The conventional wisdom on ‘going public’ is that it is a rational decision for a growing firm looking for new capital to fund investment. But many successful companies have chosen to stay private. And it can be argued that some developed countries have benefited from having fewer publicly quoted companies.

While the role of the stock market varies greatly between countries, a clear divide emerges between Anglo-Saxon and continental European countries. In the latter, where banks rather than the stock market play the more important role in financing and monitoring companies, only a few large mature corporations are listed. In the former, the resort to the market is much more widespread, especially for young companies. But even within the developed financial markets of the UK and US, some large companies are not publicly held.

Marco Pagano, Fabio Panetta and Luigi Zingales have studied a large sample of Italian companies to find out why some companies decide to go public while others do not. They compare the characteristics of companies before and after their initial public offering (IPO) with those of a large sample of private companies of similar size. And they make a distinction in the process of going public between independent companies and subsidiaries of companies that are already publicly quoted – ‘carve-outs’.

The researchers start by asking what testable hypotheses economic theory provides about the decision to go public. The most obvious benefit is to gain access to an alternative to bank finance and reduce the cost of capital. So theory predicts that companies with large investment plans and high levels of debt (leverage) in their balance sheets will take the plunge. Going public may also give the company more bargaining power relative to its bankers and reduce its interest costs on existing debt.

A third reason might be portfolio diversification: owners aim to spread their risk, either by selling part of the family business and buying equity in a broader portfolio of assets, or by raising new equity, which can then be used to acquire stakes in other companies. Going public, and the threat of takeover this brings, may also be used by owners to increase the market disciplines on the managers they employ.

A stock market listing means greater liquidity for small shareholders, thus tending to raise the share price. So if the owners want to sell to dispersed shareholders, they have a fifth incentive to go public. Going public may also be an optimal first step if the owners ultimately plan to sell the company, since an initial sale to small shareholders may boost the market value of the company. Indeed, the very fact of flotation may increase public recognition of the company and so raise its share price.

Lastly, companies which believe that other public companies in their sector are overpriced have an incentive to go public and take advantage of this window of opportunity to benefit from overpricing.

These are the benefits, but there are also costs to going public (in addition to the administrative expense). Because investors know less about private companies, there is a greater incentive for ‘bad’ companies to go public: this tends to depress the share price of all newly listed companies. In the presence of such ‘adverse selection’, the process is more expensive for small and new companies. But to prove that they are not bad companies, owners have an incentive to hold onto their shares. This loss of confidentiality after flotation also means that it is harder to keep R&D plans quiet or to avoid tax.

The authors’ analysis allows them to test many of these theoretical motivations. They use accounting data for 2,181 Italian companies for 1982–92 and compare companies going public with a large number of companies that could have gone public but chose to remain private.

Surprisingly, the need to raise new capital for investment does not seem to be a prime motivation for going public. The researchers do find, however, that the main factor affecting the probability of an IPO is the price that a new public company could expect to fetch on the stock market measured by the median ratio of the market-to-book value of equity of public companies in the same industry.

This positive relationship might suggest that the need for investment funds is an important determinant of IPOs, with a high market-to-book ratio reflecting a higher investment need in sectors with high growth opportunities. But investment is not statistically related to the probability of going public in the study. In fact, while investment tends to be higher before flotation, it tends to fall after IPOs. For previously independent companies, the fall is large and permanent, equivalent to a 7% reduction in the capital stock.

The alternative explanation for the link with market-to-book ratios is that entrepreneurs are busy looking for windows of opportunity when shares are overpriced and hence time their launch accordingly. This explanation seems particularly important for carve-outs for which the market-to-book relationship is 50% bigger than for independents.

While raising new investment capital may not be the motivation for an IPO, the desire to reduce the cost of servicing existing debt certainly is. Independent IPO firms do experience a reduction in the cost of their bank credit. They also borrow from a larger number of banks and reduce the concentration of their borrowing, suggesting an increase in a firm’s bargaining power vis-à-vis its banks.

Portfolio diversification does not appear to play an important role in the decision to go public. When an independent company undertakes an IPO, the initial owners divest only 6% of their holdings then and 3% more in the subsequent three years, hence retaining much more than a majority stake. Divestment is much larger for carve-outs, as the window-dressing hypothesis would suggest. And while profitability tends to fall after flotation for all companies, it falls further for carve-outs.

The study finds that a company’s size significantly affects the probability of listing for previously independent companies and that there are few young start-up companies that go public to finance their expansion. As administrative costs in Italy are low, this suggests that adverse selection and the costs of reputation are important obstacles to flotation. Alternatively, it may be the cost of the higher visibility to tax and legal authorities: the study finds some evidence that the fiscal burden increases when companies go public.

So does the stock market play an important and positive role for new companies? Yes, Pagano et al conclude, but a very different one from the perceived investment-enabling role in Anglo-Saxon countries. The fact that independent companies tend to display abnormally high investment and growth before flotation and then cut investment afterwards suggests that the stock market may allow the company to rebalance its accounts after a period of high investment and growth, and reduce leverage.

Carve-outs, by contrast, appear to be mainly strategic financial operations, designed to exploit favourable market conditions to increase the total proceeds the parent company receives from the eventual sale of a subsidiary. So while it remains an open question how much investment and growth may be reduced if independent entrepreneurs were deprived of the equity market option, for carve-outs the answer is clear – not at all.