sizeable and surprising differences in investment behavior between stock market listed and privately held firms in the U.S. using a rich new data source on private firms. Listed firms invest substantially less and are less responsive to changes in investment opportunities compared to matched private firms, even during the recent financial crisis. Ex ante differences between public and private firms such as lifecycle differences at most explain a third of the difference in investment behavior. The remainder appears most consistent with a propensity for public firms to suffer greater agency costs. In particular, evidence showing that investment behavior diverges most strongly in industries in which stock prices are particularly sensitive to current earnings news suggests public firms may suffer from managerial myopia.The authors comment that
This paper compares the investment behavior of stock market listed (or ‘public’) firms to that of comparable privately held firms, using a novel panel dataset of private U.S. firms covering more than 400,000 firm-years over the period 2001-2011. Almost everything we know about investment at the micro level is based on evidence from public firms, which number only a few thousand, yet private firms form a substantial part of the U.S. economy. We estimate that in 2010, private U.S. firms accounted for 52.8% of aggregate non-residential fixed investment, 68.7% of private-sector employment, 58.7% of sales, and 48.9% of aggregate pre-tax profits. Nearly all of the 5.7 million firms in the U.S. are private (only 0.06% are listed), and many are small, but even among the larger ones, private firms predominate: among those with 500+ employees, for example, private firms accounted for 86.4% in 2010.
Our empirical tests unearth two new patterns. First, private firms invest substantially more than public ones, holding firm size and industry constant. The average investment rate among private firms is nearly twice as high as among public firms, at 6.8% versus 3.7% of total assets per year. Second, private firms’ investment decisions are more than four times more responsive to changes in investment opportunities than are those of public firms, based on standard investment regressions in the tradition of tests of the Q theory of investment (see Hayashi (1982) or, more recently, Gomes (2001), Cummins, Hassett, and Oliner (2006), Bloom, Bond, and van Reenen (2007), and Bakke and Whited (2010)). This is true even during the recent financial crisis.
We find similar patterns when we exploit within-firm variation in listing status a sample of firms that go public without raising new capital and so change only their ownership structure: IPO firms are significantly more sensitive to investment opportunities in the five years before they go public than after. Indeed, once they have gone public, their investment sensitivity becomes indistinguishable from that of observably similar, already-public firms. We also find similar results when we instrument a firm’s listing status with plausibly exogenous variation in the supply of VC funding across U.S. states and time.
What would cause public and private firms to invest so differently? One possibility is that the striking difference in investment sensitivities is simply an artifact of our sampling, measurement, or methodological choices. However, extensive robustness tests show that our samples are representative, that our results are robust to various alternative matching approaches, and that the difference in investment behavior does not appear to be driven by how we measure investment opportunities.
This suggests that we need to look to more fundamental economic differences between public and private firms for an explanation. Lifecycle differences between public and private firms play only a limited role in explaining our results, accounting for less than a third of the difference in investment sensitivities. After ruling out other systematic differences between public and private firms (such as investment in intangibles, tax treatment, and accounting choices), we are left with differences in ownership and agency problems as the leading candidate explanation.
The corporate finance literature has long argued that stock market listed firms are prone to agency problems. While listing a firm on a stock market provides access to a deep pool of low cost capital, this can also have two detrimental effects. First, ownership and control must be at least partially separated, as shares are sold to outside investors who are not involved in managing the firm. This can lead to agency problems if managers’ interests diverge from those of their investors (Berle and Means (1932), Jensen and Meckling (1976)). Second, liquidity makes it easy for shareholders to sell their stock at the first sign of trouble rather than actively monitoring management – a practice sometimes called the ‘Wall Street walk.’ This can weaken incentives for effective corporate governance (Bhide (1993)).
Private firms, in contrast, are often owner-managed and even when not, are both illiquid and typically have highly concentrated ownership, which encourages their owners to monitor management more closely. Indeed, analysis of the Federal Reserve’s 2003 Survey of Small Business Finances (SSBF) shows that 94.1% of the larger private firms in that survey have fewer than ten shareholders (most have fewer than three), and 83.2% are managed by the controlling shareholder. According to another survey, keeping it that way is the main motivation for staying private in the U.S. (Brau and Fawcett (2006)). As a result, agency problems are likely to be greater among public firms than among private ones.
There are three strands of the agency literature that argue public firm’s investment decisions might be distorted due to agency problems. First, Baumol (1959), Jensen (1986), and Stulz (1990) argue that managers have a preference for scale which they satisfy by ‘empire building.’ Empire builders invest regardless of the state of their investment opportunities. This could explain the lower investment sensitivity we observe among public firms.
Second, Bertrand and Mullainathan (2003) argue the opposite: managers may have a preference for the ‘quiet life.’ When poorly monitored, managers may avoid the costly effort involved in making investment decisions, leading to lower investment levels and, presumably, lower investment sensitivities.
Third, models of ‘managerial myopia’ or ‘short-termism’ argue that a focus on short-term profits may distort investment decisions from the first-best when public-firm managers derive utility from both the firm’s current stock price and its long-term value.4 If investors have incomplete information about how much the firm should invest to maximize its long-term value, managers may see underinvestment as a way to create the impression that the firm’s profitability is greater than it really is, hoping to thereby boost today’s share price (Stein (1989)). This would lead managers to use a higher hurdle rate when evaluating investment projects than would be used absent myopic distortions, resulting in lower investment levels and lower sensitivity to changes in investment opportunities. Importantly, this would occur even if investors can perfectly observe actual investment (Grenadier and Wang (2005)). The fact that we find lower investment levels among public firms seems inconsistent with empire building. On the other hand, both the quiet life argument and short-termism predict underinvestment, thus fitting the empirical facts we document. To shed further light on what drives the observed investment difference between public and private firms, we explore how it varies with a parameter that plays a central role in short-termism models: the sensitivity of share prices to earnings news. As we explain in Section 4, under short-termism a public-firm manager has no incentive to underinvest if current earnings news has no impact on the firm’s share price, in which case we expect no difference in investment behavior. But the more sensitive share prices are to earnings news, the greater the incentive to distort investment and hence the greater the difference in public and private firms’ investment sensitivities.
To test these predictions, we follow the accounting literature and measure the sensitivity of share prices to earnings news using ‘earnings response coefficients’ or ERC (Ball and Brown (1968)). For industries whose share prices are unresponsive to earnings news (ERC = 0), we find no significant difference in investment sensitivities between public and private firms. As ERC increases, public firms’ investment sensitivity falls significantly while that of private firms remains unchanged. In other words, the difference in investment sensitivities between public and private firms increases in ERC, and this increase is driven by a change in public-firm behavior. In addition, we show that investment sensitivity is especially low among public firms with high levels of transient (i.e., short-term focused) institutional ownership and a propensity to “meet or beat” analysts’ earnings forecasts. These cross-sectional patterns are consistent with the notion that short-termist pressures induce public firms to invest myopically.
Our paper makes two contributions. First, we document economically important differences in the investment behavior of private and public firms. Because few private firms have an obligation to disclose their financials, relatively little is known about how private firms invest. A potential caveat is that our analysis focuses on public and private firms that are similar in size, so we essentially compare large private firms to smaller public firms. To what extent do our results extend to larger public firms? We show that the low investment sensitivity among smaller public firms is typical of the investment behavior of all but the largest decile of public firms, which are substantially more sensitive to investment opportunities than the public firms in the other nine deciles.
Second, our analysis suggests that agency problems in public firms, and in particular short-termism, are a plausible driver of the differences in investment behavior that we document. This finding adds to existing survey evidence of widespread short-termism in the U.S. Poterba and Summers (1995) find that public-firm managers prefer investment projects with shorter time horizons, in the belief that stock market investors fail to properly value long-term projects. Ten years on, Graham, Harvey, and Rajgopal (2005, p. 3) report the startling survey finding that “the majority of managers would avoid initiating a positive NPV project if it meant falling short of the current quarter’s consensus earnings [forecast].” This is not to say that effective corporate governance cannot reduce public-firm managers’ focus on short-term objectives. Tirole (2001) argues that large shareholders have an incentive to actively monitor managers and fire them if necessary, while Edmans’ (2009) model shows that the presence of large shareholders can reduce managerial myopia. But it is an empirical question whether these mechanisms are sufficiently effective on average. Our evidence suggests that, at least on the dimension of investment, this may not be the case.
The paper proceeds as follows. Section 1 reviews related literature. Section 2 introduces a rich new database of private U.S. firms created by Sageworks Inc. Section 3 establishes our main empirical results, that public firms invest less and are less responsive to changes in investment opportunities than private firms. Section 4 investigates possible explanations for these findings. Section 5 examines the extent to which our results might be driven by the endogeneity of a firm’s listing status. Section 6 concludes.