Capital Market Access and Financing of Private Firms n

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1 International Review of Finance, 11:2, 2011: pp DOI: /j x Capital Market Access and Financing of Private Firms n VIDHAN K. GOYAL w, ALESSANDRO NOVA ¼ AND LAURA ZANETTI ¼ w Department of Finance, Hong Kong University of Science and Technology, Kowloon, Hong Kong, and ¼ Università Bocconi, Via Röntgen 1, Milan, Italy ABSTRACT How does capital market access affect the capital structure decisions of firms? To examine this question, we compare the financing decisions of a large sample of private and public companies from 18 different European countries. We find significant differences in the leverage policies of private and public firms. Private firms have much higher leverage ratios than public firms. In particular, the leverage of private firms is more negatively related to past profitability, consistent with their less active adjustment. Other evidence corroborates sluggish adjustment and suggests that private firms face significantly higher cost of accessing external capital markets. When we compare private and public firms in countries that differ on creditor rights and contract enforceability, we find more pronounced differences in the leverage policies of private and public firms in countries that are strong on legal rights and their enforcement. In countries with weak rights and poor enforcement, the financing policies of public firms begin to resemble those of private firms. I. INTRODUCTION Much theoretical work on capital structure characterizes the choice between debt and equity in a tradeoff context in which firms determine their optimal leverage by comparing the benefits and costs of debt financing. The tests of the theory, for the most part, rely on cross-sectional regressions that explain variation in capital structure policies based on firm characteristics such as firm size, profitability, asset tangibility, growth opportunities, and industry median leverage (Rajan and Zingales 1995; Lemmon et al. 2008; Frank and Goyal 2009). Much of this literature implicitly assumes that a firm s leverage is determined by its demand for debt and equity. The supply is considered infinitely elastic at the right price. However, many firms face significant frictions in raising capital. With restricted access to capital market, firms observed leverage choices will also reflect supply side frictions. Understanding the extent to which supply side n We thank Sudipto Dasgupta and Murray Frank for many helpful comments and discussions. Vidhan Goyal thanks the Research Grants Council of the Hong Kong Special Administrative Region for financial support (Project No ).. International Review of Finance r International Review of Finance Ltd Published by Blackwell Publishing Ltd., 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

2 International Review of Finance factors affect firms leverage policies has been an important focus of recent capital structure research (Faulkender and Petersen 2006; Brav 2009; Leary 2009; Lemmon and Roberts 2010). In this paper, we use a large sample of public and private firms from 18 European countries to test the effects of capital market access on corporate financing. Private firms have restricted access to external capital markets. They are typically controlled by major shareholders who are understandably reluctant to issue external equity for fear of losing control (Stulz 1988; Amihud et al. 1990). Private firms provide lower disclosure and offer less protection to minority investors. The greater information asymmetry at private firms also increases the severity of adverse selection problems in private firms. Overall, we expect private firms relative costs of equity to debt to be larger than for public firms (Brav 2009). 1 We focus on two main questions. First, does significant variation in access to capital markets results in large differences in how private firms determine their capital structure compared with otherwise similar public firms? Second, do cross-country institutional differences in legal rights and contract enforcement amplify the variation in the financing policies of private and public firms? On the first question, we expect that private firms will prefer debt over equity when raising external finance given their higher cost of equity financing. Private firms will consequently become more levered. We also expect the leverage of private firms to be relatively more sensitive to profitability. Private firms retain more and buffer up on debt capacity. Furthermore, in dynamic trade-off models, such as those of Fischer et al. (1989) and Strebulaev (2007), firms passively accumulate earnings between refinancing points. Since private firms face higher costs of external finance, they are likely to be farther away from refinancing points compared with public firms. Consequently, in crosssectional leverage regressions, we expect private firms to exhibit a relatively larger negative coefficient on profitability. At the same time, the cost disadvantage that private firms face due to restricted access to external capital markets implies that leverage of private firms will be less sensitive to factors that are known to affect target leverage ratio. Thus, leverage of private firms will be less sensitive to factors such as firm size, asset tangibility and firm growth. On the second question, we expect weak rights and poor enforcement to reduce the advantages that public firms have in accessing public markets. 2 1 Since equity is junior to debt, its value is relatively more sensitive to private information (Myers and Majluf 1984; Noe 1988). 2 The effect of legal institutions on the costs of external financing is examined in a number of recent papers. For example, Hail and Luez (2006) find a significant effect of legal institutions on the cost of equity, which they estimate from share prices and analysts forecasts. On the debt side, Miller and Puthenpurackal (2002) examine how investor protection affects premiums on Yankee bonds and Laeven and Majnoni (2005) examine the effect of property rights enforcement on country-level interest rate spreads. Creditor rights and enforcement of property rights also affect the pricing and structure of syndicated loans and have been shown to affect the interest rates on loans, loan maturity, the syndicate structure, and syndicate composition (Esty and Megginson 2003; Esty 2006; Gatti et al. 2007; Qian and Strahan 2007; Bae and Goyal 2009). 156 International Review of Finance r International Review of Finance Ltd. 2011

3 Capital Market Access and Financing Thus, we predict the differences in leverage policies of private and public firms will be more amplified in countries with strong legal rights and enforcement. Our results show large differences between the financing decisions of private and public firms. Private firms have substantially higher leverage than public firms. The average debt to capital ratio of private firms is 36% compared with 30% for public firms. Even larger differences exist when we examine the total liabilities to assets ratio (68% for private firms versus 54% for public firms). These findings are consistent with those of Brav (2009) who compares public and private firms in the United Kingdom. The data also show that private firms exhibit heavier reliance on short-term loans than on long-term debt. Private firms also rely much more on trade credit than do public firms. Profitability negatively affects the leverage of both private and public firms, but the effects are significantly larger for private firms than for public firms. 3 And, consistent with our predictions, we find that both collateral values and firm size have a relatively smaller effect on the financial policies of private firms. In addition, the results show that firm age has a significant effect on the leverage of private firms but not so for public firms. As firm age increases, private firm leverage decreases. There are two possible explanations for this finding. One possibility is that as firms get older, they become more profitable and therefore rely less on debt financing. The other possibility is that age increases transparency which reduces the cost of raising external equity. With either explanation, we expect age to reduce leverage for private firms but not so for public firms. When we examine leverage of firms in countries that differ on the strength of creditor rights and the protection of property rights, we find that in countries with strong rights and enforcement, there are relatively more pronounced differences in capital structure policies of private and public firms. For example, in countries with strong protection of property rights, the average debt to capital ratio of private firms is 42% versus 33% for public firms. By contrast, in countries with poor enforcement of rights, leverage ratios of public firms do not differ all that much from those of private firms (31% for private firms versus 29% for public firms). We find similar differences when we stratify the sample based on creditor rights. These findings suggest that benefits of capital market access for public firms are heavily influenced by the legal environment in which the firm operates. The listing status of a company confers fewer benefits of access to capital markets when investors are poorly protected and contracts are poorly enforced. Confirming the leverage findings, we find that the differences in the effects 3 The negative relation between leverage and profitability is a well known result in the literature (Rajan and Zingales 1995; Frank and Goyal 2003, 2008, 2009). Its interpretation is subject to a great deal of debate. Myers (1993) and Fama and French (2002) consider this to be a key rejection of the trade-off theory. Frank and Goyal (2011) provide a different interpretation of the empirically observed negative relation between leverage and profitability. International Review of Finance r International Review of Finance Ltd

4 International Review of Finance of various firm characteristics on the leverage of private and public firms are also more pronounced in countries with strong rights and enforcement. Our results on how capital market access affects the financing of private firms contribute to the growing literature on how supply side frictions affect the financing decisions of firms. The results on higher leverage for private firms complement those of Faulkender and Petersen (2006) who find that among public firms, those without access to debt markets have significantly lower leverage. In our context, we show that private firms without access to public equity markets become more levered. Frank and Goyal (2008) show that at the aggregate level, the financing policies of private firms differ from those of public firms. Using data from the US Flow of Funds Accounts, they show that private firms rely more on retained earnings and bank debt than public firms do. Small public firms make more active use of equity financing while large firms primarily use retained earnings and corporate bonds. The closest study to this work is that of Brav (2009) who compares the capital structures and financial policies of public and private firms in the United Kingdom. For the most part, Brav finds similar results as we do. Our contribution here is to show that the differences in the financial policies of private and public firms hold more broadly for a larger cross-section of countries. In addition to the use of a larger sample with more countries, we establish that peer leverage has significantly larger effects on the financial policies of private firms. These results are new and are worth exploring in future work. There is also a growing literature that examines the effects of institutional differences on the leverage choices of firms. The literature largely focuses on publicly listed firms, although there are a few papers that also examine unlisted firms. Many papers examine whether leverage factors are similarly correlated with debt ratios in different countries. In an influential paper, Rajan and Zingales (1995) examine the leverage ratios of firms in G7 countries and find significant similarities in how different firm characteristics relate to the leverage of firms across these countries. Similarly, Booth et al. (2001) examine the leverage policies of firms in developing countries and find that factors affecting leverage in developing countries are similar to those affecting leverage in developed countries. Other papers in the literature examine whether cross-sectional variation in the institutional environment affect capital structure choices of firms (Demirgüç-Kunt and Maksimovic 1999; Claessens et al. 2000; Bancel and Mittoo 2004; Jong et al. 2008; Fan et al. 2010). Overall, the conclusion this literature draws is that country-specific factors play an important role in determining the leverage choices of firms. Unlisted firms are also examined in several recent papers. Giannetti (2003) examines unlisted firms and shows that financial development and creditor protection affect leverage. Jõeveer (2005, 2006) also examine unlisted firms and conclude that much of the explanatory power comes from a small number of country-level macroeconomic and institutional factors and that country factors explain more of the variation in 158 International Review of Finance r International Review of Finance Ltd. 2011

5 Capital Market Access and Financing the leverage of unlisted firms while industry factors explain more of the variation in the leverage of listed firms. 4 Our contribution to this literature is to show that the effect of capital market access on the financial policies of firms depends to a large extent on the legal rights of investors and the enforceability of contracts in the country. This paper has not dealt with the issue of choice of remaining private or going public. The mitigating factor is that many private firms in our sample are too small to contemplate going public given the listing requirements, the fixed costs associated with going public, and increased disclosure and administrative costs of staying public. But there are other private firms that clearly have a choice of going public. The literature shows that investment opportunities, firm age, and firm size are key determinants of going public decision of firms (Pagano et al. 1998; Brav 2009). While we control for all of these effects, it is possible that unobserved factors affecting a firm s decision to stay private also determine its financing policies. Understanding what determines a firm s decision to go public is an interesting question in and of itself, and we leave that for future research. The rest of the paper proceeds as follows. In Section II, we describe our data and the sample selection process. Section III presents the average balance-sheet and income statements of private and public firms in major country groups. The section also presents country averages of leverage ratios and various firm characteristics for private and public firms. Section IV presents the regression results that relate the debt to capital ratios of firms to various firm characteristics for private and public firms. The section also examines differences in the financial decisions of private and public firms in countries that differ on creditor rights and enforcement. In Section V, we examine results using a broader measure of leverage, namely, the total liabilities to assets ratio. Section VI concludes the paper. II. DATA The source of financial statement information for both public and private firms is the Amadeus (Analyze MAjor Databases from EUropean Sources) database provided by Bureau Van Dijk. It records both balance sheet and income statement information for both listed and unlisted firms. The data are harmonized by Bureau van Dijk, which makes appropriate cross-country 4 In addition to these papers, Demirgüç-Kunt and Maksimovic (1996) examine the effect of local capital market development on firm financial structure. They aggregate firm level data to country averages and report a negative relation between the stock market development and the debt equity ratio. Schmukler and Vesperoni (2001) examine the effect of liberalization on firm capital structure. Davydenko and Franks (2005) find that banks in France require more collateral and rely on particular collateral types in providing financing. Using data on Italian firms, Bonato and Faini (1990) find that leverage is negatively related to profitability and risk. Similarly, Bigelli et al. (2001) find that industry factors and taxes are relevant in explaining the leverage of Italian firms. These papers typically employ small samples and focus on listed companies. International Review of Finance r International Review of Finance Ltd

6 International Review of Finance comparisons possible. The public firm sample in Amadeus represents about 47% of all publicly listed firms in Datastream. The combined turnover of the public firm sample is about 61% of the aggregate turnover of all public firms in these countries. Thus, the Amadeus database has a relatively good coverage of public firms in these countries. Its coverage of private firms is even more complete. The sample period begins in 1997 and ends in As is standard in the literature, we exclude financial firms (SIC codes between 6000 and 6999), agricultural firms (SIC codeso1000), utilities (SIC codes between 4900 and 5000), and public sector firms (SIC codes 49000). We also exclude firms with less than 50 employees, less than h1 million in assets, or missing accounts payable, sales, or assets. 5 Furthermore, we exclude companies that are not organized as limited liability companies. We drop Denmark, Norway, and Austria because they have few observations left after these deletions. We have roughly 9700 public firm-year observations and more than 476,000 private firm-year observations for about 18 countries. The financial amounts are deflated using the consumer price index (CPI) for each country from the world development indicators database provided by the World Bank Database Group. All ratio variables are winsorized at 0.5% in either tail of the distribution. III. AVERAGE BALANCE SHEET AND INCOME STATEMENTS Table 1 reports the average balance sheet as a fraction of assets for both public and private firms in Eastern Europe, Scandinavia, Britain and Ireland, Belgium, Spain, France, Greece, Italy, and Portugal. 6 Panel A presents the average balance sheet of public firms in Europe, while Panel B presents the information for private firms. Among public firms, we see a strikingly large difference in the asset and liability structures of firms across countries. Firms in Eastern Europe, Spain and Portugal have less current assets while those in Scandinavia, France and Greece have relatively more current assets. At a more detailed level, Eastern European firms seem to differ from those in the rest of Europe in that they have lower cash balances and fewer receivables but significantly higher levels of fixed assets. French firms by contrast have less fixed assets but much higher levels of cash and accounts receivables. Large differences also exist on the liability side. Short-term bank loans are a relatively larger component of the financing mix for firms in France, Greece and Portugal, while long-term debt is more common in Belgium and Spain. Eastern European firms have more of their assets financed out of equity compared with firms in other countries. 5 By requiring nonmissing accounts payable, we ensure that the companies report detailed liability structures. 6 Scandinavia includes Finland and Sweden. Eastern Europe includes Bulgaria, Czech Republic, Estonia, Hungary, Poland, Russian Federation, Romania, and Ukraine. We also combine United Kingdom and Ireland. The rest of the countries in the sample Belgium, France, Greece, Italy, Spain, and Portugal are examined separately. 160 International Review of Finance r International Review of Finance Ltd. 2011

7 Capital Market Access and Financing Table 1 Average balance sheets of European firms, Variable Average balance sheet item as a fraction of total assets Belgium Britain and Ireland Eastern Europe Spain France Greece Italy Portugal Scandinavia Total Panel A: public firms Number of observations Number of firms Cash and cash equivalents Accounts receivable Inventory Other current assets Current assets-total Tangible fixed assets Intangibles Other1fixed assets Total assets Liabilities Loans-short term Accounts payable Other current liabilities Current liabilities total Long-term debt Other long-term liabilities Liabilities-total Shareholder capital Other shareholder funds Total liabilities and SE International Review of Finance r International Review of Finance Ltd

8 International Review of Finance Table 1 (continued) Variable Average balance sheet item as a fraction of total assets Belgium Britain and Ireland Eastern Europe Spain France Greece Italy Portugal Scandinavia Total Panel B: private firms Number of observations 20,806 88,367 72,652 67,575 90,262 12,850 74,540 20,448 29, ,959 Number of firms ,069 18,086 14,277 22, , ,450 Cash and cash equivalents Accounts receivable Inventory Other current assets Current assets-total Tangible fixed assets Intangibles Other fixed assets Total assets Liabilities Loans-short term Accounts payable Other current liabilities Current liabilities total Long-term debt Other long-term liabilities Liabilities-Total Shareholder capital Other shareholder funds Total liabilities and SE This table reports average balance sheet items of firms in various European countries. All balance sheet items are expressed as a fraction of assets. The sample period is from 1997 to Scandinavia includes Finland and Sweden. Eastern Europe includes Bulgaria, Czech Republic, Estonia, Hungary, Poland, Russian Federation, Romania, and Ukraine. We also combine United Kingdom and Ireland. The rest of the countries in the sample Belgium, France, Greece, Italy, Spain, and Portugal are examined separately. 162 International Review of Finance r International Review of Finance Ltd. 2011

9 Capital Market Access and Financing Comparing public firms with private firms, we find that private firms employ significantly more current assets (0.66 versus 0.55 for public firms). A significant amount of investment in current assets is in the form of receivables and inventories. Not surprisingly, private firms employ much less fixed assets compared with public firms. Considerablecountryvariationexistsinthestructureofassetsof private firms. For example, Scandinavian private firms have about 20% of their assets tied up in receivables while Spanish firms have almost twice as much assets in receivables. French private firms have the least amount of tangible assets (15% of assets) while Eastern European private firms have the most (nearly 40% of assets). Private firms also differ from public firms in terms of their liability structures. They also have significantly higher levels of accounts payable (23% versus 15% for public firms).privatefirmshavemoreshort-termloansandlesslong-termdebtcompared with public firms. Overall, the total liabilities of private firms are a greater fraction of assets. These differences are largely driven by differences in operating liabilities, not financial liabilities. Across countries, Eastern European private firm have lower levels of liabilities and more equity. Scandinavian firms have the least amount of short-term loans and significantly more long-term debt. Private firms in Greece and Britain and Ireland have relatively more short-term loans. Italian private firms have very little long-term debt. Table 2 reports the average income statements as a fraction of assets. Panel A reports the statements for public firms and Panel B reports the statements for private firms. We find that average firm profitability differs across countries. There are large cross-country differences in both profitability and taxes among countries. The variation in profitability is much larger among public firms than among private firms. Table 3 reports descriptive statistics on leverage ratios and firm characteristics. We report the average values by country groups for public and private firms separately. Two measures of leverage are employed in the paper (a) the debt to capital ratio and (b) the total liabilities to assets ratio. Since we are comparing public and private firms, both leverage measures are based on book values. This is not a serious limitation as many previous studies employing both book and market values have reported that the two measures behave similarly (Rajan and Zingales 1995; Fama and French 2002; Leary and Roberts 2005). Furthermore, in a recent paper, Deangelo and Roll (2011) find that the book and market leverage measures are highly correlated and conclude that there is not all that much incremental information in the market series. As predicted, the leverage ratio of private firms is much higher compared with that of public firms. The average debt to capitalization ratio of private firms is 35.9% compared with 29.9% for public firms. When we employ the broader measure of leverage, i.e., the total liabilities to assets ratio, the differences between private and public firms become even larger. The average total liabilities to assets ratio of private firms is 68% compared with only 54% for public firms. The much larger difference in this leverage measure between private and public firms suggests that private firms rely a lot more on trade credit and other non-financial liabilities than do public firms. International Review of Finance r International Review of Finance Ltd

10 International Review of Finance Table 2 Average income statements of European firms, Variable Average income statements item as a fraction of total assets Belgium Britain and Ireland Eastern Europe Spain France Greece Italy Portugal Scandinavia Total Panel A: public firms Number of observations Sales Cost of goods sold Depreciation Other operating expenses Operating income Interest expense Earnings before taxes Taxes Earnings after taxes Extraordinary items Net income Panel B: private firms Number of observations 20,806 88,367 72,652 67,575 90,262 12,850 74,540 20,448 29, ,959 Sales Cost of goods sold Depreciation Other operating expenses Operating income Interest expense Earnings before taxes Taxes Earnings after taxes Extraordinary items Net income This table reports average income statement items of firms in various European countries. All income statement items are expressed as a fraction of assets. The sample period is from 1997 to Scandinavia includes Finland and Sweden. Eastern Europe includes Bulgaria, Czech Republic, Estonia, Hungary, Poland, Russian Federation, Romania, and Ukraine. We also combine United Kingdom and Ireland. The rest of the countries in the sample Belgium, France, Greece, Italy, Spain, and Portugal are examined separately. 164 International Review of Finance r International Review of Finance Ltd. 2011

11 Capital Market Access and Financing Table 3 Descriptive statistics Belgium Britain and Ireland Eastern Europe Spain France Greece Italy Portugal Scandinavia Total Panel A: public firms Debt to capital ratio Total liabilities to assets ratio Assets (h millions) Sales growth Profitability Collateral Market/book ratio Median industry leverage Firm Age (in years) Panel B: private firms Debt to capital ratio Total liabilities to asset ratio Assets (h millions) Sales Growth Profitability Collateral Market/book ratio Median industry leverage Firm age Panel C: institutional variables Property rights index Creditor right index Mean leverage ratios, leverage factors, and institutional variables for public and private European firms. The sample period is from 1997 to Panel A reports average values for leverage ratios and firm characteristics for public firms. Panel B reports the averages for private firms, and Panel C reports average values of property rights index and creditor rights for the different country groups. The variables are defined in Appendix A. Scandinavia includes Finland and Sweden. Eastern Europe includes Bulgaria, Czech Republic, Estonia, Hungary, Poland, Russian Federation, Romania, and Ukraine. We also combine United Kingdom and Ireland. The rest of the countries in the sample Belgium, France, Greece, Italy, Spain, and Portugal are examined separately. International Review of Finance r International Review of Finance Ltd

12 International Review of Finance Private and public firms also differ on other firm characteristics. Firm sizes are different. The average book value of assets for private firm is about h73 million in assets compared with h1,582 million for public firms. Furthermore, private firms exhibit lower sales growth. This could imply that private firms face financing constraints due to a lack of capital market access. It could also imply that faster growing firms pursue listing more actively. Private firms appear more profitable and have lower collateral values. Profitability is measured as the ratio of operating income to assets. Collateral value is measured as the ratio of fixed assets plus inventory to total assets. Private and public firms also differ in age private firms are significantly younger than public firms. Firm age is measured relative to year of incorporation. Private firms, on average, are 10 years younger than public firms. Private firms in Greece are the youngest and those in Scandinavia the oldest. Greece also has the youngest public firms. Spanish public firms are the oldest in our sample. IV. RESULTS Table 4 presents results from cross-sectional regressions of the leverage ratio on firm characteristics and their interactions with public status dummies. The cross-sectional regressions examined here are similar to those in papers by Rajan and Zingales (1995), Hovakimian et al. (2001), Fama and French (2002), and Lemmon et al. (2008). Frank and Goyal (2008) provide a review of this literature. Specifically, we estimate the following regression: Lev i;j;t ¼ a 0 þ a 1 Private i;j;t þ g 1 Private i;j;t X i;j;t 1 þ g 2 Public i;j;t X i;j;t 1 þ C j þ Y t þ e i;j;t ð1þ where Lev i,j,t is the leverage of firm i in country j at time t. Here, our leverage measure is the total debt over debt plus book equity. We examine the total liabilities to assets ratio in Section V. The variables Private and Public are indicator variables that define the public status of the firm. Private i,j,t is an indicator variable that takes a value of one if the firm is private in that year and zero otherwise. The Public is the converse and takes a value of one if the firm is public and zero otherwise. X i,j,t 1 is a vector of variables that represent the firm characteristics that have been shown to be important determinants of leverage in previous papers (see, e.g., the evidence in Frank and Goyal (2009) for US firms and in Oztekin (2009) for firms in countries around the world). Following this literature, we include profitability, firm size, collateral, and industry median leverage. We include sales growth as a proxy for growth as the standard proxy for growth opportunities i.e. market/book ratio is not available for private firms. One departure from previous literature is the inclusion of firm age (measured as the number of years from the date of incorporation). The age is included to test if older firms have better access to capital markets and whether it affects the capital structure policies of firms. We expect older firms to face fewer 166 International Review of Finance r International Review of Finance Ltd. 2011

13 Capital Market Access and Financing Table 4 Capital structure of public and private firms: debt to capital ratio Variables All Firms Property rights Creditor rights Strong Weak Strong Weak (1) (2) (3) (4) (5) Private nnn nnn nnn nnn (0.019) (0.029) (0.031) (0.034) (0.024) PublicProfitability nnn nnn nnn nnn nnn (0.034) (0.050) (0.061) (0.055) (0.044) PrivateProfitability nnn nnn nnn nnn nnn (0.006) (0.009) (0.010) (0.009) (0.009) PublicCollateral nnn nnn nnn nnn nnn (0.020) (0.031) (0.031) (0.032) (0.025) PrivateCollateral nnn nnn nnn nnn nnn (0.003) (0.004) (0.004) (0.004) (0.004) PublicFirmSize nnn nnn nnn nnn nnn (0.003) (0.004) (0.004) (0.004) (0.004) PrivateFirmSize nnn nnn nnn nnn (0.000) (0.001) (0.001) (0.001) (0.001) PublicIndLev nnn nnn nnn nnn nnn (0.021) (0.035) (0.036) (0.038) (0.030) PrivateIndLev nnn nnn nnn nnn nnn (0.005) (0.007) (0.008) (0.006) (0.007) PublicSalesGrowth nn nn (0.014) (0.023) (0.022) (0.023) (0.017) PrivateSalesGrowth nnn nnn nnn nnn nnn (0.003) (0.004) (0.004) (0.004) (0.004) PublicFirmAge (0.004) (0.006) (0.008) (0.006) (0.006) PrivateFirmAge nnn nnn nnn nnn nnn (0.001) (0.001) (0.001) (0.001) (0.001) Constant nnn nnn nnn n nn (0.024) (0.032) (0.032) (0.034) (0.027) Year fixed effects Yes Yes Yes Yes Yes Country fixed effects Yes Yes Yes Yes Yes R 2 adjusted Observations 241, , , ,326 95,984 Cross-sectional leverage regression estimates with year and country fixed effects. The following specification is estimated. Lev i;j;t ¼ a 0 þ a 1 Private i;j;t þ g 1 Private i;j;t X i;j;t 1 þ g 2 Public i;j;t X i;j;t 1 þ C j þ Y t þ e i;j;t Lev i,j,t is the debt to capital ratio for firm i in country j at time t. Private is an indicator variable that takes a value of one if the firm is private and zero otherwise. Public takes a value of one if the firm is public and zero otherwise. The vector of firm characteristics, X i,j,t 1 is described in Appendix A. All firm characteristics except the log of firm age are lagged one period. C j are country fixed effects and Y t are year fixed effects. The sample period is from 1997 to The heteroscedasticitycorrected standard errors are reported in parentheses. All regressions include country and year fixed effects. Column (1) reports results for all countries. Columns (2) and (3) report regression estimates for firms in countries with strong and weak protection of property rights, respectively. Columns (4) and (5) report regression estimates for countries classified based on the strength of creditor rights. nnn Significance at the 1% level. nn Significance at the 5% level. n Significance at the 10% level. International Review of Finance r International Review of Finance Ltd

14 International Review of Finance constraints and this will show in private firms raising relatively more equity (and therefore becoming less leveraged in the process). Following previous literature, we predict firm size, collateral, and the industry median leverage to positively affect leverage and profitability to negatively affect leverage. Larger firms are more diversified and have lower costs of financial distress, which increases their target leverage ratios. Similarly, firms with more collateral assets also have lower costs of distress because collateralizable assets are easy to value and lose less of their value in distress. Profitability is generally found to be negatively related to leverage. It is unclear what the sign of sales growth should be. If sales growth is a proxy for growth opportunities, then the prediction is that it should negatively affect leverage. However, higher past sales growth also imply larger investments in fixed assets. Holding profitability fixed, higher lagged growth would result in higher leverage for private firms as these investments have to be financed with an increasing number of new debt issuances. For public firms, the prediction is unclear since they have access to both debt and equity markets. The interaction terms between these firm characteristics and the public and private status indicators permit a test of whether the effects of firm characteristics on leverage differ between private and public firms. The results reported in Table 4 show that private firms have significantly higher leverage than public firms. We predict the leverage of private and public firms using the coefficient estimates in Column (1). These estimates suggest the predicted debt to capital ratio for private firms to be 0.36 and for public firms to be about 0.31 (the difference in average predicted leverages between private and public firms is statistically significant at the 1% level). Because private firms face higher costs of raising external finance, their leverage is expected to be relatively more sensitive to firm profitability. The coefficient estimates on the interactions with profitability suggest that this is indeed the case. The leverage of private firms is significantly more sensitive to firm profitability compared with that of public firms. For private firms, the estimated coefficient on profitability is For public firms, the estimated coefficient on profitability is The higher sensitivity of leverage to profitability suggests that private firms are more passive in adjusting their leverage than are public firms. The higher costs of accessing external capital markets would also result in the leverage of private firms becoming less sensitive to standard tradeoff theory factors such as firm size, collateral value, and growth opportunities. Several of the results in Column (1) confirm this prediction. The sensitivity of leverage to collateral value and to firm size is much smaller for private firms than it is for public firms. Overall, these results confirm that private firms are relatively more passive in their leverage policies. The coefficient estimate on collateral values is for public firms while it is for private firms. Similarly, the coefficient estimate on firm size is for public firms while it is for private firms. These differences are also statistically significant. The higher sensitivity of leverage to firm size and collateral is consistent with private firms facing higher 168 International Review of Finance r International Review of Finance Ltd. 2011

15 Capital Market Access and Financing transactions costs and thus exhibiting greater persistence and slower adjustments towards their target leverage ratios. In other words, the shocks to collateral values and firm size generate a weaker response among private firms than they do among public firms. The results on the interaction terms with sales growth show that the leverage of public firms is unrelated to sales growth. By contrast, the leverage of private firms is significantly positively related to growth. The results on sales growth have many possible interpretations. If sales growth is a proxy for growth opportunities, then the signs of coefficient estimates would contradict the predictions of the theory. In our view, lagged sales growth is a poor proxy for growth opportunities. It reflects past growth which is likely to be correlated with past asset growth. Holding profitability fixed, these additional investments would force firms to seek external finance, which in the case of private firms would be in the form of debt. Thus, it is not surprising that leverage and sales growth are positively related for private firms. We expect the industry median leverage to positively affect leverage. While the results show that interactions of the industry median leverage with both public and private indicator variables are positive, the coefficient estimate for private firms is much larger than that for public firms. the industry median leverage does not have a precise interpretation and the general view is that industry leverage is a measure of product market considerations that guide the leverage policies of firms. If this view is correct, then our results suggest that industry leverage, and consequently product market competition, matters more to private firms than it does to public firms. Finally, we examine the effect of firm age on the leverage of private and public firms. We consider firm age to be a proxy for information asymmetry. As firms get older, they become more transparent and provide fuller disclosure to investors. Older firms are better known in the market and their access to capital improves with age. 7 This reduction in information asymmetry is particularly relevant for private firms. Thus, we expect private firms to reduce their reliance on debt financing as they become older. The negative relation between firm age and leverage could also be a result of older firms having accumulated earnings and thereby appearing less leveraged. In either case, we expect firm age to be negatively related to leverage, and for this to be more so for private firms. For public firms, which already have access to public equity markets, it is not clear if firm age will correlate with leverage. If firm age improves firm reputation in debt markets, then older public firms should have higher leverage. It is likely that they will find it easier to access both debt and equity and hence it is not clear how age affects their leverage. The results show that for public firms, age makes no appreciable difference to capital structures. But private firms are another matter. Here, firm age is significantly negatively related to the leverage ratios. In other words, older 7 See, for example, Berger and Udell (1995) and Petersen and Rajan (2002). International Review of Finance r International Review of Finance Ltd

16 International Review of Finance private firms have lower leverage ratios compared with younger private firms, all else being equal. Overall, the results presented in Column (1) suggest that access to public equity markets have significant effects on the capital structures of firms. The differences among private and public firms leverage policies highlighted here are consistent with private firms facing a significantly higher cost of equity. As we argued in the Introduction, this is partly due to the differences in their ownership structure and a lack of transparency due to lower disclosure requirements. Because of their higher cost of equity relative to debt, private firms issue less equity. Debt does not have the same level of adverse selection problem as equity which results in private firms issuing relatively more debt. Our findings on the leverage differences between private and public firms complement those of Brav (2009) who finds similar results for firms in the United Kingdom. These findings also relate to those of Faulkender and Petersen (2006) who find that among publicly traded firms, firms with access to public bond markets have higher leverage ratios. Columns (2) (5) of Table 4 explore how institutional differences affect the sensitivity of leverage to firm characteristics for private and public firms. The tests focus on two institutional variables contract enforceability and creditor rights. Both the content of the law (measured by creditor rights) and its enforceability (measured by the level of protection of property rights) should matter for the financing decisions of firms. There is a large prior literature on the importance of legal systems, enforcement of investor rights and financial distress resolution for the financing of firms (La porta et al. 1997, 1998; Claessens et al. 2001; Djankov et al. 2008). Weaker legal systems increase adjustment costs and make it more difficult for firms to access external financing. Because private firms already have restricted access to external capital markets and consequently rely more on internal funds and relationship-based bank loans, the effect of weak laws and poor enforcement should be more visible on public firms. As public firms rely more on public debt and equity, their relative cost of external financing should increase by much more when contracting is more difficult. To test this hypothesis, we stratify the sample countries by the strength of creditor rights and enforceability of contracts. We then re-estimate equation (1) on the these subsamples. Columns (2) and (3) report results for countries that differ in the extent to which countries respect property rights and enforce contracts. We measure the protection of property rights using three country risk variables that measure corruption, the risk of expropriation of private property, and the risk that contracts may be repudiated. The three indices measure the extent to which a country s legal system and institutions enforce contracts. The three indices are combined into an additive index of property rights protection (see Morck et al. 2000). Appendix A provides more details on the construction of the property rights index. We separate countries into two groups based on the median value of this index. 170 International Review of Finance r International Review of Finance Ltd. 2011

17 Capital Market Access and Financing The results show that the differences in leverage between private and public firms are much greater in countries with strong protection of property rights. Based on the estimated coefficients in Columns (2) and (3), the predicted leverage for private firms is 0.26 while that for public firms is By contrast, in countries with poor enforcement of property rights, the difference in the predicted leverages between private and public firms is much smaller (0.32 for private firms versus 0.29 for public firms). In addition to differences in the leverage levels between private and public firms, better contract enforceability also affects the differences in the sensitivity of leverage to firm profitability. The results in Column (2) show that the coefficient estimates on profitability are significantly more negative for private firms ( for private firms versus for public firms). By contrast, in countries with weak protection of property rights, the differences in coefficients is much smaller ( for private firms versus for public firms). Other results in Columns (2) and (3) suggest that the differences in the sensitivity of leverage to other firm characteristics such as firm size, collateral, sales growth, and firm age between private and public firms are also less pronounced in countries with weak protection of property rights. The only exception is the sensitivity of leverage to the industry median leverage, which is similar for public and private firms regardless of the strength of property rights protection. Columns (4) and (5) stratify the sample countries based on the strength of creditor rights and provide similar inferences. The differences in the financial policies of private and public firms are much starker when creditor rights are better protected but they diminish when the rights are poorly protected. Table A1 reports estimates of debt to capital regressions on firm characteristics for private and public firms by country. V. ALTERNATIVE LEVERAGE MEASURES We examine the robustness of these results by re-estimating the baseline regression models with the total liabilities to assets ratio. We expect private firms to rely more on accounts payable and other non-financial liabilities as a source of funds. Thus, it may be more appropriate to examine a broader measure of leverage that includes both financial debt and non-financial liabilities. Table 5 presents results from cross-sectional regressions of the total liabilities to assets ratio on a private firm dummy and the interactions of firm characteristics with both the public and private firm dummies. The specification are similar to those reported in Table 4 except that the dependent variable now is the total liabilities to assets ratio. Overall, these regressions yield similar results to those reported earlier. Private firms have much larger total liabilities as a fraction of assets compared with public firms. Leverage increases with past sales growth for both private and public firms, but the increase is much greater International Review of Finance r International Review of Finance Ltd

18 International Review of Finance Table 5 Capital structure of public and private firms: total liabilities to assets ratio Variables All firms Property rights Creditor rights Strong Weak Strong Weak (1) (2) (3) (4) (5) Private nnn nnn nnn nnn nnn (0.014) (0.021) (0.022) (0.024) (0.019) PublicProfitability nnn nnn nnn nnn nnn (0.025) (0.036) (0.043) (0.039) (0.034) PrivateProfitability nnn nnn nnn nnn nnn (0.004) (0.006) (0.007) (0.006) (0.007) PublicCollateral nnn nnn nnn nnn n (0.014) (0.023) (0.022) (0.022) (0.019) PrivateCollateral nnn nnn nnn nnn nnn (0.002) (0.003) (0.003) (0.003) (0.003) PublicFirmSize nnn nnn nnn nnn nnn (0.002) (0.003) (0.003) (0.003) (0.003) PrivateFirmSize nnn nnn nnn nnn nnn (0.000) (0.000) (0.001) (0.000) (0.001) PublicIndLev nnn nnn nnn nnn nnn (0.016) (0.025) (0.026) (0.027) (0.023) PrivateIndLev nnn nnn nnn nnn nnn (0.003) (0.005) (0.005) (0.004) (0.006) PublicSalesGrowth n nn nn nnn (0.010) (0.017) (0.016) (0.016) (0.013) PrivateSalesGrowth nnn nnn nnn nnn nnn (0.002) (0.003) (0.003) (0.003) (0.003) PublicFirmAge (0.003) (0.004) (0.006) (0.004) (0.005) PrivateFirmAge nnn nnn nnn nnn nnn (0.001) (0.001) (0.001) (0.001) (0.001) Constant nnn nnn nnn nnn nnn (0.017) (0.023) (0.023) (0.024) (0.021) Year fixed effects Yes Yes Yes Yes Yes Country fixed effects Yes Yes Yes Yes Yes R 2 adjusted Observation 241, , , ,571 95,993 Cross-sectional leverage regression estimates with year and country fixed effects. The leverage measure is the total liabilities to assets ratio. The following specification is estimated. Lev i;j;t ¼ a 0 þ a 1 Private i;j;t þ g 1 Private i;j;t X i;j;t 1 þ g 2 Public i;j;t X i;j;t 1 þ C j þ Y t þ e i;j;t Lev i,j,t is the total liabilities to assets ratio for firm i in country j at time t. Private is an indicator variable that takes a value of one if the firm is private and zero otherwise. Public takes a value of one if the firm is public and zero otherwise. The vector of firm characteristics, X i,j,t 1 is described in Appendix A. All firm characteristics except the log of firm age are lagged one period. C j are country fixed effects and Y i are year fixed effects. The sample period is from 1997 to The heteroscedasticity-corrected standard errors are reported in parentheses. All regressions include country and year fixed effects. Column (1) reports results for all countries. Columns (2) and (3) report regression estimates for firms in countries with strong and weak protection of property rights, respectively. Columns (4) and (5) report regression estimates for countries classified based on the strength of creditor rights. nnn indicates significance at the 1% level. nn indicates significance at the 5% level. n indicates significance at the 10% level. 172 International Review of Finance r International Review of Finance Ltd. 2011

19 Capital Market Access and Financing for private firms. This suggests that private firms increase total liabilities to a much larger extent than public firms when they increase their sales growth. As before, we find that profitability negatively affects leverage and that the effects are larger for private firms. The coefficient estimates on other firm characteristics provide a more mixed picture. Surprisingly, collateral is negatively related to the total liabilities ratio for both private and public firms. Perhaps collateral values reduce the extent to which firms rely on accounts payable and other non-financial liabilities. Firm size is positively related to leverage, as expected. The differences in the relation of profitability to leverage between private and public firms are once again bigger for public firms than for private firms. The results on firm age are also similar to our earlier findings it is significantly negatively related to the total liabilities to assets ratio for private firms but is unrelated for public firms. The sample partitions based on law and enforcement yield similar findings as those reported above. VI. CONCLUSION Public and private firms differ in their ability to access public debt and equity markets. Private firms have restricted access to external capital markets and are relatively more opaque compared with public firms. Consequently, they rely more on internal funds and bank loans to meet their financing needs. Public firms on the other hand have easier access to both public debt and public equity markets. The question that we examine in this paper is whether this variation in access to external markets affects the corporate financing decisions of firms. We expect private firms to have higher debt ratios. We also expect the leverage of private firms to be relatively more sensitive to past history variables, such as firm profitability, and less sensitive to other leverage factors such as collateral, firm size, and firm growth. We also exploit the cross-country variation in legal environments and test if variation in laws and their enforcement affect the financial policies of private and public firms differently. Our results show that private firms are much more highly levered compared with public firms, confirming the supply-side view that access to capital markets necessarily affects the financial policies of firms. We also find that the leverage of private firms is much more sensitive to firm profitability, and much less sensitive to firm size and collateral values. These results are consistent with private firms incurring significantly higher adjustment costs and thus making sluggish adjustments towards their target capital structures. An important finding of this paper is that the relative differences in the financial policies of private and public firms is a function of the legal environment of the country in which the firms operate. In countries with strong laws and effective enforcement, the differences in the financial policies of public and private firms are large, with public firms making leverage choices in a relatively unconstrained fashion. However, in countries with weak laws and International Review of Finance r International Review of Finance Ltd

20 International Review of Finance poor enforcement, the financial policies of private and public firms begin to converge, suggesting that the relative advantage of public firms in accessing external capital markets diminish when investor rights are poorly protected. In these countries, even public firms become relatively more constrained and begin relying on internal funds and bank loan financing just as private firms do. Vidhan K. Goyal Department of Finance Hong Kong University of Science and Technology Kowloon Hong Kong REFERENCES Amihud, Y., B. Lev, and N. G. Travlos (1990), Corporate Control and the Choice of Investment Financing: The Case of Corporate Acquisitions, Journal of Finance, 45, Bae, K., and V. K. Goyal (2009), Creditor Rights, Enforcement and Costs of Loan Finance, Journal of Finance, 64, Bancel, F., and U. R. Mittoo (2004), Cross-country Determinants of Capital Structure Choice: A Survey of European Firms, Financial Management, Berger, A. N., and G. F. Udell (1995), Small Firms, Commercial Lines of Credit, and Collateral, Journal of Business, 68, Bigelli, M., S. Mengoli, and S. Sandri (2001), I fattori determinanti la struttura finanziaria delle imprese italiane una verifica empirica sulle società quotate, Finanza Marketing e Produzione, 3/4, Bonato, L., and R. Faini (1990), Le scelte di indebitamento delle imprese in italia, in V. Conti and R. Hamaui (eds) Operatori e mercati nel processo di liberalizzazione, vol. L, Bologna: Il Mulino. Booth, L., V. Aivazian, A. Demirgüç-Kunt, and V. Maksimovic (2001), Capital Structures in Developing Countries, Journal of Finance, 56, Brav, O. (2009), Access to Capital, Capital Structure, and the Funding of the Firm, Journal of Finance, 64, Claessens, S., S. Djankov, and L. Lang (2000), The Separateion of Ownership and Control in East Asian Corporations, Journal of Financial Economics, 58, Claessens, S., and S. Djankov, and A. Mody (2001), Resolution of Financial Distress: An International Perspective on the Design of Bankrutcy Laws. Washington, DC: World Bank Institute Development Studies. Ddavydenko, S. A., and J. Franks (2005), Do Bankruptcy Codes Matter: A Study of Defaults in France, Germany, and the UK, Working Paper, University of Toronto and London Business School. DeAngelo, H., and R. Roll (2011), How Stable are Corporate Capital Structures?, Working Paper, University of Southern California and UCLA. Demirgüç-Kunt, A., and V. Maksimovic (1996), Stock Market Development and Firm Financing Choices, World Bank Economic Review, 10, Demirgüç-Kunt, A., and V. Maksimovic (1999), Institutions, Financial Markets, and Firm Debt Maturity, Journal of Financial Economics, 54, Djankov, S., O. Hart, C. McLiesh, and A. Shleifer (2008), Debt Enforcement Around the World, Journal of Political Economy, 116, Djankov, S., C. McLeish, and A. Shleifer (2007), Private Credit in 129 Countries, Journal of Financial Economics, 84, International Review of Finance r International Review of Finance Ltd. 2011

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