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Why are public corporations disappearing and what are the consequences?

Kevin LaCroix explores some reasons why we're seeing a decline in the number of public corporations and then looks at some of the consequences. A very good analysis of a very important issue. Recommended.

Alex Tabarrok: "The Number of Publicly Traded Firms Has Halved"

He observes that:

In the past twenty years [the] U.S. has lost almost 50% of its publicly traded firms [from 6,797 in 1997 to 3,485 in 2013, AT]. This decline has been so dramatic, that the number of firms these days is lower than it has been in the early 1970s, when the real gross domestic product in the U.S. was one third of what it is today. This phenomenon has been a general pattern that has affected over 90% of U.S. industries.

A rather stunning finding from Grullon, Larkin and Michaely.

The total number of firms has dropped far less than the number of publicly traded firms, so in part this is probably due to laws affecting publicly traded firms in particular such as Sarbanes-Oxley. But there has also been a small drop in the total number of firms (depending on year measured) and concentration ratios have increased which suggests that competition might have fallen. (I wish the authors had looked more closely at the entire size distribution). Have international firms risen to offset the decline of publicly-trade firms? The authors discuss but discount the role of globalization. I don’t see, however, how their findings of small effects on output competition are consistent with big labor market effects. Nevertheless the bottom line is that as concentration rates have increased so have profits, as a recent CEA report also argues.

Is this all the after-effects of the Great Recession? I hope so but the decline in the number of publicly traded firms is also consistent with the research on long-run declining dynamism (including my own research on regulation and dynamism) which shows that startup and reallocation rates have been trending down for thirty years.

The drop in publicly held firms reported here is consistent with other reports, so let us take it as given. And I agree with Alex that there are multiple factors at work here:

1. Lingering effects of the Great Recession, during which some estimates claim as many as 170,000 businesses failed. 
2. Consolidation. M&A activity has recovered from its 2008 lows and is resulting in a decline in the number of companies as more are combining than being created.
3. The first two factors meant that in  recent years many startups switched their exit strategy from an IPO to a sale to an established company.
4. Secular stagnation.
5. Regulation.

We all have home field biases, of course, but I tend to think the regulatory aspect has had a crushing effect on public corporations. Firms that were public went dark, while privately held firms decided to remain private or to sell to an acquirer rather than go the IPO route:

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010). UCLA School of Law, Law-Econ Research Paper No. 10-13. Available at SSRN: http://ssrn.com/abstract=1696303

Should TV investment gurus be subject to Labor Department regulation? Not if I were in charge.

There was an important article in today's WSJ about the Labor Department's forthcoming rules under ERISA that will dramatically change how investment advising for IRAs and other retirement vehicles works:

The idea of the regulation, which could be released this month by the Labor Department, seems unobjectionable enough—that brokers would follow a “fiduciary” standard when making investment recommendations. Currently, brokers’ advice only has to be “suitable,” which critics say is a weaker standard that allows the sale of expensive products that eat into returns.

The rule’s opponents, including many in the brokerage industry, say it will increase their costs and make providing investment advice to small-balance retirement accounts less profitable. ...

The rule, provisions of which would be phased in over time, could add costs at industry giants such as Morgan Stanley, which has nearly 16,000 brokers, and Bank of America Corp.’s Merrill Lynch, with more than 14,000. But it is expected to weigh far more heavily on small and midsize firms, which make up the bulk of the industry. ...

Brokerage-industry executives and analysts say the rule is likely to accelerate brokerages’ shift toward fee-based accounts and away from commissions, a trend in which smaller firms generally lag behind their bigger rivals. Smaller firms also tend to have more small accounts that might be uneconomical to serve in a fee model, and they have fewer clients across whom to spread added compliance costs.

This is a classic example of federal government regulation of the stock market and financial services: It screws small business and the middle class, while benefiting the wealthy and the largest firms. (Which leads one to wonder why people like Lucian Bebchuk are so eager for federal regulation of corporate law, but that's an issue for another day.) Because the costs apparently do not scale, the largest brokerage houses will be better able to bear them and wealthy investors will not lose access to professional advice.

But then it gets worse. Forbes reports that:

Popular financial radio show host Dave Ramsey caused a firestorm on Twitter last week when he weighed in against the “fiduciary rule”—the controversial pending Department of Labor regulation that would impose new restrictions on a vast swath of financial professionals who handle IRAs and 401(k) accounts. Yet, Ramsey was only echoing concerns about the costs of the rule already expressed by Members of Congress from both parties. ...

Fittingly, even before Ramsey came out against the rule, one of his critics called for using the rule against Ramsey, supposedly for providing advice said critic deemed harmful to savers. In an October article in LifeHealthPro, an online trade journal for insurance agents and financial advisers, Michael Markey, an insurance agent and owner of Legacy Financial Network, called for Ramsey to “be regulated and to be held accountable” by the government for the opinions he gives to listeners. Markey hailed the Labor Department rule as ushering a new era in which “entertainers like Dave Ramsey can no longer evade the pursuit of regulatory oversight.”

Classic. Markey wants to use regulation to shut down a competitor, which is a primary function of the DC bureaucracy these days.

Experts both for and against the rule I have talked to agree its broad reach could extend to financial media personalities who offer tips to individual audience members, a group that includes not just Ramsey but TV hosts like Suze Orman and Jim Cramer, as well as many other broadcasters who opine on business and investment matters. They would be ensnared by the rule’s broad redefinition of a vast swath of financial professionals as “fiduciaries” and its mandate that these “fiduciaries” only serve the “best interest” of IRA and 401(k) holders.

I admit that I am not an expert on First Amendment law--especially the complexities of commercial speech regulation--but this strikes me as a classic infringement on free speech. But as Forbes notes:

Such limits on financial discussion may seem to violate the First Amendment on its face. But a lawsuit against such restrictions would not be a slam dunk, as this is largely uncharted legal territory. Courts have tread lightly on financial regulation that may harm free speech. In Lowe v. SEC, 472 U.S. 181 (1985), the Supreme Court did strike down a ban by the Securities and Exchange Commission on an investment newsletter published by a convicted felon. But the opinion did not touch upon constitutional issues, as the Court ruled that the law itself – different from the Employee Retirement Income Security Act that governs the Labor Department – applied only to person-to-person, rather than general, advice.

It's these sort of issues that make it so essential to have judges and justices committed to liberty as opposed to being enablers of the nanny state.

The case against divesting from fossil fuel companies

Here at PB.com we oppose divestment campaigns (even in those rare cases when we agree with the proponents about the issue at hand), so we were glad to see our friend Todd Henderson take on the issue in the Chicago student newspaper:

No matter what your views are on the climate change debate, no rational person should support divestment. There is no evidence to demonstrate it will do anything to help the climate, and it will ultimately cost the University hundreds of millions of dollars—Swarthmore estimates it would cost their endowment $200 million over 10 years to divest. This is money that could be spent on research, scholarships, or perhaps best of all for the cause, reducing the University’s carbon footprint.

Here is why divestment won’t work: A central tenet of corporate finance is that demand curves for individual stocks are approximately horizontal. For most things we buy, demand curves slope downward. This means if we demand less, less will be supplied and at lower prices, but stocks are not like other products. The stock price is merely an estimate of the cash flows that ownership of the stock will produce in the future, and therefore is not determined by a “demand” for the stock. Unless the sale of stock conveys information to the market about the future cash flows, no individual sale can move the price.

If the Office of Investments, which manages the University’s nearly $9 billion endowment, sells all of the shares it owns in ExxonMobil, the stock price of ExxonMobil should not change. Others will stand ready to buy the shares at the current market price, meaning supply and demand aren’t helpful ways to think about stock prices. Unless the money that ExxonMobil is expected to earn in the future goes down, the stock price will stay the same. And nothing about the decision of a few university endowments to sell the shares provides the market information about how much oil or coal will be sold at what prices tomorrow. Undervalued shares in the near term will be bought up until their price more or less reflects the expected gain from holding those shares. In an extreme case, ExxonMobil could simply go private, removing any need to rely on public markets for funding or valuation.

The fact that the stock price of divested companies will not fall means that these firms will not experience a higher cost of capital, and therefore nothing about their capital raising activities, project choice, or other decisions will be affected by divestment. Managers with stock-based compensation won’t be affected either nor will other shareholders of these firms. In short, the economic impact of the SJSF demands on the targets of their ire would be nearly zero.

Making matters worse, universities—or rather their employees and students—would bear large costs to achieve no benefits. The endowments already have to spend money defending their investment decisions, and, if it comes to it, will spend more selling shares and accepting lower returns than would otherwise be available. Taking profitable investments off the table also means lower returns for endowments. This means taking money out of the universities’ pockets and putting it into the hands of other people, all without actually imposing any cost on the alleged bad actors.

Indeed.

Related articles

"The Feel-Good Folly of Fossil-Fuel Divestment"

Divestment mania expanding massively on college campuses, despite moral and financial flaws

Presbyterian Church Votes for Anti-Israeli Divestment: Bad Economics, Bad Politics, Bad Religion

Dupont shareholders vote for management, Dupont investors dump stock. Huh?

Marc Kodak offers an explanation.

In 2014, index funds beat hedge funds ... for 6th year running

NY Times via Greg Mankiw:

The top 25 hedge fund managers reaped $11.62 billion in compensation in 2014, according to an annual rankingpublished on Tuesday by Institutional Investor’s Alpha magazine. 

That collective payday came even as hedge funds, once high-octane money makers, returned on average low-single digits. In comparison, the benchmark Standard & Poor’s 500-stock index posted a gain of 13.68 percent last year when reinvested dividends were included.... 

For investors, 2014 was the sixth consecutive year that hedge funds have fallen short of stock market performance, returning only 3 percent on average.

Warren Buffett & Charlie Munger Shareholder Letter Annotated by Experts in Wall Street Journal

Larry Cunningham reports that:

Warren Buffett’s latest letter to Berkshire Hathaway shareholders is annotated in The Wall Street Journal by 30 professors, authors, and investors.  

The post also has a good discussion of the state of Buffett's succession plans.

"The Feel-Good Folly of Fossil-Fuel Divestment"

Daniel Fischel argues in today's WSJ that the "only ones to suffer [if colleges surrender to the anti-divestment fossil fuels movement] will be colleges that earn less money for research, services and student scholarships":

A new study that I and my colleagues at Compass Lexecon are releasing on Tuesday indicates that fossil-fuel divestment could significantly harm an investment portfolio. ...

Of the 10 major industry sectors in the U.S. equity markets, energy has the lowest correlation with all others—which means it has the largest potential diversification benefit. The sector with the second-lowest correlation with others is utilities, which includes many fossil-fuel divestment targets such as Southern Company and Duke Energy .

How does divestment affect portfolio performance? To get at this question, we constructed a model to track the performance of two hypothetical investment portfolios over a 50-year period: one that included energy-related stocks, and another that did not. What we found is that the optimal portfolio, which included energy stocks, generated average returns 0.7 percentage points greater than portfolios that excluded them on an absolute basis. In other words, the “divested” portfolio lost roughly 70 basis points compared with the optimal one—70 basis points for each and every year over the 50-year period in which the portfolios were active.

They also find that management fees are higher for funds that divest from fossil fuels, presumably due to the added administrative burden of making sure the fund's portfolio really is holier than thou.

This is a damning finding. The people who manage university investment funds are fiduciaries who must consider the long run impact of their decisions. Giving in to today's fossil fuel campaigners demonstrably will reduce future returns, negatively impacting not only current but future stakeholders. And, as we now know, the folks who have caught the divestment bug are unlikely to stop with one victory. It'll just be on to the next moronic cause.

It's time for university fund managers to grow a spine and tell the divestment crowds to take a hike.

Active fund management doesn't work

More evidence for indexing.

The agency cost problem with public pension fund activism

In my book, Corporate Governance after the Financial Crisis, I argued that:

... the costs of institutional investor activism likely outweigh any benefits such activism may confer with respect to redressing the principal-agent problem. Even if one assumes that the cost-benefit analysis comes out the other way around, however, institutional investor activism does not solve the principal-agent problem but rather merely relocates its locus.

The vast majority of large institutional investors manage the pooled savings of small individual investors. From a governance perspective, there is little to distinguish such institutions from corporations. The holders of investment company shares, for example, have no more control over the election of company trustees than do retail investors over the election of corporate directors. Accordingly, fund shareholders exhibit the same rational apathy as corporate shareholders. ...  Nor do the holders of such shares have any greater access to information about their holdings, or ability to monitor those who manage their holdings, than do corporate shareholders. Although an individual investor can always abide by the Wall Street Rule with respect to corporate stock, moreover, he cannot do so with respect to such investments as an involuntary, contributory pension plan.

For beneficiaries of union and state and local government employee pension funds, the problem is particularly pronounced. As we have seen, those who manage such funds may often put their personal or political agendas ahead of the interests of the fund’s beneficiaries. Accordingly, it is not particularly surprising that pension funds subject to direct political control tend to have poor financial results. 

As an op-ed by Andrew Biggs in today's WSJ makes clear, public pension funds suffer from agency cost problems that are at least as severe as those of the corporations excoriated by activist funds:

State and local pension plans invest roughly twice as much in risky assets as would a prudent individual saving for retirement. ...

... Calpers holds about 75% of its portfolio in stocks and other risky assets, such as real estate, private equity and, until recently, hedge funds, despite offering benefits that, unlike IRAs or 401(k)s, it guarantees against market risk. Most other states are little different: Illinois holds 75% in risky assets; the Texas teachers’ plan holds 81%; the New York state and local plan 72%; Pennsylvania 82%; New Mexico 85%. ...

Public pensions are addicted to risk and, because they are effectively “too big to fail,” require an intervention.

In addition to holding excessively risky portfoloios, of course, public pension funds notoriously are too optomistic in their actuarial assumptions:

While Americans are typically earning less than 1 percent interest on their savings accounts and watching their 401(k) balances yo-yo along with the stock market, most public pension funds are still betting they will earn annual returns of 7 to 8 percent over the long haul, a practice that Mayor Michael R. Bloomberg recently called “indefensible.” ...

“The actuary is supposedly going to lower the assumed reinvestment rate from an absolutely hysterical, laughable 8 percent to a totally indefensible 7 or 7.5 percent,” Mr. Bloomberg said during a trip to Albany in late February. “If I can give you one piece of financial advice: If somebody offers you a guaranteed 7 percent on your money for the rest of your life, you take it and just make sure the guy’s name is not Madoff.”

It's long past time that publc pension funds take a lead from Matthew 7:3-5, and remove the log from their own eyes before going after corporate splinters.

The JOBS Act apparently has not solved the problems with the American capital markets

In my essay Corporate Governance and U.S. Capital Market Competitiveness (October 22, 2010), available at SSRN: http://ssrn.com/abstract=1696303, I explained that:

During the first half of the last decade, evidence accumulated that the U.S. capital markets were becoming less competitive relative to their major competitors. The evidence reviewed herein confirms that it was not corporate governance as such that was the problem, but rather corporate governance regulation. In particular, attention focused on such issues as the massive growth in corporate and securities litigation risk and the increasing complexity and cost of the U.S. regulatory scheme.

Tentative efforts towards deregulation largely fell by the wayside in the wake of the financial crisis of 2007-2008. Instead, massive new regulations came into being, especially in the Dodd Frank Act. The competitive position of U.S. capital markets, however, continues to decline.

This essay argues that litigation and regulatory reform remain essential if U.S. capital markets are to retain their leadership position. Unfortunately, the article concludes that federal corporate governance regulation follows a ratchet effect, in which the regulatory scheme becomes more complex with each financial crisis. If so, significant reform may be difficult to achieve.

If you believed the Obama administration and the Democrats' hyoe, the JOBS Act was going to solve the problem. They were wrong, according to a new study by some economists (which I'm more inclined to accept that ones done by law professors masquerading as quants):

We examine the effects of Title I of the Jumpstart Our Business Startups Act (JOBS) for a sample of 213 EGC IPOs issued between April 5, 2012 and April 30, 2014. We show no reduction in the direct costs of issuance, accounting, legal, or underwriting fees, for EGC IPOs. Further, the indirect cost of issuance, underpricing, is significantly higher for EGCs than other IPOs. More importantly, greater underpricing is present only for larger firms that were not previously eligible for scaled disclosure under Regulation S-K. EGCs that are more definitive about their intentions to use the provisions of the Act have lower underpricing than those that are ambiguous. Finally, we find no increase in IPO volume after the Act. Overall, we find little evidence that the Act has initially been effective in achieving its main objectives and conclude that there are significant consequences to extending scaled disclosure to larger issuers.

Interestingly, one of the authors - Kathleen Weiss Hanley - was until very recently an economist at the SEC,

Will CalPERS kill hedge funds?

Timothy Spangler teaches the Hedge Funds and Private Equity Funds course and the Investment Companies and Investment Advisors course at the UCLA School of Law.  He is the author of several books on private funds, a frequent commentator in domestic and foreign press, and the Director of Research for the Lowell Milken Institute for Business Law and Policy. In today's LA Times, he has an insightful article on the future of hedge funds in the wake of CalPERS' decision to pull its hedge fund investments:

Clearly, it is too soon to write the obituary for hedge funds. These highly entrepreneurial firms will certainly need to evolve in the coming years to ensure that they meet the expectations of their investors for high returns. And the question of fees is one that cannot be dismissed out of hand. ...

The most provactive part of the op-ed is his argument in favor of active fund management:

... the state of the hedge fund industry is better grasped by looking at the top quartile of hedge fund managers and seeing how their performance varies over time. All hedge fund managers are not created equal. Simply calling yourself a hedge fund manager is no guarantee that you will actually produce eye-wateringly high returns for your investors.

The most successful investors are backing the most successful managers. Simply put, the case for backing proven investment talent remains strong.

I'm not convinced that's right. There does seem to be some evidence that top returners do persist at least over the medium term (say three years). The trouble, of course, is identifying them ex ante and backing them before their hot streak ends.

Related articles

Your Lesson From CalPERS' Dumping of Hedge Funds

Hedge funds: Lousy returns and dumped by CalPERS. What does that say about shareholder activism?

Investment Bombshell: CalPERS Exiting Hedge Funds

'Red Flags' Surround CalPERS Costly Hedge Fund Gamble

Lowell Milken Institute Law Teaching Fellowship

Hedge funds: Lousy returns and dumped by CalPERS. What does that say about shareholder activism?

The NYT reports that:

The California Public Employees’ Retirement System, the nation’s largest pension fund, will eliminate all of its hedge fund investments over the next year on concerns that investments are too complicated and expensive.

Granted, CalPERS itself engages in activism, but it's still an interesting point. As is this bit of news:

Through August, activist investors returned an average 5.9% for the year, according to HFR, compared with a 3.9% gain for hedge funds in general. Still, both trailed the S&P 500's 9.9% gain.

So you'd be better off stashing your money in an S&P 500 index that giving it to activist shareholders. Someone alert Lucian!

Good news and bad news on the University of California's "green" investing plans

The good news is that the UC has rejected the call by ecomentalist activists to divest from fossil fuel companies, which was the right decision for all the reasons I suggested the other day. The bad news is that:

The University of California will invest $1 billion over five years in companies and researchers coming up with solutions to climate change, part of an overall UC push in sustainability. ... UC also said it will implement a framework for sustainable investment by the end of June and become the first public U.S. university to adhere to United Nations-supported principles for responsible investment.

What's wrong with that, you ask? Well, as the WSJ explained a while back:

... investors tempted by green investing need to choose funds carefully and understand that some of these sectors can be very volatile, as illustrated by the bankruptcy of multiple ethanol and biofuel producers, as well as struggles among small solar-power companies, amid a drop in oil prices over the past year. It is also important to recognize that buying into green businesses and shunning those that are harder on the Earth's resources won't benefit the environment directly.

The thought that "if you are buying stock [in] an oil company, you are somehow giving money to the oil company" is just not true, says Brian Pon, a financial planner with Financial Connections Group Inc. in the San Francisco Bay area. Whether you're investing in a traditional energy company or an alternative-energy player, you are typically buying shares from another investor and not pumping cash into the firm. Further, he says, "an individual doesn't really have the money to affect investment markets. You're buying a hundred shares when hundreds of thousands of shares trade daily."

So you're taking on considerable risk by "greening" your portfolio, as illustrated by the WSJ's summary of the performance of portfolios of alternative energy during the financial crisis:

Among the narrow and volatile green portfolios are two ETFs that focus on solar energy: Claymore/MAC Global Solar Energy Index and Market Vectors Solar Energy.KWT +0.63% They are both down 45% over the past 12 months, while the Standard & Poor's 500-stock index declined 6.9%. ...

PowerShares WilderHill Clean Energy, a somewhat broader alternative-energy portfolio, has also taken investors for a bumpy ride. The ETF gives investors exposure to areas including ethanol, solar and wind power, and energy efficiency. Over the past year, the fund—one of the larger green portfolios, with a recent $783 million in assets—returned a negative 27%. Over the past three years, it has declined an average 13.5% a year, trailing the S&P 500 by more than eight percentage points.

Ouch. And the news hasn't gotten any better. The three year annual return on S&P's Global Alternative Energy Index is 7%. Compare that to the S&P 500's three year annual return of 22.7%. The Fidelity Select Environment and Alternative Energy Portfolio has underperformed the S&P 500 consistently.

So pardon me if I can't work up much enthusiasm for this new UC policy.

The American people are finally wising up: There is no point in paying for active fund management

Interesting article in the WSJ over the weekend:

Investors are pouring money into Vanguard Group, the epitome of the hands-off approach to investing, flocking to funds that track market indexes and aren't run by stock pickers or star managers. ...

The surge is part of a sea change in the fund business in which investors are increasingly opting for products that track the market rather than relying on managers to pick winners. ...

Traditional stock-fund managers—old-fashioned stock pickers—have been the hardest hit in the wave toward passive investment. Through July, passively managed stock funds have seen a net $128.4 billion in investor inflows, compared with $18 billion for traditional stock funds, according to Morningstar.

Even uber-active investor Warren Buffett has seen the light, recently disclosing how he wants his estate invested: "Mr. Buffett, 83 years old and with a net worth of $66 billion, wrote that he advised his trustee to 'put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.).'"

If you want to know why index funds are deservedly beating the crap out of actively managed funds, read this post and then go buy Burton Malkiel's book: