Eclipse of the Public Corporation or Eclipse of the Public Markets?

Craig Doidge is Professor of Finance at the University of Toronto. This post is based on a paper authored by Professor Doidge; Kathleen M. Kahle, Thomas C. Moses Professor in Finance at the University of Arizona; Andrew Karolyi, Harold Bierman, Jr. Distinguished Professor of Management at Cornell University; and René Stulz, Everett D. Reese Chair of Banking and Monetary Economics at Ohio State University.

In 1989, Jensen wrote that “the publicly held corporation has outlived its usefulness in many sectors of the economy.” He published in the Harvard Business Review an article titled “The Eclipse of the Public Corporation.” Jensen argued that the conflict between owners and managers can make the public corporation an inefficient form of organization. He made the case that new private organizational forms promoted by private equity firms reduce this conflict and are more efficient for firms in which agency problems are severe. Though the number of public firms did not initially fall following Jensen’s prediction, it eventually did, and dramatically so.

One might conclude that this dramatic drop in the number of public corporations represents the eclipse of the public corporation as predicted by Jensen. However, large and highly profitable public companies such as Google, Apple, Amazon, Microsoft, and Facebook, have arisen and flourished. Paradoxically, we have some of the most profitable and successful companies in the history of U.S. capital markets at the same time we are witnessing a collapse in the number of public firms. One common characteristic of these firms is that they have vastly more intangible than tangible capital. In our paper, Eclipse of the Public Corporation or Eclipse of the Public Markets?, we argue that U.S. public markets are not well-suited to satisfy the financing needs of young firms with mostly intangible capital. In that sense, what we are really witnessing is not an eclipse of the public corporation, but of the public markets as the place where young American companies seek their funding.

We first show the evolution of listings in the U.S. and abroad. In 1975, the number of U.S. domiciled listed firms on the U.S. exchanges was 4,818. This number increased steadily until 1997, when it peaked at 7,509. Since then it has fallen every year but 2014. At the end of 2016, the number of listed firms was 3,618, which is 52% lower than at the peak in 1997. This decline is not a global phenomenon. The number of listed firms in non-U.S. countries has increased since 1997. A regression model that relates the number of listed firms to GDP per capita, GDP growth, and investor rights confirms that the U.S. in recent years indeed has relatively fewer listed firms than other countries with similar characteristics.

For the number of listed firms to fall, there must be fewer new lists and/or more delists. Since 1997 the number of new lists has fallen dramatically and delists have increased. All else equal, new lists are smaller firms and smaller firms are more likely to delist. As a result, the disappearance of small firms from public exchanges has been dramatic. With fewer small firms on public exchanges, the average market capitalization and age of listed U.S. firms has increased.

While the number of listed U.S. firms has declined since 1997, the total number of firms in the economy has increased. Therefore, the propensity to be listed has decreased. While the propensity to be listed decreases for firms of all sizes, the decrease is largest for small firms. Thus, the size distribution of listed firms has tilted towards large firms.

Does this decline in the number of listed U.S. firms really represent an “eclipse of the public corporation”? When Jensen wrote his article in 1989, he was concerned that managers would hoard and waste resources rather than return cash to shareholders. Consistent with this concern, the average ratio of cash holdings to assets for listed firms has increased quite steadily since 1975 and is much higher now compared to previous years. At the same time, listed firms now have extremely high payout rates. They have also changed how they distribute their profits. In 1975, payouts were almost exclusively in the form of dividends. Today, repurchases represent a larger proportion of payouts than dividends. Since 1997, repurchases by listed firms exceed equity issues by $3.6 trillion. These changes make it hard to believe that hoarding of resources by empire-building CEOs is a concern for the corporate sector or that this hoarding explains the drop in listings.

Public firms in the U.S. have evolved in other important ways. We show that, for the typical listed firm, intangible assets are now more important than tangible assets. On average, listed firms spent six times more on capital expenditures than on R&D in 1975. In 2016 they spent twice as much on R&D compared to capital expenditures. Intangible assets are relatively more important for the corporate sector in the U.S. than in other countries.

We argue that public markets are not well-suited for young, R&D-intensive companies. Firms that go public may benefit from having securities registered with the Securities and Exchange Commission. However, public firms are subject to strict disclosure rules and have to follow U.S. Generally Accepted Accounting Principles (GAAP), both of which can be problematic for firms that are heavy in intangible assets. By disclosing details of an R&D program, a firm gives away some of its ideas and other firms can build on what they learn. While firms will try to reveal as little as possible of that which could be appropriated by others, outsiders cannot assess their value correctly if they disclose too little and are likely to value it at a discount. GAAP accounting also makes it difficult for outsiders to assess the value of a firm’s intangible assets.

Firms with valuable intangible assets can better convey information about their value to non-public capital providers. Hence, private forms of equity financing are likely to be preferred by young R&D intensive firms. Regulatory changes, technological changes, and the fact the young firms do not require as much capital in their build-up phase as they used to allows privately-held startups to raise enough capital privately without having to use public markets. Exit through acquisition rather than through public markets has similar advantages for firms with hard-to-value intangible assets.

This evolution has several potential downsides but it also reflects that the financial system of the U.S. has evolved in such a way that some types of firms can be financed more efficiently through private sources. No deregulatory action is likely to restore the public markets in this case. Instead, we should focus on creating a fertile ground for investment in intangible assets by having appropriate laws, appropriate financing mechanisms, and maybe new types of exchange markets, as these assets appear to be the way of the future for corporations.

The complete paper is available for download here.

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