The Blurring Lines between Private and Public Ownership

Public versus  private status is a common point of differentiation among companies and can determine, for example, how they are regulated and who can invest in them. Yet many private companies increasingly resemble their public counterparts. This blurring of the lines between public and private has been gradual, and in a new paper, I focus on three areas in which it has occurred: firms’ sources of capital, governance structures, and reliance on acquisitions to fuel growth.

First, there is growing overlap between public and private firms’ sources of capital. Private firms have traditionally been owned by founders and angel investors, venture capitalists, private equity firms, and other investors that focus on private companies. By contrast, public firms have typically had a much wider range of investors, including mutual funds, hedge funds, other institutional investors, and retail investors. Today, however, there are many exceptions to these “rules.” Among private firms that are raising capital, in particular late-stage VC-backed firms, mutual funds and hedge funds frequently represent key investors. Among public firms that are raising capital, venture capitalists often purchase newly issued shares. Specifically, VCs often purchase shares of PIPEs (Private Investment in Public Equity) that are issued by companies in the one to five years following an IPO.

The second area where the lines between private and public companies are increasingly blurry is corporate governance. As private firms become larger and their owners more diverse, their governance demands more closely resemble those of public firms. Consistent with these changes, private firms voluntarily increase the size of their boards and select more independent directors. Moreover, post-IPO dynamics are consistent with the continuing evolotuion of governance demands over the firm’s life cycle.

There is also considerable heterogeneity in how firms abide by governance rules when they go public. Many companies register to go public as controlled companies, thereby excluding them from various requirements.  Over time, a portion of these companies lose this controlled status. The ability of these companies to delay complying with various governance-related mandates provides various advantages. Newly public companies have governance demands that differ in many ways from their more mature counterparts.

The third area I discuss is firms’ growth strategy. Firms can pursue growth  either organically or inorganically: through internal investment or through acquisitions (or a combination of both). Historically, private firms typically relied primarily on organic growth, and firms began to grow through acquisitions after going public. However, firms no longer need to go public to obtain acquisition funding. I show that firms have become increasingly likely to make acquisitions while they are still private. The greater availability of capital to private firms facilitates acquisitions as a means for rapid growth – even before firms go public. Concurrent with private firms facing fewer financial constraints, the benefits of rapid growth have become larger. This is due to macro-level changes in the economy, which contribute to increased economies of scale and scope.

The increasing tendency of firms to stay private longer interacts with many other market dynamics. These changes raise intriguing questions about how markets may evolve. First, as firm founders prefer to stay private longer, VCs find it increasingly difficult to liquidate their investments and distribute proceeds to limited partners. VC funds typically have 10 to 12 year lives, a criterion that has become difficult to satisfy. While the VC general partners can obtain extensions from their limited partners, this is far from a complete solution. One approach to this problem would be for VCs to adopt the practice used frequently in private equity, whereby a PE investor sells a firm to another PE firm, rather than relying on an IPO or acquisition as a means of exiting the investment.  While such fund-to-fund sales are frequent in the PE world, they remain relatively rare for VCs. It is quite possible that this will change.

A second way in which markets may change relates to the investment opportunities of retail investors. As fewer companies are publicly traded, retail investors have fewer options. This raises the question of whether the restrictions related to investing in private companies should be lessened to allow more retail investment.

Finally, a third way in which markets may change relates to society’s approach towards environmental and social issues. Investors and regulation often pressure firms to change their policies on these issues, and the strength of that pressure can depend on whether the firm is public or private. As firms choose to stay private longer and private firms increasingly resemble public firms, this unequal treatment raises many questions. For example, will the increasing environmental and social-related pressures faced by public companies cause companies to stay private even longer?  Should large private companies be required to comply with the same environmental and social policies as their public counterparts?

As the lines between private and public companies blur, it becomes imperative to think carefully about the structure and impact of regulations, investor pressures, and even media attention. Late-stage private firms and public firms are more alike – and newly public firms and their mature counterparts are more different – than commonly recognized.

This post comes to us from Professor Michelle Lowry at Drexel University. It is based on her recent paper, “The Blurring Lines between Private and Public Ownership,” available here.