Financial Constraints, Institutions and Foreign Ownership

Ron Alquist, (AQR Capital Management), Nicolas Berman (Aix-Marseille University), Rahul Muhkerjee (Graduate Institute, Geneva), and Linda L. Tesar (University of Michigan)

Cross border mergers and acquisitions (CBMA) as a form of foreign direct investment (FDI) by multinational corporations (MNCs) have grown rapidly in the last two decades. For emerging market economies (EMEs) in particular, the number of CBMA, mostly by firms from developed markets, grew at an average annual rate of 14.5% during 1990-2014. While the determinants of the volumes of these flows are well studied, relatively little is known about what drives MNC ownership structure choices when acquiring EME firms. Yet, existing research has established that the extent of foreign ownership is an important determinant of a number of outcomes that have traditionally motivated policy makers to encourage FDI.  These include post-investment changes in labor productivity, wages, or export participation, and spillovers through technology transfer to subsidiaries.[1] In a forthcoming article, we set out to study the underlying determinants of FDI ownership structure in a broad set of EMEs.[2]

In a nutshell, our main argument is as follows.  Acquiring firms in EMEs entails both benefits and costs for MNCs from developed nations. Among the benefits, MNCs may have superior access to funding that they can use to relieve financial constraints of target firms, thus increasing the profitability of the acquired firm. At the same time, these acquisitions come with costs inflicted by weak local institutions, since operating firms in EMEs involves sourcing local inputs in an unfamiliar environment with insecure property rights and distortionary policies. So, how do MNCs deal with these competing forces? We show in our paper that an MNC’s choice of ownership structure is critical in balancing the aforementioned benefits and costs. To this end we develop a theoretical model that emphasizes the role of finance and institutions, and that delivers predictions about the optimal degree of foreign ownership, which we then take to the data.

To highlight the trade-offs facing a foreign acquirer, our theoretical model postulates that production in EMEs requires capital and a local input. The foreign acquirer solves for an optimal ownership contract between itself and the domestic target firm that captures its advantage in having greater access to capital markets relative to the credit-constrained target, and the potential disadvantages of operating a firm in an EME. The MNC’s disadvantage compared to local firms, which is due to weaker institutions, is modeled as a markup on local inputs that is paid only by an MNC. The markup thus incentivizes operating the firm with a local co-owner. The MNC then faces a choice between obtaining full control of the credit-constrained target, in which case it is compelled to pay a higher price for the local input, or to take partial ownership, in which case the domestic equity owner can provide the local input at a lower price.

Three distinctive sets of predictions emerge from the model. The first and second pertain to the ownership structure chosen by an MNC. Full (relative to partial) foreign ownership of targets is predicted to be more likely in sectors that have a greater dependence on external finance, and in countries that are less financially developed, while better institutions are found to tilt the scales towards full ownership. The effects of institutions and financial development are also predicted to be the largest for the sectors of the economy most dependent on external finance. The second set of predictions pertains to partial ownership. Here the model predicts that financial factors should play a weaker role in determining the precise size of partial stakes, while the input price markup is predicted not to influence the ownership structure in partial acquisitions at all. Our final predictions, which relate to the overall likelihood of foreign acquisitions, are that foreign acquisitions are more likely in sectors that have a greater dependence on external finance, in countries where financial markets are less developed, and when institutions are better.

We test these theoretical predictions in a large panel of CBMA transactions by developed market firms in fourteen EMEs over the period 1990-2007. We use the measure of sectoral external finance dependence due to Rajan and Zingales and country-level credit-GDP ratios as our main financial indicators, and anti-corruption indices as our baseline measure of institutional quality.[3]

The regression evidence confirms the main predictions of the model. The estimated effects are also quantitatively large. For example, the likelihood of an MNC choosing to own a domestic firm fully versus partially is predicted to be:

  • 22 percentage points larger for the sector with the highest (professional and scientific equipment) versus the lowest (tobacco) level of dependence on external finance
  • 21 percentage points lower in the most (Indonesia) versus the least (Chile) corrupt country
  • 14 percentage points lower in the most (South Africa) versus the least (Peru) financially developed country

As per the model, while dependence on external finance has the strongest effect in financially underdeveloped countries, it ceases to matter when local financial development, measured by private credit over GDP, exceeds 70%. In the same vein, external finance matters roughly three times more in countries with the lowest levels of corruption than in the most corrupt countries.

Our model’s predictions concerning the effect of financial factors on the overall prevalence of cross border acquisitions across sectors and countries are also borne out by the data. For example, we find that moving from the sector that is most to least dependent on external finance raises the share of CBMA (among all acquisitions) by 22 percentage points. At the same time, the share of CBMA is predicted to be 27 percentage points lower in the most versus the least financially developed country.

Taken together, our theoretical model and empirical evidence show that the interaction of financial, institutional, and technological factors plays an important role in determining the pattern of foreign ownership in North-South FDI flows. It also throws light on a number of empirical features of CBMA across sectors and countries, for example, why full foreign acquisitions are seldom observed (roughly 19%)  in countries such as Thailand that have both developed financial markets and weak institutions.  Our results also point towards improvements in institutions as a way to encourage higher MNC equity participation. For example, according to our estimates, a country like China would experience a doubling in the share of full acquisitions if it were to improve its corruption situation to the levels of Chile.


Alquist, R., N. Berman, R. Mukherjee, and L.L. Tesar, (forthcoming); “Financial Constraints, Institutions, and Foreign Ownership.” To appear in Journal of International Economics, DOI:

Bircan, Çağatay, (2019); “Ownership Structure and Productivity of Multinationals.” Journal of International Economics 116 (2019): 125-143.

Havranek, T., and Z. Irsova, (2011); “Estimating Vertical Spillovers from FDI: Why Results Vary and What the True Effect is.” Journal of International Economics 85(2): 234-244.

Javorcik, B. S., and M. Spatareanu, (2008); “To Share or Not to Share: Does Local Participation Matter for Spillovers from Foreign Direct Investment?Journal of Development Economics 85(1-2): 194-217.

Rajan, R., and L. Zingales, (1998); “Financial Dependence and Growth.” American Economic Review 88.3 (1998): 559-86.


[1] See for example, Javorcik and Spatareanu (2008),  Havranek and Irsova (2011), and Bircan (2019).

[2] See Alquist, Berman, Mukherjee and Tesar (forthcoming).

[3] See Rajan and Zingales (1998).