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Regulatory Costs of Being Public: Evidence from Bunching Estimation

May 20, 2022

Regulation and Gatekeepers

At the Gupta Governance Institute 15th Annual Corporate Governance Conference held on April 8, 2022, researchers presented an original methodology which quantifies the regulatory costs associated with being a publicly traded company.

Key Insights

  • The regulatory costs of being a public company are substantial: Various disclosure and internal governance rules lead to a total compliance cost of 4.1% of the market capitalization for a median U.S. public company.
  • Increases in the estimated regulatory costs are associated with a 7% decrease in the probability that a Venture Capital-backed firm will decide to go public in a year. However, regulatory costs do not drive the decisions of public firms going private. Overall, regulatory costs only explain a small fraction of the decline in public firms over the last 20 years.
  • For a US public company, there are regulatory thresholds on its public float which determine the regulatory requirements. To stay below these thresholds, companies manipulate their public float by substituting debt for equity, effectively trading off the costs of regulation with the cost of distorting their capital structure.

Summary of Complete Findings

The number of publicly listed companies in the U.S. has experienced a significant decline in the last 20 years. One common explanation for this trend is the increased burden of disclosure and governance regulations. Understanding how regulations affect the cost of being a publicly traded company can therefore shed light on the reasons for the decline of public companies. So far, the existing evidence on the impact of regulations has been mainly qualitative. This research quantifies the net costs for a company to comply with various disclosure and internal governance regulations as a public company.

Many regulatory requirements are triggered when a company’s public float (i.e. the value of its trading equity) exceeds a threshold. This research investigates companies’ decisions around three regulatory thresholds introduced in 1992, 2002 and 2012 at $25m, $75m, and $700m respectively. Each public float threshold introduces changes in the major components of disclosure and internal governance regulations faced by public companies. The first finding is that there is significant “bunching” in the distribution of companies’ public float around each regulatory threshold. “Bunching” refers to the observation that the frequency of companies just below each threshold is significantly greater than the frequency of firms just above it. On its own, such bunching provides evidence that the regulations triggered by these thresholds impose compliance costs that are large enough to encourage companies to manipulate their public float to ensure that it remains below the threshold.

The study shows that companies increase their debt to keep their public float below the thresholds. It also finds that while increasing their debt, companies do not reduce their investment or change their internal ownership, therefore leading to higher leverage. Companies that are just above the threshold shrink their public float to avoid regulations because the associated leverage distortion is small compared to the regulatory costs. In contrast, companies that are far above the threshold do not bunch because the cost of leverage distortion outweighs the cost of regulation. Companies below the threshold are more likely to release bad news in the second fiscal quarter, when the public float is calculated, suggesting an attempt to keep the value of their trading equity low.

The results of this research produce regulatory cost estimates. The median U.S. public firm spends 0.3% of its EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) on enhanced disclosure compliance, 0.9% on tightened internal control, and 2.1% on a combination of disclosure and internal control rules every year. For the median U.S. company with a public float of $102m, annual enhanced disclosure costs $45,000, compliance costs $126,000, and combined costs of disclosure and internal governance are $293,000. The present value of these regulatory costs represents 4.1% of the market capitalization for a median company. This leaves no doubt of the significant costs associated with being a publicly traded company. It is also important to note that smaller companies bear disproportionate amounts of regulatory costs relative to their size because a large portion of these costs are fixed.

Using a sample of 21,066 Venture Capital-backed firms, the study further finds that an increase in the estimated regulatory costs can be associated with a 7% decrease in the likelihood of an Initial Public Offering (IPO). However, when the researchers examine the impact of the estimated regulatory costs on public companies’ decisions to go private, they find that regulatory costs are not a significant driver of decisions to go private.

The study indicates that regulatory costs have greater impact on private companies’ IPO decisions than on public companies’ decisions to go private. Heightened regulatory costs only explain a small fraction of the decline in the number of public firms over the last two decades. Non-regulatory factors may be playing a more important role in explaining this trend.

In conclusion, the authors of this research have developed a methodology to quantify regulatory costs and assess their impact on companies’ decisions to go public or private. These findings could be used by regulators to assess costs and benefits of future regulatory policies, and could encourage new applications to other topics in governance research.

“Regulatory Costs of Being Public: Evidence from Bunching Estimation” by Michael Ewens (California Institute of Technology), Kairong Xiao (Columbia Business School), Ting Xu (University of Virginia).
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