Does Foreign Portfolio Investment Reach Small Listed Firms?

• Published date: 01 March 2013
• DOI: http://doi.org/10.1111/j.1468-036X.2010.00572.x
• Date: 01 March 2013
• Author: April M. Knill

European Financial Management, Vol. 19, No. 2, 2013, 251–303

doi: 10.1111/j.1468-036X.2010.00572.x

Does Foreign Portfolio Investment

Reach Small Listed Firms?

April M. Knill

Florida State University, 821 Academic Way, 143 RBB, Tallahassee, FL 32306, USA

E-mail: aknill@cob.fsu.edu

Abstract

Because investors generally choose to invest in large firms when investing

internationally, it is not immediately obvious whether small listed firms would

benefit from foreign portfolio investment. A capital infusion of this form could

either serve to alleviate constrained capital markets or make large f irms stronger,

increasing competition and crowding out small firms. In this paper, I examine

the impact of foreign portfolio investment on the capital issuance behaviour of

small listed firms. I find that foreign portfolio investment (scaled by grossdomestic

product) is associated with an increasedprobability of small firm security issuance

in all nations, regardless of property rights development. Evidence suggests that

the mechanism by which this occurs is a freeing up of capital in domestic markets

when large firms utilise foreign investment directly. Long-term debt levels increase

in nations where property rights are more developed, suggesting that foreign

portfolio investment may reach small firms through the banking channel as well

in these nations. The banking channel results, however, are somewhat sensitive to

the definition of foreign portfolio investment.

Keywords: foreign portfolio investment,access to capital,emerging markets,small

firm

JEL classification: D92, F32

Recipient of the Center of International Business Education and Research (CIBER) and FMA

2004 Best Dissertation in International Finance Award. Much of this work was completed

while I was a doctoral student at University of Maryland. Many thanks go to Vojislav

Maksimovic for his advising on this research; his dedication to my work is very much

appreciated. I am grateful to my committee members: Lemma Senbet, Gordon Phillips,

Nagpurnanand Prabhala and Carmen Reinhart for all of their help as well. Thanks also to

Robert Marquez, Guillermo Calvo, Enrique Mendoza, Thorsten Beck, Asli Demirg¨

uc¸-Kunt,

Leora Klapper, Robert Cull, Ali Nejadmalayeri, Chuck Lahaie, Scott Merryman, and an

anonymous referee for their help, guidance and input. I am grateful for comments received at

the FMA Doctoral Consortium, FMA Conference, SFAConference, Florida State University,

University of Missouri, and the Federal Reserve Board.

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252 April M. Knill

1. Introduction

Recent literature suggests that informational asymmetry on the part of foreign investors

hampers small firm access to international capital. A study conducted by Aggarwal

et al. (2005) finds that disclosure at the f irm level is an important determinant of firm

choice for institutional investors. Since information asymmetry appears to be worse for

smaller firms, foreign investors often steer clear of these firms, even if they are listed.

Dahlquist and Robertsson (2001), Kang and Stulz (1997), Edison and Warnock (2004),

and Cai and Warnock (2004) all find that foreign owners prefer to invest in largef irms.1

Leuz et al. (2009) find that information asymmetry and monitoring costs lead investors

to choose firms with the least opaque earnings, implying that foreign investment would

go directly to large firms.

The results of the aforementioned studies imply that it is not immediately obvious

whether small listed firms could benef it from foreign portfolio investment (FPI),

defined by the International Monetary Fund as ‘equity and debt issuances including

country funds, depository receipts, and direct purchases by foreign investors of less

than 10% control’ (Balance of Payments Manual, 1993). The allocation of FPI capital

to heterogeneous firms that might result from the opening of a country’s borders to

foreign investment is important in understanding the impact of liberalisation and if that

impact varies by firm size. Though the likelihood of small firms directly accessing

foreign capital is slight,2foreign portfolio investment could have implications on

capital allocation in the domestic market. Indeed, Wurgler (2000) f inds that financial

markets facilitate capital allocation. Henry (2000) finds that foreign investment deepens

financial markets.3Other works help to explain the impact of financial development on

financial constraints. For example, Khurana et al. (2006) find that f inancial development

alleviates financial constraints. Beck et al. (2005) suggest that financial obstacles (such

as explicit barriers to international investment) constrain small firm growth, that financial

development alleviates these effects to some degree, and that when theydo, small f irms

benefit the most. To the extent that the deepening of financial markets accompanying FPI

constitutes financial development, we could hypothesise that FPI is positivelyassociated

with the access to finance of small listed fir ms.

Extant literature suggests that the route through which FPI might reach a small listed

firm may differ, depending on the level of property rights in each nation. The level of

property rights influences whether or not and how much foreigners are willing to invest.

Lee and Mansfield (1996) f ind that the volume and composition of US foreign direct

investment is determined by perceptions of the level of (intellectual) property rights.

1However, Holland and Warnock (2003) find that f irm size does not appear to be an important

determinant for US investment in Chilean firms.

2Investment in small firms may happen as part of an index fund, a small firm-oriented mutual

fund, or even cross-listing (note that the proportion of small listed firms that are cross-listed

is not zero). This direct investment in the small firms does not contradict the conclusions of

this paper, which is that FPI improves small firm access to capital. It does, however, impact

the conclusions with regard to the mechanism by which this benefit occurs. Tothe extent that

investment occurs by one of the above vehicles, the benef it would be direct. I am grateful to

an anonymous referee for pointing this out.

3See also Kim and Singal (2000), who find that liberalisation improves returns and Bekaert

and Harvey (2000), who find that liberalisation decreases the cost of capital. Both of these

could have positive externalities with regard to small firm access to capital.

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Does Foreign Portfolio Investment Reach Small Listed Firms? 253

Chhibber and Majumdar (1999) link the extent of property rights in India to the ultimate

profitability of the invested firm. Claessens and Laeven (2003) define proper ty rights

as ‘protection against powerful competition.’ Defined in this way, property rights could

directly affect the impact of FPI on small firm access to capital (versus large firms).

In this way, protection against powerful competitors increases the likelihood of greater

returns on their assets, which could increase the willingness of foreign (and domestic)

investors to invest in these firms.

Eun et al. (1995) find that an increase in asset values of purely domestic firms based

on the cross-listing of international firms may improve access to finance for these f irms

(i.e., small listed firms). The authors suggest that this positive asset-pricing spill-over

effect might occur when markets become partially integrated. According to Miller and

Puthenpurackal (2002), however, this effect would mostly be felt in countries where

property rights were protected, further implying that property rights is a key determinant

in whether and how FPI might reach small firms.

Lastly, Johnson et al. (2002) suggest that weak property rights squelch a f irm’s desire

to reinvest profits, even when bank credit is available. The authors suggest that in an

environment where property rights are only weakly protected, small fir ms would not

utilise bank credit since protection against competition is weaker and their investment

could be stolen. Small firms, particularly dependent on bank credit as a source of capital

and particularly vulnerable to larger competition, would be more affected by inferior

protection of property rights.

Based on this evidence, we would expect small firms in environments with weakly

protected property rights to prefer accessing capital in capital markets. The disparate

effects of both the impact of and the route taken by FPI across firm size and property

rights protection suggest that the analysis be undertaken separately for strong and weak

property rights protection.

Collectively, this research implies that FPI could actually improve access to finance for

small listed firms despite investor bias for large company equity through a more efficient

allocation of capital. I examine the extent to which FPI can help small public firms4

obtain financing for growth, even when markets and institutions in their countries are

underdeveloped. I further examine which route this potential benefit takes: (1) through

the capital markets, or (2) through bank lending.

I find that the probability of a small listed f irm issuing capital in a givenyear increases

with the level of FPI (scaled by the nation’s GDP). This relation exists regardless of

the development of property rights in the firm’s domicile nation. Consistent with the

implications of Johnson et al. (2002), the route that FPI takes to reach small listed firms

in nations with less developed property rights (LDPR) is through the capital markets

only. This can be seen by the increased probability of domestic capital issuance along

with decreased levels of short-term, long-term, and total debt. The route that FPI takes to

reach small listed firms in nations with developed property rights (DPR) is through both

capital markets and bank lending. Results show an increased probability of domestic

capital issuance in these nations, as well as a decrease (an increase) in the short-term

(long-term) debt levels.

4Small is defined here as listed f irms that havetotal assets less than the country-year median.

This paper does not attempt to empirically examine private firms. Number of employees is

not used due to lack of data and resultant sample selection problems.

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