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E-MailRené M. Stulz is the Everett D. Reese Chair of Banking and Monetary Economics at the Fisher College of Business at The Ohio State University. This post is based on his recent paper.
Over the last twenty-five years, the U.S. has undergone a dramatic transformation in the role of public equity. The number of public firms has fallen by roughly half since 1997. In contrast, the number of companies backed by private equity (PE) funds has doubled from 2006 to 2017 according to McKinsey. Why is it that public markets appear to be struggling while private markets are expanding rapidly and attracting considerable capital? Does this contrasting evolution mean that the public form of corporate organization is less suited to the business models of firms in the 21st century than it was to the business models of firms last century? Or is it that regulatory changes have decreased the advantage of the public form of organization? Another way to put this is: Are public markets doing less well because firms have changed or because public and/or private markets have changed? I address these issues in my paper titled Public versus Private Equity.
I present a framework that makes it possible to evaluate the relative benefits and costs of public versus private ownership and why these relative benefits and costs have changed over time. I then show that two important changes have taken place that help understand the relative evolution of private and public firms: First, the net benefit of private ownership falls as information asymmetry between insiders of a corporation and potential investors increases and the increase in the role of intangible assets in corporations has increased this information asymmetry; second, funds available for private equity investments have increased sharply partly because of deregulation and partly because of the institutionalization of investment.
Insiders of public firms can use the firms’ assets to benefit themselves as opposed to the public shareholders. If shareholders think the return on shares will be low, they will only be willing to buy the shares at a low price and the firm may not be able to finance itself. Public investors have the disadvantage that they are not as well informed as the insiders, so that they may not know when insiders take advantage of them. Also, they cannot verify many claims that insiders may make about the prospect of shares. Laws and regulations that govern public firms are motivated by the intent of making it more likely that shareholders receive a return. Further, insiders of public firms can increase the value of shares through better governance. For instance, the firm can have directors known for their independence and competence, so that they will not rubber stamp management’s decisions but will instead make sure that the interests of shareholders predominate. The firm can choose to list shares on an exchange with shareholder-friendly standards. The firm can elect to have auditors that reassure shareholders.
The steps that a public firm can take to reassure shareholders may not be enough to enable it to raise funds on acceptable terms to insiders because information asymmetries are too big. For instance, a firm’s main asset may be a research project. If it discloses much about this project, it provides valuable information to competitors and may destroy the value of the project. Alternatively, the interests of insiders may conflict too much with the interests of shareholders. For instance, the firm’s CEO would lose her job if the firm is sold, but selling the firm might be the best outcome for shareholders. U.S. firms have changed since the 1980s. There are many more young firms that invest more in intangible assets, such as R&D, than invest in physical assets. Information asymmetries are much higher with intangible assets for young firms. For young firms, this change in investment has affected the benefits and costs of being public compared to being private. Young firms building intangible assets can be much better off receiving private funding. With private funding, they do not have to disclose information in a way that could potentially help competitors. They can sell shares to specialized investors who have incentives, both legal and reputational, to keep information private and who have the expertise to value the shares accurately. When a firm’s CEO has incentives that differ sharply from those of shareholders, specialized investors can acquire concentrated ownership to monitor the CEO better and make sure that the right decisions are taken.
The growth of investment in intangible assets has increased the demand for private equity funding. For young firms with high intangible investments, the alternative to private equity funding is not public funding, but selling out to a larger firm. If private equity funding had not increased, we would see less investment in intangible assets and less innovation. However, private equity funding has increased sharply. Part of the reason is deregulation. A major motivation for securities laws is to limit the ability of firms and investment vehicles to raise funds privately to force these firms and investment vehicles into the public domain so that investors are protected by these laws. Before the 1980s, firms were extremely limited in the number of shareholders they could have without going public. Investment vehicles faced severe constraints in the number of investors they could raise funds from without using public issues. These constraints started to be significantly relaxed in the 1980s. In 1996, the cap of 100 investors for investment vehicles was removed. A recent study shows that the 1996 law change played an important role in the decrease of IPOs. Now, a firm can have 2,000 shareholders and still be private. Though many observers have focused on increased regulation of public firms with Sarbanes-Oxley as a reason for the decrease in the number of public firms, deregulation of private firms and private investment vehicles is a more important explanation for this decline than Sarbanes-Oxley. There was a massive decrease in the number of public firms before Sarbanes-Oxley was ever implemented. While these changes took place, investment through institutional investors also increased dramatically. Thus, it is now much easier for PE to raise funds privately as a small number of investors can fund large private equity investments. In addition, the pool of potential funds available to PE is now substantially larger.
Looking to the future, there is no reason to think that the evolution that has taken place over the last twenty years will be reversed soon. Public policy could make it more attractive for firms to be public, but it is unlikely that measures to decrease the transaction costs of going public will have much of an impact on the number of public firms as evidenced by the JOBS Act. Even if going public involved no transaction costs, firms would still have to disclose information that might be used advantageously by their competitors, so that firms might want to wait until they are established to do so. Having firms disclose less to public markets does not really solve the problem because when firms disclose less, they may receive less value for their equity compared to selling equity to specialized investors to whom they can disclose more. Going public, firms give information away. Staying private, they are able to have investors who have specialized knowledge that can help them develop. This does not mean that there are no risks to the growth of private equity and the decrease in public equity. Price discovery is much poorer in private markets, so that bubbles can develop and there is a high potential for misvaluations. Though there has been progress in making private equity investments more liquid, it is not possible to sell such investments short. It is well-known from the finance literature that securities that cannot be sold short can be overvalued as investors who believe the securities to be overvalued have no way to take advantage of their knowledge.
The complete paper is available here.
