The Deregulation of Private Capital and the Decline of the Public Company

Despite attracting little notice until recently, the proportion of companies choosing to go public in the U.S. has been plummeting for more than two decades. Why is this happening? Most observers blame public companies’ increasing regulatory costs—particularly disclosure costs. Yet rising costs cannot be the full story, given that the downward trend began well before Sarbanes-Oxley, the supposed game-changer for public-company regulation. In a recent article, The Deregulation of Private Capital and the Decline of the Public Company, I argue that the culprit need not be rising costs of corporate disclosure, but declining benefits.

From their inception, the federal securities laws proposed a simple bargain to U.S. companies: disclosure in exchange for investors. Companies that went public took on substantial disclosure obligations and, in return, were permitted to solicit the largest (and therefore cheapest) source of capital: the general public. Conversely, private companies were restricted to raising capital primarily from insiders and financial institutions, without publicity and subject to severe restrictions on subsequent transfers of their securities—effectively precluding any sort of market for private company equity. Over the last three decades, however, the disclosure bargain has largely been revoked. While maintaining (or increasing) substantial disclosure burdens on public companies, regulators have repeatedly and dramatically loosened the restrictions on private capital-raising. Today, private companies can raise ample, cheap capital with relative ease. Thus, public companies benefit significantly less from their disclosure obligations under the new regime and can justifiably complain of a regulatory bait-and-switch.

Why are investors so willing to pour capital into companies that are not subject to disclosure requirements, particularly when the private markets still cannot compete with the liquidity of public equity? One explanation lies in the information effects of our new securities-law paradigm. Together, public companies’ mandatory disclosure and stock trading prices provide a major information subsidy to private companies. Indeed, the (much-debated) economic argument in favor of a mandatory disclosure regime is that in the absence of regulation companies will fail to disclose the socially optimal amount of information to the public. One reason is that disclosure has material third-party effects or externalities: information disclosed by one company may help its competitor, for example, which discourages voluntary disclosure. In this view, a well-designed mandatory disclosure regime should benefit disclosing companies as a group and reduce their collective cost of capital by compelling them to disclose the optimal amount of information to the market.

This conclusion assumes that firms have no meaningful choice as to whether to be subject to the disclosure regime, however. Under the old regulatory bargain, broadly speaking, this was a valid assumption. Because of the restrictions on private capital raising, for the most part issuers needing to raise significant equity capital had no choice but to go public and take on the disclosure burden. Public companies and private companies thus tended to differ significantly in both size and investor base. The third-party effects of mandatory disclosure were therefore unlikely to be materially harmful to public companies as a group. To the extent that a public company’s disclosure proved helpful to a particular private company, the two were unlikely to be in direct competition in either the product or the capital markets.

Yet the ongoing deregulation of private capital has made the mandatory disclosure regime largely elective. With issuers and investors increasingly free to cross the public-private divide, public and private companies now compete more directly for both investors and customers. The result is that the mandatory disclosure regime is no longer a closed system for the benefit of public companies: The third-party effects of disclosure amount to a penalty on public companies and a subsidy to private companies.

This is not the happy outcome envisioned by proponents of mandatory disclosure. Private companies today can raise large amounts of capital while disclosing less than their public company counterparts in part by freeriding on the enormous volume of public side information, which makes private company valuation vastly easier and more accurate.

But, if the public side’s loss is simply the private side’s gain, why worry? Clearly there is much to like about private firms and private capital. The difficulty is that the status quo is unstable. The thriving market for private company equity currently receives a material benefit from the vast amounts of public company information available. For precisely that reason, public companies have little reason to continue to provide this subsidy. The ongoing decline of public equity thus seems likely to persist for some time to come, reducing the massive flow of public-market information currently available to the private markets. If so, private firms will face information problems of their own. At a minimum, they will either have to significantly increase their spending on disclosure or face a higher cost of capital. Thus, the golden age of cheap and abundant private capital need not survive the decline of public equity.

The full article is available for download here.