Foreign Investment: A Big Boost for Small Business

Research by April M. Knill

Giant multinational corporations get most of the attention, but small firms have tremendous economic importance. A presidential report finds that small firms represent 99 percent of all businesses, employ half of those Americans who have jobs and create two-thirds of the job openings in the United States, and the statistics are similar across the globe. Small firms are an important driving factor for the global economy, but they experience some significant roadblocks: lack of liquidity, an excessive sensitivity to government regulation, difficulty in obtaining equity capital, and size-bias from potential investors. New research at Smith shows that foreign investment can make a big difference for small businesses.

Smith School PhD candidate April M. Knill, in her paper “Can Foreign Portfolio Investment Bridge the Smaller Firm Financing Gap Around the World,” finds that foreign portfolio investment provides a valuable source of capital and credit for smaller firms, both in more- and less-developed countries. Knill posits that there are two ways in which foreign portfolio investment reaches the smaller firm: the direct route, through the capital markets, and the indirect route, through bank lending.

Because no existing dataset listed the smaller firms that Knill wished to study, her first task was the creation of a database from which to work, a process that took almost six months of painstaking labor.

Knill began with data from the SDC Global New Issues database from January 1996 to March 2003. She then hand-collected firm-year financial information from both Reuters and Worldscope. Upon completion, more than 187,000 firm-year observations from 24,000 firms in 53 countries were compiled in Knill’s dataset. She ranked firms by size annually, divided the ranked list into thirds, and focused her study on the smallest size tercile in each country.

The information collected from Reuters was key to off-setting the larger firm bias present in most existing international databases. The Smith School is the largest academic user of Reuters 3000Xtra software; a Reuters certification course is offered as part of the finance department coursework.

Knill found that foreign portfolio investment does help small firms by easing their financial constraints. Firms benefit from this infusion of capital directly through investments or indirectly, through bank lending. Knill believes that this indirect effect is due to several factors. If there is more money in the system, then banks can lend more. Even more important for small firms, due to increased liquidity in their balance sheets, banks can afford to lend to smaller firms, which carry a higher level of risk than their larger counterparts.

Developed nations are the biggest providers of foreign portfolio investment, a trend that Knill expects will continue. “There is more of a trend toward foreign portfolio investment. As individual investors become savvier, they’re less frightened to invest overseas,” says Knill.

Foreign portfolio investment can ease the financial constraints of smaller firms by increasing the capital available to them. The form of the capital appears to be debt for smaller firms, and a mix of debt and equity for larger firms.

Although small businesses have a difficult time accessing equity capital in general, Knill found that foreign portfolio investment increases the probability that these firms in more developed nations may be able to access this form of capital. This is, of course, an advantage over small firms in less developed nations, who are generally unable to access equity capital. Knill found that foreign investors favor larger firms in less developed countries, regarding them as less risky than their smaller counterparts.

Smaller firms in both more- and less-developed nations also benefited marginally from increased bank liquidity resulting from foreign portfolio investment. Although there is modest evidence of this indirect route, Knill found that the route of foreign portfolio investment taken is primarily direct, through the capital markets.

Improvements in a country’s foreign investment environment in less-developed nations can help alleviate financial constraints of both large and smaller firms. Knill believes that easing foreign investment portfolio restrictions on cash flows, stabilizing these investment cash flows and improving the treatment of foreign companies and investors could have a significant, positive influence on the lifetime of smaller firms.

As more countries consider reforming investment policy to include foreign investors, Knill hopes that her research may help resolve the debate on the merit of foreign portfolio investment as a vehicle to growth.

Knill is continuing to use this dataset to explore what works in security laws for small firms with Nela Thomas Richardson, a PhD candidate in economics at the University of Maryland. Knill is a Smith PhD candidate in the finance department and a consultant for The World Bank.