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Company ownership in question

For an increasing number of companies, having large numbers of outside shareholders is the wrong form of ownership
January 9, 2020

Stock markets have fallen out of favour with company owners. Around the world, the number of companies listing on stock markets last year fell to a three-year low. And the takeover of Cobham by US private equity firm Advent reminds us that many companies now prefer more concentrated ownership.

These developments continue a long-term trend. The number of companies listed on the UK stock market has fallen from 2,093 in 1999 to just 1,146 now. This means that fewer than one UK company in 2,500 is now quoted on the stock market. The number of listed smaller companies has fallen even more. In 1999 there were more than 1,200 companies on the market with a capitalisation of under £100m. Today, there are fewer than 400.

This steady decline in the number of listed companies tells us something important – that the market believes that, in many cases, it is not a good idea for companies to be owned by many dispersed outside shareholders.

A big problem with such ownership is that it means that nobody has the incentive (or, often, ability) to properly monitor management. This is because of the classic problem of collective action. For each individual shareholder, the costs of such monitoring are high (the time and effort of getting to grips with the minutiae of the company) while the benefits of doing so are small: a higher share price would add only a little to the value of a diversified portfolio. Each individual shareholder thus has an incentive to free-ride on the efforts of others, with the result that nobody does the job. The upshot is that managers can plunder the company by extracting big salaries or – much more seriously – by making bad investments.

And even when shareholders do put pressure on managers, they often force them to deliver things they can easily track, such as short-term earnings, rather than do things that maximise longer-term profits. For this reason, Jonathan Haskell, now a member of the MPC, has said that equity investors tend to undervalue intangible assets and discourage research and development.

By contrast, a great advantage of private equity and venture capital is that more concentrated ownership puts managers on a tighter leash. Better still, such owners often have the expertise to give managers specialist advice and contacts.

Because markets (albeit very imperfectly) tend to transfer ownership of assets to those who can use them best and value them the most, this advantage of concentrated ownership has caused a decline in stock market listings over time.

This does not, however, mean that stock markets are redundant.

One great thing they do is to allow entrepreneurs to cash out by floating their companies. Yes, they often do so at inflated prices: new stocks tend to fall in the months after flotation. But this is a good thing. It incentivises entrepreneurship, which is what we want as citizens and consumers, if not as investors.

There’s something else to be said for a stock market listing. Having easily tradeable shares allows owners to reduce exposure to risk by limiting their ownership to small stakes. This is why businesses exposed to big cyclical risks tend to be quoted, such as miners, housebuilders and banks. Because of this, companies can raise more from a stock market listing than they can from private equity or venture capital. This is why very large companies are more likely to be listed than small ones.

And in some cases the inefficiencies caused by inadequate monitoring of managers are tolerable. If a company has lots of great investment opportunities it’s no disaster if it chooses second-best ones: a return on equity of (say) 20 per cent rather than 30 per cent is tolerable. This is one good reason why the number of stock market listings rises in booms – because this is when investors believe there are more investment opportunities. It also explains why the number of listed companies has fallen in our era of secular stagnation. When profitable opportunities are scarce, companies must make the best use of the few they have. And concentrated rather than dispersed ownership is one way to achieve this. It is also for this reason that companies in mature or declining industries are better owned by private equity rather than by dispersed shareholders.

But, of course, private equity is only one of several alternatives to a stock market listing. And it too has drawbacks.

One thing we know about innovation is that it spills over: good ideas in one company can help other companies. This is one reason why Yale University’s William Nordhaus has found that companies capture “only a miniscule fraction of the social returns from technological advances”. Such spillovers mean that companies underinvest in such innovations. This, plus the fact that reducing carbon emissions requires massive investments in new power plants, is why many economists support a green new deal – state-owned and financed investments in green technologies.

In other cases, business success depends on monitoring and selecting the right employees. For these, worker ownership often works best, because employees often know best who their best peers are. This is why legal, medical and accountancy practices are usually owned by partners rather than shareholders or private equity.

For investors, all this poses a question. We should ask of each company we’re considering investing in: is this really suited to a stock market listing? If the answer is no, its price might get a big boost if the company is bought by a private equity firm. If it isn’t, however, it might be destined for long-term decline. It’s no accident that the last two decades have seen not only a fall in the number of listed companies, but also poor returns on many of those companies that are still on the market.

It also has a more obvious, and more easily implemented, implication. All this suggests that the best growth opportunities might be found not among listed equities, but among private equity and venture capital funds.