Wednesday, May 30, 2012

Are Public Corporations Becoming Obsolete?

There is a fascinating article in The Economist: The endangered public company. The authors raise the possibility that time has overtaken the form of business organization that has been the engine of capitalism for more than a century. The public company with shareholders as owners has provided an efficient means of raising capital and it has been an effective means of rewarding entrepreneurs and inventors with wealth as they took their enterprises public. There now may be alternative paths available to accomplish these same things.

The authors were somewhat disappointed, or rather, irritated, to note that developing countries did not embrace the traditional public corporation model completely. Variations that include state ownership or even family control seem to be capable of functioning quite efficiently. More troublesome to them was an apparent trend towards obsolescence in the UK and, particularly, in the US.

The evidence that companies are choosing other organizational models can be found in the following charts.

"The number of public companies has dropped dramatically in the Anglo-Saxon world—by 38% since 1997 in America and by 48% in Britain’s main markets."

Further evidence arises from the dramatic decrease in initial public offerings (IPOs).

The authors suggest three attributes of public companies that have gotten worse over the years and may have encouraged others to look into alternate types of organizations. They consist of the temptation for managers to play loose with others’ money to improve their personal financial gain, the increased hassle of regulation, and a growing focus on short-term market issues.

"....their biggest drawback is what economists call the principal-agent problem: the split between the people who own the company (principals) and those who run it (agents). Agents have a nasty habit of trying to feather their own nests."

"Public companies have always had to put up with more regulation than private ones because they encourage ordinary people to risk their capital. But the regulatory burden has become heavier, especially after the 2007-08 financial crisis."

"Companies must strike a balance between the short and long term, satisfying the market’s demand for profits today, while planning for the future.....Leo Strine, a judge with expertise in corporate law, accuses institutional investors of ‘gerbil-like’ activity as they move money from one company to another. Standard Life Investors complains that the noise generated by quarterly earnings has become an "unwelcome distraction" from thinking about the long term."

What have become the main competitors for public companies? In the US the main alternatives have come from the return of partnerships as viable models.

"Now, thanks to three decades of legal reforms, partnerships can offer most of the benefits of listing, such as limited liability and tradable shares. In America they also boast a big tax advantage: partnerships are liable for only one lot of taxes, whereas companies must pay corporate taxes as well as taxes on dividends."

"The result has been a revolution: one-third of America’s tax-reporting businesses now classify themselves as partnerships. They have adopted exotic forms of corporate organisation, such as Limited Liability Limited Partnerships (LLLPs), Publicly Traded Partnerships (PTPs) and Real Estate Investment Trusts (REITs). Private-equity firms are typically organised as private partnerships. The individual funds through which they raise money are limited partnerships. And they treat their managers more like partners than employees, rewarding them accordingly."

Entrepreneurs have a variety of choices available to them if they wish to cash in on the success of their enterprise. One is to go public to bring in big money, but to maintain control of the running of the company.

"Google introduced a third class of non-voting shares despite the fact that its three bosses, Eric Schmidt, Sergey Brin and Larry Page owned 60% of voting shares. Mr Zuckerberg put off taking Facebook public until he had little choice (you have to publish quarterly accounts like a public company once you have more than 500 private shareholders); he will control more than half of Facebook’s voting stock."

Many seem more interested in developing another enterprise than managing the one they just created.

"Venture capitalists are recouping their investment by selling new companies to established ones rather than preparing them for independent life. In 2010 five large companies gobbled up 134 start-ups—more than the entire crop of American IPOs that year. Two of the most talked-about start-ups of recent years—Skype and Zappos—chose to sell themselves to giant firms (Microsoft and Amazon respectively)."

Those who wish to sell their companies while still maintaining control have numerous partnership options that can be created in alliance with wealthy private equity investors or other groups of individuals.

The authors worry that these changes will diminish the dynamism of the economy and lead to less innovation. Being who they are, they try to lay blame for all unfortunate developments on government regulators. There is another issue that the article touches briefly on that ultimately may prove to be more troubling.

One of the positive aspects of twentieth-century capitalism is that ownership in companies was broadened to include a large slice of the population. Pension funds, the popularity of mutual funds, and the rise of IRAs and 401Ks encouraged individuals from all income groups to participate in the economy as stakeholders. This trend may reverse itself as more companies prefer to keep ownership in the private realm.

"Today shareholding is in danger of narrowing again. The reduction in the number of IPOs is making it harder for ordinary people to put money into a future Google. The rise of the private-equity industry and the proliferation of private markets such as SecondMarket gives more power to a magic circle of company founders and experienced investors."

Can it be that wealth has become so concentrated in the hands of a few individuals that young companies no longer need to turn to uncertain public markets for funds? Is it possible that a few extremely wealthy individuals are in a position to select winners and losers for the economy as a whole?

The trend toward fewer publicly-owned companies is particularly pronounced in the US and in the UK. These are the countries that have most avidly embraced what has come to be called "free-market capitalism." In truth, markets in these countries are anything but free. Could this capitalist system be evolving—inevitably—in a direction that gives large corporations and wealthy individuals even greater say over what paths the economy is allowed to take?

Taking companies off the public exchanges and putting them in private hands can only increase the already extreme concentration of wealth.

"Private-equity companies have taken some of the most familiar names on the high street private, including Boots, J.Crew, Toys "R" Us, and Burger King. They also bagged some of the biggest stockmarket beasts: in 2007 Blackstone bought Hilton Hotels for $25.8 billion."

The trends noted in this article bear watching. Not all change is bad, but it is easier to stumble in the many wrong directions than in the few beneficial directions.

1 comment:

  1. The popular literature touts that the stock market is attractive "over time" for the public. This maxim fails to account for the reality that the benefits fall to insiders, privileged IPO recipients, and stock options. The public gets left holding the bag. The outlook? The stock market spirals into decline.


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