Case Study Arabian Nights

Arabian Nights
A.U.S. manufacturer of medical diagnostic equipment was thinking of setting up a subsidiary in Saudi Arabia. The market looked good. But how should it be financed? What currency should be used to finance the venture, and what would be the appropriate capital structure for the subsidiary?
Foreign investors generally seek to finance a substantial proportion of foreign operations in the local market, in order to hedge currency and other risks. In Saudi Arabia, many investors used foreign finance (U.S. dollars) instead, because the Saudi riyal was fixed against the U.S. dollar and there were no exchange controls limiting funds going into or out of the country.
From the company’s point of view, the special considerations for funding in Saudi Arabia include (a) the availability of subsidized financing from the Saudi Industrial Development Fund (SIDF) (b) that to take advantage of tax and other benefits the investments should be joint ventures with a majority Saudi ownership and thus must forego the full parent company backing that many investments in other countries enjoy, (c) the special nature of debt servicing in a country where the legal system is founded in Islamic law (i.e. the ordinary payment of interest may be contrary to the Koran), and (d) that Saudi Arabia, like many countries at a similar stage of development possesses a bank-dominated financial system with only a very limited market for direct financing (equity and bonds) by companies. There are no insurance companies or pension funds apart from the government social insurance agency.
The company’s financing goals could be divided into three parts:
? A major consideration is how the investment will be financed initially.
? To conduct ongoing business, the firm will want short tern working capital financing. The local money market should be capable of providing short-term bank loans, supplemented perhaps by other money market instruments such as bills of exchange, discounted receivables and commercial paper.
? The availability of supplementary sources of medium term funds is important for companies engaging in subsequent expansion of existing investment.
A typical initial financing mix for foreign companies in Saudi Arabia was:
SIDF up to 50 percent
Medium term bank loans 25 percent
Saudi equity 12.5 percent
Foreign equity 12.5 percent
The U.S company was willing to go along with this structure. Looking at each of the four potential sources in turn, however, it found that each had its disadvantages as well as its advantages:
¦ The Saudi Industrial Development Fund (SDIF) supposed contributes up to half of the total initial financing of an industrial investment, at no explicit interest rate apart from up-front costs and an annual servicing fee of 1-2 percent. Because it is constrained to lend at below-market rates, those fees in no way reflect the risk ness of the project. Since SIDF cannot be compensated for taking risk, it must avoid it. This means it must undertake an abnormally stringent and time consuming evaluation and screening process before committing funds. Smaller, riskier ventures, especially if they are not backed by a prominent foreign partner, stand a good chance of being turned down. In addition the SIDF insists on taking a mortgage on the borrower’s Saudi property and normally expects the partner company to guarantee its share of the firm’s debt.
¦ Given the absence of long-term institutional investors, the gap between total financing needs and that satisfied by subsidized finance must be filled by medium-or long-term lending by the commercial banks. There was no shortage of bank funds in Saudi Arabia —— indeed most of the banks’ deposits were invested abroad in the international interbank market. Yet the banks are constrained by a lack of medium-term lending experience and the subordinated status that their loans must take relative to SIDF loans, considering that the latter typically appropriate the borrower’s best assets as collateral.
¦ Domestic equity investors are expected to put up 50 percent or more of equity capital in order to qualify for incentives and government contract eligibility. Yet local investors in a new venture in Saudi Arabia recognize that they may not have effective control, and where the poor state of development of the market for equity, as well as the difficulty of taking such companies public mean that they have no assurance of liquidity for their stock. The supply of equity investment that is long term i.e. unconcerned with liquidity is limited by the absence of institutional investors such as pension funds and insurance companies.
¦ Finally, from the U.S. company’s point of view, it would be willing to put up equity capital in a venture where the potential return may be high. But this was a part of the world known for conflict. And how much should one invest in a venture in which one cannot have a majority of the equity (without sacrificing many advantages important to the profitability of the venture)?
1. How should it be financed?
2. What currency should be used to finance the venture
3 What would be the appropriate capital structure for the subsidiary?