In a new paper, we examine the differences between private and public firms to see whether one outshines the other when it comes to investment efficiency. Our analysis begins with three theories.
The Agency Theory: Although going public offers investors liquidity, diversification, and lower capital costs, a separation between management and ownership arises, leading to agency problems where managers’ interests may diverge from those of shareholders. Managers of public firms may fall into the trap of empire building, i.e., invest excessively, irrespective of opportunities. Alternatively, they might choose a quieter approach, avoiding the intense effort require to make optimal investments. Private firms, with their tighter ownership structures and relatively weak short-term performance pressure, are likely to experience fewer agency issues, thereby fostering more efficient investment decisions.
The Complexity Hypothesis: Compared with private firms, public firms often have more diverse and complex organizational structures, operations, and decision-making environments. For instance, public firms with multiple business segments often need to combine diverse operations and are thus subject to information aggregation problems, resulting in information asymmetries and inefficient capital allocation within the firm. Likewise, public firms with international operations deal with complexities resulting from currency exposure, auditing costs, taxes, and legal systems, as well as cultural and linguistic differences. These complexities make it challenging for firms to make accurate predictions about future growth and product demand, thus hampering the efficiency of their investment decisions. According to this hypothesis, public firms might stumble in their investment efficiency due to their intricate structures.
The Access‑To‑Finance Hypothesis: Private firms typically face a higher cost of capital due to factors such as lower asset liquidity, concentrated ownership, and less public disclosure. Such higher financing costs might discourage private firms from investing optimally. On the other hand, capital constraints might induce private firms to adopt a conservative approach to financing. Such a cautious stance is conducive to more stringent liquidity management and meticulous investment decisions, thereby resulting in less over‑ and underspending. However, when facing capital constraints, private firms might find themselves in the precarious position of underinvesting. This hypothesis, therefore, posits that private firms might be more or less efficient in their investment decisions.
To test the above three theories, we construct a comprehensive sample of U.S. private and publicly listed firms (over 68,000 firm-year observations; 4,775 private and 5,040 public firms) from 1995 to 2019 using data from the Capital IQ database. Using a parametric approach following prior literature (e.g., Biddle et al., 2009; Chen et al., 2011), a firm’s investment inefficiency is measured as the absolute deviation of actual investment from the expected level of investment fitted from an investment model.
Our baseline regression analysis reveals that private firms exhibit investment inefficiency levels that are nearly 30 percent lower than are those of their public peers. Separating investment inefficiency into categories of under- and overinvestment, our tests show that the greater relative efficiency of private firms stems from both less under- and overinvestment. Our results hold in endogeneity tests, propensity score matching analysis, and when we use alternative proxies of investment inefficiency.
Next, we perform a series of in-depth analyses to understand which theory is better at explaining our results. First, among the sample of public firms, we find that common governance proxies, such as those capturing shareholder and board monitoring, market discipline, and managerial entrenchments, fail to explain investment inefficiency, inconsistent with the agency theory.
Second, to formally distinguish between the agency theory and complexity hypothesis, we use the Sarbanes-Oxley Act (SOX) as a setting and perform difference‑in‑differences (DiD) tests surrounding its introduction. Although SOX was shown to lead to improved governance, it significantly raised board, internal control, and regulatory-compliance costs for public firms. Hence, if the agency theory is dominant, the public firms should become more efficient in investment after SOX as a result of fewer agency issues. However, the complexity hypothesis posits that increased SOX-related compliance costs make public firms even more inefficient post-SOX relative to private firms. Our DiD tests show that to be the case, especially for public firms with more complex operations as captured by having multiple business or geographic segments. The results are in line with the complexity theory.
An additional prediction under the complexity hypothesis is that firms with complex operations likely face greater coordination, informational, communication, and resource-allocation problems within the organization during periods of higher uncertainty. Using a state-level economic policy uncertainty index and staggered U.S. state gubernatorial elections, we confirm that investment inefficiency of public firms soared in the face of rising policy uncertainty, thus lending further credence to the complexity hypothesis.
Moreover, we examine the role of stakeholder pressure in moderating the relation between private firm status and investment efficiency. The complexity hypothesis posits that firms, especially those with complex operations, facing more intense pressure from their stakeholders are likely to have greater conflicts in decision-making and thus inefficiency due to conflicting interests and objectives. Consistent with this, we find that firms operating in industries characterized by heightened environmental activism, stronger consumer orientation, and greater labor spending displayed a more pronounced efficiency gap between public and private firms.
Finally, we test the access‑to‑finance hypothesis. The results show that the lower overinvestment of private firms relative with public ones is more pronounced among firms that are more financially constrained, as captured by small size and non-dividend-payer status. It appears that limited access to financing induces private firms to make more conservative investment decisions.
Our final task was to examine firm profitability. We find that private firms, because of their investment decisions, are more profitable than public firms over the next one, two, and three years. Our mediation analysis shows that the greater profitability of private firms was at least partly due to their more optimal investment decisions. Investment efficiency is thus an important factor guiding private firms to financial success.
Our analysis reveals a multi-faceted narrative. Our results are most consistent with the complexity hypothesis, thus providing valuable insights into the investment disparities between private and public firms. Our work underscores the broader debate about what truly drives efficiency within organizations. The choices firms make about their organizational form can have profound implications for investment strategies and, ultimately, their financial performance.
This post comes to us from Pantelis Kazakis, assistant professor of finance at the Adam Smith Business School of the University of Glasgow; Woon Sau Leung, professor of finance at the University of Southampton; Steven Ongena, professor of banking and finance at the University of Zurich and an affiliate of KU Leuven, NTNU Business School, the Swiss Finance Institute, and CEPR. The post is based on their recent paper, “Investment Efficiency of Private and Public Firms,” available here.