The Disappearance of Public Firms

Gustavo Grullon is Professor of Finance at Rice University. This post is based on an article authored by Professor Grullon; Yelena Larkin, Assistant Professor of Finance at Penn State University; and Roni Michaely, Professor of Finance at Cornell University.

In our paper, The Disappearance of Public Firms and the Changing Nature of U.S. Industries, which was recently made publicly available on SSRN, we show that contrary to popular beliefs, U.S. industries have become more concentrated since the beginning of the 21st century due to a systematic decline in the number of publicly-traded firms. This decline has been so dramatic that the number of firms these days is lower than it was in the early 1970s, when the real gross domestic product in the U.S. was one third of what it is today.

We show that the decline in the number of public firms has not been compensated by other mechanisms that could reduce market concentration. First, private firms did not replace public firms, as the aggregate number of both public and private firms declined in over half of the industries, and the concentration ratio based on revenues of public and private firms has increased. Second, we examine whether the intensified foreign competition could provide an alternative source of rivalry to domestic firms, and find that the share of imports out of the total revenues by U.S. public firms has remained flat since 2000. Third, we show that the decrease in the number of public firms has been a general pattern that has affected over 90% of U.S. industries, and is not driven by distressed industries, or business niches that have disappeared due to technological innovations or changes in consumer preferences. Instead, it has been driven by a combination of a lower number of IPOs as well as high M&A activity.

We show that the reduction in the number of firms has had implications to both corporate and asset pricing aspects of the remaining firms. Specifically, we find strong association between the reduction in the number of public firms in the U.S. and the remaining firms’ profitability, stock returns, and investment opportunities as captured by M&A gains.

We start by examining firm profitability, as measured by returns on assets (ROA), and find that it has significantly increased over the past two decades, especially in industries with a higher decline in the number of public firms. When we decompose return on assets into asset utilization (or sales to assets ratio) and operating profit margins, we find that the higher returns on assets are mainly driven by the firms’ ability to extract higher operating profit margins. The abnormal profits that firms are able to extract are consistent with higher market power and potential change in the nature of the U.S. industries.

We also show that the higher profitability of firms in markets with a declining number of competitors has important implications to their acquisition activity. We find that mergers have become more profitable to shareholders in general, and even more so in concentrated industries. Further, the market reaction is especially high for horizontal mergers in industries with fewer participants, suggesting that market power is becoming an important source of value during M&A transactions.

Finally, we find evidence that the returns to investors of the public firms increase with higher market concentration. Specifically, we construct a trading strategy of buying firms in industries with the largest decline in the number of firms, and shorting firms in industries with the largest increase in the number of public firms. We find that over the period of 2001-2013, this strategy generates excess returns of 8.76% per year, after controlling for the standard risk factors. Thus, the higher profit margins that firms enjoy as a consequence of the change in concentration are reflected in higher profits to shareholders.

Finally, we ask what could explain the link between increase in concentration and firm profitability. One possible reason is greater barriers to entry driven by changes in technology. Henderson and Cockburn (1996) and Ciftci and Cready (2011) show that technological advances benefit from the economy of scale. Given the increased contribution of computer-related technology and innovative property to the growth in output in the past two decades (Corrado and Hulton (2010)), the recent technological advances could have created barriers of entry to new firms. To support this idea in our empirical setting, we examine the relation between the number of firms in the industry and the number of patents that firms generate. We find that while the association has been positive in the early period, it has reversed in the last decade.

To summarize, the trend of increased competition across U.S. industries has reversed in the past two decades. Markets have become more concentrated, and profit margins have increased with industry concentration. The increased profit margins are not driven by better operational efficiency, but rather by higher operating margins, perhaps due to greater market power. Consistent with this notion, we also find that higher market concentration has resulted in more profitable investment opportunities, as the market reaction to M&A announcements has become more positive, especially across horizontal deals. Taken together, these findings suggest that product markets have undergone a structural change that significantly transformed the nature of competition.

The full paper is available for download here.

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