Don’t Blame the Stock Market for Corporate Myopia
One aspect of the debate involves the question whether public companies are forced by stock-market pressures to favor short-term gain instead of building patiently for sustainable success. Another is whether the trend toward private market activity is taking place in debt as well as equity. The short answers are no and yes, respectively.
A common complaint about public companies is that they focus on quarterly results instead of long-term earnings. If that’s true, then the decline in publicly traded companies could be beneficial.
It’s a popular theory, but careful study appears to undermine it. Recent U.S. Federal Reserve research suggests that public firms are actually more likely to invest for the long term than their private counterparts.
The researchers examined corporate tax returns filed from 2004 to 2015. Tax returns, which are generally not available except under special circumstances, gave the researchers important information that would have been hard to obtain elsewhere. They included financial data of private firms, for example, and contained detailed enough information to separate short-term investments from long-term ones. Also, the sample of companies was not selective, since all firms must file tax returns.
In particular, the researchers used depreciation schedules as an admittedly imperfect guide to the life of the asset; they classified any physical investment with an initial depreciation allowance of more than 10 years, along with research and development expenditures and investments in physical property, as long-term.
Their findings were striking and surprising. Compared to otherwise similar private firms, publicly listed companies invested almost 50 percentage points more as a share of their assets. Most of the difference was due to long-term investments, and especially to R&D. As the study noted:
It is not simply that public firms invest more relative to their asset base and thus out-invest private firms, they also direct a greater share of their investment portfolios to long-term assets. Public firms allocate 9 percentage points more of their total investment dollars to long-term assets than comparable private firms. The long-term investment advantage of pubic firms over private firms largely stems from their outsized investments in R&D. Public firms invest 39.2 percentage points more in R&D expenditures relative to physical assets, and dedicate 11 percentage points more of their investment budgets towards R&D than private firms.
The authors also examined what happens to a firm when it becomes public or goes private. They found that a firm undergoing an initial public stock offering increases its long-term investments and its R&D spending by a substantial amount — and that the increases occur immediately after the IPO and persist for a decade. The results are weaker in the other direction — when firms go private — but also suggest a reduction in R&D investments after such an event.
In other words, if there’s myopia in investment patterns, we may be better off focusing on why that occurs in private companies rather than publicly traded ones.
The other question is whether the shift away from public equity markets is also occurring in debt markets. Recent analysis by Robert Prilmeier of Tulane University and Rene Stulz of Ohio State University suggests that the answer is yes — and that many of the same forces causing a decline in the number of publicly traded firms are also causing companies to shift away from issuing public bonds and instead to seek out private loans from banks.
Prilmeier and Stulz argue that the move away from issuing bonds explains the recent rise in the $1.3 trillion leveraged loan market (leveraged loans are loans extended by banks to highly indebted companies). Both the International Monetary Fund and former Fed chair Janet Yellen have sounded alarms about leveraged debt, not only because of its rapid expansion but also because fewer loans have strong covenants that protect the lender by requiring the borrower to meet certain conditions throughout the life of the loan. The share of leveraged lending governed by agreements without extensive protections for borrowers has risen to more than 80 percent today from roughly 30 percent in 2007.
Prilmeier and Stulz argue that firms have been reluctant to undertake the public disclosure associated with issuing bonds and registering them with the U.S. Securities and Exchange Commission. But since publicly traded firms already must disclose substantial amounts of information, this explanation would only make sense if it occurred disproportionately among private firms or those about to become private.
Using a sample of more than 5,000 leveraged loans issued between 2005 and 2015, the researchers indeed found that private firms and those about to become private rely dramatically more than public companies on leveraged loans compared to bonds. The authors also argue that the rise in covenant-lite lending makes the leveraged loans more liquid, and thus a closer substitute for a bond. The rise in the leveraged-loan market and its lightweight covenants are thus tied to avoiding SEC registration, which is also one of the motivations behind the decline in the number of companies with publicly listed equity.
These explanations provide insight into why the private debt market has grown, but they don’t attenuate the concerns expressed by the IMF and others about highly leveraged lending.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Peter R. Orszag is a Bloomberg Opinion columnist. He is a vice chairman of investment banking at Lazard. He was director of the Office of Management and Budget from 2009 to 2010, and director of the Congressional Budget Office from 2007 to 2008.
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