At its core, the economy’s essential role is to allocate resources toward the most productive investment prospects. Traditionally, stock markets have been particularly efficient at allocating capital to firms with the most promising investment projects. In recent times, however, private equity (PE) markets have experienced significant expansion and have provided more capital through private than through public equity offerings (i.e., the combined value of initial public offerings (IPOs) and seasoned equity offerings (SEOs)) (Ewens and Farre-Mensa, 2022). This overshadowing of public markets has captured the interest of regulators and scholars due to the potential repercussions on the overall efficiency of resource allocation within the U.S. economy.
The primary role of markets is connecting businesses that need capital to innovate and grow with investors with excess capital. Banks have played this role by channeling funds between those supplying the capital (e.g., depositors) and those who need the capital (e.g., entrepreneurs, businesses, etc.). U.S. public equity markets offer an alternative source of capital for firms and bring visibility, accountability, and cheap sources of capital for firms listed on public exchanges. But the exponential growth in funding of private equity markets in recent years has brought these benefits for firms or investors into the spotlight.
Naturally, the rapid growth of the private equity industry has spurred considerable debate about the value that private markets create for investors relative to public markets (Phalippou and Gottschalg, 2009). This debate has also been fueled partly because of the high fees private equity funds charge for their services. Clearly, evaluating the returns investors earn in each market is of utmost importance. However, an equally significant, yet often overlooked question, pertains to the efficiency of investments in private and public equity markets. In other words, how much output can private markets produce for each dollar invested compared to the output generated from a dollar invested in public markets? For instance, private and public markets can help investors identify firms with the best growth potential, or they may directly contribute to firms’ ability to generate more output out of every dollar of equity they receive. Regardless of the mechanism, this question warrants thorough exploration to understand better the implications of the growing private equity industry and its impact on capital allocation efficiency in the broader economy.
Our recent study aims to inform this debate by focusing on the micro-foundations of firms’ performance that receive investments in private and public equity markets. Specifically, we compare how much sales firms generate for every dollar of equity they receive in private relative to public markets. This measure, often referred to as the marginal product of capital or MPK, is our primary measure for comparing how efficiently firms allocate capital in private and public markets.
It is unclear whether private or public markets allocate capital more efficiently—i.e., which one has a higher MPK, on average. Explaining the nuanced differences between these markets is the key to understanding how the listing status of the stock affects the efficiency of capital allocation. For example, public equity markets enhance allocation efficiency by gathering information not available to all investors and integrating it into public stock prices with their trades. Simply put, market prices contain the most informative signal regarding firms’ growth potential. By contrast, most private equity investments involve intermediaries whose experience can increase allocation efficiency by filtering out unsuitable projects—this is precisely how venture capitalists build their reputation for creating value.
We study the allocation efficiency of private and public markets by comparing the MPK of firms receiving equity in public markets with the MPK of similar firms receiving equity in private markets. To this end, we first obtain equity information from one of the largest and most established VC databases in the U.S., VentureXpert. Next, we match this information with firm sales and employment and validate our results using data from two different large data vendors. Overcoming the data challenge clears up significant measurement-related obstacles for our analysis. Our main tests focus on public firms raising equity through SEOs and private firms raising equity through private VC deals. Our final sample contains approximately 9,623 private and 20,656 public market deals.
We define a market as more efficient if it directs capital toward firms with higher MPK. First, we measure a firm’s MPK using the three-year average annual growth in their sales for each dollar of equity they raise. Although this three-year sales growth assessment might be considered short-term to medium-term, it offers a balanced approach by minimizing the influence of unrelated factors that inevitably transpire over extended periods while still effectively capturing the long-term variations in the efficiency of capital allocation. Temporary market fluctuations could potentially sway shorter horizons, while general economic trends and changes in industry dynamics might influence longer horizons.
We find that firms receiving equity in public markets have substantially larger MPK than private markets. Specifically, allocating $1 in public markets generates $0.64 more annual sales over the next three years than allocating $1 in private markets. This result suggests that public markets allocate capital more efficiently than private markets, with this difference in efficiency persisting across time and sectors.
The comparison in firms’ allocation efficiency faces two main challenges: (a) public firms differ from private firms, and (b) public-equity deals differ from private-equity deals. We address these challenges by comparing public and private firms with similar size, age, industry, and deal size. In our more restrictive tests, we also compare the MPK of firms while private with their MPK after listing their stock on a public exchange. Finally, to address the second challenge, we compare deals similar to SEOs, such as late-stage VC and growth equity deals, and control for deal size. In all cases, we find similar estimates for the allocation efficiency gap in public and private markets. In all comparisons, the MPK of public markets consistently exceeds the MPK of private markets.
The analysis accounts for a host of firm and industry characteristics that may account for the gap in allocation efficiency. Still, biases from omitted variables or selection mechanisms that we cannot account for may persist. Nevertheless, it is crucial to underscore that such biases would likely skew our estimations in the reverse direction in this context. Numerous research studies present evidence that the MPK of small, privately held firms should be higher rather than lower when compared to their larger, publicly traded counterparts.
Finally, we explore potential mechanisms to help explain the superior allocation efficiency in public equity markets. Our tests show that investors in public markets can more efficiently identify firms with high-MPK projects than equity investors in private markets. We also examine whether the allocation efficiency gap is driven by differences in information efficiency and corporate governance quality in the two markets. We find that firms with greater information efficiency are associated with larger MPK when raising equity, and public firms with better corporate governance have higher sales growth rates after raising equity.
In summary, our findings underscore the critical role stock markets play in the capital allocation process in our economy. The capital allocation process is crucial for driving innovation and business expansion. Our study highlights that by directing resources towards high-MPK projects, public markets provide a transparent and well-regulated environment, enabling investors to identify and support corporate growth. Moreover, a burgeoning private equity industry may further exacerbate inefficiencies in capital allocation. These concerns emphasize the need for continued monitoring and oversight of public and private markets to ensure capital flows toward firms with the highest growth potential.
Ali Sanati is an Assistant Professor in the Department of Finance and Real Estate at American University.
Ioannis Spyridopoulos is an Assistant Professor in the Department of Finance and Real Estate at American University.
This post was adapted from their paper, “Comparing Capital Allocation Efficiency in Public and Private Equity Markets,” available on SSRN.
