Preliminary Draft – Do Not Cite or Quote Without Permission
Who Needs Outside Equity?
By
Lawrence E. Mitchell
The George Washington University
I feel like a bit of an interloper here, since I’m not particularly expert in the
governance or economics of law firms. But reading through Larry’s and Gordon’s
papers, their prior work, and some other work on the subject, what struck me is that one
of the major themes underlying the call for law firm deregulation is that it will make
capital markets, and particularly equity markets, more accessible to law firms. This
struck me as a bit odd. Every student of finance knows that, all else equal, equity is the
most expensive form of financing. So why would law firms want to engage in expensive
equity financing rather than other possible forms of finance?
The scholarly debate involves a lot of theory. I’d like to introduce some facts. A
brief look at American finance history suggests that law firms, if they are indeed like
other business firms as Larry and Gordon argue, should not be especially interested in
equity finance, at least if their goal is to increase their source of productive capital. To
illustrate why, I’m going to present some truncated data, which I’ve drawn from a much
broader and more detailed study in which I’m engaged, to illustrate the highlights. The
punchline is that American business firms don’t typically finance with equity at all. The
hypothesis for purposes of this comment is that the only rational purpose for external law
firm equity finance is to allow partners to cash out at higher multiples than they can get
simply by withdrawing their partnership shares in the ordinary course.
A broad historical view demonstrates that external equity financing has been
relatively unimportant for US industrial corporations throughout the 20th and 21st
centuries (much the same could be said of British companies. I rely on American data
because I rely heavily on corporate balance sheet data and I only have had time to
examine the IRS archives to see what has been going on.
I begin with my research of recent years which has led me to the conclusion that
equity financing played a relatively insignificant role in financing American
industrialization in the 19th century, whether we’re talking about the first of our major
industries, the railroads, or any of the other great enterprises that characterized the
American economy for much of the 20th century.
Economists writing in the 1950s and early 1960s, when good data first became
available, almost universally note the essential irrelevance of the stock market to
industrial finance. My own research thus far seems to confirm that from 1926 until the
1960s (based on the best data I have at the moment), retained earnings and debt played a
far greater role in capital formation, and thus real economy production, than did equity
While limited time requires that I proceed quickly through the slides, the
following graphs show the ratios of retained earnings and various forms of debt (long-
term, and short-term and accounts payable) to capital.
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1959
1956
1953
1950
1947
1944
1941
1938
1935
1932
1929
1926
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1959
1956
1953
1950
1947
1944
1941
1938
1935
1932
1929
1926
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1959
1956
1953
1950
1947
1944
1941
1938
1935
1932
1929
1926
Surplus and Retained Earnings/Capital
10
9
8
7
6
5
4
3
2
1
0
Accounts payable and short term debt/capital
4.5
5
3.5
4
2.5
3
1.5
2
0.5
1
0
Long Term Debt/Capital
4
3.5
2.5
3
2
1.5
1
0.5
0
As you can see from the graphs, capital, by which I mean outside equity, is a
relatively low percentage of financing throughout the historical period.
This conclusion is also supported by other data, drawn from the Bureau of
Economic Analysis by Simon Kuznets in 1956 and extended to 1962 by Arnold Sametz.
These data show that, not only was external equity financing unimportant in general, but
that its importance declined significantly in the post-World War II years.
RATIOS OF INTERNAL TO TOTAL SOURCES OF FUNDS
NON-FINANCIAL CORPORATIONS, 1901-1956
1901-1912
0.55
1913-1922
0.60
1923-1929
0.55
1930-1933
1934-1939
0.98
1940-1949
0.71
1946-1956
0.61
Source: Kuznets, Table 39, page 248.
1957-1962
0. 61
Source: Sametz, Table 4, page 455.
Now the data I presented in the graphs have to be qualified. The graphs are
drawn from data compiled by Naomi Lamoreaux for the Millenial Edition of the
Historical Abstracts of the United States. In compiling IRS data, Lamoreaux presented
retained earnings and surplus as an aggregate figure. Of course surplus largely represents
capital raised from equity sales, and thus the retained earnings figures are overstated.
When I turn to the more recent years, you’ll see that I have separated paid-in surplus and
retained earnings from 1978 on, based on the original IRS records. [ I intend to do this
going back as far as the IRS records allow, to 1926, but I’m waiting for a response from
the IRS to my FOIA request to compel it to let me see the earlier data. ] At any rate, and
for what it’s worth at the moment, the graphs support my conclusion, that external equity
financing was not terribly important at least through the middle of the century.
The question becomes more interesting when the data for the period from 1978
are examined. What becomes immediately apparent is that the historical relative
importance of debt and retained earnings as a matter of productive finance diminishes,
while the relative importance of stock increases. [To remind you, I compiled these data
directly from IRS corporate balance sheet records, so I was able to break out paid-in
surplus from retained earnings, thus isolating real external equity.] It turns out that
Lamoreaux’s numbers overstate the ratios, but evidently not by much based on the work
of Kuznets and Sametz, as well as others. I also combined capital and surplus to give a
better idea of funding from external equity in general.
Ratio of
Ratio of
Ratio of
Retained
Retained
Retained
Ratio of Retained
Ratio of Retained
Earnings to
Earnings to Long
Earnings to Short
Accounts
Term Debt
Term Debt
Earnings to
Earnings to
Capital+Paid
External
in or Capital
Financing
Payable
Surplus
1978
0.370
1.21
2.070
1.070
2.194
1979
0.366
1.20
1.994
1.084
2.121
1980
0.359
1.13
1.972
1.084
2.118
1981
0.337
0.97
1.887
1.106
1.997
1982
0.305
0.85
1.809
0.987
1.841
1983
0.289
0.77
1.898
0.963
1.678
1984
0.261
0.69
1.764
0.875
1.509
1985
0.230
0.58
1.532
0.804
1.364
1986
0.201
0.47
1.517
0.704
1.272
1987
0.175
0.41
1.344
0.626
1.075
1988
0.166
0.39
1.360
0.591
0.972
1989
0.165
0.37
1.396
0.611
0.951
1990
0.142
0.32
1.289
0.529
0.782
1991
0.132
0.29
0.857
0.534
0.961
1992
0.125
0.26
0.892
0.522
0.918
1993
0.137
0.27
1.134
0.579
1.059
1994
0.126
0.25
1.057
0.548
0.928
1995
0.148
0.29
1.253
0.657
1.078
1996
0.152
0.29
1.322
0.690
1.082
1997
0.164
0.31
1.475
0.765
1.206
1998
0.151
0.28
1.350
0.701
1.050
1999
0.154
0.29
1.416
0.726
1.080
2000
0.120
0.22
0.965
0.587
0.902
2001
0.065
0.12
0.543
0.314
0.516
2002
0.032
0.06
0.273
0.155
0.291
2003
0.068
0.13
0.532
0.313
0.577
2004
0.089
0.18
0.581
0.402
0.745
2005
0.111
0.21
0.718
0.520
1.033
Source: IRS
Look especially at column 1, the ratio of retained earnings to external financing.
In place of the Kuznets-Sametz first half century range of 55% to 71% (leaving aside the
extraordinary 98% during the period when America was emerging from the Great
Depression), we see 37% in 1978, dropping as low as 3% in 2002 (which can be
explained by the consequences of 9/11), but still well below 20% from 1986 on. Clearly,
the importance of retained earnings in relation to external financing has evaporated and,
as you can see from the chart, this is also true of the various forms of debt, although
accounts payable shows some degree of relative stability.
The next graph maps all of the ratios together:
Ratio of Retained Earnings and Other Debt to Total External Financing
0.400
0.350
0.300
0.250
0.200
0.150
0.100
Ratio of Retained Earnings to External
Financing
Ratio of Accounts Payable to External
Financing
Ratio of LT Debt toExternal Financing
0.050
Ratio of ST Debt to External Financing
Ratio of Capital+Paid in or Capital Surplus to
External Financing
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
0.000
Perhaps the most striking thing about these data is not only that they depart from
historical trends but that they are entirely counterintuitive. For what we see is that,
almost precisely when the going-private movement began, in the late ‘70s, in the form of
leveraged transactions, in which it has principally continued, the relative importance of
retained earnings and all forms of debt plummet and equity rises. In light of the fact that,
by definition, going private transactions remove equity from the public market, and the
common understanding that debt financing was the principal means of accomplishing
this, we would expect to see exactly the opposite result, even accounting for the dot.com
boom of the late ‘90s. The diminution in the ratio of retained earnings to external
financing by itself isn’t especially surprising, since one characteristic of attractive
takeover targets is large amounts of cash with which to pay debt service, and one might
conclude that leveraged going private transactions eat internal equity and continue to eat
cash flows that might add to that equity, but the debt numbers in light of what we know,
or at least think we know, about the period are astonishing, although some portion of this
diminution undoubtedly is accounted for by off-balance sheet financing transactions. The
astonishment is compounded when we also recognize that the mid-‘90s to the present
have been a time of historically low interest rates, which would also suggest that debt
financing would have become increasingly attractive as a matter of financing
productivity.
And add to the going private transactions data showing huge volumes of corporate
stock buybacks, also suggestive of a diminution in outstanding equity, and the reverse
trends become even more puzzling.
S&P 500 - Stock Buybacks (Billions of Dollars)
200
180
160
140
120
100
80
60
40
20
Mar-98
Jun-98
Sep-98
Dec-98
Mar-99
Jun-99
Sep-99
Dec-99
Mar-00
Jun-00
Sep-00
Dec-00
Mar-01
Jun-01
Sep-01
Dec-01
Mar-02
Jun-02
Sep-02
Dec-02
Mar-03
Jun-03
Sep-03
Dec-03
Mar-04
Jun-04
Sep-04
Dec-04
Mar-05
Jun-05
Sep-05
Dec-05
Mar-06
Jun-06
Sep-06
Dec-06
Mar-07
Jun-07
Sep-07
0
Market
Value
Operating
Earnings
AS
Reported
Earnings
Dividends
Buybacks
Mar-98
8,626
86
81
29
26
Jun-98
8,956
90
78
33
29
Sep-98
8,125
83
72
34
38
Dec-98
9,942
93
69
32
32
Mar-99
Jun-99
10,513
11,232
96
108
90
102
33
34
34
32
Mar03
Jun03
Sep03
Dec03
Mar04
Jun-
Market
Value
Operating
Earnings
AS
Reported
Earnings
Dividends
Buybacks
7,827
115
110
36
30
9,001
119
103
38
28
9,208
133
126
40
34
10,286
138
122
47
39
10,461
10,623
147
158
141
142
42
43
43
42
Sep-99
10,554
107
98
37
31
Dec-99
12,315
115
107
34
45
Mar-00
12,686
118
116
35
49
Jun-00
12,484
128
116
35
37
Sep-00
12,599
124
120
36
31
Dec-00
11,715
116
80
35
34
Mar-01
10,463
91
50
36
33
Jun-01
10,385
96
82
34
31
Sep-01
11,027
81
44
35
34
Dec-01
9,437
83
47
38
35
Mar-02
10,502
99
84
35
30
Jun-02
9,091
107
63
38
31
04
Sep04
Dec04
Mar05
Jun05
Sep05
Dec05
Mar06
Jun06
Sep06
Dec06
Mar07
Jun07
10,398
157
132
46
46
11,289
167
130
50
66
10,820
164
154
49
81
10,890
178
167
49
81
11,083
170
161
55
104
11,255
182
156
53
100
11,660
187
177
54
117
11,497
199
182
55
110
12,020
207
193
62
105
12,729
197
182
58
118
12,706
200
191
58
118
13,350
205
208
59
158
In the three year period ended December 31, 2007, the corporations comprising
the S&P 500 spent $1.3 trillion in buybacks, compared to $1.27 trillion on capital
expenditures, $376 billion on R&D, and $605 billion on dividends. And while aggregate
data can be misleading, 279 of the S&P 500 companies spent more on buybacks than
capital investment. [During this period, 12.5% of the outstanding shares on the market
were removed due to buybacks alone, just under a majority of which went into treasury
stock with the balance used for M&A and options.[ Financial corporations, while active
in buybacks, only account for 20% of the buybacks in recent years. The relevance of this
last fact will become clear in a moment.
The reverse trend becomes positively astounding when you look at Federal Flow
of Funds data and see that from 1982, except for two brief periods between 1991 and
1993, and between 2000 and 2003, net equity issuances by all corporations have been flat
or negative, and that a significant dip occurs between 1996 and 1998 during the dot.com
boom:
Corporate Equity - Net issues (Billions of Dollars)
200
100
0
-100
-200
-300
-400
2006
2003
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
1967
1964
1961
1958
1955
1952
1949
1946
-500
It then occurred to me to separate out non-financial corporations from financial
corporations and here’s what we get. An immaterial positive blip here and there but
tending around zero to deeply negative in the case of non-financial corporations, largely
following the overall story for all corporations:
Corporate Equity - Nonfinancial Corporate Business (Billions of Dollars)
100
0
-100
-200
-300
-400
-500
-600
So perhaps the dramatic increase appears elsewhere, and the likely suspect is on the
balance sheets of financial corporations.
In fact it does. Note that the first uptrend begins almost precisely at the time of the
beginning of the going-private movement, when overall equity issuances were down, and
2006
2003
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
1967
1964
1961
1958
1955
1952
1949
1946
-700
that the most recent and significant up-trend begins in 1997, just a year after the big dip
started during the dot.com boom when we thought we saw countless IPOs:
Corporate Equity - Financial Sectors (Billions of Dollars)
120
100
80
60
40
20
0
-20
So here we are. Financial corporations, which have huge demands for liquid
capital, are the only class of American corporations that issue significant amounts of
equity for financing purposes. The entire history of American finance in the 20th and 21st
centuries tell us that no other class of corporation issues large amounts of equity to
finance the formation of productive capital. While I don’t have final data yet, it appears
that much of the equity issued during the late 1990s was secondary, to provide liquidity
for entrepreneurs and venture capitalists, not for corporate production. So I end with the
question with which I began. Why would law firms issue equity? It cannot be the case
2006
2003
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
1967
1964
1961
1958
1955
1952
1949
1946
-40
that they have anything like the need for liquid capital that financial firms do. The
obvious conclusion is that it is the liquidity of the partners, not the firms, that matters. If
this is true, and unless law firms are dramatically different from other kinds of industries,
which in this respect I doubt, the deregulation of law firms to allow them to access capital
markets requires serious examination with this conclusion in mind. I don’t remotely have
time to go into how the analysis changes, or the implications of allowing law firms to
access the public markets, but clearly it does.