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Raising Equity Globally

Introduction

Gaining access to global capital markets lowers a firm's marginal cost of capital and increase its availability by improving its market liquidity of its shares and by overcoming market segmentation. In order to implement such a lofty goals the firm must design a strategy that will attract international investors. This means identifying and choosing among alternative paths to access global markets. Usually this requires restructuring of the firm, improving the quality and level of disclosure and making its accounting and reporting standards more transparent to potential foreign investors.

Firms from emerging countries are increasingly tapping capital markets of Europe and USA. Indian firms like Infosys which raised $294 million by an ADR in 2003 is a classic example of a firm doing it right to raise capital abroad. Even though US market did not offer a favorable terms on the cost of capital or availability of capital, Infosys found value in ADR as means to raise funds for foreign expansion and raise its visibility in US.

Depositary receipts are negotiatiable certificates issued by a bank to represent the underlying shares of the stock, which are held in trust at a foreign custodian bank. Global Depositary Receipts (GDRs) refer to certificates traded outside the United States. American Depositary Receipts (ADRs) refer to certificates traded in United States and denominated in US Dollars. ADRs are sold, registered and transferred in the United States in the same manner as any share of stock, with each ADR representing some multiple of the underlying foreign share. This multiple allows ADRs to possess a price per share appropriate for the US market (typically between $20 and $60) even if the price of the foreign share is inappropriate when converted to US Dollars directly.

Designing a capital sourcing strategy requires management to agree upon a long run financial objective and choose among the various alternatives paths to get there. The choice of paths and implementation is aided by an early appointment of an investment bank as official advisor to the firm. The investment bankers are the persons in touch with potential foreign investors and knowledgeable about what these investors are currently requiring. The can also help navigate the various institutional requirements and barriers that must be surmounted. Their services include advising on when and where a cross listing should be initiated. They usually prepare the required stock prospectus if an equity issue is desired, help to price the issue, and maintain an after-market to prevent the share price from falling below its initial price.

ADRs can be exchanged for the underlying foreign shares or vice versa. The difference in prices between the ADRs and the shares in foreign country is the arbitrage, and is usually equal to the transferring cost of the ADRs to shares.

ADRs are either sponsored or unsponsored. Sponsored ADRs are created at the request of a foreign firm wanting its shares traded in the United States. The firm applies to the SEC and a US Bank for registration and issuance of ADRs. The foreign firm pays all costs of creating such sponsored ADRs. If a foreign firm does not seek to have its shares traded in the United States but US investors are interested, a US securities firm may initiate creation of ADRs. Such an ADR would be unsponsored, but the SEC still requires that all new ADR programs, even unsponsored ones, must be approved by the firm itself.

Mechanics of ADRs

 

 

Table-1: Types of ADRs traded in the United States

ADRs are classified into different levels, distinguished by necessary accounting standards, SEC registration requirement, time to completion, and costs.

Level-I: Over-The-Counter (OTC) (also called pink sheets) is the easiest to satisfy. It facilitates trading in foreign securities that have been acquired by US investors, but securities are not registered with the SEC. It is the lowest cost approach but has minimal impact on liquidity.

Level II: Level II applies to firms that want to list exchange shares on the NYSE, ASE, or NASDAQ markets. They must meet the full registration requirements of the SEC. This means reconciling their financial accounts with those used under US GAAP, and that raises the cost considerably.

Level III: Level III applies to the sale of new equity issued in the United States. It too requires full registration requirements of the SEC and an elaborate stock prospectus. This is the most expensive alternative but is the most likely to improve the stock's liquidity and ability to escape from home market segmentation.

SEC 144A: SEC 144A type ADRs refer to private placement of equity. A private placement is the sale of a security to a small set of qualified institutional buyers (usually insurance companies and investment firms). Since the securities are not registered for sale to public, investors have typically followed a "buy and hold" policy, and trade only between qualified institutional buyers. Private placements of equity offers an easy way to raise capital from US but it does not have favorable impact on either liquidity or stock price.

By crosslisting or raising new equity in foreign markets, a firm typically tries to accomplish one or more of the following objectives:

Improve the liquidity of its existing shares and support a liquid secondary market for new equity issues in foreign markets.

Increase its share price by overcoming mispricing in a segmented and illiquid home capital market.

Increase the firm's visibility and political acceptance to its customers, suppliers, creditors and foreign governments

Establish a secondary market for shares used to acquire other firms in the foreign market.

Create a secondary market for shares that can be used to compensate local management and employees in foreign affiliate

Firms domiciled in countries with small illiquid capital markets often outgrow these markets and are forced to raise new equity abroad. Listing on a stock exchange in the market in which funds are to be raised is typically required by the underwriters to ensure post issue liquidity in the shares.

Quite often foreign investors have acquired a firm's shares through normal brokerage channels, and though the shares are not listed in the investor's home market and are not traded in the investor's preferred currency. Crosslisting is a way to encourage investors to continue to hold and trade these shares, thus improving secondary market liquidity. This listing is usually done through ADRs. In order to maximize liquidity, it is best to crosslist and issue equity in a prestigious market and eventually be able to offer a global equity issue.

In order to maximize liquidity, it is desirable to crosslist and/or sell equity in the most liquid stock exchanges, such as: London Stock Exchange, NYSE, NASDAQ, Deutsche Borse (German).

Favorable impact on share prices by crosslisting on a foreign exchange depends on the degree to which markets are segmented. If a firm's home capital market is segmented, the firm could theoretically benefit by crosslisting in a foreign market if that market values the firm or its industry more than does the home market. However, most capital markets are becoming more integrated with global markets. Even emerging markets are less segmented than they were just a few years ago.

Multinational companies list in markets where they have substantial physical operations. Commercial objectives are to enhance their corporate image, advertise trademarks and products, get better local press coverage, and become more familiar with the local financial community in order to raise working capital locally. Political objectives may include the need to meet local ownership requirements for a firm's foreign joint venture. Local ownership of a parent firm's shares might provide a forum for publicizing the firm's activities and how they support the host country. This objective is most important for Japanese firms. The Japanese domestic market has both low cost capital and high availability, therefore Japanese firms are listing in NYSE or NASDAQ to improve their visibility and political acceptance in US.

Firms that follow a strategy of growth through acquisitions are always looking for creative ways to find these acquisitions rather than pay by cash. Offering their shares as partial payment is considered more attractive if those shares have a liquid secondary market. In that case, the target's shareholders have an easy way to convert their acquired shares to cash if they do not prefer a share swap. However, a share swap is often attractive as a tax free exchange.

If a MNC wishes to use stock options and share purchase compensation plans for local management and employees, local listing would enhance the perceived value of such plans. It should reduce transaction and foreign exchange costs for the local beneficiaries.

Although a firm may decide to crosslist and/or sell equity abroad, certain barriers exist. The most serious barrier is the future commitment to providing full disclosure of operating results and balance sheets, as well as to continuous program of investor relations.

The commitment to disclosure and Investor Relations

A decision to crosslist must be balanced against the implied increased commitment to full disclosure and to a continuing investor relations program. For firms resident in Anglo-American markets, listing abroad may not appear to be much of a barrier. For example, the SEC's disclosure rules for listing in the United States are so stringent and costly that any other market's rules are mere child's play. Reversing the logic, however, non-U.S. firms must really think twice before crosslisting in the United States. Not only are the disclosure requirements breathtaking but also a continuous demand for quarterly information is required by U.S. investors. As a result, the foreign firm must provide a costly continuous investor relations program for its U.S. shareholders, including frequent "road shows" and the time consuming personal involvement of top management.

Disclosure is a double-edged sword

The U.S. school of thought is that the worldwide trend toward requiring fuller and more standardized financial disclosure if operating results and balance sheet positions may have the desirable effect of lowering the cost of equity capital.

"Increased firm disclosure tends to improve the subjective probability distributions of a security's expected return streams in the mind of an individual investor by reducing the uncertainty associated with the return stream. For firms which generally outperforming the industry average, it is also argued that improved financial disclosure will tend to increase the relative weighting which an average will place on favorable firm statistics relative to the firm. Both the foregoing effects will entice an individual to pay a larger amount for a given security than otherwise, thus lowering a firm's cost of capital." -- Choi 1973 p. 279

The other school of though is that the U.S. level of required disclosure is an onerous, costly burden. It chases away many potential listers, thereby narrowing the choice of securities that are available to U.S. investors at reasonable transaction cost. At year end 1998, only 391 foreign firms were listed on the NYSE, whereas 466 foreign firms were listed in the London Stock Exchange, and 2,784 foreign firms were listed on the German stock exchanges.

A study of 203 internationally traded shares concluded that there is a statistically significant relationship between the level of financial disclosure required and the market on which the firms chose to list. The higher level of disclosure required, the less likely that a firm would list in that market. However, for those firms that do list despite the disclosure and cost barriers, the payoff could be needed to access additional equity funding for expansion or acquisition in the United States.

Alternative instruments to source equity in international markets include:

Sale of a directed public share issue to investors in a target market

A directed public share issue is targeted at investors in a single country and underwritten in whole or in part by investment institutions from that country. The issue might or might not be denominated in the currency of the target market. The shares might or might not be crosslisted on a stock exchange in the target market.

Sale of a Euroequity public issue to investors in more than one market, including both foreign and domestic markets

The gradual integration of the world's capital markets and increased international portfolio investment have spawned the emergence of a very viable Euroequity market. (The term Euro does not imply that the issuers or investors are located in Europe. Euro equity is a generic term for international equity issues originating and sold anywhere in the world.)

A firm can issue equity that is underwritten and distributed in multiple foreign equity markets, sometimes simultaneously with distribution in the domestic market. The same financial institutions that had previously created an infrastructure for Euronote and Eurobond were responsible for the Euroequity market.

Private placements under SEC rule 144A

A private placement is the sale of a security to a small set of qualified institutional buyers (usually insurance companies and investment firms). Since the securities are not registered for sale to public, investors have typically followed a "buy and hold" policy, and trade only between qualified institutional buyers. Private placements of equity offers an easy way to raise capital from US but it does not have favorable impact on either liquidity or stock price.

In April 1990, the SEC approved Rule 144A. It permits qualified institutional buyers to trade privately placed securities without the previous holding period restrictions and without SEC registration. Simultaneously, the SEC modified its regulation S to permit foreign issuers to tap the U.S. private placement market through an SEC 144A issue, also without SEC registration. A screen based automated trading system called PORTAL was established by National Association of Security Dealers (NASD) to support the distribution of primary issues and to create a liquid secondary market for those unregistered private placements.

Since SEC registration has been identified as the main barrier to foreign firms wishing to raise funds in the United States, SEC rule 144A placements are proving attractive to foreign issuers of both equity and debt securities.

Sale of shares to private equity funds

Many mature family owned firms resident in emerging markets are unlikely to qualify for a global cost and availability of capital even if they follow a global strategy. Although they might be consistently profitable and growing, they are still too small, too invisible for foreign investors, lacking in managerial depth, and unable to fund the upfront costs of globalization. For these firms private equity funds may be a solution.

Private equity funds are usually limited partnerships of institutional and wealthy individual investors that raise their capital in the most liquid capital markets, especially the United States. Then they invest the private equity fund in mature, family-owned firms located in emerging markets.

Private equity funds differ from traditional venture capital funds, Venture capitalists usually operate mainly in highly developed countries, they typically invest in high tech startups with the goal of exiting the investment with in Initial Public Offering (IPO) placed in those same highly liquid markets. Very little venture capital is available in emerging markets, partly because it would be difficult to exit with an IPO in an illiquid market. The same exiting problem faces the private equity funds, but they have a longer time horizon, to invest in already mature and profitable business and are content with growing them through better management and mergers with other firms.

Sale of share to a foreign firm as part of strategic alliance

Strategic Alliances are normally formed by firms that expect to gain synergies from one or more of the following joint efforts. They might share the cost of developing technology or pursue complementary marketing activities. They might gain economies of scale or scope or a variety of other commercial advantages. However, one synergy that may sometimes be overlooked is the possibility for a financially strong firm to help a financially weaker firm to lower its cost of capital by providing attractively priced equity or debt financing in return for technology or a better market access.

Designing a capital sourcing strategy requires management to agree upon a longrun financial objective. Management ten must choose among the various alternative paths to get there, including where to crosslist its shares, and where to issue new equity, and in what form. A firm has to examine barriers to listing, and means to lower its cost of capital to determine the best path to raise equity abroad.

Indian firms are new in the global equity markets, and only a handful of Indian firms have raised equity abroad. However in the coming years, more companies will need to seek equity funds abroad to fund their global expansion abroad.