The decision to invest in a foreign market is an important strategic decision for any firm. (Goerzen & Beamish, 2003; Hitt, Hoskisson, & Kim, 1997; Luo & Tung, ...
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NOT ALL DISTANCES ARE CREATED EQUAL: CULTURE, GEOGRAPHY, AND THE INTERACTION EFFECT OF NETWORKS ON PRIVATE EQUITY INVESTMENTS IN THREE EMERGING MARKET REGIONS SANTIAGO MINGO Universidad Adolfo Ibáñez Av. Diagonal Las Torres 2700 Santiago, Chile FRANCISCO MORALES University of Colorado – Boulder INTRODUCTION The decision to invest in a foreign market is an important strategic decision for any firm (Goerzen & Beamish, 2003; Hitt, Hoskisson, & Kim, 1997; Luo & Tung, 2007; Melin, 1992). The process of internationalization is, however, fraught with difficulties due to the uncertainties associated with settings that can be significantly different from the home country (Delios & Henisz, 2000). The literature on cross-border investments has emphasized the effects of differences or distances between host and home countries, such as cultural distance, and geographic distance (Boeh & Beamish, 2012; Guler & Guillén, 2010; Kogut & Singh, 1988). In this study, we focus on the investment strategy of private equity (PE) firms investing in emerging markets. Integrating social network analysis and the literature on cross-border investments and national distance, we theorize about how culture, geography, and syndication networks affect the investment strategy of PE firms investing in emerging markets. More specifically, we focus on how the decision to invest in an emerging market is affected by (i) the cultural distance between the PE firm’s country and the emerging market destination, and (ii) the geographic distance between the firm’s country and the emerging market destination. We particularly examine the moderating role played by the position of the firm within the syndication network of PE firms investing in the emerging market region—for example, Latin America—where a destination country is located. Our results show that higher levels of cultural proximity and geographic proximity are associated with a higher likelihood of investment. More specifically, the positive effect of cultural proximity strengthens when the firm is more central in the regional syndication network. On the other hand, the positive effect of geographic proximity strengthens when the firm is less central in the regional syndication network. This study seeks to address several gaps in the literature. First, the international business strategy literature on cultural distance and geographic distance needs to adopt a more contingent approach—the impact of culture and geography can depend on firm-level factors, such as how well connected is a firm within a region or country. Second, the literature on networks and PE investments has mainly focused on venture capital (VC) firms investing locally rather than internationally. International strategy research can benefit considerably from using a network approach to understand cross-border investments. Finally, the few existing studies on the internationalization strategy of PE firms have been slow to adopt a regional approach, especially in the case of emerging market regions. This work makes important contributions to the existing literature. We show that social networks can play an important role in the internationalization process of PE firms. The social
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network approach offers an insightful way to analyze the effects of cross-country distances on foreign investment strategy. We also provide a new way to understand the syndication process in business environments that are different from those in advanced economies, proposing that a central position in the syndication network is not necessarily attractive in the case of emerging market firms investing locally. Another important and novel contribution is the analysis of the effects of national distances on the strategic decision of investing abroad. We show that these effects depend on the position of investors in the regional syndication network. Different types of national distances can have different and complex effects on the investment strategy of firms. Our theorizing about the interaction effect of networks offers a new way to understand the internationalization process of a firm, recognizing that firm-level characteristics can mitigate or exacerbate the effects of different kinds of national distances (Zaheer, Schomaker, & Nachum, 2012). This work contributes to the fields of strategic management and international business by improving our understanding of the determinants of cross-border investment decisions, especially those targeted to companies in emerging markets (Bruton, Ahlstrom, & Puky, 2009; Guler & Guillén, 2010). The regional approach that we use to define the network— distinguishing between regions and destination countries—is also important, especially because investments in emerging markets are affected by regional dynamics in significant ways (Arregle, Beamish, & Hébert, 2009; Arregle et al., 2013; Qian et al., 2010). To test our hypotheses, we put together a dataset that includes PE investment transactions made by 531 firms in Latin America, Southeast Asia, and Eastern Europe from 1996 to 2011. The sample considers PE firms investing both internationally and domestically. PE activity in these three regions has been increasing significantly, totaling more than US$8 billion in 2012 (EMPEA, 2013). THEORY AND HYPOTHESES Cultural Distance and PE Investments Cultural distance refers to the extent of dissimilarity between the cultural values of two countries. Cultural distance is a widely used construct that has been applied to many disciplines, including management, marketing, finance, and accounting (Shenkar, 2001). The construct has had its greatest impact on foreign direct investment (FDI) research. We argue that the cultural distance between the PE firm’s country and the emerging market destination is an important determinant of the likelihood that the PE firm will make an investment. A PE firm that invests in a culturally distant country is more likely to experience additional costs and difficulties in finding good investment opportunities, evaluating them, and subsequently managing the investments. High cultural distance can complicate the assessment of the true value of a target company and make the negotiations about the deal between the firm and the target more difficult to handle. One of the most important features of a PE investment is the financial contract that allocates the rights between the investor and the company that receives the investment (Kaplan & Strömberg, 2001, 2003). Handling the development of this contract is substantially more difficult when cultural distance is high. Cultural differences can also affect the capacity to monitor investments and the ability to manage contractual relationships with the investees. Moreover, investment practices that have been optimized in a particular cultural environment might not work properly in countries with significant cultural differences. In a sense, cross-border PE investments in culturally distant countries involve higher transaction costs and can exacerbate
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information asymmetries (Williamson, 1981). Therefore, we expect that PE firms will be more likely to invest in emerging markets that are culturally proximate. Hypothesis 1. A higher level of cultural proximity between a PE firm’s country and the emerging market destination is associated with a higher probability of investment. Geographic Distance and PE Investments The construct of geographic distance has been the subject of many empirical studies in business and management (Beugelsdijk & Mudambi, 2013; Chakrabarti & Mitchell, 2013; Malhotra & Gaur, 2014; Mingo, 2013; Petersen & Rajan, 2002; Reuer & Lahiri, 2014; Stuart & Sorenson, 2003a). Higher geographic distance between the actors involved in a transaction typically translates into greater information asymmetries, risk of adverse selection, and higher transaction costs in general (Reuer & Lahiri, 2014; Williamson, 1981). These problems can be even worse in the context of emerging markets, where institutional voids and idiosyncratic business environments exacerbate the difficulties generated by geographic distance (Khanna & Palepu, 2010; Khanna & Rivkin, 2001; Peng, Wang, & Jiang, 2008). Previous studies have found that the geographic distance between a PE firm and the target company has a significant impact on investment behavior (Aizenman & Kendall, 2008; Chen et al., 2010; Lerner, 1995; Lutz et al., 2013; Sorenson & Stuart, 2001; Stuart & Sorenson, 2003b). The difficulties associated with geographic distance are especially important when conducting business abroad (Beugelsdijk & Mudambi, 2013; Hymer, 1976). Cross-border PE investments are more likely to occur when geographic proximity is higher. First, geographic proximity facilitates the identification and evaluation of investment opportunities. Second, monitoring the investments is much easier when the portfolio company is geographically close. Hypothesis 2. A higher level of geographic proximity between a PE firm’s country and the emerging market destination is associated with a higher probability of investment. Syndication Networks and PE Investments Networks are crucial in the PE industry: firms frequently syndicate their investments with other firms instead of investing alone (Dimov & Milanov, 2010; Gu & Lu, 2014; Lerner, 1994; Lerner, Leamon, & Hardymon, 2012). A syndicated investment takes place when two or more private equity firms invest together in the same company. Therefore, firms’ current and past syndicated investments generate a web of relationships between them that can be represented by a network. Firms with higher levels of centrality in a region’s syndication network of PE firms enjoy more influential and advantageous network positions that can translate into a higher probability of investment. Network centrality is defined as the extent to which an actor is central to a network (Brass et al., 2004). A firm that is more central in the network has better access to information and investment opportunities. In emerging markets, we argue that there are also important shortcomings associated with centrality and syndication. Some firms—especially those investing domestically—may have
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better information and knowledge about investing in a particular emerging market. Since these types of markets are typically characterized by the presence of significant information asymmetries and high transaction costs, a local firm can protect and take advantage of its better information, connections, legitimacy, and knowledge on how to operate in a particular emerging market by making solo investments and avoiding syndication and centrality in the network. The Interaction Effect of Centrality in the Regional Syndication Network The ambiguous effect of network centrality on the probability of investment can be disentangled through an interaction effect (or moderation) argument. We propose that network centrality moderates the effect of cultural distance and geographic distance on the probability of investment. In other words, there are contingent benefits associated with the position in the network (Zaheer & Bell, 2005). To explain how this interaction or moderation operates, we use an Uppsala-internationalization-process-model approach (Johanson & Vahlne, 1977). Based on empirical observations of Swedish firms, Johanson and Vahlne (1977) found that “internationalization frequently started in foreign markets that were close to the domestic market in terms of psychic distance, defined as factors that make it difficult to understand foreign environments. The companies would then gradually enter other markets that were further away in psychic distance terms” (Johanson & Vahlne, 2009: 1412). Interestingly, Johanson & Vahlne (2009) discuss the importance of adding a business network perspective to the classic Uppsala internationalization process model. Building on the Uppsala model, we argue that a PE firm that wants to access a specific emerging market—located in a particular region—needs to “cross” two doors: (i) the regional door, and (ii) the destination country door. The investment process involves decisions about both the selection of attractive regions and the selection of attractive countries within regions (Arregle, Beamish, & Hébert, 2009; Arregle et al., 2013). The metaphor of crossing a regional door and a destination country door is linked to the concepts of liability of regional foreignness (LRF) and liability of country foreignness (LCF) (Qian, Li, & Rugman, 2013). LRF relates to the costs of doing business in a different region. On the other hand, LCF relates to the costs associated with the subtleties of doing business in a different country. The concepts of LRF and LCF can be used to understand why it is difficult to cross a regional door and a destination country door, respectively. Low cultural distance to a particular destination country is a “key” that helps to open the destination country door but not necessarily the regional door. On the other hand, high centrality in the regional syndication network facilitates crossing the regional door. We argue that the positive effect of cultural proximity on the likelihood of investment strengthens (weakens) when the firm has a high (low) centrality in the regional syndication network. Since a high centrality in the regional syndication network means that it is easier to cross the regional door, a more central firm should be able to take advantage more effectively of the benefits of cultural proximity to a particular destination country inside the region. On the other hand, low centrality means that it is more difficult to benefit from cultural proximity because it will be harder for the firm to cross the regional door in the first place. Hypothesis 3a. If a PE firm has a high level of centrality in the regional syndication network, the positive relationship between cultural proximity and the probability of investment strengthens.
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Regarding geographic distance, we argue that geographic proximity to the destination country facilitates crossing both the regional and destination country doors—if geographic distance is zero you are actually inside the destination country. Thus, geographic distance operates differently than cultural distance: while geographic proximity helps the firm to cross both the regional and destination country doors, cultural proximity helps the firm to cross the destination country door but not necessarily the regional door. We argue that when the geographic distance between the firm’s country and the emerging market destination is low, centrality in the regional syndication network is not as crucial to access the destination country. Low geographic distance can even encourage firms to avoid a central position in the regional syndication network: a firm may want to take full advantage and exploit its probably superior information about a geographically close emerging market by following a stand-alone approach to investments. By going solo, the firm avoids sharing with other firms the advantages associated with geographic proximity. It is more likely that firms geographically proximate to the destination country will be able to develop a pool of destination-specific resources, capabilities, and local contacts that facilitates finding, evaluating, and monitoring investments—which, as discussed earlier, is particularly important in the case of investments in emerging markets (Khanna & Palepu, 2010; Khanna & Rivkin, 2001). This means that geographically proximate firms tend to be less reliant on partners to succeed, making them more likely to benefit from proceeding alone in their investments. Therefore, the positive effect of geographic proximity on the probability of investment should strengthen when the firm has a low centrality in the regional syndication network: a firm can take advantage more actively and effectively from a close geographical position when it is less central. In other words, if the countries are geographically proximate, low centrality in the regional network should lead to a higher likelihood of investment compared to the case of a firm with high centrality in the network: the positive effect of geographic proximity on the likelihood of investment strengthens (weakens) when the firm has a low (high) centrality in the regional syndication network. Hypothesis 3b. If a PE firm has a low level of centrality in the regional syndication network, the positive relationship between geographic proximity and the probability of investment strengthens. DATA AND METHODOLOGY We focus on PE firms that were involved in one or more investment transactions in Latin America, Southeast Asia or Eastern Europe between 1996 and 2011. The sample of PE investments comes from Thomson ONE Investment Banking’s Private Equity Module. Our dataset is based on 5,181 investments made by 531 PE firms. The dataset has a total of 66,115 observations. We use a probit model to perform the main statistical analyses. Dependent Variable The dependent variable is a binary variable that is equal to one if the PE firm made one or more investment transactions in a particular country during a year. Otherwise, the variable is equal to zero.
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Independent Variables Following Kogut and Singh (1988), we use an index to measure cultural distance between two countries based on Hofstede’s dimensions of national culture (Hofstede, 2001). The four cultural dimensions considered in this study are: power distance, uncertainty avoidance, individualism versus collectivism, and masculinity versus femininity. We measure geographic distance between two countries using their capital cities (Dai, Jo, & Kassicieh, 2012). The variable is the log of the great-circle distance (in kilometers) between the capital cities of two particular countries plus one. We build the syndication network for each region using the dataset described earlier. A five-year window is used to build the network (Hochberg, Ljungqvist & Lu, 2007, 2010). Each node in the network represents a PE firm, while a tie between two firms indicates that they have invested together on at least one occasion during the time window. We measure network centrality using the Bonacich’s (1987) eigenvector centrality of a PE firm in the regional syndication network during a time window. Finally, we include two interactions terms. The first one is the interaction between cultural distance and network centrality, and the second one is the interaction between geographic distance and network centrality. Control Variables We include several firm- and country-level control variables, as well as various sets of indicators, to help isolate the effects of our independent variables. RESULTS The results support all of our hypotheses, showing that cultural and geographic distances have differing effects on investment behavior depending on the level of centrality of the firm in the regional syndication network. We also conduct different analyses to assess the robustness of our results. More details about the results and robustness checks are available from the authors. CONCLUSIONS Building on social network analysis and the literature on cross-border investments and national distance, we develop a theoretical framework to explain how two types of national distances affect the investment strategy of a PE firm investing in an emerging market. Most interestingly, we propose an interactive relationship with a firm-level characteristic: network centrality. The results are consistent with our hypotheses. We conclude that, in the context of cross-border investments in emerging markets, different types of national distances can affect investments in different ways depending on firm-level characteristics. This work has important implications for firms making investments in emerging markets, especially those involved in cross-border investments. Firms making cross-border investments should understand that networks at the regional level could play a crucial role when the investment is targeting an emerging market. REFERENCES AVAILABLE FROM THE AUTHORS
