What Is Vertical Foreign Direct Investment?

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 a foreign country.

A horizontal direct investment occurs when a company establishes the same type of business operation in a foreign country as it operates in its home country. For example, Toyota assembles cars in both the United States and China. 

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 cost of raw materials or the supply of certain key components. For example, a Japanese car manufacturer acquires a tire manufacturer.

Key Takeaways:

  • Vertical foreign direct investment occurs when a multinational acquires an operation that either acts as a supplier or distributor.
  • Horizontal FDI occurs when a company initiates a similar operation or business model in another country.
  • Companies engaging in vertical FDI typically seek to either lower the cost of raw materials or gain greater control of their supply chain.

A third type of FDI is a conglomerate investment. This occurs whens a company acquires an unrelated business in another country. There are two main challenges to this strategy, entering a foreign market and engaging in a new industry. 

Understanding Vertical Foreign Direct Investment

To better grasp the concept of vertical FDI, consider an American car manufacturer. 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 a price as possible to please its owners or shareholders. If the car manufacturer acquires the foreign steel supplier, the car manufacturer would no longer need to transact with the steel supplier and its market-driven prices.

Most FDI is horizontal rather than vertical. Because developed countries engage more heavily in FDI suggests that market access is more important than reducing production costs as a motive for FDI. 

A company that engages in forward vertical FDI may experience a challenge finding distributors in 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 lack sales channels. In this case, the manufacturer might engage in vertical FDI and build its own distribution network in Japan to fill this niche.

Special Consideration for Foreign Direct Investment (FDI)

FDI is a way for countries and companies with limited capital to obtain financing beyond national borders from wealthier countries. China's rapid economic growth was aided by exports and FDI. The World Bank states that FDI is one way to develop the private sector in lower-income economies and reduce poverty.