Comparing the Investment Behavior of Public and Private Firms

Private firms invest substantially more... [and are] more responsive to changes in investment opportunities than are public firms.

Although private firms form a substantial part of the U.S. economy, most of the evidence on corporate investment at the firm level has been based on stock-market listed (or "public") firms, mainly because of lack of available data. In Comparing the Investment Behavior of Public and Private Firms (NBER Working Paper No. 17394), co-authors John Asker, Joan Farre-Mensa, and Alexander Ljungqvist analyze a new dataset on around 250,000 private U.S. firms between 2001 and 2007 to compare their investment behavior to that of public firms that are similar in terms of size and industry.

Two intriguing new patterns emerge from this research. First, private firms invest substantially more than public firms of their size and industry do. On average, private firms invest nearly 10 percent of total assets each year compared to only 4 percent among public firms. Second, private firms are 3.5 times more responsive to changes in investment opportunities than are public firms. The authors conclude that these findings can be interpreted as evidence of an important potential cost of a stock market listing, because the investment of public firms in their sample seems to be distorted relative to that of comparable private firms.

The observed difference in investment sensitivities does not appear to be driven by how old the company is, how investment opportunities are measured, or which characteristics the authors match. In fact, to sidestep the need to directly measure investment opportunities, the authors use a change in tax policy, which can be viewed as a shock to firm' after-tax return on investment and thus to their investment opportunity sets. Their results still hold: a cut in state corporate income taxes induces private firms to increase investment by 7.2 percent of total assets, while public firms increase investment by only 1.6 percent of their assets.

To remove any bias related to matching the data on public and private firms, the authors study changes in investment for a given firm as it transitions from private to public status without raising new capital. Their evidence suggests that IPO firms are significantly more sensitive to investment opportunities in the five years before they go public than in the five years afterward. Once they are public, their investment sensitivity becomes indistinguishable from that of observably similar, already-public firms.

What drives these differences in investment between public and private firms? The authors argue that going public weakens incentives for effective corporate governance because it leads to greater dispersion of ownership. As a result, a public firm manager who derives utility from his firm's current stock price may have an incentive to influence that price by making "short-term-ist" investment decisions.

To shed further light on that issue, the authors explore how the difference in investment behavior between public and private firms varies with the sensitivity of share prices to earnings news. The idea is that the more sensitive share prices are to earnings news, the greater is the incentive to distort investment, and hence the greater should be the difference between public and private firms' investment sensitivities. The authors find evidence to support that claim. They also observe that the share of public firms is significantly lower in industries where share prices are highly sensitive to earnings news, which suggests that investors and entrepreneurs view short-termism as a cost of being public.

--Claire Brunel