DO PUBLIC AND PRIVATE FIRMS BEHAVE DIFFERENTLY?
Albert Sheen finds that private firms make better investment decisions
Albert Sheen completed his Ph.D. at UCLA Anderson in June and moved on to become an assistant professor at Harvard Business School. He expects to teach a core course in finance next spring. One reason for his success in the job market was a paper in which he made creative use of data on chemical firms to show that private firms made better investment decisions than public firms in anticipation of market demand. The paper is entitled, “Do Public and Private Firms Behave Differently? An Examination of Investment in the Chemical Industry.”
Sheen started his research in 2007 when private equity firms were frequently in the news. “Private equity was really hot,” he says. “Everyone was talking about it and wondering whether it’s good or bad for a public firm to be taken over by a private equity firm. I thought it would be interesting to look at this empirically.”
Sheen says both public and private firms have characteristics that are cited as benefits and neither type of firm has been proven to have an inherent edge in the marketplace. “Private firms don’t have to deal with shareholders or Wall Street analysts and they may be free to take a longer term perspective,” he says. “At the same time, public firms may have easier access to capital markets and they tend to be more visible than private firms in the marketplace.”
He began looking at different industries hoping to find a way to compare the performance of public and private firms. Since financial and accounting data are not readily available for private firms, Sheen looked for something to serve as a proxy. He examined data on supermarket chains and homebuilders before learning that UCLA Anderson professor Marvin Lieberman had studied the chemical industry.
“Marvin showed me some data he had used in a previous study and I thought it might work for what I wanted to do,” says Sheen. “He told me where to get it and what it looked like, so I went in and collected the most recent data.”
Sheen soon realized he could use the data to monitor changes in the production capacity of firms. “I can’t see how much profit they’re making or what their revenues are,” he says. “But I can see how much production capacity they have from year to year. For example, a company may suddenly increase its capacity to produce ammonia. The question is … How do I evaluate that?”
The answer turned out to be fairly simple. “Since everything I’m looking at here is a commodity chemical,” he says, “I can get pricing and sales data and do some basic supply and demand curves. This shows when there were positive demand shocks for these chemicals.”
By comparing changes in production capacity with changes in price and demand, Sheen was able to measure the effectiveness of firms’ investment decisions. “It’s a good thing to add capacity when demand is strong,” he says. “What you don’t want to do is open a new plant just as demand is falling off a cliff.”
Sheen separated the data for public and private firms and showed that private firms were five percent more likely to expand capacity prior to a market upturn than a public firm. Private firms were also significantly less likely to expand capacity prior to a downturn. “This is the first time that public and private firms have been shown to behave differently,” he says.
Why is that? “Well, it seems to be basically an agency story,” he says. “In other words, executives in private firms may have stronger incentives to take initiative, think long term and focus on adding value to the company. Or you could have a story where a public firm with full coffers decides to go ahead and build a new plant without regard for market demand.”
To understand this better, Sheen separated private equity and LBO firms from other private firms in his sample. “A lot of people think private equity and LBO firms have the strongest incentives for executives,” he says. “These firms have very strong boards and tend to pressure executives. What I found was that private equity and LBO firms really seemed to do the best job of investing. They were better than other private firms who, in turn, were better than public firms.”
“So to the extent that you believe private equity and LBO firms really do have the strongest incentives,” he continues, “the fact that they performed best would support a story where agency issues are the differentiating factor. I don’t have direct evidence for this -- but it would be consistent with the results of this study.”
Sheen also explored whether the results of his study were due to endogeneity. In other words, is it being public that causes firms to act a certain way? Or is it that firms behaving this way also happen to be those that go public? “Maybe firms that pay less attention to demand shocks decide to go public,” says Sheen. “So it’s not being public, itself, that matters. If you took a random public firm and forced it to go private but kept everything else the same, would it actually behave like a private company?”
To address this, Sheen looked only at firms that switched from private to public or public to private. “What I found was that these firms invested worse during their public years than they did during their private years,” he says. “There’s probably still something that’s making them go public, and maybe that’s correlated with this change in behavior, but at least management and corporate culture are constant. It’s basically the same firm -- it’s just gone public or private. This helps relieve the endogeneity concern.”
Sheen is careful to say that this study does not necessarily imply that it’s always better for a chemical firm to be private. “I’m just looking at one aspect of what they do,” he says. “It’s possible that having better access to capital or better publicity or regular contact with analysts gives you other advantages. Maybe you can better diversify into non-chemical businesses. All I’m saying is that, on this one dimension of behavior, there’s something that private firms are doing better than public firms.”