Sunday, April 7, 2019

The New American Model of Equity Finance

In my undergraduate course, The Law of Business Organization, we’re studying material on “Investor Protection, Insider Trading, and Corporate Governance.”  During our last class, we examined the registration statement for last year’s Dropbox IPO.  Before this exercise, however, we reviewed a highly-generalized funding life cycle for businesses in the U.S. that eventually went public.  In doing this, I shared with students that an important caveat to this presentation was the increasing role of private capital in U.S. debt and equity markets.  I mentioned that the cost not only of going public, but also of the related and continuing reporting and compliance requirements could be a potential explanation for this shift.  As it turns out, I’m planning to supplement my explanation of the role of regulation in this shift during tomorrow’s class.     

Several weeks ago, I mentioned in a post the increasing role of private capital in U.S. capital markets.  Shortly thereafter, I was chatting with my Finance Division colleague, Bill Megginson, about this trend and other financial market developments.  It proved to be good timing as Megginson (along with coauthors Gabriele Lattanzio and Ali Sanati) had recently posted a new article, Listing Gaps, Merger Waves, and the New American Model of Equity Finance to SSRN.  I’ve finally had a chance to review it this weekend.

Megginson and coauthors argue that a “new model of equity finance has emerged in the United States,” which “is characterized by four inter-related features: (1) a dramatic decline in the number of publicly listed corporations…(2) a surge in U.S. merger and acquisition (M&A) activity…(3) an ‘aggregate capitalization premium’ assigned to U.S. listed stocks that emerged in the early 1990s…(4) the ‘privatization of U.S. equity finance’ reflected in the massive increase in private equity funding for U.S. entrepreneurial growth companies…Today more than five times as much external equity is provided to American businesses through private markets as through the public markets…”  They econometrically examine each of these features both individually, and in connection to each another. 

The authors’ intriguing findings include that “the massive and sustained increase in mergers after 1993 explains virtually completely both the magnitude and the timing of the decline in the number of U.S. public corporations;” that “the U.S. public stock market has become populated exclusively by behemoths,” suggesting that public companies are “the shining pinnacle of the modern U.S. financial economy, rather than its core building block;” and, that though belatedly, other economically developed countries seem to be following the U.S. model of equity finance.  Hence, one of the many important takeaways of this article is that the U.S. listing gap (the decrease in the incidence of public companies) largely predates a wave of regulation in the early 2000s, which is often held responsible for this decrease.  At the same time, the National Securities Market Improvement Act of 1996, “might have played a significant role in widening the U.S. listing gap” (hence the need to supplement my regulation comments!). 

What exciting research to incorporate into tomorrow’s class!  We’ll also be discussing Lorenzo v Securities Exchange Commission, a recent U.S. Supreme Court decision covered in a post by my co-blogger Ann Lipton - definitely also a must read!

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This paper sounds something similar to what Steve Solomon wrote about in the NY Times a couple of years back, . In any event, even though it makes sense that companies would delay going public, it seems strange that a lot of companies would be willing to retain private equity funding or be bought out without attempting to become the next Alphabet or Facebook. My thought is that the leadership of promising companies want to avoid going public, even with dual class shares, because they realize that being a public company means immediately entering into a war of attrition with its own shareholders, namely public pension funds and more recently mutual fund advisers, proxy advisors, and now index providers. This is a very unpleasant and distracting way to run a company that is trying to accomplish something great. Being bought out or being able to attract private equity funding in exchange for maintaining autonomy and keeping public shareholders off their backs may be a better alternative for the leaders of a lot of promising companies. Just a thought.

Posted by: Bernard S. Sharfman | Apr 8, 2019 7:02:57 AM

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