By Revealing More, Private Firms May Lure Investors Away From Public Equity

Investments in publicly traded companies shift when their private competitors share information, a new study finds.

December 15, 2022

| by Maggie Overfelt
llustration of an outstretched arm holding a magnifying glass, and a man walking up the arm toward it. iStock/SvetaZi

Globally, 98% of all financial disclosures come from privately held firms. | iStock/SvetaZi

It can be pretty easy to track the impact of public companies’ disclosures on the global movement of public equity. Look at how the Nasdaq rises whenever Apple reports positive news about its supply chain, for example. Or how the tech-heavy stock index fell more than 2% in October when Google’s parent Alphabet reported declining YouTube ad revenue — news that spurred investors to move their money out of other firms that rely on digital ad spending.

But what happens to the markets when private firms disclose financial information? Does it have a similar effect on public equity? A new paper coauthored by Jinhwan Kim, an assistant professor of accounting at Stanford Graduate School of Business, tackles this question by comparing the number of financial disclosures from private companies to the global movement of public equity investment dollars.

Kim’s research suggests that investors lose their appetite for buying shares in public firms when private firms in the same sector are more transparent. Specifically, a 10% increase in private firm disclosures is associated with a 4.3% — or $358 million — decrease in equity demand by global investors.

“It’s important because every economic agent — investor, regulator, etc. — has to make their investment decision based on information that’s primarily coming from corporate disclosures,” says Kim, who conducted the research with Marcel Olbert, an assistant professor of accounting at London Business School. “While a lot of the focus in this type of research has to do with publicly traded firms, if you look at more of a global scale, 98% of all financial disclosures are from privately held firms.

Private firms’ disclosures are hot right now, especially those coming from pre-IPO buzzworthy sectors like tech, biotech, and healthcare. Yet despite the economic importance of investors knowing as much as possible about firms they’re hoping to inject capital into, there’s a dearth of such information from U.S. private corporations, which are exempt from most SEC registration requirements.

Responding to Disclosure

To that end, Kim and Olbert’s analysis didn’t include U.S. firms in its sample, which centers on companies from France, Germany, Japan, and other countries where private firms are subject to more disclosure oversight. Mining the Orbis database, the researchers looked at the total number of financial statement line items that private firms disclosed between 2003 and 2017. Using data from the Global Capital Allocation Project, they then compared those numbers with capital investment in public firms in the same year and sector. For example, the researchers were able to track U.S. investors’ annual demand for shares of public manufacturing firms in Japan versus Germany.

While regulating private firms to disclose more information can have a host of benefits, it can also hurt public firms that are losing demand as a result of making their nonpublic counterparts more competitive.
Jinhwan Kim

Kim and Olbert found that when private firms disclosed a sizeable amount of financial information, public companies in the same industry and country received a smaller infusion of investor capital in the year after these disclosures became available. Without insight into investors’ decision-making, the researchers can’t say if this money was funneled into private firms. Yet their findings shed light on the value of transparency and company-specific metrics to global investors.

Kim and Olbert also found that increases in each of the three types of information that private companies tend to disclose — balance sheet items, income statements, and footnote entries — are associated with a significant drop in public equity demand. “These findings suggest global investors find various elements of the financial statements useful when reallocating capital,” they write.

Kim says that figuring out which elements of private firms’ financial disclosures are most valuable to investors requires more digging. “Right now, we’re simply counting line items,” he says. “Are there more sophisticated ways to operationalize and delve deep to access the context of the data? Maybe there’s something in the footnote disclosures that has qualitative information about employees, for example.”

While further dissection of private firms’ disclosures may yield clearer insight into investors’ preferences for investing in public versus private companies, the new findings can also serve as a starting point for policymakers. “It’s not just about those entities that are being regulated, but what about unintended targets?” Kim says. “While regulating private firms to disclose more information can have a host of benefits, it can also hurt public firms that are losing demand as a result of making their nonpublic counterparts more competitive.”

Up next for Kim and Olbert: Exploring whether or not environmental, social, and governance (ESG) initiatives are causing inequality in investing. It’s costly for firms to implement ESG plans, says Kim, and many do so because “society is forcing them to — there is evidence showing that if you adopt these, you are rewarded by being a more favorable target for investors. Richer firms can afford to do such virtue signaling, but the poorer firms who can’t must not only bear the costs, they could be losing investors, too.”

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