Sep 21, 2011 - We then examine whether firm profitability, defined as return on net ..... This relates directly to the passage of the Sarbanes-Oxley Act in 2002.
Private versus Public Corporate Ownership: Implications for Future Profitability
Kristian D. Allee Michigan State University Brad A. Badertscher University of Notre Dame and Teri Lombardi Yohn Indiana University Draft: September 2011 Preliminary and Incomplete – Do not cite without permission.
Abstract: There is a long history of academic research that attempts to provide insight into the
effect of public ownership on firm performance. We extend this line of research by evaluating the differences in future profitability between publicly traded and privately held firms. We posit that private firms are more profitable than public firms and this is mainly driven by differences in the profit margin of the firms. We empirically test these predictions using a matched sample of private and public firms. Our results indicate that private firms have greater future profitability than public firms. We also find differences in the future profit margin but not future asset turnover of the private firms relative to the public firms. These results provide useful evidence in understanding the overall effect that public and private ownership has on the future profitability. _____________________________________________________________________________________
JEL classification: Keywords: private companies, profitability, future performance, and ownership structure
All errors are our own.
I. INTRODUCTION The advantages and disadvantages of public corporate ownership have been debated for years (Berle and Means 1932). Public ownership allows for greater access to credit, enhanced stock-based management compensation packages, external monitoring of the business, and to greater publicity for the company. These advantages of public ownership have the potential to increase investment opportunities, attract the best employee talent, and lead to an enhanced reputation relative to what would be possible if the company were private. On the other hand, there are potential disadvantages of public ownership. The diffuse ownership and separation of ownership from control could potentially create agency problems such that managers do not make decisions that are in the best interest of shareholders. The cost of regulation, especially since the implementation of the Sarbanes-Oxley Act (SOX), can be daunting, and the disclosure requirements can diminish the competitiveness of the business. In addition, public monitoring can lead managers of public companies to focus on short-term metrics instead of long-run future profitability. In general, there are fundamental differences between private and public ownership that could potentially affect corporate growth and profitability. Public ownership could aid companies in generating higher future profitability or it could inhibit companies from meeting their potential relative to private ownership. Warren Buffett has noted the potential concerns with publicly traded companies and has recently demonstrated a preference for investments in private companies. Hough (2011), in a discussion of Warren Buffett’s letter to Berkshire Hathaway shareholders, states that “Wall Street’s short-sighted focus on stock earnings hinders company performance, whereas private companies are free to prosper.” Google (2004), prior to its initial public offering, noted that “outside pressures too often tempt [public] companies to sacrifice long term opportunities to meet quarterly market expectations." Furthermore, Berman (2011) notes that a 1
benefit of private investment into Automated Data Systems is that “all the margin information, so useful to competitors, stays hidden from public view.” These arguments suggest that there are tradeoffs associated with being publicly owned that could hinder future profitability. Therefore, the benefits of public ownership associated with greater access to credit, publicity, and management talent could be completely offset by agency issues, a short-term focus from market pressures, and regulatory and disclosure requirements associated with public ownership. This could lead public companies to experience lower future profitability relative to their private counterparts. Despite the interest in both practice and academics on the effect of private versus public ownership structure on firm performance, little research has examined this issue. The lack of empirical evidence is primarily due to the lack of data on private companies. In this study, we are able to provide empirical evidence on the relative future profitability of private and public companies by using data from Sageworks Inc., which has recently made private firm data more available to academic researchers. The Sageworks database contains balance sheet and income statement data for more than 100,000 unique private firms over the period 2001 to 2010 and was designed to assist accounting firms and banks in performing analytical procedures and ratio analyses on private clients. These data allow our study to take a first step toward examining the relative differences in future profitability between public and private companies from a broad set of industries using actual financial statement data. We hypothesize, after matching on year, industry, size, and current profitability, that private companies experience higher future operating profitability than public companies. We also hypothesize that the greater profitability for private companies is driven by higher future profit margins rather than higher future asset turnovers. Finally, we recognize that public companies will
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likely experience lower costs of debt due to the disclosure requirements of a public company, but also suggest that this will not offset the hypothesized lower operating profitability resulting from diminished profit margins. Therefore, we predict that private companies will have higher future return on equity. To test these hypotheses, we first match public and private companies based on year, industry, firm size (net operating assets), and current profitability (return on net operating assets, profit and loss firms). We then examine whether firm profitability, defined as return on net operating assets, one, three, and five years ahead, differs between public and private firms, holding constant the matched variables in univariate results. In multivariate tests, we control for current growth and profitability as well as the components of profitability. We also test for differences between private and public companies with respect to the components of return on net operating assets, asset turnover and profit margin, to improve our understanding of the differences in profitability between public and private firm ownership. Finally, we investigate differences in the cost of debt for public and private companies, and test for differences in future return on equity between public and private firm ownership to assess whether financing costs affect future profitability differentially. We find evidence consistent with our predictions. Specifically, we find that private companies have significantly higher return on net operating assets one, three, and five years ahead. We find that the relatively higher profitability for private versus public companies is driven by higher profit margins. We find no significant difference in future asset turnover between public and private companies. We also find that while private companies experience a significantly higher cost of debt, private companies also experience a higher return on equity after controlling for the relative disadvantage of debt in their capital structure.
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These results suggest that, for private and public companies in the same industry, of similar size, and similar current profitability, private companies experience higher future profitability in the form of return on net operating assets, profit margins, and return on equity. These results provide evidence on the overall effect of public versus private ownership on corporate future profitability. These results provide empirical evidence helpful to managers, lenders, and equity fund managers, both public and private, in terms of the future costs and benefits associated with ownership differences. Our results are also consistent with differences in future profitability deriving from the costs associated with being a public firm and not necessarily from the financial reporting pressures of reporting consistent and increasing earnings as many researchers and practitioners have suggested. This study contributes to the literature on the effect of ownership structure on firm performance. Prior work provides evidence on the effect of specific corporate ownership characteristics on current profitability (Demsetz and Lehn 1985; Demsetz and Villalonga 2001). While these studies examine the relation between current profitability and specific ownership structures within public companies, they do not provide evidence regarding the overall effect of public versus private ownership on current or future profitability. This study also contributes to the literature that examines firm performance before and after an initial public offering (Pagano, et al. 1998; Jain and Kini 1994; Mikkelson, et al 1997) or a public offering via a reverse leveraged buyout (DeGeoge and Zeckhauser 1993). Our study contributes to this literature by examining a sample of private firms compared to a matched sample of public firms. By examining the future profitability of these two samples, as opposed to examining companies around public offerings, the observed future performance is not influenced by the effects of the public offering itself. Our sample of firms are, therefore, likely to be more
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stable, which allows for a more complete analysis of the impact of private versus public ownership on firm performance and is able to provide additional insight into the association between private versus public ownership and long-run performance. The remainder of the paper is organized as follows. Section II provides some background and develops the hypotheses. Section III describes sample selection and matching procedures, and provides descriptive statistics. Section IV presents the results of the empirical analyses, and Section V offers concluding remarks.
II. BACKGROUND, HYPOTHESES DEVELOPMENT, AND RESEARCH DESIGN Prior Literature There is a long history of academic research that attempts to provide insight into the effect of public ownership on firm performance. Much of the research has examined the association between specific ownership characteristics and firm performance. For example, Himmelberg et al. (1999) and Demsetz and Lehn (1985) find no relation between return on assets and managerial ownership. Demsetz and Villalong (2001) find no relation between various ownership structure characteristics and firm performance. Holderness and Sheehan (1988) and Denis and Denis (1994) find no association between firm performance and the diffusion of ownership. Other research has examined specific costs associated with ownership structure. For example, Ang et al. (2000) find that agency costs increase with non-managerial ownership. Research has also examined the performance of companies after initial public offerings to assess the association between public ownership and firm performance. For example, Pagano et al. (1998) find a reduction in the profitability of companies after an initial public offering for a sample of Italian companies. Jain and Kini (1994) find a reduction in operating profitability after an initial
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public offering for a sample of U.S. firms. Mikkelson et al. (1997) find reduced profitability from prior to the initial public offering to the end of the first year after public offering for a sample of U.S. firms, but find no further decline in profitability for the ten years after the public offering. DeGeorge and Zeckhauser (1993) find a reduction in firm performance after companies go public through a reverse leveraged buyout. While these studies provide insight into whether specific ownership characteristics are associated with firm performance or whether having an initial public offering is associated with a change in profitability, it is difficult to assess whether public companies are associated with differential future profitability relative to private companies. Research on specific ownership characteristics and company performance cannot provide insight into the overall effect of public versus private ownership on firm performance. In addition, research on changes in company performance around public offerings is unable to provide insight into whether there are differences in firm performance between public and private companies in a stable environment when there is not a significant inflow of capital. A direct empirical comparison of future profitability between private versus public firms would provide insight into this issue. However, the difficulty in obtaining data on private firms has led to a lack of research in this area. Some studies have overcome the data problem by focusing on regulated industries, such as banking and insurance companies, or using data collected from surveys of private companies. For example, Ke et al. (1999) perform a univariate comparison of a sample of 45 privately-held property-liability insurers and 18 publicly-held property-liability insurers, and detect no significant difference in profitability between public and private firms. However, this analysis examines a small sample of firms within one industry. Using the Forbes survey of the 500 biggest private companies in the United States, Coles et al. (2003) find that private firms are less profitable than
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similar public firms, when profitability is measured as operating margin and profit margin. However, Coles, et al (2003) uses estimated data and does not employ a matched pair research design. We contribute to this stream of literature by presenting empirical evidence on differences in future profitability between a matched sample of private and public companies. Hypotheses Development The public corporation is believed to have numerous advantages over its private counterpart (Renneboog et al. 2007). For example, public firms are likely to be able to invest in more profitable projects to due greater access to capital. Additionally, public firms have access to more media exposure, greater publicity and an increased reputation. Public firms have greater use of stock price-based compensation packages that can attract the best employee and management talent. All of these factors could result in public companies outperforming private companies in terms of long-run future profitability. On the other hand, recently there have been arguments that public companies may be less profitable in the long-run than private companies. The agency conflict in which managers may not act in the best interest of shareholders is the most debated potential disadvantage of public ownership (Berle and Means 1932). Detailed disclosure requirements for public companies may also hinder profitability (Pagano and Roell 1998). In fact, Brau and Fawcett (2006) find, in a survey of CFOs, that “disclosing information to competitors” and “SEC reporting requirements” are among the five most important reasons why private firms remain private in the U.S. Therefore, firms organized as private companies have distinctive long-run advantages over public companies due to increased exposure of public firm corporate strategies and trade secrets. In addition, the cost of regulation, especially since the implementation of SOX, can hinder profitability. CFOs surveyed by Brau and Fawcett (2006) suggest that expenses associated with listing requirements
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imposed by securities exchanges, SEC rules and regulations, and accounting requirements for public companies, estimated at over a million dollars annually, can affect long-run profitability (Hartman 2006). Moreover, organizing as a private firm avoids some of the pressures of myopic investment decisions due to demands from short-term oriented investors (Stein 1988; 1989).1 For example, Beatty et al. (2002) compare samples of publicly and privately held bank holding companies because they expect public banks’ diffuse shareholders to be more likely than private banks’ more concentrated shareholders to rely on simple earnings-based heuristics in evaluating firm performance. Beatty et al. (2002) expect public banks managers to face more pressure than private bank managers to report earnings in line with expectations and find evidence consistent with their expectations. In summary, while we recognize there are valid reasons to expect public ownership to enhance a firm’s performance, we hypothesize that these will be overpowered by the costs associated with public ownership. Specifically, public ownership accentuates agency conflicts, requires disclosure of detailed information to competitors, is relatively more costly due to listing requirements imposed by securities exchanges and the SEC, and can lead managers of public companies to focus on short-term metrics instead of long-run future profitability in order to report earnings in line with expectations. This leads to our first hypothesis: H1:
The future operating profitability is higher for private companies relative to the public companies. Operating profitability, defined as return on net operating assets, is a multiplicative
function of the company’s asset turnover and profit margin (Fairfield and Yohn 2001). Public
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Charles Koch, chief executive of Koch Industries Inc., the United States’ second-largest private company, claims chief executives that obsess about delivering those “ever-increasing and predictable quarterly earnings” are “going to sacrifice long-term value” in the end (Shlaes 2007).
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ownership could affect the two components of profitability differentially. Asset turnover is likely to differ between public and private companies if public companies obtain a capital infusion and overinvest in projects such that each incremental dollar of investment in net operating assets generates fewer sales. However, prior research suggests that companies tend to decrease investment and decrease leverage after initial public offerings. This is consistent with Myers and Majluf (1984) and suggests that overinvestment into less effective net operating assets is not likely to occur with public ownership. On the other hand, public ownership does require increased disclosures about the profitability of individual segments and costs. The increased disclosure requirements are likely to expose information on margins to competitors (Berman 2011). This suggests that public ownership might lead to greater competition in high margin products, which will eventually lead to lower margins for the publicly disclosing firms. This leads us to predict that public ownership is likely to lead to lower future profit margins relative to private ownership in our second hypothesis: H2:
The future profit margin is higher for private companies relative to public companies. As noted above, public ownership allows for greater access to capital, leads to improved
reputation, and requires improved disclosures about the company. These factors are likely to benefit public companies with respect to access to and cost of debt financing. Consistent with this notion, Pagano et al. (1998) document that Italian public companies experience lower borrowing costs than private companies subsequent to an initial public offering. A company’s return on equity is a function of its operating profitability (return on net operating assets) as well as its leverage and the spread between operating profitability and the cost of debt. We hypothesize above that public companies will experience lower future operating profitability. We also expect public companies to have a lower cost of debt relative to private companies. However, we argue
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that the effect of public ownership on return on net operating assets is likely to outweigh the effect of public ownership on the cost of debt with respect to the company’s return on equity. We make this assertion based on the notion that public companies are likely to rely less on debt after an equity offering (Pagano et al. 1998). Therefore, the benefit of the lower cost of debt is likely to have a small effect on return on equity. This leads to our third hypothesis: H3:
The future return on equity is higher for private companies relative to public companies.
Research Design To test our hypotheses that private companies are likely to experience greater future profitability than public companies, primarily due to differences in profit margins, we estimate the regression model shown in equation (1).2 ௧ା ଵ ଶ ௧ ଷ ∆௧ ସ ∆௧ ହ ௧ ∆௧ ௧ ଼ ∆ ௧ ଽ ௧ ଵ ∆௧ ଵଵ ∆௧ ଵଶ ௧ ଵଷ ∆௧ ଵସ ௧ ଵହ ∆ ௧ ௧
(1)
The left-hand side variable is a future profitability metric of interest. We evaluate the following future profitability metrics: (1) future return on net operating assets, measured as RNOAt+1, RNOAt+3, and RNOAt+5; (2) future profit margin, measured as PMt+1, PMt+3, and PMt+5; and (3) future asset turnover, measured as ATOt+1, ATOt+3, and ATOt+5. RNOA is calculated as net operating income (before any financing costs or investment income) in the numerator, and average net operating assets (operating assets net of operating liabilities) in the denominator
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We examine all of our hypotheses using a matched-pair design which is described later in this section.
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(Fairfield et al. 2009).3 PM is the firm profit margin and equals operating income divided by sales and ATO is asset turnover defined as sales divided by net operating assets. ∆RNOA is the change in RNOA as described above from t-1 to t. ∆NOA is the change in average net operating assets from t-1 to t. ∆ATO and ∆PM are the changes in ATO and profit margin from t-1 to t, respectively. The indicator variable PRIVATE is coded one when the firm is a private firm and zero otherwise. The coefficient of interest for our first and second hypothesis is b1 for which we expect a positive and statistically significant sign on the coefficient. We also run equation (1) using future RNOA as the dependent variable for private firms with audited financial statements, and their matched public firms to examine the future profitability differences between public and private firms holding constant the presence of audited financial statements.4 Although this specification reduces our sample size, we want to be sure that our results are not driven by non-audited private firms. To test our last hypothesis, H3, we analyze the future profitability of public and private firms after including financing costs by examining future ROE, defined as net income divided by stockholders’ equity. The difference between RNOA and ROE is generally related to the capital structure of the company. All else equal, a more levered firm will have a higher ROE than a less levered firm and that will result in a larger gap between RNOA and ROE, but that difference also depends on the ability of the firm to earn a return on net operating assets greater than the cost of the debt incurred. Public firms likely have greater access to and lower costs of debt due to the disclosure, audit, and regulatory requirements of the SEC. Our univariate results confirm that
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Operating income equals sales minus costs of goods sold, overhead costs, and depreciation and amortization. Net operating assets equals stockholders’ equity minus cash and short term investments plus interest plus debt in current liabilities plus long-term debt. 4 Note here that we recognize that we cannot hold constant the cost of the audited financial statements and that the cost of the audit for a public firm is likely higher than the cost of the audit for a private firm due to the increasing costs of litigation for the auditor (Badertscher et al. 2011).
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public firms indeed have lower cost of debt relative to private firms. However, since public firms have access to public equity, they are unlikely to finance their operations through significant increases in debt. Thus, while there is a benefit associated with being public, on the margin, we hypothesize that it is not likely to reverse the effects we hypothesize for RNOA after incorporating the effects of debt. Therefore, ROEt+1, ROEt+3, and ROEt+5 are the dependent variables in equation (2) and H3 predicts a positive and statistically significant coefficient on c1 below. ௧ା ଵ ଶ ௧ ଷ ∆ ௧ ସ ௧ ହ ∆௧ ௧ ∆ ௧ ଼ ௧ ଽ ∆ ௧ ଵ ଵଵ ∆ ௧ ଵଶ ௧ ଵଷ ∆௧ ଵସ ௧ ଵହ ∆ ௧ ଵ ௧ ଵ ∆ ௧ ௧
(2)
New variables in equation (2) are defined as follows: ∆BVE is the change in book value of equity from t-1 to t; LEV is long-term debt divided by the book value of equity; and ∆LEV is the change in that variable from t-1 to t. As stated earlier, leverage will only be a benefit to current and future ROE when the firm earns a return on net operating assets greater than the cost of the debt incurred from the liability. This difference is often referred to as the spread. The importance of spread for increasing ROE can be established by disaggregating ROE as follows:
⁄ !" # $ ′ %&
( ) * + , – .$ / 01 ) * + 2 #
(3)
According to equation (3), return on equity can be increased by i) increases in the rate of return on the firm’s net operating assets, ii) increases in leverage, and iii) decreases in the cost of debt relative to the return on net operating assets (Wahlen et al. 2011). Thus, we also examine ROEt+1, ROEt+3, and ROEt+5 by breaking current ROE into its three components (i.e., RNOA, Leverage, and Spread). Specifically, we examine the d1 coefficient in equation (4) to further test H3. 12
௧ା # #ଵ #ଶ ௧ #ଷ ௧ #ସ /_ ௧ #ହ /_4௧ # ௧ /_ ௧ # ௧ /_4௧ #଼ ௧ #ଽ ௧ #ଵ /_ ௧ #ଵଵ /_4௧ #ଵଶ ௧ /_ ௧ #ଵଷ ௧ /_4௧ ௧
(4)
Because of sample limitations we define SPREAD_POS (SPREAD_NEG) equal to one if RNOA is greater (less) than the cost of debt and zero if the cost of debt is missing because the firm has no debt and/or interest expense. All other variables are previously defined. Matching Procedure Our research question involves examining the performance of public and private firms relative to one another. As documented by prior research, public companies are substantially larger than private companies. Using a sample of private and public firms, Asker et al. (2010) provide evidence that the median public firm has total assets of $246.2 million, compared to $1.3 million for private firms. To ensure that our results are not driven by size we use a matched dataset designed to identify large private companies and small public companies. Specifically, we match public and private firm-years based on fiscal year, firm industry, net operating assets, return on net operating assets, and whether the firm reported a loss. Consistent with Asker et al. (2010), our matching procedure is a variant of nearest-neighbor matching used in the program evaluation literature (Imbens and Wooldridge 2009). Starting in 2001, for each private firm, we identify a public firm in the same four-digit NAICS industry (equivalent to three-digit SIC), same fiscal year, closest in terms of net operating assets (NOA), such that max(NOApublic, NOAprivate) / min(NOApublic, NOAprivate) < 2, closest in terms of return on net operating assets (RNOA), such that max(RNOApublic, RNOAprivate) / min(RNOApublic, RNOAprivate) < 2, and whether the private and public firms
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are loss firms (pre-tax net income
