Foreign direct investment (FDI) is an investment made by a company (or individual) into a business located in another country. It can either be in the form of establishing business operations or acquiring business assets in the foreign country.

For example, an American retailer that builds a store in China is trying to earn more money by exploring the Chinese market.

What Is Vertical Foreign Direct Investment?

On the other hand, vertical foreign direct investment occurs when a multinational decides to acquire or build an operation that either fulfills the role of a supplier (backward vertical FDI) or the role of a distributor (forward vertical FDI). Companies that seek to enter into a backward vertical FDI typically seek to improve to the cost of raw materials or the supply of certain key components.

For example, one of the major materials used for car manufacturing is steel. An American car manufacturer would prefer that steel be as cheap as possible, but the price of steel can fluctuate dramatically depending on overall supply and demand. Furthermore, the foreign steel supplier would prefer to sell steel for as high as possible in order to please its owners or shareholders. If the car manufacturer acquires the foreign steel supplier, the car manufacturer would no longer need to deal with the steel supplier and its market-driven prices.

On the other hand, the need for a forward vertical FDI stems from the problem of finding distributors for a specific market. For example, assume that the earlier mentioned American car manufacturer wants to sell its cars in the Japanese auto market. Since many Japanese auto dealers do not wish to carry foreign brand vehicles, the American car manufacturer may have a very difficult time finding a distributor. In this case, the manufacturer would build its own distribution network in Japan to fulfill this niche.

(To learn more about acquisitions, see Mergers and Acquisitions: Path to Profitable Trades.)