Corporate Responsibility and society

The endangered public company

The big engine that couldn’t

Public companies have had a difficult

decade, battered by scandals, tied up by

regulations and challenged by alternative

corporate forms

May 19th 2012 | from the print edition

PUBLIC companies have been the locomotives of capitalism since they were invented in the

mid-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, shunting

aside older forms of corporate organisation such as partnerships, and newer rivals such as state-

owned enterprises (SOEs). China’s former president, Jiang Zemin, described NASDAQ as “the

crown jewel of all that is great about America”. Russia rejected five-year plans in favour of

stockmarket listings and Wall Street banks abandoned cosy partnerships in favour of public

equity: Goldman Sachs, the last big holdout, went public as the decade came to an end.

The Endangered Public Company, The Economist, 19-May-2012

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Related topics

 Private equity  Google  Mark Zuckerberg  Facebook  Asia

Public companies triumphed because they provided three things that make for durable success:

limited liability, which encourages the public to invest, professional management, which boosts

productivity, and “corporate personhood”, which means businesses can survive the removal of a

founder. In 1997 the number of American companies reached an all-time high of 7,888 (see chart

1). 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”, by

Michael Jensen of Harvard Business School, has turned out to be prescient. In 2001-02 some of

America’s most prominent public companies imploded. They included Enron, Tyco, WorldCom

and Global Crossing, which, before their demise, were admired. Six years later Lehman Brothers

collapsed 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 the

biggest fishes in the sea. Private-equity firms flourished in the West, challenging the idea that

public companies are the best managed. And the rise of the Asian economies, with their legions

of family-owned conglomerates, challenged the idea that they are best equipped to advance

capitalism’s geographical frontier.

So, even though public companies are flush with cash (American firms are sitting on $2.23

trillion, 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 health

are misleading. Public companies are in danger of becoming like a fading London club. Their

The Endangered Public Company, The Economist, 19-May-2012

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membership is falling. They spend their time fussing over club rules. And, as they peer out of the

window, 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 public

offerings (IPOs) in America dropped from an average of 311 a year in 1980-2000 to just 81 in

2011 (chart 2).

Going public no longer has the glamour it once had. Entrepreneurs have to wait longer—an

average of ten years for companies backed by venture capital, compared with four in 1985—and

must jump through more hoops. Lawyers and accountants are increasingly specialised and

expensive; 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 famine

Even when their firms do go public, the most successful technology entrepreneurs manage to

preserve a lot of personal control. 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.

The IPO crisis has coincided with a boom in other corporate life forms. Familiar companies have

started to put unfamiliar letters after their names: Chrysler LLC and Sears Brands LLC. The

University of Illinois’s Larry Ribstein called this “the rise of the uncorporation”.

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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.

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 limited

their number. This meant partners could be ruined if their company failed (as Dombey was) but

could not expand if it boomed. 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. The

former CEO of the Gap retail chain made $300m running J.Crew, a clothing firm, on behalf of

Texas Pacific.

Policymakers have embraced alternatives to the public company, too. Britain’s Conservative

prime minister, David Cameron, is happier praising employee-owned John Lewis than your

average PLC (public limited company). American corporate reformers regularly cite a private

firm, 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 their

employees but shield themselves from the capital markets. Employees become co-owners when

they join and may not sell their shares when they leave.

Governments have made it easier to create such alternative corporate structures. Seven American

states have passed laws to allow companies to register as “B” corporations which explicitly

subordinate profits to social benefits. The British government has established a class of

Community Interest Companies which issue shares and dividends but exist to promote social

purposes. It has also handed over the management of hospitals to “trusts”— public-private

hybrids.

The rise of new economic powers has further changed corporate organisation. In the 1990s it

seemed 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 family

conglomerates. These companies list on the stockmarket but do little to constrain the power of

the 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 oil

companies, the biggest gas company (Gazprom), the biggest mobile-phone company (China

Mobile), the biggest ports operator (Dubai Ports).

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The most serious challenge to SOEs comes from family-controlled conglomerates. Family

businesses account for about half of listed companies in the Asia-Pacific region and two-thirds in

India. Families exercise tight control of their empires—and limit the power of other

shareholders—through a variety of mechanisms such as family-controlled trusts (which have

more power than boards), appointing family members to managerial positions and attaching

different voting rights to different classes of stock. Diversified family firms are good at taking a

long-term view, diverting money from cash cows to new industries that might take a long time to

produce results. They are also good at dealing with the government failures that plague emerging

markets. It is remarkable how fast even India’s lumbering government can move if a Tata or an

Ambani calls.

Family companies of a different type have had a good decade in Europe. German family firms

have 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 pride

themselves 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 choose

their CEOs through primogeniture compared with two-thirds of family-owned firms in Britain

and France. They also pride themselves on long-termism, investing heavily in training and

upgrading their machinery.

Getting better versus getting worse

Some of the reasons for the decline of public companies and the success of alternatives may

prove temporary. The fall in the number of listed firms owes something to the dotcom bust, a

one-off event. The private-equity boom was fuelled by cheap debt. SOEs have been

turbocharged by the rise in the price of oil and other commodities. The next decade may not be

as easy for the emerging-world’s family conglomerates as the past decade. But there is also

something more fundamental going on: these various corporate forms have all learned how to

manage their problems better than public companies have, while continuing to exploit their

advantages.

The biggest advantage of SOEs is political: ties with governments can protect them from

unwelcome competition. That, of course, is also their problem: they can easily become bloated

and lazy. So state-capitalist governments, particularly the Chinese, have turned to overseas

listings 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 family

feuds and a lack of professionalism in the second or third generations. So, like state-capitalist

governments, family companies are turning to market mechanisms: professional managers,

private-equity firms and private markets such as SecondMarket and SharesPost, which allow

private firms to trade shares without public scrutiny.

In contrast, public companies have got worse at managing their problems, three in particular. Mr

Jensen 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).

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Agents have a nasty habit of trying to feather their own nests. Dennis Kozlowski, Tyco’s former

boss, even spent company money throwing a $2.1m birthday bash for his wife that featured a

Manneken-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 reflect

company performance so they act like owners. This has backfired: some bosses manipulated

their companies’ share prices to enrich themselves and most have seen their pay outpace

company performance. The total remuneration of FTSE 100 chief executives rose by an annual

average 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 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. America has

introduced a raft of new rules, from the 2002 Sarbanes-Oxley legislation on accounting to the

Dodd-Frank financial regulations of 2010. According to one calculation, Sarbanes-Oxley

increased 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 Capital

Management, a hedge-fund advisory firm, chose to raise $880m in a private placement rather

than an IPO because, as the founders put it, “they were happy to sacrifice a little public market

liquidity, and even take a slightly lower valuation, in return for a less onerous regulatory

environment and the benefits of remaining private.”

The third problem is growing short-termism. The capital markets have increased their power

dramatically with the rise of huge institutional investors and the intensification of shareholder

activism. Mutual funds count their money in trillions rather than billions. Data providers such as

Risk Metrics arm shareholder activists with plenty of ammunition. And hedge funds are not

afraid to take on corporate Goliaths such as McDonald’s and Time Warner if they think they are

failing. And as capital markets have flourished, corporate life has become riskier. The average

life expectancy of public companies shrank from 65 years in the 1920s to less than ten in the

1990s. So has the life expectancy of CEOs. The average job tenure of the CEO fell from 8.1

years in 2000 to 6.3 years in 2009, according to Booz & Co, a consultancy. Léo Apotheker lasted

just 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). Companies

must strike a balance between the short and long term, satisfying the market’s demand for profits

today, while planning for the future. The worry is that regulators and owners both seem to be

making it harder for bosses to look beyond quarterly earnings. Boards are devoting less time to

strategy 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 to

another. Standard Life Investors complains that the noise generated by quarterly earnings has

become an “unwelcome distraction” from thinking about the long term.

Public company as public good

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What should one make of the public company’s travails? There is every reason to celebrate the

fact that businesses have more corporate forms to choose from. Indeed, the menu should be

lengthened by inventing new arrangements or revisiting old ones. France’s “SCAs” or Sociétés

en Commandite par Actions have two tiers of partners: general ones jointly and severally liable

for a company’s debts, and limited partners who are ordinary shareholders with little power and

who 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-equity

industry function properly if private investors cannot easily cash out through IPOs? Can SOEs

avoid stagnation if conventional multinationals are struggling? Public companies are parts of an

ecosystem of innovation and job creation. IPOs give venture capitalists and entrepreneurs a

chance to make fortunes if they spot a game-changing idea. They also provide new companies

with capital. The Kauffman Foundation has shown that one reason America has been better at

generating jobs than Europe is its skill at creating innovative companies such as Amazon, eBay

and Google. These companies took off when they went public.

William Draper, one of Silicon Valley’s most successful investors, speaks for many when he

argues that this ecosystem may be drying up. 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). This may not be

good for the start-ups. Imagine if Microsoft or Apple had sold themselves to IBM in the 1980s

and you get a sense of the problem.

Public companies produce annual reports, hold shareholder meetings and explain themselves to

analysts. Private companies by comparison operate behind a veil of secrecy. The danger is that

regulators are creating a corporate version of the dual labour market. By shining a spotlight on

public companies, they are encouraging businesses to take refuge in the shade of the private

sector.

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Public companies also foster popular capitalism. The 20th century saw shareholding broadened

thanks to privatisations in the 1980s and the rise of mutual funds. 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.

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 to

them looks unusually strong at the moment, and the auguries for the future grim.

Rival versions of capitalism

The endangered public company The rise and fall of a great invention, and why it matters

May 19th 2012 | from the print edition The Economist.

AS THIS newspaper went to press, Facebook was about to become a public company. It will be

one of the biggest stockmarket flotations ever: the social-networking giant expects investors to

value 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 us

about the state of the public company itself.

At first glance, all is well. The public company was invented in the mid-19th century to provide

the giants of the industrial age with capital. That Facebook is joining Microsoft and Google on

the stockmarket suggests that public listings are performing the same miracle for the internet age.

Not every 19th-century invention has weathered so well.

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But look closer and the picture changes (see article). Mark Zuckerberg, Facebook’s young

founder, resisted going public for as long as he could, not least because so many heads of listed

companies advised him to. He is taking the plunge only because American law requires any firm

with more than a certain number of shareholders to publish quarterly accounts just as if it were

listed. Like Google before it, Facebook has structured itself more like a private firm than a public

one: 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% in

America since 1997 and 48% in Britain. The number of initial public offerings (IPOs) in

America has declined from an average of 311 a year in 1980-2000 to 99 a year in 2001-11. Small

companies, 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 2001-

09 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 the

long-term decline.

Companies are like jets; the elite go private

Mr Zuckerberg will be joining a troubled club. The burden of regulation has grown heavier for

public companies since the collapse of Enron in 2001. Corporate chiefs complain that the

combination of fussy regulators and demanding money managers makes it impossible to focus

on long-term growth. Shareholders are also angry. Their interests seldom seem to be properly

aligned at public companies with those of the managers, who often waste squillions on empire-

building and sumptuous perks. Shareholders are typically too dispersed to monitor the men on

the 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 every

CEO’s dream; now it is perfectly respectable to “go private”, like Burger King, Boots and

countless other famous names. State-run enterprises have recovered from the wreck of

communism and now include the world’s biggest mobile-phone company (China Mobile), its

most successful port operator (Dubai World), its fastest-growing big airline (Emirates) and its 13

biggest oil companies.

No doubt the sluggish public equity markets have played a role in this. But these alternative

corporate 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 have

cash to spare, and there are private markets such as SecondMarket (where $1 billion-worth of

shares 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 employ

them by the HBS-load and state-owned ones are no longer just sinecures for the well-connected.

Make capitalism popular again

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Does all this matter? The increase in the number of corporate forms is a good thing: a varied

ecosystem is more robust. But there are reasons to worry about the decline of an organisation

that has spread prosperity for 150 years.

First, public companies have been central to innovation and job creation. One reason why

entrepreneurs work so hard, and why venture capitalists place so many risky bets, is because they

hope to make a fortune by going public. IPOs provide young firms with cash to hire new hands

and 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 been

bought by IBM.

Second, public companies let in daylight. They have to publish quarterly reports, hold

shareholder meetings (which have grown acrimonious of late), deal with analysts and generally

conduct themselves in an open manner. By contrast, private companies and family firms operate

in a fog of secrecy.

Third, public companies give ordinary people a chance to invest directly in capitalism’s most

important wealth-creating machines. The 20th century saw shareholding broadened, as state

firms 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 of

privileged investors.

All this argues for a change in thinking—especially among the politicians who have heaped

regulations onto Western public companies, blithely assuming that businessfolk have no choice

but to go public in the long run. Many firms now go (or stay) private to avoid red tape. The result

is that ever more business is conducted in the dark, with rich insiders playing a more powerful

role.

Public companies built the railroads of the 19th century. They filled the world with cars and

televisions and computers. They brought transparency to business life and opportunities to small

investors. Because public companies sell shares to the unsophisticated, policymakers are right to

regulate them more tightly than other forms of corporate organisation. But not so tightly that

entrepreneurs start to dread the prospect of a public listing. The public company has long been

the locomotive of capitalism. Governments should not derail it.