Direct investments are largely restricted to private family-owned companies and star t-up companies that have attracted specialist venture capital or private equity interest. Many small companies have to rely on direct investments for the bulk of their financing. In general, however, direct investments present a number of specific problems to both the providers and users of capital:
Matching. It is difficult for individual investors to find suitable companies or projects to invest in. It is also difficult for these companies to identify individual potential investors. There is also a matching problem between the size of individual’s savings and the financing needs of large companies.
Liquidity. Direct investments are inherently illiquid, due to the absence of a secondary market, and this means that savers cannot readily turn their investment into cash. Par ties needing to raise funds in a hurr y from direct investments would also find it extremely difficult.
Counterparty risk. It is difficult for individual investors to determine the credit-wor thiness or viability of the company or project they are investing in. This makes such investments relatively high risk. This higher risk is reflected by the higher returns demanded by investors and hence higher financing costs for the users.
Costs. Appraisal costs for investors in total will be high if each investor has to carr y out their own analysis. The costs of attracting investments will also be high if each investor has to be persuaded of the merits of the case. It is much cheaper and more effective for a company to raise a relatively large amount in one go than raise relatively small amounts from many investors and have to ser vice each investor individually.
Diversification. It is difficult for individual savers to diversify their risks by finding lots of attractive companies or projects to invest in directly.
There is, however, one common form of direct financing that is easy to overlook. This is the credit that many suppliers provide their customers for ser vices and products that have been delivered and on which payment has not yet been made. Most of this credit is ver y shor t term (30- to 60-day payment terms are common) but in a few specialized industries, the aviation business is a good example, vendor financing can be very long term.
Individuals, cor porations and even governments and state institutions may have savings or money that is sur plus to their current requirements. For convenience sake we will refer to them all as investors. Investors seek the following:
Risks and returns. To get the highest level of return available for a given level of risk taken, or the lowest level of risk possible for a given level of return. These are not at all the same thing. There is a wide range of tolerances to risk between investors.
Economic term. To make investments whose economic term matches that of their liabilities. An individual seeking to invest in order to generate an ongoing income in their retirement will look for investments that meet that objective rather than investments offering a shor t-term return only, for example.
Liquidity. To match the liquidity of their investments with their own liquidity requirements. Some investors need to keep most of their funds in investments that are close to being cash equivalents and can be easily and quickly liquidated. Other investors may be willing to accept a much lower level of liquidity in return for higher long-term returns.
Counterparty risk. To minimize counter par ty specific risk.
Costs. To keep the costs associated with making the investments, and liquidating them if necessary, as low as possible within the primary constraints of meeting the overall objectives in terms of risks and returns.
Diversification. To select a level of diversification that matches their risk tolerances. Diversification reduces specific risks and individual investors may be willing to pay for diver- sification benefits that they cannot readily achieve on their own.
Although these investment objectives appear relatively straightforward, when taken in combination they result in ver y many different specific objectives. Many financial intermediaries (fund managers) have developed whose only products are investment funds tailored to meet these varying, and conflicting, objectives. All investors would like to make the investments that have the highest returns and the lowest risks. The only place where such investments exist is in their dreams.
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The focus of this blog is on financial markets and financial institutions. The subject of public sector finance is fortunately well outside our scope other than to the extent that it impacts on these markets and institutions. In brief, however :
Income. Government income comes from taxes imposed on cor porates and individuals. The receipt of these taxes is highly seasonal. The absolute level of taxes expected is based on government economists’ forecasts for economic activity. The best economists are all born with two hands, thick skins and a good sense of humor. The actual level of tax receipts is often ver y different from that expected.
Expenditure. Cer tain par ts of government expenditure are fixed but larger par ts depend on the level of economic activity and unemployment. Little, if any, provision is made for major unexpected events, such as a war. The actual level of expenditure is usually ver y different from that expected.
Political pressures. Political pressures mean that forecasts for income have a bias towards being too high while forecasts for expenditure are biased towards being too low.
The difference between income and expenditure has to be financed through borrowing and this is usually achieved through the issue of bonds. The level of borrowing should also be affected by the economic cycle. Deficits tend to be largest during recessions and smallest (or even become surpluses) at the peak of the cycle. It is difficult, however, to differentiate between deficits that are due to cyclical factors and those that are structural in nature.
The overall result is that most governments are continually paying off debt from old bond issues while attracting new financing by issuing new bonds. These bonds are issued across a range of maturities var ying anywhere between three months and 30 years. The level of government borrowing has a direct effect on the demand for, and hence price of, money. Excessive levels of government borrowing make it harder and more expensive for the private sector to borrow and this is the phenomenon referred to as “crowding out” by economists. Just what constitutes excessive requires a political as much as an economic judgement.
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The range of retail financing requirements is much narrower than for cor porations:
Homes. Many people, for a number of reasons, aspire to own their own home whether it be a castle in the English countr yside, a condo in New York or a semi-detached house in suburbia. Financing for such purchases is long term in nature and usually paid for from the income of the occupier or occupiers.
Automobiles. Automobiles are usually second only to proper ty in terms of retail big-ticket acquisitions. These are depreciating assets and most owners look to pay off any financing they obtain within three to five years.
Seasonal. While an individual’s behavior may be impossible to predict with any cer tainty people as a whole still tend to act as a herd. Spending on many goods rises in winter as people go out to buy carefully chosen gifts for their loved ones and socks and chocolates for their other relatives. Spending on vacations peaks in the summer months as the masses head for the beaches. During the rest of the year people either save for their next holiday or work to pay off their last.
Consumer goods. White goods such as washing machines and refrigerators have now become so cheap that their cost relative to income has fallen shar ply. Most men love toys, however, and there is always the next generation of mobile phone, personal digital assistant, plasma screen or home enter tainment system to salivate over. Many women are fashion victims and this may help to explain why the smaller bikinis become the more they seem to cost. These types of purchases are often made on a whim and have to be paid for either from savings or by borrowing. Real consumers would need a dictionar y to find out the meaning of the word savings. And such people are easy prey for predators such as unscrupulous finance companies and banks.
Occasional. Cer tain events, weddings and medical emergencies are good examples, occur infrequently but may require significant outlays. The timing of such events cannot usually be predicted well in advance.
Education. Most students have to pay for ter tiar y education. Financing is usually provided by a combination of parental contributions, income from par t-time or summer jobs and long- term education loans.
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