This paper review Omer Brav’s empirical study on capital, capital structure and financial policy on privately held firms in respect of their public counterparts. Focus will be put on the main author’s findings along with the brief description of the methodology and data used in support of the findings.
Brav has empirically examined relatively unexplored topic from the perspective of privately held firms. He provides evidences that public and private companies have systematic differences regarding their financial policies, due to the fact that private equity capital is more expensive than the public equity capital. As main factors contributing to this, are stated ownership structure and information asymmetry. Moreover, he shows that access to public equity capital has influence on other aspects of firms’ funding and investments such as cash management and dividend policy.
Methodology and Data
Brav tests the trade-off and pecking order theories regarding their predictions of the systematic differences between public and private firms. He refers to the Myers’s and Majluf’s pecking order theory (1984) and its prediction that firms will rely less on equity and more on debt, as asymmetric information between insiders and outsiders increases. Author also refers to the trade off theory which predicts that firms tend to create optimum capital structure where marginal costs of the equity and debt equals. At the optimal debt ratio, private firms will prefer internal financing as it becomes more expensive to raise capital in the external markets. He groups the predictions into level and sensitivity effect. The consequence from level effect is that the probability that private firms choose equity over debt is lower compared to public firms, because for them equity has higher relative cost compared to the debt. The consequence from sensitivity effect is that private firms have more passive financial policies than public firms, as it is more costly for them to obtain equity capital. Under the assumption that private equity is more expensive than public equity, Brav formulated and examined the following level effect (L1, L2) and sensitivity effect (S1, S2, S3, S4) hypothesis: “L1: Private firms have higher debt ratios than public firms”; “L2: Conditional on visiting the external capital market and facing the debt-equity choice, private firms are less likely to use equity than public firms”; “S1: Compared to public firms, private firms’ financial policies are more passive, that is, private firms are less likely to raise or retire capital”; “S2: Compared to public firms, private firms’ leverage is more sensitive to operational performance and less sensitive to other variables that the traditional trade-off theory predicts to be determinants of a firm’s capital structure”; “S3: The leverage of private firms exhibits greater persistence and lower adjustment speed”; “S4: Compared to public firms, private firms’ financial policy is less in line with the target adjustment hypothesis. That is, the debt-equity choice of private firms exhibits a weaker tendency to move leverage toward its target”. Concerning the data, Brav used several databases to obtain information about UK public and private firms for the period of 1993 to 2003: Financial Analysis Made Easy (FAME) database; SDC Platinum, Zephyr, Worldscope and World Development Indicators (WDI). The sample includes medium and large companies in compliance with the auditing requirements that is, companies which have annual sales of more than 350,000 pounds per annum before June 2000 and annual sales of more than 1,000,000 pounds after June 2000.
Summary Statistics show significant differences between private and public firms. For example, private firms have higher average and median short term debt ratios of 63.7% and 72.7% respectively, compared to the public firms with 36.9% and 29.0%, respectively. Brav argues that these major differences are caused by the fact that private firms are limited to the short-term borrowing on the debt market in providing liquidity, while public companies have more options such as combining equity and public debt. Additionally, firms’ decision for going public is determined by the greater growth rates and need for capital. Also, he found evidences that private companies who go public afterwards have decrease in their leverage and increase in the equity issuing. What he surprisingly discovered is that public firms have larger proportion of cash to total assets. Further, author focused his research on the access to public capital and its impact on firms’ financial policy. Using cross-sectional regression, he discovered more supporting evidences for hypothesis L1 and S2. His results are in line with Faulkender and Peterson (2006) findings: “when frictions in the debt (equity) channel are larger, firms exhibits a preference for equity (debt) financing”. Moreover, Brav shows that frictions have impact on leverage sensitivity to other variables, not only on the leverage’s level. Author fails to reject S3 hypothesis and concluded that private firms are more passive in rebalancing their leverage. He retested the hypothesis by following Frank and Goyal (2003) disaggregating deficits approach, and provided further evidences in support of S3 hypothesis which show that private firms finance each component of their deficit with more debt than equity. Differences in decision making between public and private firms to raise or retire capital are also investigated. Results show that public and private firms raise external capital only when they have to, and smaller the company is greater the probability to raise or retire capital. Brav explains that public firms are more active in issuance because of the lower costs. However, he offers an alternative explanation for more active capital issuance of public firms. He refers to Easterbook (1984) who argues that public firms have higher dividend payouts due to conflict of interest between managers and owners. In general, evidences are in favour of S1 hypothesis. Regarding L2 hypothesis, results show that dummy variable for public firms is highly positively significant which indicates that public firms prefer more equity over debt. Moreover, for all public and private firms in the sample, he calculated predicted probability that firm will choose equity and find out that predicted probability is greater for public than for private companies. Tests also support S4 hypothesis with only one exception: “profitability effect is larger for private firms in repurchase regression”. Author argues that this is due to the difficulties of unprofitable private firms to obtain permission from banks for refinancing their debt. Furthermore in his analysis, Brav reveals that ownership structure and information asymmetry is the frictions which influence public equity to be less costly than private equity. Public companies are more in favour for equity financing because of the management control concerns. Issuing stocks is positively (negatively) related to the extent of managers’ (shareholders’) control i.e. more stocks ‘issuing, less dominant shareholders and more powerful managers. Taking into consideration public firms’ feature of strict separation between ownership and management, managers in public firms are willing to use issuing equity as a tool for control keeping. Additionally, Brav re-examined the debt-equity choice from the perspective of information asymmetry between “insiders and outsiders” by using a smaller sample. He shows that as private firms are less transparent and as equity’s value is more sensitive to information asymmetry than debt’s value, equity is more expensive and less attractive for private firms compared to the public firms. Given the above mentioned findings, Brav examined how financial policy affects firms’ debt ratios, cash management, investment decisions and dividend policy. Results from regression demonstrate that debt ratios of private firms are more affected by their performance as they adjust the leverage less often through the external capital markets compared to the public firms. Also, limited access to capital affects private companies to preserve more cash when are operating in favourable market conditions and to reduce it faster in crisis circumstances. Thus, private firms’ investment decisions in a situation of an increased profitability are lagging. Opposite of private firms, public firms use without a delay extra cash made to enhance their investments. Regarding the dividend policy, his findings show that it is more stable and less affected by changes in performance for public rather than for private firms.
Empirical study of Omar Brav has documented significant differences between public and private firms regarding their capital structure and financial policy. First, Brav shows that private firms prefer debt over capital compared to public firms, because of the higher relative cost of equity to the debt capital. Also, private firms have more passive financial policies than public firms, as it is more costly for them to obtain equity capital. Second, he identified ownership structure and information asymmetry as main contributors to the different capital structure and financial policy of private and public firms. In this direction, issuing stocks is negatively related to the extent of shareholders’ control. Thus, as private firms usually have few shareholders with significant control power, issuing equity becomes more costly option for them. In addition, he shows that cost of equity is higher for private firms, because they are less transparent and their equity value is more affected by the information asymmetry than the debt value. At the end, Brav shows that limited access to capital has influence on private companies to preserve more cash and to delay investments in good times. More concrete, private firms’ debt ratios, investment decisions and dividend policy are more sensitive to their performance compared to the public companies.