American Depository Receipts, abbreviated
ADRs, are extremely important
financial instruments in
international business. These instruments allow companies in
foreign markets to grow even when they become too big for their home
capital market.
ADR's are used especially by companies that are located in segmented markets. Due to government rules, economic conditions, interference, or just small size, many capital markets around the world do not allow corporations to effectively raise the capital they need for expansion and growth. These markets are known as segmented markets. Nations that have and allow for a great amount of capital to be easily and effectively available for companies are said to have highly liquid markets. The worlds largest and most liquid market is the United States. Many Western European markets, especially Britain and Germany, are also highly liquid.
As a result, many companies wish to raise capital in the US. The first step is to realize the need to raise capital above the bounds of the company's home market. Usually, the company will first undertake a cross listing on a less prestigeous exchange within the liquid market. This will allow them to make a name for themselves, and allow the investors in that particular nation to value their company in their own currency. Next, the company can make a cross listing on a more prestigeous exchange, followed by an eventual debt offering.
If a company needs even more capital or rather does not want to raise debt capital, they can continue and cross list on different exchanges. If they decide to sell equity in the foreign market, they require the use of ADRs. When they sell equity, it is not directly to an investor. It is rather to a bank within their home market or within the host nation. The bank itself underwrites the offering, and keeps the equity, but sells the rights to the equity in the host currency to investors. This way, investors can invest in a foreign company and do not have to undertake transaction risk (the risk associated with buying currency to invest in the first place, then after cashing out, buying back your own currency).
Because of the stringent reporting rules of the SEC, many foreign companies find it extremely expensive to undertake the process of listing and offering equity or debt in the US. As a result, only the companies that can afford to take on these expenses can crosslist. Many other companies cross list in nations like Germany and Britain, where the disclosure rules are not as stringent, but the market is still highly liquid.