Academic journal article Multinational Business Review

International Venture Capital Portfolio Diversification & Agency Costs

Academic journal article Multinational Business Review

International Venture Capital Portfolio Diversification & Agency Costs

Article excerpt

INTRODUCTION

With the development of international trade and the integration of capital markets, the flow of funds from one country to another to seek higher investment returns has become more and more prevalent. One striking trend is the flow of funds from the newly-developed countries such as Taiwan, Hong Kong, Singapore. and some other southeast Asian countries to the developed countries. This reverse in the direction of the flow of funds has created unique opportunities for many entrepreneurs in the U.S. to seek international venture capital for funding of their investment projects. Several reasons tend to encourage international investors to participate in risky projects in the U.S.. These reasons include diversification, lower expected returns in the domestic markets, and hedging local economies. The concept of international diversification and returns will be examined in the next section of this paper.

The sale of part of the equity ownership by the entrepreneur to international investors may give rise to a conflict of interests between the investor and the entrepreneur. The conflict can occur due to the difficulties in monitoring the entrepreneur-manager, This situation is particularly evident in the case of international investors where cultural differences and physical distance between the two parties come into play. The potential agency costs resulting from the conflict of interests are anticipated by the investor and consequently will be born by the original owner. The role of the agency problem in an international venture capital setting will be investigated in the third section.

The desire of international investors to gain the benefits of international diversification may tend to be offset by the higher agency costs involved with international ventures. Simply put, international investors will seek to diversify their investments up to the point where the marginal benefit from the investment is equal to the marginal cost of the investment. An approach to reduce agency costs and improve the attractiveness of U.S. venture capital investments will be presented in the fourth section.

Venture Capital & International Portfolio Diversification

The nature of the venture capital industry began to solidify soon after the Second World War as investors began to search for investments that would allow them to increase their returns. These investors formed venture capital companies to invest in special situations. These investors usually had an ultimate objective of earning returns in excess of 20 percent per year over the life of the investment (which in many cases may be 10 or more years).

For the international investor, there is an opportunity to diversify one's portfolio to reduce risk while at the same time potentially increase the portfolio return. This change in portfolio holdings creates a marginal benefit for the investor. A reduction in risk will occur if the diversification takes place in a country whose economy and markets are not perfectly correlated with the investor's domestic markets.

The total risk (SD sub f ) to a foreign investor of the investor's portfolio in the investor's domestic currency, given it contains only domestic securities and a U.S. investment, can be given by (equation 1):

(Equation 1)

SD sub f = (SD sub d sup 2 W sub d sup 2 + SD sub u sup 2 W sub u sup 2 + 2SD sub d SD sub u W sub d W sub u P) sup 1/2

where:

SD sub d = the standard deviation of returns from the domestic portfolio,

SD sub u = the standard deviation of returns from the U.S. venture capital investment adjusted for changes in the exchange rate risk, and

P = the correlation of returns between the domestic portfolio and the U.S. venture capital investment adjusted for the change in exchange rates such that

w sub d + w sub u = 1, 0 <= w sub d , w sub u <= 1.

The covariance factor in equation (1) will depend upon the relationship between the distribution of returns in the domestic securities market and the distribution of returns of the U. …

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