Financial data on US companies is easy to come by—if they are listed on the stock market. More than 99 percent of them are not, presenting a challenge for researchers intent on studying how privately held firms operate.
“It seemed natural for us to look at how the investment behavior of public and private firms differs.”
So when Harvard Business School Assistant Professor Joan Farre-Mensa learned he'd been granted access to a database of accounting information on tens of thousands of private American firms, he knew it was an extraordinary opportunity.
The working paper "Comparing the Investment Behavior of Public and Private Firms," written by Farre-Mensa with New York University's John Asker and Alexander Ljungqvist, details how and why public and private companies differ when it comes to expanding a company through acquisitions, plant upgrades, and the like.
According to their research, public firms invest less than half as much as private firms of similar size and industry—and private firms are 3.5 times more responsive to changes in investment opportunities.
The authors argue that this is largely due to "managerial myopia"—the tendency for public-firm managers to favor short-term profits over long-term gains. The research results suggest that managers of public companies are under much more pressure than their private-firm counterparts to show short-term financial results.
Peeking In On Private Companies
The researchers drew on a database created by Sageworks, a financial information company based in Raleigh, North Carolina. When Sageworks decided to open up its nearly 250,000 private-firm database of detailed accounting information to academic researchers, Ljungqvist was one of the fortunate few the company called.
The researchers' decision on where to focus their efforts was an easy one. "It seemed natural for us to look at how the investment behavior of public and private firms differs," Farre-Mensa says. The fact that there were no similar studies, coupled with the robustness of the data, confirmed they were ready to move on.
The next step involved creating a match sample. "The first thing we did was try to find for each public firm in the United States a private firm that was of similar size and in the same industry," Farre-Mensa says. Although this turned out to be impossible for the largest companies, the researchers were able to find similar private firms for a good number of public firms.
The team then studied the investment patterns of public and private companies within the match sample. "In particular, we looked at the level of investment relative to their size and at how responsive firms were to their investment opportunities," Farre-Mensa explains.
Investment opportunities are usually measured by market-to-book ratio, the relationship between the market value of a company and the book value of its assets. Unfortunately, market value is determined by a stock price, something private companies don't have. As such, the team decided to use sales growth as a proxy for investment opportunity responsiveness, since a rise in sales should trigger a rise in investment by any given firm.
Changes in state corporate tax policy, which the researchers viewed as exogenous economic shocks, were the basis of a second proxy. When corporate income taxes decline, investment opportunities of the firms improve—fewer taxes means companies can keep a larger fraction of the profits they generate with their investments.
A Surprising Disparity
Proxies in place, the team dove into the data and came up with surprising results: Between 2002 and 2007 (the years covered by the database), public firms increased their gross fixed assets (as a percentage of total assets) by 4.0 percent a year on average versus 9.7 percent at similar private firms. And when state corporate income taxes went down, public firms increased investments by just 1.6 percent versus 7.4 percent at the matched private firms.
The researchers hypothesized that short-termist pressure was the reason behind this disparity. In order to test the theory they analyzed whether their data fit the predictions of a well-known theoretical model of short-termism developed by Harvard economics professor Jeremy Stein, who was recently named to the Board of Governors of the Federal Reserve System.
"One thing that comes out of Stein's theoretical work is that the short-termist pressure will have an impact only in the case of managers whose company's stock price is very sensitive to earnings news," Farre-Mensa says. Stein's model suggests that such managers might avoid investing in a long-term profitable project if it meant current profits would fall short of analysts' earnings forecasts, which is typically seen as bad news by investors.
Asker, Farre-Mensa, and Ljungqvist's empirical results turned out to be consistent with this prediction. They found that the higher the sensitivity of stock prices to earnings news in a firm's industry, the greater the tendency of public firms to underreact to investment opportunities relative to similar private firms.
A blow to the stock price induced by today's investment might be impossible to avoid, says Farre-Mensa. Ideally, public-firm managers would be able to convey to analysts and investors that lower profits near term would lead to future gains once those investments became productive. Unfortunately, communicating with public investors is often hard to do, none the least because public-firm managers are not allowed to talk to investors privately. And once information conveyed to investors becomes public, it is also available to competitors.
It's clear that public-firm managers will care about the stock price to the extent that analysts and their shareholders care, Farre-Mensa adds. Management compensation at public firms is often linked to the stock price of the firm; a manager may hold shares or stock options, or bonuses may be tied to how well the firm is doing relative to its peers. In essence, the stock price is a very public measure of the performance of the firm and its managers.
The situation at private firms is typically very different. First, while both public and private firms have investors, private firms have far fewer investors and are in much closer contact with them. "Very often it's even the manager himself who's a large shareholder," Farre-Mensa says.
Second, even external investors in private firms tend to have a much closer relationship with the manager and company. "So the manager will have a much easier time going to his investors, a small group of people, many of whom sit on the company board," Farre-Mensa says. "He will be able to convey information to them and openly discuss whether an investment is worth undertaking."
To overcome an executive's short-term bias, boards of public firms must be careful with the type of incentives they set or risk that managers will behave in a way that might harm the long-term interests of the company.
"It's important that boards of public firms insulate managers from short-termist pressure as much as possible," Farre-Mensa stresses.
One way to do this is by tying managerial compensation to a firm's long-term performance, including clawback provisions if future poor results turn out to be due to bad management.
For investors in public companies, knowing the short-term versus long-term priorities of management is a good starting point when making an investment decision.
"The first thing you want to figure out is whether your view is long term or short term," Farre-Mensa says. "If you're going for a long-term investment, you'll want to see whether the board is doing a good job of making sure the managers' incentives are aligned for the long term." For a short-term investment, it may make more sense to invest in short-termist companies.
Farre-Mensa can only speculate as to whether being less responsive to investment opportunities is bad for public companies in the long run.
"It's something we haven't been able to test with our data, at least not yet," he says. "But this is something I think will be a natural conclusion from our findings in the paper."