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The Determinants of Capital Structure: A Comparative Study of Public and Private Firms

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Abstract
  This paper investigates the determinants of capital structure of a large sample of quoted and unquoted firms incorporated in the United Kingdom, The Netherlands and Germany. It explores whether the traditional determinants of leverage of quoted firms, namely firm size, profitability, tangibility, growth and earnings volatility also hold across unquoted firms. Further, I attempt to analyse the differences in capital structure and financing behaviour of quoted and unquoted firms. My findings suggest that private firms have significantly higher leverage than public firms. Also, my results support the traditional determinants of leverage. In the case of public firms, leverage is positively correlated to size, tangibility and volatility and negatively correlated with profitability. In the case of private firms, leverage appears to be positively correlated with growth, tangibility and volatility and negatively correlated with size and profitability, ceteris paribus. Hence, there seems to be a difference in the financing behaviour of public and private firms with regards to size and growth opportunities. However, a critical finding of my study is the importance of institutional factors in the determination of capital structure of firms. Firms in the Netherlands are less levered whereas those in Germany are more highly levered as compared to the firms in the United Kingdom.
Table of Contents
  1. Introduction………………………………………………………1
  2. Theoretical Framework………………………………………………4
    1. The Pecking order Theory……………………………………….4
    2. The Trade-off Theory………………………………………….5
    3. The Agency Theory……………………………………………5
    4. The Signalling Theory………………………………………….6
    5. Determinants of Leverage……………………………………….7
      1. overview…………………………………………………7
      2. Size 11
      3. Asset Tangibility………………………………………….12
      4. Growth………………………………………………….12
      5. Profitability……………………………………………..13
      6. Earnings Volatility…………………………………………14
    6. Differences in Capital Structure of Public and Private Firms………………14
      1. Access to Capital Market……………………………………..15
      2. Information Asymmetry……………………………………..15
      3. ownership Concentration……………………………………..15
    7. Institutional Factors…………………………………………..16
  3. Hypothesis Development……………………………………………18
  4. Data… 19
    1. Sources……………………………………………………19
    2. Sample……………………………………………………2o
    3. Research Methodology…………………………………………22
    4. Variable Measurement………………………………………….23
    5. Descriptive Statistics………………………………………….26
  5. Empirical Results…………………………………………………..3o
    1. Multivariate Analysis………………………………………….3o
    2. Cross-Country Analysis………………………………………..34
    3. Analysis of Variance………………………………………….36
    4. Institutional Differences………………………………………..37
    5. Robustness Tests…………………………………………….39
    6. Limitations………………………………………………….44
  1. Conclusion………………………………………………44

References……………………………………………………….46 Appendix……………………………………………………….5o

I.                   Introduction

  The influential paper of Modigliani and Miller on capital structure irrelevancy has been followed by extensive theoretical research to determine the “optimal capital structure”. Modigliani and Miller show that firm value is independent of the capital structure under the strict assumptions of perfect and frictionless capital markets (1958). However, in reality market frictions exist. Latter literature has been devoted to studying these market imperfections in order to determine optimal capital structure. Four main theories have been proposed since then which attempt to explain the amount of leverage to be undertaken through a cost-benefit analysis of leverage. These theories try to explain the choices behind corporate financing sources in light of potential costs associated with each source vis-à-vis agency, information asymmetry, transaction and bankruptcy costs. There have been extensive empirical studies investigating the theories of capital structure. These studies have identified certain key determinants of leverage such as collateral value of assets, firm size, growth opportunities and profitability amongst many (Titman and Wessels, 1988; Harris and Raviv, 1991; Rajan and Zingales, 1995). However, these studies have almost exclusively focused on public firms due to data availability. Consequently, this leaves a gap in the literature focusing on the financing behaviour of private firms. It is assumed that the general theories of capital structure are applicable across the private sector as well. However, this may not be the case as public and private firms are inherently faced with different costs of financing. This may lead to different financing choices. Public firms have access to capital markets whereas this access is limited for private firms. As a result, private firms face relatively higher costs of both debt and equity (Brav, 2009). other than these traditional firm-specific characteristics, certain institutional factors may determine the capital structure of a firm. Differences in bankruptcy and tax laws, lender- borrower relationship, ownership concentration and financial orientation may also effect leverage (Rajan and Zingales, 1995; Antoniou et al., 2008). To give an example, Germany and the United Kingdom have strict creditor rights in place as compared to the Netherlands (La Porta et al., 1998). This might lead us to observe relatively higher leverage in the UK and Germany as suppliers would be more willing to lend if their rights are well-protected. Similar differences persist across countries depending on their legal traditions which might dictate leverage.

Fundamental questions thus arise as to whether the predictions offered by the theories of capital structure are also applicable to private firms. If not, then what drives the capital structure of private firms and how does that differ from its public counterpart. Are the stylized factors determining private firm leverage different from those of public firms? Also, are factors other than firm-specific characteristics such as institutional setup important determinants of leverage? The objective of my study is to answer these questions. I attempt to identify the characteristics that determine the leverage of unquoted firms and to analyse the differences between the capital structure of public and private firms. I further extend my investigation to provide a cross country analysis of the differences in leverage. I try to explain these differences in light of institutional factors facing each country. This paper thus explores two key areas in the field of corporate finance. It first examines the determinants of capital structure of private firms based on a large sample of private firms in the United Kingdom, the Netherlands and Germany for the period 2003-2o11. Second, it incorporates the effects of the legal economy in which the firm operates on leverage by providing a cross-country comparison. I limit myself to the study of five firm-specific factors, namely, asset tangibility, profitability, growth, size and earnings volatility. Four of these factors (asset tangibility, profitability, growth and size) have been identified as being consistent determinants of leverage, namely, asset tangibility, profitability, growth, size and earnings volatility (Bradley et al., 1984; Rajan and Zingales, 1995; Frank and Goyal, 20071). However, these have been found to be consistent factors for public firms only. Some initial studies on private sector by Deloof and Verschueren (1998) and Schoubben and Hulle (2004) find a significant relationship between earnings volatility and leverage. Hence, I include this variable in my analysis as well.  My choice of the three countries is motivated by two reasons. First, these countries are the financial hubs of Europe. Hence, access to capital markets can be considered homogenous across the countries and does not bias my analysis. Second, these countries are characterized by different legal traditions. The UK is defined by the English legal origin, Germany by the Germanic legal origin and the Netherlands by the French legal origin. Therefore, these countries provide me with an ideal data set to study the relationship between institutional factors and leverage. 1 Frank and Goyal (2007) also find industry mean leverage to be a reliable determinant of capital structure. However, I exclude this from my analysis as I introduce industry fixed effects in my analysis to control for inherent variation across industries.
There are certain limitations to the existing literature on capital structure. Due to data limitations, the study on private firms has largely been neglected. Results derived from the study of public firms are generalized to the private firms. Since studies have focused primarily on firm-specific characteristics only, this leaves a gap between the relationship of capital structure with institutional factors which might be very important. Also, a significant portion of current literature is based on cross-sectional data. My study thus contributes to the existing literature in three ways. First, it extends the existing empirical analysis of firm- specific determinants of leverage to the private sector. Second, it incorporates an analysis of institutional factors in the study of capital structure. Third, the application of panel data reduces the collinearity among explanatory variables and gives more efficient coefficients (Hsiao, 1985). My findings suggest that private firms have significantly higher leverage than public firms. Also, my results support the traditional determinants of leverage. In the case of public firms, leverage is positively correlated to size, tangibility and volatility and negatively correlated with profitability. The relationship with growth is statistically insignificant. In the case of private firms, leverage appears to be positively correlated with growth, tangibility and volatility and negatively correlated with size and profitability, ceteris paribus. Hence, there seems to be a difference in the financing behaviour of public and private firms with regards to size and growth opportunities. However, a critical finding of my study is the importance of institutional factors in the determination of capital structure of firms. Firms in the Netherlands are less levered whereas those in Germany are more highly levered as compared to the firms in the United Kingdom. This can be explained in terms of creditor rights protection. As the legal origin of the Netherlands allows for poor creditor protection, in terms of bankruptcy laws, reorganization and automatic stays, Dutch firms have lower leverage. This may be explained by possibly a higher cost of debt in the Netherlands to incorporate the higher risk that lenders face. The following paper is organized as follows: In Section II, I review the existing literature on the subject; in Section III, I develop my hypothesis in light of the empirical evidence; in Section IV, I discuss the sample and my research methodology; in Section V, I comment on the empirical findings of the study followed by the limitations; and in Section VI, I conclude and draw reference to the future scope of the research.

II.                Theoretical Framework

  Four main theories have been proposed which provide some insight into the financing behavior of firms. These theories hypothesize the amount of leverage to be undertaken through a cost-benefit analysis of leverage. The benefits of debt as a source of capital primarily include the tax-advantage of debt as interest expense is tax deductible. on the other side, potential costs of debt are the agency costs, bankruptcy costs and the loss of non-debt tax shields (Brealy and Myers, 2002). Theoretically, the optimal capital structure then involves a careful balancing between these costs and benefits. A brief overview of the theories put forth is as follows:

  1. The Pecking order Theory

  According to this theory, the firms follow a financing hierarchy due to information costs (Myers and Majluf, 1984). Firms primarily face two potential costs when they approach the external markets to raise capital, information asymmetry costs and transaction costs. These additional costs make external capital more expensive and naturally lead firms to use internal over external funds. Information asymmetry arises due to the separation of ownership and management. Managers have more information about the value of the firm and would attempt to issue equity when its market value is higher (Myers and Majluf, 1984). Due to this information asymmetry between outside investors and managers, equity may be under-priced to account for this managerial incentive. This may make equity an expensive source of financing and lead firms to under-invest. Retained earnings are unaffected by such problems. Also, as debt requires fixed payments of interest, it is less sensitive to information asymmetries. Similarly, transaction costs can dictate a firm’s sources of financing. Baskin (1989) has found that costs for borrowing can be as low as 1% of the amount raised whereas the costs for issuing equity are anywhere between 4% and 15% of the total amount. This evidence suggests that debt would be a preferred source of external financing compared to equity. Taking these costs into consideration, firms will prefer internal financing to external financing, and debt to equity in the event of external financing (Donaldoson, 1961). This theory suggests that there is no optimal capital structure. In fact the capital structure is a

function of the firm’s needs to tap the external markets when internal funds are insufficient to meet investment opportunities.

  1. The Trade-off Theory

  This theory is an off-shoot of the Modigliani and Miller model. Interest expense is tax deductible. Hence, a larger interest expense will result in lower taxable profits and consequently lower taxes. By increasing the amount of debt on their balance sheets, firms can derive tax benefit through the interest tax shield. However, increasing debt can also increase financial distress. With very high levels of debt, firms may be unable to meet their debt obligations increasing the probability of default. There is thus a trade-off between the costs and benefits of debt. Firms are faced with a diminishing marginal benefit of debt and an increasing marginal cost of debt. In an attempt to maximize value, firms would then borrow up to a point where the marginal tax benefit is offset by the marginal costs of bankruptcy (Myers, 1984).

  1. The Agency Theory

  Agency costs stem from the separation of ownership and management which inherently leads to a conflict of interest between the managers and the shareholders. A classical case of the agency problem has been put forth by Jensen (1986) also known as the free cash flow problem. He argues that the managers of a firm having excess free cash flows may over- invest and engage in value destroying activities such as empire building. Firms can thereby increase leverage to discipline the managers. Increased leverage commits management to pay out the excess free cash flows in interest payments and invest in profitable ventures to service the debt. In such a case, leverage maybe desirable even when internal funds are available. It serves as a control mechanism to discipline managers and limits the expropriation of private benefits (Jensen, 1986; Dewatripont and Tirole, 1994; Lewis and Sappington, 1995). Another implication of the agency theory is the potential conflict of interest between the bondholders and the shareholders (Jensen and Meckling, 1976). Debt-holders have a priority on claims over equity-holders. Equity-holders can either engage in riskier projects or under- invest to minimize the flow of benefits to debt-holders. Myers (1977) notes that the problem of under-investment is particularly stronger for growth companies as it will cause them to pass on valuable investment opportunities. Such firms are better off under equity financing.

However, Grossman and Hart (1988) suggest that the problem of under-investment can be overcome by the use of short term debt. Short term debt can help align the interests of the shareholders and the management.

  1. The Signaling Theory

  This theory attempts to address the problem of under-investment caused by information asymmetries through the choice of capital structure. Ross (1977) develops a model to show that information can be transferred and firm value can be signalled to the outside investors by considering various financing alternatives. He argues that that higher leverage signals higher quality earnings and future cash flows to investors. By increasing debt levels, firms are in effect implicitly stating that they would be able to meet the additional debt obligation (increased interest expense) vis-a-vis higher future profitability and cash flows. Hence, firms may commit to higher debt levels to signal their future expectations to the market. However, the question arises that “how do firms choose their capital structure?” (Myers, 1984). Certain firm-specific characteristics that determine the capital structure of firms have come to light. These test the theories developed over the years that focus on agency costs, information asymmetry and tax benefits particularly. Titman and Wessels (1988) identify the following characteristics that can impact the financing behaviour of firms: asset structure, non-debt tax shields, growth opportunities, uniqueness, industry classification, size, earnings volatility and profitability. The hypothesized relationships between these firm-specific characteristics and leverage are based on groundings in theory. In part E, I first briefly discuss the theories surrounding the determinants proposed by Titman and Wessels (1988), followed by a detailed theoretical framework of my variables of interest which are firm size, asset tangibility, profitability, growth and earnings volatility. Four of these factors, namely firm size, asset tangibility, profitability and growth have been identified by Rajan and Zingales (1995) and Frank and Goyal (2007) as being the most reliable determinants2. However, these have been found to be consistent factors for public firms only. Some initial studies on private sector by Deloof and Verschueren (1998) and Schoubben and Hulle (2004) find a significant relationship between earnings volatility and leverage. Some other factors such as equity risk premium and share  2 Frank and Goyal (2007) also find industry mean leverage to be a reliable determinant of capital structure. However, I exclude this from my analysis as I introduce industry fixed effects in my analysis to control for inherent variation across industries.

price performance have also been used as determinants of capital structure. However, these can only be studied for public firms. I, therefore, limit my study to the aforementioned five firm-specific characteristics. In part F, I draw references to the fundamental differences between public and private firms and how these differences may lead to differences in funding behaviour. In part G, I discuss certain institutional factors that may contribute to the differences in leverage across countries.

  1. Determinants of Leverage

 

  1. overview

  Myers and Majluf (1984) propose a positive relation between the collateral value of assets and leverage. They argue that firms may be better-off selling secured debt as means to reduce information asymmetries. According to DeAnglo and Masulis (198o), firms having large non-debt tax shields will have a reduced incentive to benefit from the tax advantage of debt. Consequently they would undertake less leverage. Firms having high amounts of debt are likely to forego profitable investment opportunities (Myers, 1977). Therefore, firms  expecting high future growth will be motivated to issue equity to finance their projects. Similarly, firms offering unique products face higher costs of bankruptcy in the event of liquidation (Titman, 1988). This is due to the specialized skills and needs of the employees and customers respectively that cannot be duplicated easily. Hence, such firms would be expected to have lower leverage. Building onto this hypothesis, Titman (1988) argues that manufacturing firms should have lower leverage compared to specialized industry firms. Likewise, larger firms are able to undertake higher leverage as they tend to be more diversified and hence, face lower bankruptcy risks (Ang, Chua and McConnell, 1982; Warner, 1977). Firms with more volatile earnings also have less incentive to have high debt levels due to limited tax advantage of debt (Deloof and Verschueren, 1998). Last, in line with the Pecking order theory, the literature suggests that profitable firms will utilize internal funds and thus have lower leverage (Myers, 1984; Donaldson, 1961). In their survey of European firms, Bancel and Mittoo (2o11) find that that financial flexibility, credit ratings and tax advantages of debt are the most important factors shaping the debt policy of firms. Moreover, the level of interest rates and share price are considered in timing the debt and equity issues. An enormous amount of literature has been devoted to

empirically test the determinants of capital structure. The results suggest significant departures from theory in practice. Titman and Wessels (1988) find that uniqueness and profitability of firms are negatively related to the debt levels. However, they find no evidence between the relationship of leverage and firm’s expected growth, non-debt tax shields, collateral value of assets and earnings volatility. on the other hand, Harris and Raviv (1991) perform a survey and find that leverage is positively correlated to firm size, asset tangibility, non-debt tax shields and investment opportunities but negatively related to bankruptcy risk and uniqueness. Rajan and Zingales (1995) report that leverage is positively correlated with size and asset tangibility but negatively correlated with profitability and growth. A summary of some of the earlier empirical studies conducted on public and private firms are provided in the following tables.
Relationship between Leverage and its Determinants in prior Empirical Studies on Public Firms  

Study Sample Period Country Relationship between Leverage and Firm-Characteristics
  Size   Tangibility   Growth   Profitability Earnings volatility Effective Tax Rate Dividend Payout Non-debt Tax Shields Share Price Performance Term Structure of Interest Equity Premium
Titman and Wessels (1988) 1974- 1982 USA + NS NS NS X X NS X X X
Rajan and Zingales (1995) 1987- 1991 G-7 + + X X X X X X X
Frank and Goyal (2001) 1971- 1993 USA + + X X X X X X
Antoniou, Guney and Paudyal (2008) 1987- 200o   G-5   +   +   –   –   NS   –   NS   –   +   –   +

X: Not Applicable NS: Not siginificant All other hypothesized relationships are significant

Relationship between Leverage and its Determinants in prior Empirical Studies on Public and Private Firms  

Study Sample Period Country Relationship between Leverage and Firm-Characteristics
Size Tangibility Growth Profitability Earnings volatility
Shuetrim, Lowe and Morling (1993) 1973-1991 Australia + + + X
Deloof and Verschueren (1998) 1992-1994 Belgium + + +
Schoubben and Hulle (2004) 1992-2002 Belgium + + +
Brav (2009) 1993-2002 UK + + + X

X: Not Applicable NS: Not siginificant All other hypothesized relationships are significant

The above tables give an insight into the capital structure determinants of public and private firms. Empirical research suggests that firm size and tangibility are overall positively correlated with leverage. Profitability appears to be negatively correlated with leverage across public and private firms. However, leverage tends to differ amongst public and private firms with respect to growth opportunities. While public firms have a negative relation with leverage, private firms appear to have a negative relation. This could be due to the inability of private firms to generate sufficient internal funds to fund their operations relative to the public counterparts. They may therefore, tap the debt markets to raise funds. Below, the theories behind the observed relationships between leverage and firm-specific characteristics are provided.

  1. Size

  Ang et al. (1982) suggest that there is an inverse relation between bankruptcy costs as a portion of firm value and firm value itself. They state that “direct bankruptcy costs appear to constitute a larger proportion of firm value as that value decreases”. Also, it appears that larger firms face lower bankruptcy costs as they tend to be more diversified (Titman and Wessels, 1988). Hence, in line with the trade-off theory, larger firms may be more levered as they have lower costs of financial distress. Rajan and Zingales (1995) report leverage to be positively correlated to firm size for all G-7 countries except Germany which shows a negative relationship. Deloof and Verschueren (1998) also conclude size to be positively reported to leverage but this relationship does not hold when considering short-term debt only. However, some other studies have also shown that due to higher information asymmetries, the cost of issuing equity for small firms is relatively high (Smith, 1977). Rajan and Zingales (1995) suggest that information asymmetry between the inside managers and external capital markets is less in larger firms. Thus the cost of equity should correspondingly be lower for larger firms and hence a preferred medium of financing. Issuance costs maybe another consideration when deciding between different sources of external capital. These costs may be a major deterrent for small firms to tap equity markets (Schoubben and Hulle, 2004). They may therefore issue debt to reduce these issuance costs. The latter two theories predict a negative relationship between size and leverage.

  1. Asset Tangibility

  The type of assets owned by a firm may motivate the financing behaviour of firms. Myers and Majluf (1984) propose a positive relation between the collateral value of assets and leverage. They argue that firms may be better-off selling secured debt as means to reduce information asymmetries. It may be more costly for firms to sell a security about which outside investors have little information. Likewise, Scott (1977) has proposed that firms may increase the value of their equity by issuing secured debt. Extending this argument, Galai and Masulis (1976) suggest that if debt is collateralized, borrowers are constrained to use the funds for a specific project only. Since no such restriction can be enforced in the case of unsecured debt, lenders may negotiate more costly terms of debt financing. This may lead firms to issue equity rather than debt. Rajan and Zingales (1995) suggest that the collateral value of assets should serve to reduce the agency costs of debt and equity such as risk shifting. Lenders would thus be more willing to provide credit to firms having high asset tangibility. on the contrary, Grossman and Hart (1982) propose leverage to be negatively correlated with asset tangibility in line with the agency theory. Higher levels of debt can be undertaken to align the interests of the managers and the shareholders. Higher leverage would induce higher bankruptcy costs and thus limit the expropriation of private benefits by managers. Grossman and Hart (1982) argue that agency costs maybe higher for firms having lower collateralizable assets as it is more difficult to monitor the capital outlay of such firms. It may thus be the case that firms with low collateral value of assets may be more levered in an attempt to discipline managers. Previous empirical studies, such as Rajan and Zingales (1995) and Harris and Raviv (1991), have generally reported a positive relationship between asset tangibility and leverage.

  1. Growth

  The relationship between growth and leverage is ambiguous. Financing firm operations through debt commits the firms to service the debt. on one hand, growth firms may avoid taking debt as it may lead them to pass on profitable investment opportunities due to debt servicing (Myers, 1977). Titman and Wessels (1988) note that “growth opportunities are capital assets that add value to a firm but cannot be collateralized and do not generate current taxable income”. Hence, this suggests a negative relationship between debt and growth opportunities consistent with the aforementioned theories. on the other hand, growth firms

may be in need of capital, beyond internal financing, to fund their investments. Hence, they may be more likely to tap the debt market rather than equity markets as hypothesized by Myers and Majluf’s Pecking order theory (1984). Deloof and Verschueren (1998) find a positive relationship between leverage and growth. Galai and Masulis (1976) and Jensen and Meckling (1976) have modelled that shareholders of levered firms have an incentive to invest sub-optimally to divert wealth from bondholders. They find that this agency problem is more pronounced for growth firms that have significantly large investment opportunities. In order to avoid the sub-optimal investment, firms in growing industries would prefer to use equity financing over debt financing. Myers (1984) suggests that this agency problem can be mitigated through the issue of short term debt rather than long term debt and Green (1984) suggests the use of convertible debt. Rajan and Zingales (1995) find a negative relation between growth and leverage. However, they suggest that this negative relationship could also be due to firms timing their equity issue when their stock prices are high. This temporarily causes leverage to be lower. Alternatively, Fama and French (1992) argue that high leverage induces high costs of financial distress. The market tends to discount the shares of firms in financial distress at a higher rate thus leading  to the above stated negative relation.

  1. Profitability

  The relationship between profitability and leverage is the most critical means of testing the Pecking order theory proposed by Myers and Majluf (1984). According to this theory, firms follow a financing hierarchy. In an environment characterized by information asymmetry, it is costly to issue a security about which outside investors have little information. Thus, internal financing is the cheapest means of funding projects. As debt-holders have a higher claim on firm assets as compared to equity-holders and they receive regular streams of interest payments, debt suffers less from information asymmetry as compared to equity. Hence in deciding the sources of financing, firms will prefer internal funds to debt and debt to equity. The Pecking order theory suggests that profitable firms will have lower leverage as they will primarily meet their financing needs through retained earnings. Also, cash flow rich firms may suffer from the agency problems of free cash flows as proposed by Jensen (1986). Managers may expropriate private benefits creating a conflict of interest between the managers and the shareholders. Leverage may thereby be increased to discipline the managers

and limit their consumption or perquisites. This predicts a negative relationship between leverage and profitability. However, it may be the case that lenders may be more willing to lend to profitable firms. If  so, more profitable firms would have greater access to debt markets. Moreover, profitable firms would more likely be able to benefit from greater tax advantages of debt. This might induce them to be more levered as dictated by the Trade-off theory. Also, Schoubben and Hulle (2004) suggest that profitable firms may be less inclined to take debt in an attempt to reinstate their profitability as a signal of high quality. Titman and Wessels (1988) and Rajan and Zingales (1995) report a negative relationship between leverage and profitability.

  1. Earnings Volatility

  Volatility of earnings is a proxy for firm risk. The riskier the firm, the higher are the costs of financial distress and greater is the probability of default. The Trade-off theory predicts that riskier firms would then be less levered due to high bankruptcy costs. Also, firms having volatile earnings may not be able to fully benefit from the tax advantage of debt. Similarly, Titman and Wessels (1988) state optimal debt level to be a decreasing function of earnings volatility. Deloof and Verschueren (1998) report a negative relationship between earnings volatility and leverage. Schoubben and Hulle (2004) argue that as risk of a firm increases, the cost of debt increases simultaneously. Creditors incorporate the cost of bankruptcy in their debt contracts to protect themselves. This causes the cost of debt to increase. Hence, in line with the Pecking order theory and the general higher cost of debt, risky firms should rely on internal funds rather than debt. This suggests a negative relation between leverage and a firm’s earnings volatility. However, they argue that the impact of asymmetric information is heightened in riskier firms. There is thus a need for “quality signalling and discipline” (Schoubben and Hulle, 2004). As per the capital structure theories, this would imply a positive relationship between the two.

  1. Differences in Capital Structure of Public and Private Firms

  Public and private firms differ primarily in their listing status, ownership concentration and information asymmetry. Public firms are listed on a stock exchange, usually have a diversified shareholder base and are legally required to disseminate detailed information to their shareholders through quarterly and annual reports. on the other hand, private firms are

unlisted, usually have concentrated ownership and are not required to make detailed financial disclosures.

  1. Access to Capital Markets

  Public firms can issue capital to the general public whereas private firms cannot approach the general public for capital as they are not listed on an exchange. Consequently, public firms have a greater access to capital markets than their private counterparts. Brav (2009) categorizes the predictions offered by the theories of capital structure into two effects, namely the level effect and the sensitivity effect. According to the level effect, he argues that the level of debt ratios of private firms is higher than the public firm debt ratios due to high costs of equity of private firms relative to the cost of debt. As per the sensitivity effect, he states that due to the overall higher costs of tapping the capital markets, private firms are likely to  exhibit passive financial behaviour. His study finds strong support for these effects. A similar study done by Faulkender and Petersen (2006) on public firms shows that firms which have greater access to debt markets (as proxied by a credit rating) have a greater ability to borrow and hence, have higher leverage.

  1. Information Asymmetry

  Similarly, the degree of information asymmetry can also influence the financing behaviour of firms. Private firms are more opaque than public firms as they are not required to make detailed disclosures about their financial position. outside investors only have limited information available to assess the financial health of private companies. As equity has a secondary claim on the firm’s cash flows as compared to debt, it is more sensitive to information asymmetry (Myers and Majluf, 1984). Investors would, thus, require a higher return to compensate from this additional risk of opacity. Noe (1988) notes that due to the  lack of transparency, the cost of equity is much higher for private firms than public firms. Also, the cost of equity relative to debt is higher for private firms (Brav, 2009). Hence, private firms would prefer debt to equity financing.

  1. ownership Concentration

  As aforementioned, private firms have high ownership concentration. on the contrary, public firms have a diversified shareholder base. Thus, control is highly valuable for equity share

blockholders of unquoted firms. This has two important implications for the cost of equity of private firms relative to public equity. First, as Stulz (199o) points out that a majority shareholder would be unwilling to resort to equity financing if it would potentially result in a dilution of his shareholding and thus, his control. Hence, the cost of giving away this control (cost of equity) is higher for private firms (Amihud et al., 199o). The existing majority shareholders would require a greater compensation to transfer their control. Also, the new shareholders would not only be paying for a residual claim on the firms cash flows but will also pay for the value of control. As, public firms have diluted ownership, the value of control is almost non-existent. Second, as minority shareholders of private firms do not have the same protection and disclosure as under public firms, equity of private firms is riskier for a minority shareholder (Brav, 2009). He would thus require a higher return to compensate him for this additional risk factor in order to purchase it. There is a third dimension added to this argument by Morrellec (2004). He argues that due to a more prominent separation between the management and the ownership in public firms, the managers of a public firm may use equity as a means to dilute the ownership of any single large shareholder. This implies that equity becomes a preferred means of financing for public firms as compared to private firms.

  1. Institutional Factors

  Differences in leverage across countries can be attributable to differences in institutional factors. Countries are broadly characterized as belonging to two distinct legal traditions namely the common law regime and the civil (code) law regime. The English common law is the most dominant legal origin of the common law regimes. The civil law regime has various legal origins which include the Germanic code, the French code and the Scandinavian code. The legal environment of each country is determined by first and foremost the prevalent legal tradition and second by the legal origin to which they belong. Investor protection is then a function of these two factors. My sample countries are ideal for studying these institutional differences. The UK belongs to the English common law regime whereas Germany and the Netherlands are characterized by the Germanic code law and the French code law respectively.

Each of these three legal origins has distinct laws which provide for the protection of investors. Such laws and the degree of enforcement of these laws might dictate the financing behaviour of firms. La Porta et al. (1997, 1998) make an attempt to extensively investigate the impact of legal origins on certain firm specific characteristics such as ownership concentration. They provide an index measuring the degree of investor protection (creditors and shareholders) based on different enacted laws such as bankruptcy laws, shareholder activism laws and so on3. The index calculated by them rates creditor and shareholder protection on a scale of o to 4 and o to 6 respectively, 4 and 6 being the most highly protected environment. The UK is reported to have a creditor rights rating of 4, whereas it is 3 and 2 for Germany and the Netherlands respectively. Due to stronger creditor protection in the UK, one might expect UK firms to have higher leverage as creditors will be willing to lend on favourable terms. Similarly, shareholder rights, as proxied by the anti-director rights, are highest for the UK (5) and lowest for Germany (1) whereas the Netherlands is midway at a rating of two. Also, La Porta et al. (1998) report a highly efficient judicial system in all three countries implying a high degree of enforcement. These measures seem to suggest that investors overall are most highly protected in the UK. Low shareholder protection and relatively high creditor protection in the Germany might make debt a preferred medium of financing for firms as cost of equity might be very high. Similarly, poor outside shareholder protection in Germany and the Netherlands suggests why firms in these countries are closely held whereas UK firms have dispersed ownership. Also, the relatively high ownership concentration in Germany may very well suggest that firms in Germany on average have higher leverage as shareholders may not be willing to dilute their control by issuing equity. Some prior studies on capital structure have identified cross-country differences in leverage. Rajan and Zingales (1995) find that countries with similar capital markets, such as the UK and the United States, have very different leverage. Hence, other institutional factors such as tax laws and bankruptcy laws are important considerations. Antoniou et al. (2008) find that leverage across countries differ significantly. They further conclude that ownership  3 For a greater explanation of the index creation, please refer to La Porta, Rafael; Florencio Lopez-de-Silanes; Andrei Shleifer; and Robert W. Vishny, 1998, Law and Finance, Journal of Political Economy 1o6, 1113–1155.
concentration and leverage are positively related. This is in line with the agency theory whereby closely held firms would prefer debt over equity to avoid dilution of their control. Creditor rights and leverage are also found to be positively related as higher protection of creditors reduces the cost of debt and makes debt a favourable financing medium. However, they also report a positive relation between debt and shareholder protection. They argue that higher shareholder protection reduces information asymmetry and thereby increases debt capacity. overall, it can be seen that significant differences in leverage are seen to persist across countries.

III.             Hypothesis Development

  In line with the theoretical framework and prior empirical investigations, I develop my hypotheses. Consistent with the trade-off theory, I expect size and leverage to be positively correlated. Private firms by nature suffer from high information asymmetries. Hence, large private firms should have the ability to have more debt due to lower bankruptcy costs and greater access to capital markets than small private ones. H1a: Larger firms are likely to have higher leverage, ceteris paribus.   Firms may decrease their cost of debt by issuing secured debt. Alternatively, lenders may also be more willing to provide credit to firms that have a high collateral value of assets. Hence, firms having higher asset tangibility should have more access to debt markets. H1b: Firms with higher asset tangibility are likely to have higher leverage, ceteris paribus.   Theory supports a negative relation between firm leverage and growth opportunities as higher costs of external capital may cause firms to pass up profitable investments. However, majority of the prior empirical studies on public firms have shown a positive relationship between  these variables. This can be due to limited internal funds to finance the growth opportunities and hence a reliance on debt rather than equity in line with the Pecking order theory. Hence, I expect to find a positive correlation between leverage and growth. H1c: Firms with higher growth are likely to have higher leverage, ceteris paribus.

In line with the Pecking order theory and prior empirical findings, I expect private firms having sufficient retained earnings to be less levered. I expect the more profitable firms to utilize internal funds before tapping the external market. H1d: Firms having high profitability are more likely to have lower leverage, all else equal.   Higher earnings volatility may reduce the tax benefit incentive of private firms. Also, riskier private firms may be more reluctant to finance using debt due to higher costs of bankruptcy. H1e: Firms having higher earnings volatility more likely to have lower leverage, ceteris paribus.   Private firms have limited access to capital markets relative to public firms. Hence, it is likely that they tap the external markets less frequently. In the event of raising external capital, the cost of issuing equity for private firms is much higher relative to, both, debt and public equity. Hence, when faced with financing decisions, private firms are more likely to resort to debt compared to public firms, leading to higher leverage ratios. H2: Private firms are likely to have relatively higher leverage than public firms, ceteris paribus.  

IV.             Data

 

  1. Sources

  I use the Amadeus database, managed by the Bureau van Dijk (BvD) to collect financial statement information (balance sheet, income statement and cash flow statement items) of private and public companies in the UK, Germany and the Netherlands for the period 2003- 2o11. BvD only covers consolidated statements for up to a maximum of ten years for any firm. Data for an active firm therefore is available till 2002 at the latest, whereas it may go beyond for an inactive firm. Therefore, I restrict my study to the period 2003-2o11 to avoid any selection bias. As aforementioned, my choice of the three countries is motivated by their developed financial markets and their different legal traditions. The UK is defined by the English legal origin, Germany by the Germanic legal origin and the Netherlands by the  French legal origin.

Amadeus is a comprehensive database containing financial information for over 19 million public and private companies across forty-one countries in Europe. It focuses specifically on private firms and hence, is an ideal source for my research. In fact, the strength of the database lies in its extensive coverage of private firms which otherwise offer very little information to the general public. Moreover, it represents data in a standard format which is easy to compare and understand. Bureau van Dijk partners with various information  providers to collect, process and deliver authentic and updated information products. In addition to this, Amadeus particularly combines news and information from various sources such as Financial Times, Reuters and original annual/interim reports of companies. In addition to the financial data, I require information regarding the listing status of the firms under study. Though this is provided by the Amadeus database, the variable reported only represents the status of the firm as of the latest fiscal year. Since my study spans a period of ten years, there is a likelihood that some firms in the sample were taken private while some had an initial public offering (IPo). Hence, I make use of the Zephyr database, also managed by the BvD, to complement the data extracted from Amadeus. The Zephyr database, like Amadeus, contains extensive coverage deal information related to Mergers and Acquisitions, Initial Public offerings, Private Equity and Venture capital deals. Moreover, as both these databases are managed by BvD, I can easily merge the datasets using the unique BvD identification code for each company. I identify all take private and IPo deals within the three countries and merge it with my original data set.

  1. Sample

  My sample includes all the incorporated entities in the UK, Germany and the Netherlands for the period 2003-2o11. Very small firms often have missing data as they are not required to furbish an income statement. Hence, these firms are automatically excluded from the analysis. I follow certain criteria to restrict my sample to obtain robust findings. First, I screen firms on the basis of the type of accounts they prepare and report. Rajan and Zingales (1995) duly notify that firms with unconsolidated balance sheets tend to understate leverage as compared to comparable firms that provide consolidated statements. The reasons for this are two-fold.

  1. Firms having unconsolidated balance sheets report an affiliate’s net assets as long term investments resulting in a higher asset base.
  2. These firms may report lower debt on the balance sheet via inter-firm credit transactions conducted with an affiliate.

In line with these arguments put forth by Rajan and Zingales (1995), I only include firms reporting consolidated financial statements to avoid inconsistencies in the analysis. Second, I exclude firms belonging to certain industries as identified by the first two digits of their Nace-Rev 2 Code. Brav (2009) identifies certain industries whose capital structure is regulated and have an entirely different scope and nature of operations. These firms include the financial sector firms (Nace-Rev 2: 64-66), public sector firms (Nace-Rev 2: 84) and public utilities (Nace-Rev 2: 35-39). Third, I follow the approach used by Brav (2009) in his analysis on private firms. According to this approach, I include only the following types of firms: Private/Public Limited Liability, Public Not Quoted, Public Quoted, Public Quoted oFEX (off-Exchange) and Public AIM (Alternative Investment Management) as the theories of capital structure are based on limited liability companies. My analysis excludes Guarantee, Limited Liability Partnership, Public Investment Trust and Unlimited firms. Last, I identify firms that went public via an IPo or were taken private during the study period. For a firm that underwent an IPo, I define the status of the firm as private pre-IPo and public thereafter. Similarly, with the take private deals, I earmark the firm as being public before the deal year and private thereafter. After screening my dataset on these criteria, my sample consists of a total of 14,863 firms of which 5,598 are public and 9,265 are private, 17 IPo deals and 1o take-private deals as shown in Table 3 below. Table 3 Sample Statistics

Germany Netherlands United Kingdom All
Public firms 54 112 877 5,598
Private firms 8o2 4,667 8,351 9,265
All firms 856 4,779 9,228 14,863
  1. Research Methodology

  I follow the methodology used by Brav (2009) in his empirical study on the funding behavior of public and private firms in the UK. Following this methodology, I employ a pooled panel ordinary least



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