How Does Private Firm Disclosure Affect Demand for Public Firm Equity?

In 2020, over 98 percent of the 40 million firms that disclosed detailed financial statement information worldwide were privately owned. Given their economic importance, the social value (or cost) of regulating private firm disclosures is likely significant, and how much to regulate these disclosures has been a central topic of debate among regulators. Key to informing this debate is understanding the potential spillover effects of these disclosures. While emerging research has made progress in investigating both the determinants and firm-level costs and benefits of private firm disclosures, relatively little is known about the spillover effects of these disclosures.

In a new paper, we extend this literature by examining an important but underexplored spillover effect: Whether and how private firm disclosures affect investor demand for equity of their publicly traded peers.

To estimate variation in private firm disclosures, we develop a novel measure applicable to a broad cross-section of countries and industries using Bureau van Dijk’s (BvD) Orbis database for the period 2005 to 2017. Specifically, we divide the number of financial statement line items that private firms disclose by the total number of line items that these private firms can hypothetically disclose. In our tests, we exploit variation of this measure across countries, industries, and years. For example, in 2013 we observe private firms in Japan’s manufacturing industry disclosed 53 percent, on average, of their financial statement line items relative to the hypothetical full disclosure, whereas private firms in Germany’s manufacturing industry disclosed only 43 percent on average.  Our measure suggests that manufacturing private firms in Japan were more transparent than that of Germany in 2013¸ ceteris paribus.

We find a one standard deviation increase (i.e., a 28 percentage-point increase) in our private firm disclosure measure is associated with a 13 percent to 16 percent or $206 million to $253 million decrease in average total future equity demand by foreign investors per investee-industry-year, suggesting that the effect is material. Moreover, we find that the three subcomponents of our disclosure measure – balance sheet items, income statement items, and footnote disclosures – individually have significant negative relations with future equity demand. These findings suggest global investors consume various elements of financial statements, shedding new light on the precise type of financial information global investors use when reallocating capital.

A reallocation of capital from public to private firms is implicitly assumed in the argument that private firm disclosures reduce demand for public firm equity. We address this implied relationship in two steps. First, we expect and find the negative link between private firm disclosures and demand for public equity is more pronounced when investors are constrained in their ability to invest new capital in an investee country. Specifically, following prior research, we use each investor-investee pair’s strictness in controlling foreign capital flows as a proxy for the investor country’s constraints in investing new capital in an investee country.  We document that our capital control proxy is linked to significant additional reductions in public equity relative to baseline averages.  This is consistent with capital constraints inducing investors to reallocate their existing capital (i.e., public equity) – rather than injecting new capital – to invest in private firms with transparent financial statement disclosures.

Second, we find that investee-industries that experience the most significant reduction in public equity demand by global investors are indeed the ones that experience the greatest inflow of foreign capital into private firms. Specifically, we find that a one standard deviation increase in our private firm disclosure proxy is associated with a 14 percent to 27 percent increase in M&A and venture capital activity by global investors targeting the investee country’s private firms. Moreover, consistent with reallocation of capital from public to private firms driving our results, we do not find this relation for M&A activity that targets public firms. Taken together, the results from these additional tests are difficult to fully explain absent a reallocation effect, raising the bar for omitted factors to be the sole driver of our results.

To further shed light on which private firms – the disclosing private firm versus its private firm peers – benefit from the reallocation of capital, we conduct a firm-level analysis. We find evidence consistent with both the disclosing private firm and its private firm peers benefiting from the reallocation. Specifically, we find a positive link between private firm transparency and the future likelihood of the disclosing firm being an M&A target by foreign investors. In economic terms, a one standard deviation increase in our firm-specific measure of private firm transparency is linked to a 5 percent greater likelihood of the disclosing private firm being an M&A target. Moreover, in stark contrast to the documented negative pecuniary externalities of private firm disclosures on public firms, we find evidence consistent with private firm disclosures generating positive information externalities that benefit other private firms that also become more likely M&A targets by foreign investors.

Our paper contributes to the literature in several ways. First, we contribute to the disclosure spillover literature, which has primarily focused on the informational transfers from public firm disclosures to outside stakeholders such as private firms, but less so on the reverse effect – that private firm disclosures can affect public firm outcomes.

Second, we contribute to the literature that examines the allocation of global capital. How public equity capital moves around the world is a central issue in international policy, especially since many countries have poor domestic capital markets and rely on global capital flows. We add to this literature by showing that private firm disclosure is an important determinant for the international flow and allocation of public equity capital.

Third, we contribute to the literature on the measurement of corporate transparency. Unlike the numerous firm-level measures available for publicly traded U.S. firms, there is a dearth of available proxies for private firms, particularly in a global setting. By developing an easily implementable yet widely applicable measure of transparency, we not only uncover new insights on what information global equity investors consume but also offer a useful tool for future researchers interested in examining the determinants and consequences of private firm disclosures in an international setting.

This post comes to us from professors Jinhwan Kim at Stanford Graduate School of Business and Marcel Olbert at London Business School. It is based on their recent article, “How Does Private Firm Disclosure Affect Demand for Public Firm Equity? Evidence from the Global Equity Market,” available here.

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