Capital structure choices for private firms

James Campbell

2022-09-15 11:38:00 Thu ET

Capital structure choices for private firms

The Kauffman Firm Survey (KFS) database provides comprehensive panel data on 5,000+ American private firms from 2004 to the present. The U.S. Federal Reserve Board's Survey of Small Business Finance (SSBF) provides cross-sectional data on about 2,000+ American private firms in 1987, 1993, 1998, and 2003. Robb and Robinson (RFS 2012) study the capital structure choices that about 5,000+ KFS private firms make in their initial years of business operations. The sample startups rely heavily on external debt sources such as bank finance and less extensively on angel finance from families and friends. This reliance on external debt underscores the importance of credit markets for the success of nascent business activity.

 

Cole (FM 2013) Frank and Goyal's (FM 2009) study of major determinants of small business capital structure choices. Past studies shine fresh light on the empirical nexus between bank relationships and private firm funds (Petersen and Rajan, JF 1994; Berger and Udell, JB 1995, JBF 1998, EJ 2002). A private firm with no banking relationships has significantly lower leverage, whereas, a private firm with multiple banking relationships has significantly higher leverage. A private firm's primary-owner characteristics affect the firm's capital structure choice (e.g. Ang, Cole, and Lin, JF 2000; Villalonga and Amit, JF 2006). Cole (FM 2013) empirically finds that minority owners tend to use debt finance in a conservative manner relative to the median owner.

 

Myers (JEP 2001) points out that capital structure theories are not designed to be general for testing them on a broad heterogeneous dataset to yield informative results. Fama and French (RFS 2002, JFE 2005) suggest that both the trade-off and pecking-order theories represent some elements of truth as stable mates in capital structure decisions. The lack of panel data on the leverage ratios of private firms severely restricts the econometrician's ability to deal with the dynamic versions of capital structure theories. This logic spans the studies by Fama and French (RFS 2002), Baker and Wurgler (JF 2002), Welch (JPE 2004), Flannery and Rangan (JFE 2006), Antoniou et al (JFQA 2008), and Huang and Ritter (JFQA 2009). This strand of capital structure literature specifies the dynamic tests and suggests a wide range of target adjustment speed estimates from 3 years to nearly 20 years. Specifically, Huang and Ritter (JFQA 2009) point out that target leverage is highly persistent through time (Lemmon, Roberts, and Zender, JF 2008; DeAngelo and Roll, JF 2015). This persistence requires the use of Hausman et al's (JE 2007) long-differencing panel estimator to address firm-specific unobservable heterogeneity in capital structure choice. This long-differencing panel estimator results in point estimates of partial adjustment toward target leverage of about 5 to 7 years. Huang and Ritter (JFQA 2009) discuss each econometric method in detail (e.g. Fama-MacBeth cross-sectional regressions, mean-differencing panel regressions, dynamic GMM panel regressions, and long-differencing panel regressions).

 

Because private firms do not list equity issues on major stock exchanges, the econometrician cannot test the market-timing theory for these sample firms. Cole (FM 2013) finds empirical support for pervasive trade-off and pecking-order determinants of capital structure choices by private firms. Cole (FM 2013) reports that American private firms employ a comparable degree of leverage relative to small public firms on Compustat. This latter evidence contradicts Brav's (JF 2009) main thesis that British private firms use much greater leverage there.

 

The econometrician can estimate the partial adjustment speed by carrying out Fama-MacBeth regressions, mean-differencing and long-differencing panel regressions, and dynamic GMM panel regressions (Fama and French, RFS 2002; Baker and Wurgler, JF 2002; Welch, JPE 2004; Flannery and Rangan, JFE 2006; Antoniou, Guney, and Paudyal, JFQA 2008; Huang and Ritter, JFQA 2009; Petersen, RFS 2009). In each case, the target leverage ratio can be quantified as a linear combination of financial ratios, firm characteristics, and owner attributes. Persistent deviations from target leverage would be detrimental to the private firm's fair value and its ability to raise debt (but not market equity) as the dominant form of financial flexibility (DeAngelo, DeAngelo, and Whited, JFE 2011; McLean, JFE 2011; Denis and McKeon, RFS 2012).  Just as the target payout adjustment is faster for private firms (Michaely and Roberts, RFS 2011), the target leverage adjustment should be faster for private firms in favor of primary-owner utility maximization because agency costs are substantially lower at these private firms relative to public firms. The econometrician can carry out some time-series analysis of the secular trend in the typical private firm’s capital structure to ascertain whether this trend is similar to the steep increase in aggregate corporate leverage that significantly correlates with both government leverage and financial-sector output from private business credit and equity issuance (Graham, Leary, and Roberts, JFE 2015).

 

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