Corporate Investment and Stock Market Listing: A Puzzle?

The following post comes to us from John Asker, Professor of Economics at UCLA; Joan Farre-Mensa of the Entrepreneurial Management Unit at Harvard Business School; and Alexander Ljungqvist, Professor of Finance at NYU.

Economists have long worried that a stock market listing can induce short-termist pressures that distort the investment decisions of public firms. Back in 1985 Narayanan wrote in the Journal of Finance that “American managers tend to make decisions that yield short-term gains at the expense of the long-term interests of the shareholders.” More recently, a growing number of commentators blame the sluggish performance of the U.S. economy since the 2008–2009 financial crisis on short-termism. For example, in a recent Harvard Business Review article, Barton and Wiseman, global managing director at McKinsey & Co. and CEO of the Canada Pension Plan Investment Board, respectively, argue that “the ongoing short-termism in the business world is undermining corporate investment, holding back economic growth.”

Yet, systematic empirical evidence of widespread short-termism has proved elusive, largely because identifying its effects is challenging. A chief challenge is the difficulty of finding a plausible counterfactual for how firms would invest absent short-termist pressures. In our paper, Corporate Investment and Stock Market Listing: A Puzzle?, which is forthcoming at the Review of Financial Studies, we address this difficulty by comparing the investment behavior of stock market-listed firms to that of comparable privately held firms, using a novel panel dataset of private U.S. firms covering more than 400,000 firm years over the period 2001–2011. Building on prior work, our key identification assumption is that, on average, private firms suffer from fewer agency problems and, in particular, are subject to fewer short-termist pressures than are their listed counterparts. This assumption is motivated by the fact that private firms are often owner managed and, even when not, are both illiquid and typically have highly concentrated ownership. These features encourage their owners to monitor management more closely to ensure long-term value is maximized.

Theoretical models of “managerial myopia” or “short-termism” argue that a focus on short-term profits may distort investment decisions from the first-best when public-firm managers derive utility from both the firm’s current stock price and its long-term value. If investors have incomplete information about how much the firm should invest to maximize its long-term value, managers may see underinvestment as a way to create the impression that the firm’s profitability is greater than it really is, hoping to thereby boost today’s share price. This would lead managers to use a higher hurdle rate when evaluating investment projects than would be used absent myopic distortions, resulting in lower investment levels and lower sensitivity to changes in investment opportunities. Importantly, this would occur even if investors can perfectly observe actual investment.

Our empirical results are consistent with these two predictions. We first show that private firms invest substantially more than do public ones on average, holding firm size, industry, and investment opportunities constant. This pattern is surprising in light of the fact that a stock market listing gives firms access to cheaper investment capital. Second, we show that private firms’ investment decisions are around four times more responsive to changes in investment opportunities than are those of public firms. This is true even during the recent financial crisis. Our results are robust to a variety of matching criteria, to exploiting within-firm variation in listing status, and to instrumenting a firm’s listing status with plausibly exogenous variation in the supply of start-up funding across U.S. states and time.

The stylized facts we document are consistent with public-firm managers behaving in a short-termist way, but they may also be consistent with other hypotheses, such as a preference for a quiet life. To investigate this further, we test a key cross-sectional prediction that is unique to short-termism models: a public-firm manager’s incentive to engage in short-termist behavior—and thus the associated distortion in investment behavior—should increase in the sensitivity of his firm’s share price to earnings news.

To test this prediction, we follow the accounting literature and measure the sensitivity of share prices to earnings news using “earnings response coefficients” or ERC. If short-termism explains the difference in investment sensitivity between public and private firms, then this difference should increase in ERC. This is precisely what we find. When share prices are unresponsive to earnings news (ERC = 0), investment sensitivities are no different, consistent with the absence of an incentive to distort investment to boost the share price. As ERC increases, public firms’ investment sensitivity falls significantly while that of private firms remains unchanged. In other words, the difference in sensitivities increases in ERC, and this increase is driven by a change in the behavior of public firms.

This conclusion is supported by auxiliary evidence showing that investment sensitivity is especially low among public firms with high levels of transient (i.e., short-term focused) institutional ownership and those with a propensity to “meet or beat” analysts’ earnings forecasts. These cross-sectional patterns are consistent with the notion that short-termist pressures induce public firms to invest myopically.

Our findings highlight short-termist pressures as a potentially important cost of a stock market listing. A number of authors have emphasized other costs and benefits of being public, such as costs associated with disclosure requirements or benefits due to a reduction in financing costs, greater scope for risk sharing, and the opportunity to attract better-qualified human capital. Our paper thus can be seen as part of a larger research agenda that tries to understand the trade-offs associated with the going-public decision against the background of companies’ waning interest in a stock market listing in the United States, where the number of listed firms has more than halved since 1997.

The full paper is available for download here.

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