America the Difficult: Harvard Business School's Mihir Desai Explains Why It's So Tough for Sovereign Wealth Funds to Make a Buck in the United States-And Why the U.S. Should Put out the Welcome Mat

Article excerpt

Foreign investors increased their acquisition of corporate assets in the United States last year by 90 percent, setting new records for foreign investment. And 2008 began with nearly daily stories of American financial executives courting foreign investors, particularly sovereign wealth funds, for new investments. Citigroup raised more than $7.5 billion from Abu Dhabi, and Merrill Lynch raised more than $5 billion from South Korea and Kuwait.

All this foreign interest in American firms and assets raised eyebrows in Washington. Calls for increased government oversight of such investments have already begun to percolate, and discussion of a "grand bargain" or new institutional framework for governing these transactions has emerged.

Indeed, several American lawmakers have suggested that the federal law that provides for review of acquisitions involving national security through the Committee on Foreign Investment in the United States (CFIUS) should be expanded. Specifically, these lawmakers suggest that the U.S. government should be able to block foreign acquisition of companies in "economically strategic areas," especially when the investors are foreign governments.

Are these concerns warranted, and should domestic regulators begin to expand their purview in this manner?

If history is any guide, foreign investors in the United States have more to worry about than domestic regulators do. The singular fact about such investing is just how unsuccessful it is--foreign direct investments appear systematically to earn low returns. The recent decision by Daimler to pay a private equity firm to take Chrysler off their hands after paying $37 billion for the company eight years ago appears to be more representative than not of the experience of foreign investors in the United States.

Consider the accounting returns for both American outbound foreign direct investment (FDI) and for FDI inbound to the United States over the last 25 years. FDI is classified as positions that exceed 10 percent of the ownership of a corporation (below 10 percent is called foreign portfolio investment, or FPI). This effectively compares the experiences of major American multinational firms like General Electric when they invest abroad with the experiences of foreign firms like Siemens when they invest in the United States.

As it turns out, American inbound FDI has underperformed American outbound FDI consistently for the last 25 years and usually by a wide margin. Over that period, the rate of return on inbound FDI has averaged 4.3 percent, while outbound has been 12.1 percent.


Moreover, this underperformance happened during a time when no such persistent return differential existed for FPI. Indeed, a simple comparison of S&P 500 returns to the returns of a broad foreign stock index such as MSCI EAFE for the same period reveals that U.S. capital markets outperformed non-U.S. capital markets for the vast majority of those same years. America is a beautiful country for portfolio investors. But it is a very difficult one for direct investors.

Of course, this differential on FDI returns could reflect nothing real and may just show the ability of multinational firms to relocate profits in response to tax differences. Perhaps non-U.S. firms are particularly adept at shielding profits from U.S. tax authorities. Or perhaps tax rate differentials make the United States a particularly unattractive place to report profits. This explanation would appear lacking, however, given that this underperformance spans periods when U.S. tax rates were not high relative to other countries. And, if anything, the United States has greater relative expertise in guarding against transfer-pricing abuses.

So why is it so difficult to make money as a direct investor in the United States? Indeed, much of the rhetoric on investing environments argues that the major destinations for U. …