The Oscillating Domains of Public and Private Markets

More than three decades ago, Nobel laureate Michael Jensen had predicted the ‘eclipse of the public corporation’ (Harvard Business Review, 1989). Time and again, market developments seemed to corroborate Jensen’s hypothesis with various trajectories of growing private markets and lagging public markets. Similarly, private markets have seen eye-catching growth in recent years, while public markets appear to be withering both in the US and Europe. Increased private capital raising and declining IPO and public company numbers in leading capital markets support this observation. These developments have caused much discussion, with some commentators again seeing a fundamental shift in the relevance of public and private markets for corporate finance and alarmed regulators.

In our recent article “The Oscillating Domains of Public and Private Markets”, we contribute to the debate about the future of capital markets and corporate finance on both sides of the Atlantic. We shed light on the fluctuating significance of public and private markets for corporate finance over time and challenge the conventional view of a linear trend from one market to the other. Although recent years have seen a steady rise of private markets, a deeper dive into modern financial history shows that these developments are not evidence per se of a stable and linear trend. Putting the recent developments in capital markets in a broader historical context reveals a more complex pattern that does not align with the ‘end of history’ type of predictions some have been making. In particular, financial history shows various boom-and-bust periods in private market activity (see Kaplan & Strömberg, 2009). Therefore, caution is called for when making absolute predictions about capital markets and corporate finance developments, as cyclical booms might purport to be secular trends.

Therefore, we provide an alternative, novel theory on the interaction between public and private markets, which aligns better with the historical evidence. Specifically, we argue that there is a dynamic divide between public and private markets whereby the significance of these markets for corporate finance is in constant flux. Our analytical framework draws on the idea of functional finance by Robert Merton (1995) . He argues that financial functions move back and forth between markets and intermediaries. Our concept of ‘the dynamic public/private divide’ makes an analogous case for the relationship between public and private markets. The gist of our theory is the following: at a particular time, certain factors determine whether investors, capital, and companies gravitate more towards one market than the other. However, this will not be a steady state: other factors will create a countervailing effect and push the balance in favor of the other market. These factors are also subject to adaptation. This interplay will result in a continuous cycle whereby the domains of public and private markets oscillate. With some examples, we further illustrate and specify how, at the margin, firms’ choices to raise capital in private or public markets constantly change, depending on specific determinants we describe in detail, and create the oscillations between the two markets. This dynamic divide, we believe, better captures capital market developments and thus provides a more accurate perspective from which to understand markets and regulate them informedly.

Furthermore, from a static perspective, public and private markets are competing institutions, competition representing a zero-sum game in which the expansion of one market leads to the decline of the other. However, when viewed from a dynamic perspective, the two markets also feature complementarities, reinforcing and improving each other in their functions. Therefore, at the margin, neither market can effectively eliminate the other. These efficiency considerations introduce additional determinants that drive the oscillations we predict. On the one hand, private market investors need public markets as an exit opportunity and indirectly benefit from the rich information environment that public markets provide. Meanwhile, public markets also piggyback on private markets in various ways. For example, private markets incubate companies initially unsuited for public markets. Furthermore, private markets enhance the efficiency of public markets. A realistic threat of private equity acquisitions, for instance, the presence of highly-capitalized buy-out funds, invigorates the market for corporate control and thus incentivizes corporate management to increase value.

In our theory, we see regulators as boundedly rational social planners. Regulation is, of course, an essential determinant of market developments. Yet, the original regulatory intervention induces responses in the system, which feed back into the dynamics and substance of regulation, creating what we call ‘regulatory dialectics.’ Specifically, market participants will adapt their behavior more comprehensively than intended and envisioned in response to new rules and standards, potentially precipitating further amendments in the regulatory framework. Regulation can produce a short-term effect related to its intended goal. Still, it will induce other changes in the financial system, which will attenuate the impact of the original intervention over time and affect the regulation itself later. Boundedly rational regulators who cannot foresee every latent effect of their intervention cannot escape these regulatory dialectics. In other words, as the time horizon lengthens, regulation becomes determined by market developments (‘endogenous’) rather than shaping them (‘exogenous’). We illustrate this with examples of the second-round effects of regulations that reduced public listing costs and liberalized fundraising rules.

Based on our understanding of capital market developments and regulators’ role and market-shaping ability, we argue that the best course of action for regulators is to adopt a functional approach which implies that regulators should, in principle, be agnostic as to whether a firm (re)finances itself on public or private markets. Firstly, this suggests that regulators should avoid regulating one market only if policy objectives evenhandedly apply to both. We add further specifications to this fundamental insight based on our findings, highlighting welfare losses regulators inflict on the economy if they abide by the zig-zag approach to regulation that simply retroactively follows oscillating market developments. In this context, we discuss the increasingly relevant issue of transparency requirements that apply equally across public and private firms. Secondly, regulators should not aim to facilitate capital raising in one market relative to the other unless there are compelling reasons to do so. We argue that such reasons are currently missing, and regulators should therefore focus on growing the overall pie (by improving the efficiency of capital markets as such), always being mindful of the effects of their actions across markets.