The endangered public companyThe big engine that couldn’tPublic companies have had a difficultdecade battered by scandals tied up byregulations and challenged by alternativecorporate formsMay 19th 2012 | from the print editionPUBLIC companies have been the locomotives of capitalism since they were invented in themid-19th century. They have installed themselves at the heart of the world’s largest economy the United States. In the 1990s they looked as if they would spread round the world shuntingaside older forms of corporate organisation such as partnerships and newer rivals such as stateowned enterprises (SOEs). China’s former president Jiang Zemin described NASDAQ as “thecrown jewel of all that is great about America”. Russia rejected five-year plans in favour ofstockmarket listings and Wall Street banks abandoned cosy partnerships in favour of publicequity: Goldman Sachs the last big holdout went public as the decade came to an end. The Endangered Public Company The Economist 19-May-2012Related topicsPrivate equityGoogleMark ZuckerbergFacebookAsiaPublic companies triumphed because they provided three things that make for durable success:limited liability which encourages the public to invest professional management which boostsproductivity and “corporate personhood” which means businesses can survive the removal of afounder. In 1997 the number of American companies reached an all-time high of 7 888 (see chart1). Even now American listed companies are as profitable as than they have been for 60 years.But during the past decade the title of a 1989 essay “Eclipse of the Public Corporation” byMichael Jensen of Harvard Business School has turned out to be prescient. In 2001-02 some ofAmerica’s most prominent public companies imploded. They included Enron Tyco WorldComand Global Crossing which before their demise were admired. Six years later Lehman Brotherscollapsed and Citigroup and General Motors turned to the government for salvation. Meanwhile SOEs were growing in emerging markets challenging the idea that public companies are thebiggest fishes in the sea. Private-equity firms flourished in the West challenging the idea thatpublic companies are the best managed. And the rise of the Asian economies with their legionsof family-owned conglomerates challenged the idea that they are best equipped to advancecapitalism’s geographical frontier.So even though public companies are flush with cash (American firms are sitting on $2.23trillion see Free Exchange) and even though the world’s most talked-about entrepreneur Facebook’s Mark Zuckerberg is due to take his company public on May 18th the signs of healthare misleading. Public companies are in danger of becoming like a fading London club. Their2 The Endangered Public Company The Economist 19-May-2012membership is falling. They spend their time fussing over club rules. And as they peer out of thewindow they see the bright young things heading elsewhere.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. The number of initial publicofferings (IPOs) in America dropped from an average of 311 a year in 1980-2000 to just 81 in2011 (chart 2).Going public no longer has the glamour it once had. Entrepreneurs have to wait longer—anaverage of ten years for companies backed by venture capital compared with four in 1985—andmust jump through more hoops. Lawyers and accountants are increasingly specialised andexpensive; bankers are less willing to take them public; qualified directors are harder to find since even “non-execs” can go to prison if they sign false accounts.The great IPO famineEven when their firms do go public the most successful technology entrepreneurs manage topreserve a lot of personal control. Google introduced a third class of non-voting shares despitethe fact that its three bosses Eric Schmidt Sergey Brin and Larry Page owned 60% of votingshares. Mr Zuckerberg put off taking Facebook public until he had little choice (you have topublish quarterly accounts like a public company once you have more than 500 privateshareholders); he will control more than half of Facebook’s voting stock.The IPO crisis has coincided with a boom in other corporate life forms. Familiar companies havestarted to put unfamiliar letters after their names: Chrysler LLC and Sears Brands LLC. TheUniversity of Illinois’s Larry Ribstein called this “the rise of the uncorporation”.3 The Endangered Public Company The Economist 19-May-2012Private-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 biggeststockmarket beasts: in 2007 Blackstone bought Hilton Hotels for $25.8 billion.Partnerships too are thriving reversing a decline that began in the era of Charles Dickens’s“Dombey and Son” (1848). Partnerships provided unlimited liability to the partners but limitedtheir number. This meant partners could be ruined if their company failed (as Dombey was) butcould not expand if it boomed. Now thanks to three decades of legal reforms partnerships canoffer most of the benefits of listing such as limited liability and tradable shares. In America theyalso boast a big tax advantage: partnerships are liable for only one lot of taxes whereascompanies 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 classifythemselves as partnerships. They have adopted exotic forms of corporate organisation such asLimited Liability Limited Partnerships (LLLPs) Publicly Traded Partnerships (PTPs) and RealEstate Investment Trusts (REITs). Private-equity firms are typically organised as privatepartnerships. The individual funds through which they raise money are limited partnerships. Andthey treat their managers more like partners than employees rewarding them accordingly. Theformer CEO of the Gap retail chain made $300m running J.Crew a clothing firm on behalf ofTexas Pacific.Policymakers have embraced alternatives to the public company too. Britain’s Conservativeprime minister David Cameron is happier praising employee-owned John Lewis than youraverage PLC (public limited company). American corporate reformers regularly cite a privatefirm W.L. Gore as a model; the maker of the eponymous Gore-Tex employs 9 500 “associates”and “sponsors” (not workers and bosses). Such companies use shares to motivate theiremployees but shield themselves from the capital markets. Employees become co-owners whenthey join and may not sell their shares when they leave.Governments have made it easier to create such alternative corporate structures. Seven Americanstates have passed laws to allow companies to register as “B” corporations which explicitlysubordinate profits to social benefits. The British government has established a class ofCommunity Interest Companies which issue shares and dividends but exist to promote socialpurposes. It has also handed over the management of hospitals to “trusts”— public-privatehybrids.The rise of new economic powers has further changed corporate organisation. In the 1990s itseemed that emerging-market companies would take the Western public company as their model.In fact they have embraced two slightly different corporate forms: SOEs and familyconglomerates. These companies list on the stockmarket but do little to constrain the power ofthe state or of family shareholders.In June 2011 SOEs accounted for 80% of the value of China’s market 62% of Russia’s and 38%of Brazil’s. They include some of the world’s most important concerns: the 13 largest oilcompanies the biggest gas company (Gazprom) the biggest mobile-phone company (ChinaMobile) the biggest ports operator (Dubai Ports).4 The Endangered Public Company The Economist 19-May-2012The most serious challenge to SOEs comes from family-controlled conglomerates. Familybusinesses account for about half of listed companies in the Asia-Pacific region and two-thirds inIndia. Families exercise tight control of their empires—and limit the power of othershareholders—through a variety of mechanisms such as family-controlled trusts (which havemore power than boards) appointing family members to managerial positions and attachingdifferent voting rights to different classes of stock. Diversified family firms are good at taking along-term view diverting money from cash cows to new industries that might take a long time toproduce results. They are also good at dealing with the government failures that plague emergingmarkets. It is remarkable how fast even India’s lumbering government can move if a Tata or anAmbani calls.Family companies of a different type have had a good decade in Europe. German family firmshave led the country’s export boom by dominating niche markets such as printing presses(Koenig & Bauer) licence plates (UTSCH) and fly swatters (Aeroxon). These firms pridethemselves on a professional approach to management: Nicholas Bloom and John Van Reneen of the London School of Economics point out that only 10% of German family firms choosetheir CEOs through primogeniture compared with two-thirds of family-owned firms in Britainand France. They also pride themselves on long-termism investing heavily in training andupgrading their machinery.Getting better versus getting worseSome of the reasons for the decline of public companies and the success of alternatives mayprove temporary. The fall in the number of listed firms owes something to the dotcom bust aone-off event. The private-equity boom was fuelled by cheap debt. SOEs have beenturbocharged by the rise in the price of oil and other commodities. The next decade may not beas easy for the emerging-world’s family conglomerates as the past decade. But there is alsosomething more fundamental going on: these various corporate forms have all learned how tomanage their problems better than public companies have while continuing to exploit theiradvantages.The biggest advantage of SOEs is political: ties with governments can protect them fromunwelcome competition. That of course is also their problem: they can easily become bloatedand lazy. So state-capitalist governments particularly the Chinese have turned to overseaslistings to force staid monopolies to become nimbler capable of responding to market demands as well as government fiat.The big advantage for family firms is their capacity for long-termism. The drawbacks are familyfeuds and a lack of professionalism in the second or third generations. So like state-capitalistgovernments family companies are turning to market mechanisms: professional managers private-equity firms and private markets such as SecondMarket and SharesPost which allowprivate firms to trade shares without public scrutiny.In contrast public companies have got worse at managing their problems three in particular. MrJensen argues that 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).5 The Endangered Public Company The Economist 19-May-2012Agents have a nasty habit of trying to feather their own nests. Dennis Kozlowski Tyco’s formerboss even spent company money throwing a $2.1m birthday bash for his wife that featured aManneken-Pis-like replica of Michelangelo’s David dispensing vodka. But as the current“shareholder spring” attests principals have been bad at monitoring their agents.Mr Jensen’s solution was to give managers “skin in the game”—that is make their pay reflectcompany performance so they act like owners. This has backfired: some bosses manipulatedtheir companies’ share prices to enrich themselves and most have seen their pay outpacecompany performance. The total remuneration of FTSE 100 chief executives rose by an annualaverage of 10% in 1999-2010 whereas returns on the FTSE 100 rose by an annual 1.9%.The second problem is regulation. Public companies have always had to put up with moreregulation than private ones because they encourage ordinary people to risk their capital. But theregulatory burden has become heavier especially after the 2007-08 financial crisis. America hasintroduced a raft of new rules from the 2002 Sarbanes-Oxley legislation on accounting to theDodd-Frank financial regulations of 2010. According to one calculation Sarbanes-Oxleyincreased the annual cost of complying with securities law from $1.1m per company to roughly$2.8m. But that is nothing compared with the costs of distraction. In 2007 Oaktree CapitalManagement a hedge-fund advisory firm chose to raise $880m in a private placement ratherthan an IPO because as the founders put it “they were happy to sacrifice a little public marketliquidity and even take a slightly lower valuation in return for a less onerous regulatoryenvironment and the benefits of remaining private.”The third problem is growing short-termism. The capital markets have increased their powerdramatically with the rise of huge institutional investors and the intensification of shareholderactivism. Mutual funds count their money in trillions rather than billions. Data providers such asRisk Metrics arm shareholder activists with plenty of ammunition. And hedge funds are notafraid to take on corporate Goliaths such as McDonald’s and Time Warner if they think they arefailing. And as capital markets have flourished corporate life has become riskier. The averagelife expectancy of public companies shrank from 65 years in the 1920s to less than ten in the1990s. So has the life expectancy of CEOs. The average job tenure of the CEO fell from 8.1years in 2000 to 6.3 years in 2009 according to Booz & Co a consultancy. Léo Apotheker lastedjust nine months as head of SAP and ten as head of Hewlett-Packard.Sometimes investors are right to kick out managers (they own the firm after all). Companiesmust strike a balance between the short and long term satisfying the market’s demand for profitstoday while planning for the future. The worry is that regulators and owners both seem to bemaking it harder for bosses to look beyond quarterly earnings. Boards are devoting less time tostrategy and more to enforcing regulations. Leo Strine a judge with expertise in corporate law accuses institutional investors of “gerbil-like” activity as they move money from one company toanother. Standard Life Investors complains that the noise generated by quarterly earnings hasbecome an “unwelcome distraction” from thinking about the long term.Public company as public good6 The Endangered Public Company The Economist 19-May-2012What should one make of the public company’s travails? There is every reason to celebrate thefact that businesses have more corporate forms to choose from. Indeed the menu should belengthened by inventing new arrangements or revisiting old ones. France’s “SCAs” or Sociétésen Commandite par Actions have two tiers of partners: general ones jointly and severally liablefor a company’s debts and limited partners who are ordinary shareholders with little power andwho can lose only what they invest. This might provide a model for investment banks.But there are reasons to worry that the downgrading might go too far. Can the private-equityindustry function properly if private investors cannot easily cash out through IPOs? Can SOEsavoid stagnation if conventional multinationals are struggling? Public companies are parts of anecosystem of innovation and job creation. IPOs give venture capitalists and entrepreneurs achance to make fortunes if they spot a game-changing idea. They also provide new companieswith capital. The Kauffman Foundation has shown that one reason America has been better atgenerating jobs than Europe is its skill at creating innovative companies such as Amazon eBayand Google. These companies took off when they went public.William Draper one of Silicon Valley’s most successful investors speaks for many when heargues that this ecosystem may be drying up. Venture capitalists are recouping their investmentby selling new companies to established ones rather than preparing them for independent life. In2010 five large companies gobbled up 134 start-ups—more than the entire crop of AmericanIPOs 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). This may not begood for the start-ups. Imagine if Microsoft or Apple had sold themselves to IBM in the 1980sand you get a sense of the problem.Public companies produce annual reports hold shareholder meetings and explain themselves toanalysts. Private companies by comparison operate behind a veil of secrecy. The danger is thatregulators are creating a corporate version of the dual labour market. By shining a spotlight onpublic companies they are encouraging businesses to take refuge in the shade of the privatesector.7 The Endangered Public Company The Economist 19-May-2012Public companies also foster popular capitalism. The 20th century saw shareholding broadenedthanks to privatisations in the 1980s and the rise of mutual funds. Today shareholding is indanger of narrowing again. The reduction in the number of IPOs is making it harder for ordinarypeople to put money into a future Google. The rise of the private-equity industry and theproliferation of private markets such as SecondMarket gives more power to a magic circle ofcompany founders and experienced investors.Public companies have shown an extraordinary resilience. They have survived the Depression the fashion for nationalisation and the buy-out revolution of the 1980s. But the challenge tothem looks unusually strong at the moment and the auguries for the future grim.Rival versions of capitalismThe endangered public companyThe rise and fall of a great invention and why it mattersMay 19th 2012 | from the print edition The Economist.AS THIS newspaper went to press Facebook was about to become a public company. It will beone of the biggest stockmarket flotations ever: the social-networking giant expects investors tovalue it at $100 billion or so. The news raises several questions from “Is it worth that much?” to“What will it do next?” But the most intriguing question is what Facebook’s flotation tells usabout the state of the public company itself.At first glance all is well. The public company was invented in the mid-19th century to providethe giants of the industrial age with capital. That Facebook is joining Microsoft and Google onthe stockmarket suggests that public listings are performing the same miracle for the internet age.Not every 19th-century invention has weathered so well.8 The Endangered Public Company The Economist 19-May-2012But look closer and the picture changes (see article). Mark Zuckerberg Facebook’s youngfounder resisted going public for as long as he could not least because so many heads of listedcompanies advised him to. He is taking the plunge only because American law requires any firmwith more than a certain number of shareholders to publish quarterly accounts just as if it werelisted. Like Google before it Facebook has structured itself more like a private firm than a publicone: Mr Zuckerberg will keep most of the voting rights for example.The number of public companies has fallen dramatically over the past decade—by 38% inAmerica since 1997 and 48% in Britain. The number of initial public offerings (IPOs) inAmerica has declined from an average of 311 a year in 1980-2000 to 99 a year in 2001-11. Smallcompanies those with annual sales of less than $50m before their IPOs—have been hardest hit.In 1980-2000 an average of 165 small companies undertook IPOs in America each year. In 200109 that number fell to 30. Facebook will probably give the IPO market a temporary boost—several other companies are queuing up to follow its lead—but they will do little to offset thelong-term decline.Companies are like jets; the elite go privateMr Zuckerberg will be joining a troubled club. The burden of regulation has grown heavier forpublic companies since the collapse of Enron in 2001. Corporate chiefs complain that thecombination of fussy regulators and demanding money managers makes it impossible to focuson long-term growth. Shareholders are also angry. Their interests seldom seem to be properlyaligned at public companies with those of the managers who often waste squillions on empirebuilding and sumptuous perks. Shareholders are typically too dispersed to monitor the men onthe spot. Attempts to solve the problem by giving managers shares have largely failed.At the same time alternative corporate forms are flourishing. Once “going public” was everyCEO’s dream; now it is perfectly respectable to “go private” like Burger King Boots andcountless other famous names. State-run enterprises have recovered from the wreck ofcommunism and now include the world’s biggest mobile-phone company (China Mobile) itsmost successful port operator (Dubai World) its fastest-growing big airline (Emirates) and its 13biggest oil companies.No doubt the sluggish public equity markets have played a role in this. But these alternativecorporate forms have addressed some of the structural weaknesses that once held them back.Access to capital? Private-equity firms helped by tax breaks and venture capitalists both havecash to spare and there are private markets such as SecondMarket (where $1 billion-worth ofshares has changed hands since 2008). Limited liability? Partners need no longer be fully liable and firms can have as many partners as they want. Professional managers? Family firms employthem by the HBS-load and state-owned ones are no longer just sinecures for the well-connected.Make capitalism popular again9 The Endangered Public Company The Economist 19-May-2012Does all this matter? The increase in the number of corporate forms is a good thing: a variedecosystem is more robust. But there are reasons to worry about the decline of an organisationthat has spread prosperity for 150 years.First public companies have been central to innovation and job creation. One reason whyentrepreneurs work so hard and why venture capitalists place so many risky bets is because theyhope to make a fortune by going public. IPOs provide young firms with cash to hire new handsand disrupt established markets. The alternative is to sell themselves to established firms—hardly a recipe for creative destruction. Imagine if the fledgling Apple and Google had beenbought by IBM.Second public companies let in daylight. They have to publish quarterly reports holdshareholder meetings (which have grown acrimonious of late) deal with analysts and generallyconduct themselves in an open manner. By contrast private companies and family firms operatein a fog of secrecy.Third public companies give ordinary people a chance to invest directly in capitalism’s mostimportant wealth-creating machines. The 20th century saw shareholding broadened as statefirms were privatised and mutual funds proliferated. But today popular capitalism is in retreat.Fewer IPOs mean fewer chances for ordinary people to put their money into a future Google.The rise of private equity and the spread of private markets are returning power to a club ofprivileged investors.All this argues for a change in thinking—especially among the politicians who have heapedregulations onto Western public companies blithely assuming that businessfolk have no choicebut to go public in the long run. Many firms now go (or stay) private to avoid red tape. The resultis that ever more business is conducted in the dark with rich insiders playing a more powerfulrole.Public companies built the railroads of the 19th century. They filled the world with cars andtelevisions and computers. They brought transparency to business life and opportunities to smallinvestors. Because public companies sell shares to the unsophisticated policymakers are right toregulate them more tightly than other forms of corporate organisation. But not so tightly thatentrepreneurs start to dread the prospect of a public listing. The public company has long beenthe locomotive of capitalism. Governments should not derail it.10Can the endangered public company survive? Should it surviveEvaluate the challenges that for-profit public companies face from recurrent scandals political attacks and alternative corporate structures such as the B-corp. Can public companies survive? Should they survive?Use the Special Report from The Economist as a starting point. Draw on additional sources as appropriate.10 pages
