average financial resources, investment is 14% higher in multinational subsidiaries than in standalone firms In firms with below average investment opportunities and above average financial resources, investment is 8% lower in MNE subsidiaries than in standalone firms

7. Response to Shocks In the Asian crisis between 1996 and 1998, foreign owned firms cut their investment by 68% while domestically owned firms cut theirs by 48% Parents outside Asia cut back Investment in their subsidiaries by significantly more than did parents within the region More generally, during recessions foreign subsidiaries cut their investment by approximately twice the amount of domestic firms (19% cf. 10%).

8. Is the subsidiary�s investment response in a recession related to how arms-length is the relationship?Proxies: the size of the parent�s stake; the physical distance between them

9. Summary of descriptive data Investment behaviour of stand-alones appears different from that of subsidiaries Prima facie evidence of reallocation within the MNE�s internal capital market During host country recessions, Investment by foreign-owned firms is cut back more than that of stand-alones Investment by less tightly owned and more distant subsidiaries is cut back more than of more tightly owned and closer ones

10. Regression analysis Is there evidence of an internal capital market � in particular, how does a change in investment opportunities in the parent affect investment by the subsidiary? How does the investment behaviour of subsidiaries compare with that of stand-alone firms? How is any �parent effect� on subsidiary investment influenced by distance ownership concentration financial development?

11. Related literatures Financial economics / boundaries of the firm: Unresolved debate about dark v. bright side of internal capital markets: survey Stein (2003; Handbook chapter) Investment in multinational enterprises (MNEs): Internal capital markets in MNEs (cf. domestic subsidiaries of conglomerate firms) Macro impact of MNEs: - Related findings on plant shut-downs: plants owned by MNEs are more likely to be closed than are purely domestically owned plants, controlling for plant characteristics both in host & home countries (Bernard & Jensen 2007) - Impact of foreign-owned firms in weak capital markets; in recessions; in financial crises (e.g. Asian crisis � Desai, Foley & Forbes 2007) - Transition economies

12. Internal capital markets - theory Bright side Internal finance provider (HQ) has high levels of information and control HQ has authority to reallocate resources Internal competition for investment funds: �Darwinism� (Stein 2003) Dark side (Lamont 1997, Scharfstein 1998) Internal socialism � cross-subsidization Influence effects � interference

13. Existing evidence of ICM effects is ambiguous Is this because of flawed tests? Testing for ICM: holding investment conditions of one division constant does its investment vary when cash flow changes in another division? Shin & Stulz 1998 report evidence of such cross-subsidization: �internal socialism� But Chevalier finds this cross-subsidization effect for financially unrelated firms that merge later Whited casts doubt on diversification discounts & increased sensitivity of Inv to Q after spin-offs as evidence of inefficient ICM Bottom line: Cross-subsidization and diversification discounts predict mergers/spin-offs & are uninformative about ICM Why are tests flawed? No reliable measure of the subsidiary�s investment opportunities

14. Our data � parent-subsidiary pairs both listed OSIRIS database (Bureau van Dijk): 28,915 firms listed on global stock exchanges: �comprehensive coverage of listed companies around the world� 74% stand-alone 23% subsidiaries (i.e. subsidiaries where parent has >50% stake); 8% foreign-owned 3% owners NB Definition: Subsidiaries: 50%<ownership<100% Both investment and Q are observable for subsidiary & its parent

15. Comparison between listed (our sample) & unlisted subsidiaries Use all listed & unlisted subsidiaries of all European firms with at least one of top 2,000 listed & unlisted subsidiaries (Table 4)

16. Estimation strategy Debate about cash flow in investment equations � does it signify liquidity constraints? Neither necess nor sufficient (Gomes) � not necess because fin constraints should be included in Q; not suffic because non-linearities in Q could be captured by CF in linear inv equation. Debate about cash flow in investment equations � does it signify liquidity constraints? Neither necess nor sufficient (Gomes) � not necess because fin constraints should be included in Q; not suffic because non-linearities in Q could be captured by CF in linear inv equation.

17. We include industryxtime effects in Column (3) to control for the possibility that industry shocks are causing the relationship between parent Q and subsidiary investment. We include industryxtime effects in Column (3) to control for the possibility that industry shocks are causing the relationship between parent Q and subsidiary investment.

18. Endogeneity issues (1) 1st By finding surrogate parents, we test whether the �parent-Q� effect is picking up some more general relationship between parents and subsidiaries other than one arising from the financial relationship 2nd We are concerned that although we have taken out the direct effect of subsidiary Q on parent Q in calculating Qj there may be some indirect channel through which subsidiary investment affects parent Q � look at partial correlations Surrogate parents in same industry and country. Surrogate parents in same industry and country.

19. Endogeneity issues (2) Using foreign-owned subsidiaries: Assumption is that a recession in the parent�s country affects parent�s Q but will not directly affect subsidiary investment. Very low correlation between parent country recession and subsid investment (0.018). Using foreign-owned subsidiaries: Assumption is that a recession in the parent�s country affects parent�s Q but will not directly affect subsidiary investment. Very low correlation between parent country recession and subsid investment (0.018).

21. Comments on Parent Q effect OLS regression, parent Q effect is negative and significant - shift from 25th to 75th percentile is associated with a fall in investment/asset ratio by 5% cf. median Estimated size of the coefficient on parent Q is 10x larger when estimated by IV � within range of estimates when own-Q is instrumented to deal with measurement error and endogeneity (Cummins et al. 1996, Erickson & Whited 2000, Bond & Cummins 2001) Robust to looking at sub-samples � e.g. only manufacturing firms or non-US firms (Table 8)

22. Comparing subsidiary / stand-alone firms Use propensity score matching to find a sample of stand-alones to compare with the subsidiaries Find that as compared with stand-alones (full or matched sample), investment of subsidiaries is significantly (see Table 8) � More sensitive to own-Q Less sensitive to own cash flow Suggests that parents ease the financial constraints faced by subsidiaries Caution still � firms are not randomly allocated between subsidiary & stand-alone status

23. How does the internal capital market work? Does a more arms-length relationship enhance or diminish reallocation in the MNE network? Is reallocation in response to relative profitability diminished in settings more likely to invite influence activities? The literature: Dark side: Influence activities (Meyer, Milgrom & Roberts 1992) arise from relationship between CEO and managers of subsidiaries Bright side: Information & control advantages of CEO as a provider of internal finance cf. providers of external finance Hence a more arms-length relationship may minimize influence effects & allow the bright-side to dominate Influence activities: well-cited example of GE rotating divisional managers to reduce benefits from lobbying for excess capital. Influence activities: well-cited example of GE rotating divisional managers to reduce benefits from lobbying for excess capital.

24. Proxies for arms-length relationships Hypothesis: Influence effects have the potential to outweigh the informational and control benefits of Geographical closeness (Portes & Rey, 2001, Guiso, Sapienza and Zingales 2004, Mian, 2005) Size of owner�s stake (Allen & Gale, 2000: e.g. Shleifer & Vishny, 1986 versus Burkhart, Gromb & Panunzi 1997)

26. Results: Distance and Ownership Concentration Negative parent Q effect enhanced with greater �arms-length� - lower ownership concentration greater distance from parent Both suggest influence outweighs information Failure to find parent cash flow effect earlier is due to heterogeneity Parent CF has +ve effect on subsidiary investment, which appears to confirm presence of ICM

27. Is there more reallocation in response to relative profitability when subsidiaries are in weak financial markets?

28. Increase in Privcred means narrowing of fin. Devt gap � as this narrows, the �ve parent Q effect strengthensIncrease in Privcred means narrowing of fin. Devt gap � as this narrows, the �ve parent Q effect strengthens

29. Results: Level of Financial Development Introduce relative level of financial development between subsidiary & parent countries Negative parent Q effect enhanced as financial development gap narrows: information effects dominate in MNEs in advanced economies Positive parent cash flow effect reduced as financial development gap narrows Suggests influence effects are more important in less well-developed financial environments

30. Conclusions Negative parent Q effect indicates reallocation to superior investment opportunities in the firm network Investment by subsidiaries appears to be different from stand-alone firms (more responsive to own Q and less to own cash flow) Results are consistent with the existence of internal capital markets within firm networks Reallocation toward profitable opportunities is more in evidence when relationships are more arms-length: parent�s ownership stake is relatively modest or when it is distant Results are suggestive of the role of influence effects on allocation of investment Influence effects appear more prevalent in less financially developed economies

31. Back to the Asian crisis � Recessions: why do foreign-owned firms cut investment by more than stand-alone firms? Our results point toward: Reallocation within the multi-national network as better investment prospects emerge elsewhere Likely bigger effect when ownership stakes are smaller, parents more distant �Influence effects� prevail with more concentrated or closer owners or with weaker financial development Foreign owners may substitute �fire-sale� purchases of host country assets for fixed investment in their subsidiaries (see Aguiar & Gopinath 2005)