Investment and financing decisions of private and public firms

• Author: Wolfgang Drobetz,Malte Janzen,Iwan Meier
• Published date: 01 January 2019
• Date: 01 January 2019
• DOI: http://doi.org/10.1111/jbfa.12367

DOI: 10.1111/jbfa.12367

Investment and financing decisions of private

and public firms

Wolfgang Drobetz1Malte Janzen1Iwan Meier2

1University of Hamburg, Faculty of Business,

Moorweidenstrasse18, 20148 Hamburg,

Germany

2HEC Montréal, 3000, chemin de la

Côte-Sainte-Catherine, Montréal, Québec,

Canada

Correspondence

WolfgangDrobetz, University of Hamburg,

Facultyof Business, Moorweidenstrasse 18,

20148Hamburg, Germany.

Email:wolfgang.drobetz@uni-hamburg.de

Abstract

Weexamine differences in the allocation of cash flow between West-

ern European private and public firms. Public firms have a higher

investment-cash flow sensitivity than comparableprivate firms. This

difference is not attributable to more severe financing constraints

of public firms. Instead, because differences in investment-cash flow

sensitivities are only observed for the unexpected portion of firms’

cash flow, the empirical evidence supports an agency-based expla-

nation. Similar patterns are observable for the expected and unex-

pected portion of firms’ shareholder distributions. Our results are

driven by firms from countries with low ownership concentration

and more liquid stock markets, where shareholders have lower

incentives to monitor.The results are also more pronounced for pub-

lic firms with low industry Tobin'sqandhigh free cash flow, which are

more prone to suffer from agency problems.

KEYWORDS

agency problems, cash flow allocation, corporateinvestment, private

firms

1INTRODUCTION

Since the emergence of public corporations, questions about the optimal ownership type, public or private, have been

subject to much debate in the literature. On the one hand, going back to Berle and Means (1932), arguments against a

firm's stock being publicly tradedon an organized exchange emphasize the separation of ownership and control. In par-

ticular, Jensen (1986,1989) argues that public corporations are beset by agency problems. Agency conflicts between

managers (insiders) and firm owners (outsiders) lead to value-decreasing investment decisions through managerial

consumption of perquisites, empire-building, and myopia.1Public firms are viewed as inefficient organizational forms

that suffer from agency costs of equity, and private firms financed by debt and private equity are assumed to resolve

agency conflicts between investors and managers better than public firms.2

1Jensen's(1986, 1986, 1989) ideas are further developedand refined in formal models in Harris and Raviv (1990), Hart and Moore (1995), Stulz (1990), and

Zwiebel(1996). Managerialtendencies to base investment decisions on what would increase prices in the short run are discussed in Narayanan (1985), Stein

(1988,1989), and Bebchuk and Stole (1993).

2Ang, Cole, and Lin (2000) and Singh and Davidson(2003) assess the agency costs of equity attributable to the separationof ownership and control by com-

paringthe efficiency of firms managed by a sole shareholder with the efficiency of firms with low managerial ownership share.

J Bus Fin Acc. 2019;46:225–262. wileyonlinelibrary.com/journal/jbfa c

2018 John Wiley & Sons Ltd 225

226 DROBETZ ETAL.

On the other hand, however, public firms havebetter access to equity markets.3Through public trading, the risks

of owning a firm can be diversified over a large number of small investors, and allocated to those who are best able

to assume them. This eventually lowers the cost of capital (Jensen, 1989). Better access to public equity markets and

lower costs of capital enable public firms to seize growth opportunities that they would otherwise be constrainedfrom

taking.

To the extent that share prices contain information related to firm performance that is otherwise unavailable

to investors, secondary market prices stimulate information production (Bond, Edmans, & Goldstein, 2012; Dow &

Gorton, 1997; Subrahmanyam & Titman, 1999) and help with monitoring and contracting (Edmans, 2009; Holmström

& Tirole, 1993). This facilitates value-maximizing investment decisions. The benefits associated with being listed on a

public equity market maycause public firms to allocate capital more efficiently than private firms.4

We study the differences in investment and financing decisions of private and public firms using a large sample

of firms from 11 Western European countries. As emphasized by Gatchev,Pulvino, and Tarhan (2010) and Dasgupta,

Noe, and Wang (2011), focusing on the investment-cash flow sensitivity only provides an indirect test of restricted

access to capital marketsbecause it ignores financing-cash flow sensitivities. Therefore, we use the empirical approach

presented in Lewellen and Lewellen (2016) to estimate cash flow sensitivities for each channel to which a firm can

allocate cash flow.5

Given the systematic differences between private and public firms, we follow prior research (Asker,Farre-Mensa,

& Ljungqvist, 2015; Maksimovic, Phillips, & Yang,2017; Mortal & Reisel, 2013) and construct a sample of comparable

private and public firms by using a matching procedure. Most important, we find that public firms exhibit statistically

and economically larger investment-cashflow sensitivities than private firms. On average, managers of public firms use

16 cents per $1 of additional cash flow for investment,while we find no significant investment-cash flow sensitivity for

private firms.

What explains the higher investment-cash flow sensitivity of public firms? We analyze the two dominating, albeit

competing, interpretations of the investment-cash flow sensitivity literature for the positivelink between investment

and cash flow: 1) financing constraints,and 2) an agency-based explanation.6Following Fazzari, Hubbard, and Petersen

(1988), significant investment-cash flow sensitivities are an indicator for financing constraints. This explanation is

unlikely. Due to their better access to capital markets,we would not expect public firms to be more financially con-

strained than their private counterparts.

A different interpretation of investment-cash flow sensitivities is based on Jensen's (1986) free cash flow theory.

In the presence of agency conflicts between managers and owners, if cash flow is abundant, managers may increase

firm size beyond an optimal level with respect to firm value at the expense of the owners. This tendency is known as

‘empire-building’.7Conversely,when cash flow is low, managers may forgo profitable investment opportunities to meet

earnings expectations and to smooth shareholder distributions.

To understand what causes the observed difference in investment-cash flow sensitivities, we first search for

evidence consistent with the financing constraints hypothesis. Almeida, Campello, and Weisbach (2004) find that

3Asker,Farre-Mensa, and Ljungqvist (2015), Brav(2009), Derrien and Kecskés (2007), Hsu, Reed, and Rocholl (2010), Lyandres, Marchica, Michaely,and Mura

(2018), Pagano,Panetta, and Zingales (1998), Saunders and Steffen (2011) and Schenone (2010), show that public firms have easier access to external funds

thanprivate ones.

4Bond and Goldstein (2012) argue that the value of secondary markets also depends on the amount of information that managers themselves obtain from

prices. Although managers are better informed than outsiders, they receiveinformation about their company from the stock price that would not otherwise

be available to them, and theyexploit this information in their investment decisions (Bakke & Whited, 2010; Chen, Goldstein, & Jiang, 2007; Dow & Gorton,

1997; Edmans, Goldstein, & Jiang, 2012). The concept of ‘revelatoryprice efficiency’ (as opposed to traditional ‘forecasting price efficiency’) implies that the

stockprice reveals information necessary for corporate decision-makers to pursue value-maximizing actions.

5Their framework is also used in Döring, Drobetz, Janzen, and Meier (2018) for a global sample of firms. Firms from countries with a stronger institutional

framework exhibit higher financing-cash flow sensitivities. These firms are more likelyto substitute for a cash flow shortfall by issuing equity. Conversely,

investment-cashflow sensitivities are higher for firms in countries with a weaker institutional framework.

6Based on work by Erickson and Whited (2000, 2012), a third explanation is based on an errors-in-variables problem. We address this explanationin our

robustnesstests.

7AsStein (2003) emphasizes, empire-building does not predict overinvestment during all time periods. However,in situations where the level of available cash

flowthat managers can allocate at their discretion is high, it can lead to a positive investment-cash flow sensitivity.

DROBETZ ETAL.227

financing constraints lead to a higher propensity to save cash flow, thereby increasing cash holdings. Our results

extend their findings by demonstrating that both privateand public firms exhibit positive cash-cash flow sensitivities.

Managers of private and public firms adjust their cash holdings in a similar manner in reaction to changes in cash flow.

This contradicts the conjecture that the larger investment-cash flow sensitivities of public firms are attributable to

more severe financing constraints. Our results on investment-cash flow sensitivities remain robust even when we

focus on the subgroups of firms that are most likely to suffer from fianancing constraints: 1) by restricting the sample

to young private and public firms, and 2) by comparing public firms to the group of smallest private firms.

In a second step, we examine the agency-based explanation and separate cash flow into an expected and an

unexpected part. The expected portion of a firm's cash flow is forecasted using past financial information. This type

of information is available for both managers and owners, and thus information asymmetry about expected cash flow

should be low.The unexpected portion is the difference between expected and actual cash flow. In line with the agency-

based explanation, a higher investment-cash flow sensitivity of public firms cannot be observed for the expected

part. We conclude that managers of public firms exploit the greater information asymmetries around the unex-

pected fraction of cash flow to a magnitude that is not observed for private firms in order to pursue empire-building

preferences.

Another closely related and recurring finding in our empirical analysis is that managers of public firms smooth

shareholder distributions more than their private peers. Instead of aligning shareholder distributions with changes

in (unexpected) cash flow, they rather adjust investment activities. This behavior also supports our agency-based

explanation. As in Michaely and Roberts’ (2012) study, we find that private firms follow a residual payout policy,

stabilizing investment and adjusting shareholder distributions in response to a cash flow shortfall.

In addition, we test the distinct patterns in cash flow sensitivities of private and public firms as well as the agency-

based explanation in two different settings. First, in cross-country analyses, we show that our results are driven by

firms from countries with liquid stock markets. In these countries, selling shares is less costly and the incentives for

small shareholders to actively monitor managers are lower, enabling managers to allocate cash flow less efficiently.

Second, taking private firms as the benchmark case, we focus only on public firms and classify them according to dif-

ferent proxies for agency costs of equity.The investment-cash flow sensitivity is higher for high agency cost firms. In

contrast to private firms, agency costs arise in public firms because they are less efficient in their investment deci-

sions with respect to changes in cash flow. In addition, the shareholder distribution-cash flow sensitivity decreases

with increasing agency costs. All these findings support our agency-based interpretation.

Our results hold across various robustness tests. First, we address a potential self-selection bias from a firm's deci-

sion to be either privately or publicly owned by using the Heckman (1979) correction method. Second, we test whether

our results are simply an artifact of a measurement error in our proxy for investment opportunities. In particular,we

compute an alternative measure for the growth opportunities a firm faces based on fundamental data, and then repli-

cate our main results using IV regressions. Last, we use alternative matching algorithms.

Theremainder of this paper isstructured as follows: Section 2 provides a literature review, while Section 3 describes

the sample and our empirical design. Section 4 outlines the main results and discusses potential explanations.Section 5

describes country- and firm-level tests that reinforce the agency-based explanation,and Section 6 provides sensitivity

tests. Section 7 concludes.

2LITERATURE REVIEW

We add to a relatively new strandof literature that compares investment and financing decisions of private and public

firms. Empirical financial research, driven by the mere availabilityof data, has long been focused on public firms. How-

ever, an increasing number of studies analyze differences in the financing and investmentbehavior of private versus

public firms.

Asker,Farre-Mensa, and Ljunqvist (2015) find that public companies’ investment in the US reacts to a lesser degree

to changes in investmentopportunities than that of comparable private firms. This behavior is particularly pronounced