There is a long and venerable tradition of predicting the demise of the American public corporation. For example, back in 1989, Harvard Business School Professor Michael Jensen famously questioned whether we were seeing the “eclipse of the public corporation.” In a February 2017 paper entitled “Is the American Public Corporation in Trouble?” (here) University of Arizona finance professor Kathleen Kahle and Ohio State University finance professor René M. Stulz reexamine the question and suggest that in the years since Jensen’s landmark article, there have been “striking changes” in the landscape for American corporations. The relatively few remaining public companies are, in effect, “survivors,” and few “want to join their club,” as new enterprises prefer private equity and other non-public finance sources to the public securities markets. A March 24, 2017 summary of the authors’ paper on the Harvard Law School Forum on Corporate Governance and Financial Regulation can be found here.
The authors document the evolution of U.S. public companies over the 40-year period between 1975 and 2015. During that time, the authors note, public companies have “experienced striking changes.”
One trend for U.S. public corporations that has been well documented is that there are now far fewer U.S.-listed companies than there were just a few years ago. The authors note that in 1975, there were 4,819 publicly listed U.S. corporations. In the years immediately following, the number of U.S. public companies increased to 7,002 in 1995; the number of public companies peaked in 1997 at 7,507. However, by 2015, the number of public corporations fell to 3,766, roughly half the number at the peak.
Not only are there fewer public companies, the authors note, but the remaining public companies are “very different.” They are, among other things, “older and larger,” and are in different industries. The aggregate market capitalization of U.S. public companies is seven times larger than it was in 1975. Because of the increase in overall market capitalization and decrease in the number of listed firms, the 2015 mean and median market values of the equity of public companies (in constant 2015 dollars) is almost ten times the market values in 1975. In 1975, the industries with the most listed firms were utilities, banks, and machinery. In 2015, the industries with the most firms were in banks, business services, and drugs.
This increase in size of U.S. public companies has been accompanied by “a striking increase in concentration of performance and assets.” In 1975, 94 companies accounted for half of the assets of all public companies and 109 companies accounted for half of the net income. By comparison, in 2015, 35 corporations accounted for half of the assets and 30 accounted for half of the net income.
In addition, between 1975 and 2015, there has been a dramatic shift in how firms invest. Firms now spend more on R&D and less on capital expenditures. Capital expenditures as a percentage of assets fell in half between 1975 and 2015, while R&D expenditure increased fivefold. As a consequence of accounting rules, increasing R&D and decreasing capital expenditure makes corporate performance look worse. Capital expenditures are depreciated over time while R&D costs are expense in the year incurred. Thus if a company increases its R&D investment at the expense of capital expenditures, its accounting performance suffers.
The authors also found that the ownership of public companies has changed as well. In 1980, the first year for which the data are complete, the authors found that institutional owners represented 17.7% of ownership of U.S. public companies. By 2015, the figure was 50.4%.
Corporate payouts to shareholders also differ now compared to 1975. The average dividends per dollar of corporate assets were lower in 2015 compared to 1975; however, share repurchases are much higher now than either twenty or forty years ago. Since the late 1990s, public corporations have spent more on repurchases than on dividends, and repurchases per dollar of assets are more than six times higher than forty years ago. Because of this increase in repurchases, the highest percent of net income paid out to shareholders during the forty-year period between 1975 and 2015 was in 2015.
One of the features of the long-standing predicted demise of the U.S. corporation was the so-called “agency problem” — that is, that corporate managers would tend to work to maximize their own interests rather than those of shareholders. However, the authors suggest that in fact the real problem may be the exact opposite. That is, firms pay out too much, perhaps as a result of institutional investor influence.
Based on their forty-year overview of U.S. public companies, the authors conclude that “the firms that remain are survivors.” A small number of firms “account for most of the market capitalization, most of the net income, most of the cash, and most of the payouts of public firms.” Revenues are more concentrated, so that there are fewer public companies competing for customers. A large fraction of firms are unprofitable every year, particularly toward the end of the authors’ forty-year study period. The increase in the number of unprofitable firms “indicates that many public companies are fragile,” and helps explain the high level of delistings over time. Accounting standards do not reflect “the importance of intangible assets for these firms, “which makes it harder for executives to invest for the long run.”
In conclusion, the authors note, public firms “appear to lack ambition, proper incentives, or opportunities.” They are “returning capital to investors and hoarding cash rather than raising funds to invest more.”
That there are fewer public companies and that American industry has become increasingly concentrated are both developments that have been well-documented. Just last week, the Wall Street Journal had a very interesting article entitled “Why You Probably Work for a Giant Company, in Twenty Charts” (here) showing just how concentrated certain industries have become. The Journal article notes that we have become “a nation of employees working for large companies, often very large ones.”
The Journal article also notes that “Huge companies dominate American economic life well beyond employment. They ring up a disproportionate share of sales for goods and services, both to consumers and to other businesses.”
The authors of the academic paper discussed further substantiate these generalizations about the concentration of U.S. businesses, and further show that these developments are not necessarily in the long-run best interests either of companies or of their investors.
UCLA Law Professor Stephen Bainbridge, commenting on the authors’ analysis, suggests that among the solutions may be to eliminate the high costs imposed by litigation and regulation.
Whatever may be the causes and whatever may be the solutions, it is critically important to understand what is happening and to consider the repercussions. These developments have many implications, including also for those of us in the D&O insurance industry.
The fact that there are so many fewer public companies and that the ones that remain are so much larger means that both that there is less spread of risk and that there is greater concentration of risk.
The fact that there are greater numbers of unprofitable companies means that the remaining public companies are “more fragile,” as the authors note, and therefore represent in the aggregate an increased pool of risk for D&O insurers.
The shift in the industries of U.S. public companies has important D&O underwriting implications as well, as industry is an important indication of frequency risk.
The fact that the interaction between the trends and the accounting rules make it harder for corporate managers to concentrate on longer-term strategies means that companies become increasingly focused on the short-term, which means both volatility in the near term and vulnerability in the longer term.
The concentration of market capitalization has important severity implications. As aggregate market capitalization is concentrated among fewer individual companies, the likelihood of a flame-through loss (or, worse, of multiple flame-through losses) increases significantly. This obviously has important implications for D&O insurers that focus on writing excess insurance, particularly for those writing upper level excess insurance. Past severity patterns may prove to be a poor guide with respect to future losses.
There is a larger discussion of these themes and what they mean for the D&O insurance that needs to happen, as I believe many of these trends and developments are largely unobserved (or at least underappreciated) within the D&O insurance community. At a minimum, however, these trends and developments suggest that insurers face a liability arena in which risk is both concentrated and heightened.
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