Is the American Public Corporation in Trouble?

Kathleen M. Kahle is Thomas C. Moses Professor in Finance at the University of Arizona and René M. Stulz is Everett D. Reese Chair of Banking and Monetary Economics and the Director of the Dice Center for Research in Financial Economics at The Ohio State University. This post is based on a recent paper by Professor Kahle and Professor Stulz.

In his famous 1989 Harvard Business Review article predicting the demise of the public corporation, Jensen argues that public companies are inefficient organizational forms because private firms can better resolve agency conflicts between investors and managers. His prediction initially appeared to be invalid. The number of public firms increased sharply in the years following the article’s publication. However, as Doidge, Karolyi, and Stulz show in the March 2017 issue of the Journal of Financial Economics, the number of listed firms peaked in 1997 and has since fallen by half, such that there are fewer public corporations today than forty years ago. Does this fall vindicate Jensen?  Is the public corporation in trouble?

In Is the American Public Corporation in Trouble?, we examine the evolution of U.S. public corporations over the last forty years by comparing snapshots in 1975, 1995, and 2015. During this time, public firms experience striking changes. Not only are there fewer public corporations today than forty years ago, but these corporations are very different. They are older and larger. They are in different industries. Their asset structure has changed, as they have fewer physical assets and more intangible assets, which has resulted in changes in the way they finance themselves. They are less profitable, especially if they are small. Total payouts to shareholders are higher, but these payouts now often are in the form of repurchases rather than of dividends. Institutions now typically own more than 50% of corporations large enough to be suitable investments for such investors.

In 1975, there are 4,819 publicly listed U.S. corporations. That number increases to 7,002 in 1995 and peaks at 7,507 firms in 1997. However, by 2015, the number of public corporations falls to 3,766. In contrast to the sharp rise and fall in listings, the market capitalization (in 2015 dollars) of listed firms fluctuates sharply throughout the last forty years. We find that the aggregate market capitalization of public corporations in 2015 is seven times larger than forty years ago. The end result of the increase in market capitalization and decrease in listed firms is that both the mean and median market values of the equity of public corporations (in constant 2015 dollars) in 2015 are almost ten times the market values in 1975. Hence, there are fewer public corporations, but they are much larger. This increase in size is accompanied by a striking increase in the concentration of performance and assets. In 2015, 35 corporations account for half the assets of public corporations and 30 account for half the net income. In 1975, these numbers were, respectively, 94 and 109.

Since 1975, there has been a dramatic shift in how firms invest—firms spend more on R&D and less on capital expenditures. This shift is dramatic when examining averages; capital expenditures as a percentage of assets falls in half from 1975 to 2015. In contrast, R&D increases fivefold. Whereas in 1975, the average public corporation spends almost seven times more on capital expenditures than R&D, by 2015, average spending on R&D surpasses that on capital expenditures. Since firms invest less in tangible assets, property, plant, and equipment (PPE) is a smaller fraction of the assets in 2015. While corporations’ assets comprise less PPE, the fraction of assets held in cash and liquid assets more than doubles.

As a consequence of accounting rules, increasing R&D and decreasing capital expenditures makes the performance of U.S. firms look worse. Capital expenditures are depreciated over time, but R&D is expensed in the year incurred. Hence, if a firm increases its R&D investment at the expense of capital expenditures, its accounting performance suffers. For example, a well-accepted measure of profitability is a firm’s operating cash flow to assets, which is calculated after depreciation and other non-cash charges. From 1996 through 2015, the yearly equally-weighted average of operating cash flow to assets for public firms averages 0.2% of assets. From 1975 to 1995, it averages 4.3%. However, if we add R&D expense to this measure, the deterioration in profitability is dramatically smaller: cash flow as a percentage of assets falls from 6.9% in the first twenty years of our sample to 5.3% in the last twenty.

We also examine how corporations finance themselves.  Compared to 1975, public firms have less debt on average, even though leverage has increased over the last few years. Perhaps the best measure of financial health is net leverage, defined as the ratio of debt minus cash over total assets. In the first twenty years of our sample, the average equally-weighted net leverage ratio is 12.1%; since 1995, it is 0.7%. However, this ratio is negative in almost every year from 2003 to 2014, indicating that U.S. public firms have more cash than debt in those years. If we instead examine asset-weighted averages, which weight large firms more heavily, the asset-weighted averages of leverage and net leverage in 2015 are at about the same level as in 1975. In other words, for large firms, leverage has not declined.

Finally, we examine changes in the composition of and payouts to shareholders. Our data on institutional ownership begins in 1980, when institutional ownership averages 17.7%. In 2015, average institutional ownership is 50.4%. Shareholders’ payouts also differ now compared to 1975. Average dividends per dollar of assets are lower in 2015 than in 1975, in spite of the fact that average dividends per dollar of assets have increased by a factor of almost three since 2000. Share repurchases are much higher now than either twenty or forty years ago. Since the late 1990s, public corporations spend more on repurchases than on dividends, and repurchases per dollar of assets are more than six times higher than forty years ago. Because of this increase in repurchases, the highest percent of net income paid out to shareholders during our sample period is in 2015. When we use an asset-weighted average, U.S. public firms have negative net equity issuance, meaning that large firms repurchase more shares than they issue for most years since the late 1990s.

Jensen’s key argument in his forecast of the demise of the public firm is that public firms are beset by agency problems. The fact that American firms pay out more to shareholders now than at any time since 1975 seems inconsistent with the view that the agency problems of free cash flow is important on average for U.S. public firms. The problem seems to be the opposite, namely that firms pay out too much. However, Jensen’s prediction of the rise of private equity is on the mark. It has become very important, but mostly for private firms, and may be a contributing factor to why so few firms choose to participate in the public markets.

The firms that remain public are survivors. Few firms want to join their club.  A small number of firms account for most of the market capitalization, most of the net income, most of the cash, and most of the payouts of public firms. At the industry level, revenues are more concentrated, so there are fewer public firms competing for customers. A large fraction of firms are unprofitable every year, especially at the end of our sample period. The increase in unprofitable firms indicates that many public firms are fragile and helps explain the high level of delists. Accounting standards do not reflect the importance of intangible assets for these firms. Such a bias may make it harder for executives to invest for the long run.

As a whole, public firms appear to lack ambition, proper incentives, or opportunities. They are returning capital to investors and hoarding cash rather than raising funds to invest more.

The complete paper is available for download here.


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