Capital flowing around the world is changing the way businesses grow and shrink. And, like an explorer trying to find his way out of the wilderness, business leaders would be wise to follow the pathways that capital follows. In so doing, business leaders can uncover new business opportunities and shun emerging risks.
We recently published a book (titled Capital Rising) looking at the effects of global capital flows. It is based on interviews, over four years, with executives at more than 50 companies—as well as on our work with governments and several firms. Our research suggests the kinds of questions the executives should scrutinize to profit from globalization of capital.
What Drives Global Capital Flows?
Like minnows swimming toward a more nutrient-rich bay, capital hones in on markets where it can grow the fastest. And, those fastest growing markets are China and India, two countries that have been growing at between 9 and 11 percent a year for the at least last decade. This growth has attracted rapidly growing flows of private equity and venture capital into companies that can surge along with that general economic growth. Moreover, hedge funds have found ways to profit from investing in these rapidly growing countries as well.
The importance of capital flows for better global economic performance has always been high and has become paramount in recent years. For example, according to UNCTAD and the Institute for International Finance, global capital flows have been growing steadily for the last decade. Global Foreign Direct Investment (FDI) by firms investing abroad hit $1.7 trillion in 2008 while private capital flows to emerging markets totaled $588 billion that year. While both of these fell during the economic contraction in 2009—FDI declined to $1.2 trillion in 2009 while emerging market private capital flows hit $531 billion—both are expected to grow again as the world economy recovers. By 2011, FDI will be 50 percent higher while capital to emerging markets will spike 40 percent.
Often, what is missed in this statistical assessment is how, in recent years, private capital providers who invest in nascent firms, have begun to invest abroad. We found many examples of private equity firms tapping into emerging market growth and cleverly getting ahead of their competitors through their shrewd insights into the changing factors that shaped entrepreneurial activity there. For example, we examined the case of Warburg Pincus, a private equity firm that generated 10-year average Internal Rates of Return of 35 percent by investing in India when things looked too risky to most players, and selling when peers piled in to replicate WP’s high returns that it earned by anticipating changes in India’s capital markets.
One of WP’s greatest investments was in Bharti Tele-Ventures, a wireless company. Between 1999 and 2005, WP’s $300 million stake in, grew to $1.5 billion. WP looked at India’s weak infrastructure as an opportunity to leapfrog technologies—skipping over a network of copper wires right to a wireless one. And, when India’s corporate governance and capital markets became more favorable, WP’s investment in Bharti Tele-Ventures was the beneficiary.
What is the Country’s Entrepreneurial Ecosystem?
Capital thrives when key factors, such as corporate governance and IP protection, interlink to support entrepreneurial activity. Collectively, we dub these interlinking factors as a country’s “Entrepreneurial Ecosystem.” Yet our research has found significant weaknesses in the Entrepreneurial Ecosystems of these growing countries.
For example, China’s financial markets are relatively shallow and opaque and its IP protection system is notoriously weak. Moreover, India, while having made big strides in corporate governance and financial markets, still has certain restrictions—such as laws preventing foreign companies from operating storefronts in India.
Despite those limitations, capital is flowing to these countries. This is because the capital providers try to work around the limitations of the entrepreneurial ecosystems in these countries to capture the more rapid growth there. For example, consider Vinapay, a Vietnamese a mobile payments service. IDG Ventures bought a stake in this company, which, by 2007, was worth an estimated 100 times the original investment. Since Vietnam lacked strong IP protection, IDG decided to invest in a company that did not depend for its success on new technology. Instead IDG bet correctly that the adaptation of a business model that had worked in the U.S. also could become a moneymaker in Vietnam. No doubt, these workarounds limit the profitability of the investments in these countries. But given the much faster growth, the net effect is to still provide higher returns than elsewhere.
How Do Managers Adapt to Global Capital Flows?
Globalization of capital flows has injected a new challenge to managers of well-established companies. The capital flows permit rivals from emerging markets or smaller firms in developed countries to formulate and implement new global strategies leveraging their capital access. Witness how Tata Steel was able to buy Corus Steel in Europe using capital raised abroad. More recently, Indian telecom firm Bharti has sought to become a global player by seeking to acquire MTN, the largest Africa-based telecom firm. In turn, these competitive moves by emerging market players call for managers in existing firms in the West need to be nimble and strategic in their responses.
Managers of existing firms face some difficult questions:
- Should they preserve the corporate strategies that got their companies to their current position?
- Do those strategies represent a core rigidity that makes their companies unable to adapt to change and thus vulnerable to upstart competitors?
- If so, do acquisitions represent a profitable means of reviving a moribund company’s growth?
In some cases, global acquisitions can represent a logical way to extend a firm’s corporate strategy. Deals that make the most strategic sense target large, rapidly growing markets and assemble a set of capabilities that enables the combined company to take significant share in those growing markets.
Such deals are likely to pay off for managers by reviving a stagnant company. In other cases, acquisitions are a mistake because the availability of private equity and bank debt enables deals that would otherwise not make strategic sense.
Deals that are driven primarily by the availability of capital to finance them, rather than a sound strategic logic, tend to fall apart rather quickly once the appetite for such financing switches off. Such failed deals should be a cautionary tale for managers in existing industries.
Their key lesson is that managers must separate investment decisions from financing decisions. If the availability of financing causes managers to seek investments that make little economic sense, the managers will later regret their inability to resist the deal.
In general, managers make their companies vulnerable if they do not remain keenly attuned to changes in their competitive environment. The globalization of capital flows and the resultant entrepreneurial moves by new players represent a threat to companies that refuse to pay attention to how this force can upend their business. Yet for managers willing to tap its power, the globalization of entrepreneurship can revive a moribund company in a mature industry.
How Can Managers Profit From Opportunities and Bypass Risks?
What can managers do to capture the opportunities of capital globalization and avoid the risks of capital going global? We suggest the following six-step methodology:
1. Pinpoint large countries growing fast with industries in which your company competes.
To find such markets, managers may seek to focus on developing countries with large populations where there is demonstrably rapid growth in demand for their products. It is worth noting that unless the manager’s company can satisfy that demand better than competitors already do, then the investment it might make in trying to take a share of that market is likely to be wasted. To avoid that fate, managers ought to conduct research into the specific criteria that channels and end-users apply to competing suppliers to assess which one to pick.
2. Identify risks and opportunities in the country’s regulations regarding foreign ownership and other corporate governance matters, its capital markets, its human capital, and its IP regime.
However, if managers see an opportunity in meeting customer needs better than the competition, they should next consider whether the country’s entrepreneurship ecosystem is at odds with their own. Such differences do not necessarily mean that the managers should not seek to enter that new market. However, managers will find themselves at a disadvantage if they do not explore those differences early in the process of considering a new country in which to expand.
3. Identify companies in those countries/industries that could be acquisition candidates.
Having settled on a particular country in which to invest, managers may wish to consider whether they should seek to take market share through a de novo venture, partnership, or acquisition.
4. Rank the companies based on their fit with your company’s skills and the potential for an attractive investment return.
Such data can help managers as they decide which of those companies they should approach first, and which they should shun.
5. Complete the acquisition and integration of the company that best fits these criteria. The next step is to execute.
In general, this involves a huge amount of management effort, in conjunction with advisers, capital providers, target company management, and regulators, to complete all the tasks from contacting the target company to completing the integration of the target into the acquiring company.
6. Set performance milestones and manage the company to achieve them.
This implies the willingness to re-examine the premises that underlie how the value chain of the firm is currently distributed globally and how it could be reconfigured to benefit the firm strategically.
Global capital flows follow the pathway of country entrepreneurship ecosystems. Managers in existing firms can tap the growth that these capital flows seek. But along with the opportunities of competing in these countries and industries come risks. Our analysis shows that the six-step process outlined above can help managers to get the best opportunities while skating around the most treacherous risks.