Argentum, in cooperation with NHH and SIFR, will arrange the Argentum Conference and Symposium in Stockholm this September. One of the objectives is to highlight the latest in private equity research. Leading up to the conference, we will present an introduction to each of the papers that will be presented each week.

Daniel Ferreira (London School of Economics): Incentives to Innovate and the Decision to Go Public or Private

Co-authors: Gustavo Manso and André C. Silva

This paper takes a closer look at how public and private ownership structures affect firms’ incentives to choose innovative projects. The paper finds that the optimal decision is to go public when companies wish to exploit the current technology and to go private when companies wish to explore new ideas. The model used links private equity to innovation and creative destruction and generates new predictions regarding the determinants of going public and going private decisions.

Studies have shown that private firms are more innovative than publicly-traded firms and that private equity may be a catalyst for creative destruction. This paper introduces a model where the choice of ownership structure of the firm affects managers' incentive to innovate. The authors find that private ownership creates incentives for innovation, while public ownership creates incentives against innovation.

The model is based on a risk-neutral insider which chooses between a conventional project and an innovative project. The insider has the possibility to liquidate his stake early by using his private information. The paper shows that if the insider can choose an early exit strategy after bad news, he becomes more tolerant of early failures and more inclined to choose the innovative project under private ownership. This tolerance-for-failure effect is the key driver of innovation in private companies. 

Under public ownership, an early exit after bad news is not profitable since cash flows are observable. The fact that market prices react quickly to good news is also creating incentives for short-termist behaviour. An insider may therefore prefer the conventional project because it has a higher probability of an early success.

Since incentives in public firms are biased towards conventional projects and incentives in private firms ar biased towards innovative projects, the optimal ownership structure changes with the firm's life cycle. It is usually believed that exploration is important early in a firm's life. Hence, it is optimal to start private to maximize incentives to explore.

The model sheds light on a number of controversial issues raised in the empirical literature. The main empirical implications are:

• Firms become more innovative after public-to-private transitions and more innovative industries ayttract more private equity investment.
• There can be too much innovation in private companies
• Venture capital investment does not necessarily lead to an increase in innovation activities
• Public-to-private-transitions are necessary for innvation to occur.

Read more about the Argentum Symposium