Key Takeaways:
- Direct investment aims to acquire a controlling interest in a foreign business without buying regular stock shares.
- Foreign direct investment often involves setting up new operations or acquiring assets in another country.
- There are three main types of direct investment: vertical, horizontal, and conglomerate.
- Vertical investments add foreign activities to an existing business, like a U.S. auto manufacturer building dealerships abroad.
- Horizontal investments replicate a company’s home-country business operations abroad, such as a fast-food franchise opening new locations overseas.
What Is Direct Investment?
Direct investment, often called foreign direct investment (FDI), is when a company invests in a foreign business to gain a controlling equity interest rather than buying traded shares. Unlike portfolio investment, it’s about control and can be vertical, horizontal, or conglomerate in structure.
How Direct Investment Works
The purpose of FDI is to gain an equity interest sufficient to control a company. In some instances, it involves a company in one country opening its own business operations in another country. In other cases, direct investment involves acquiring control of existing assets of a business already operating in the foreign country. A direct investment can mean gaining either a majority or minority interest, but enough to have effective control.
Direct investment is primarily distinguished from portfolio investment, the purchase of common or preferred stock shares of a foreign company, and by the element of control that is sought.
Control can come from sources other than an investment of capital; however, control of assets such as technology is considered only a critical input. In fact, FDI is frequently not a simple monetary transfer of ownership or controlling interest but can include complementary factors, such as organizational and management systems or technology.
Foreign direct investments can be made by individuals but are more commonly made by companies wishing to establish a business presence in a foreign country.
Types and Examples of Foreign Direct Investment
Foreign direct investment takes many forms in practice but is generally classified as either a vertical, horizontal, or conglomerate investment.
For a vertical direct investment, the investor adds foreign activities to an existing business. An example is an American auto manufacturer that establishes dealerships or acquires a parts supply business in a foreign country.
Horizontal direct investment is perhaps the most common form of direct investment. For horizontal investments, a business already existing in one country establishes the same business operations in a foreign country. A fast-food franchise based in the United States might open restaurant locations in China. Horizontal direct investment is also referred to as green-field entry into a foreign market.
For a conglomerate-type direct investment, an existing company in one country adds an unrelated business operation in a foreign country. This is a particularly challenging form of direct investment since it requires simultaneously establishing a new business and establishing it in a foreign country. An example of conglomerate direct investment might be an insurance firm opening a resort park in a foreign country.
The Bottom Line
Direct investment (FDI) is taking control of a foreign business, unlike portfolio investing which doesn’t seek control. It can be horizontal, vertical, or conglomerate, and is usually done by companies pursuing new markets or resources, sometimes bringing technology or management too, along with higher commitment and risk.