“Because the financier risks losing his money to uncertainty, adverse selection, or moral hazard, he hesitates to lend when the financial infrastructure is not adequate to resolve these problems. But he can still protect himself by requiring collateral-valuable assets that the financier can keep in case the borrower defaults.” Rajan and Zingales, Saving Capitalism from the Capitalists.
When most people think of investment, what comes to mind is the purchase of new equipment and structures. A restaurant might start with construction, and then fill its new building with tables, chairs, stoves, and the like. This is the world of tangible capital.
We still need buildings and machines (and restaurants). But, over the past few decades, the nature of business capital has changed. Much of what firms invest in today—especially the biggest and fastest growing ones—is intangible. This includes software, data, market analysis, scientific research and development (R&D), employee training, organizational design, development of intellectual and entertainment products, mineral exploration, and the like.
In this post, we discuss the implications of this shift for the structure of finance. Tangible capital can serve as collateral, providing lenders with some protection against default (see the opening quote). As a result, firms with an abundance of physical assets can finance themselves readily by issuing debt. By contrast, a company that focuses on software development, employee training, or improving the efficiency of its organization, will find it more difficult and costly to borrow because the resulting assets cannot easily be re-sold. That means relying more on retained earnings or the issuance of equity.
The following chart reveals the scale of the shift from tangible to intangible investment in the United States over the past four decades. The blue and black lines plot capital expenditure as a fraction of private-sector gross value added (GVA). The two lines move in opposite directions: tangible investment has declined from roughly 14% of GVA to less than 10%, while intangible investment has done almost exactly the reverse, rising from 10% to 14%. This means that when we measure total investment properly, it has remained a reasonably stable share of GVA over the long run.
Tangible and intangible investment as a share of U.S. private-sector gross value added, 1977-2014
Source: Lee Branstetter and Daniel Sichel, “The Case for an American Productivity Revival,” Peterson Institution for International Economics, Policy Brief 17-26, June 2017.
The shift from tangible to intangible investment is hardly surprising. Consider, for example, what has happened to prices of computer hardware and software, and the related expenditure to purchase the two. The first IBM PC, built in 1981, cost the equivalent of $8,000 today. While it came with a Microsoft operating system, most of the expenditure was for a very expensive machine—a tangible asset. Today, you could acquire hardware that runs at least 10,000 times faster for barely one quarter of the price. But, if you want that machine to do anything useful, you will likely fork over a substantial amount for software and then spend time learning how to use it. When it comes to expenditure on computing and information technology, intangibles have gradually substituted for tangibles.
This evolution creates accounting headaches, both for private firms and for those measuring GDP and its components. For example, U.S. GAAP requires firms to expense most intangibles. That is, it treats the purchase of data, employee training, and reorganizations as current expenditures. But if these activities make a firm more productive, then its book value will understate its true economic value.
Following a similar practice, the national income and product accounts (NIPA) treat the bulk of intangible investment as a production cost, thereby understating both total investment (gross and net) and GDP. To see the magnitude of this second problem, compare the red line—the NIPA version of investment—with the black line that includes a comprehensive treatment of intangibles. Not only is the NIPA number substantially smaller, but the gap between the two lines has widened over time. That is, the measurement problem has been getting progressively worse. (An enormous amount of work and effort goes into improving GDP statistics. For U.S. efforts, see here; and for work on the EU, see here.)
What are the intrinsic economic characteristics of intangible capital? In their recent book, Haskel and Westlake enumerate four distinctive properties. Intangible assets:
- are often non-rival, so one person’s use does not impede someone else from using it simultaneously;
- have little market value, so the cost of producing them is almost entirely sunk;
- generate positive spillovers that benefit people other than the producer; and
- exhibit synergies, so they work more effectively when combined.
As a result, intangible assets tend to be difficult to value and can be impossible to resell, but offer potentially very large benefits to society as a whole.
Given these properties, the financing of intangible investment requires overcoming the tyranny of collateral. That is, while industries with tangible assets are able to borrow at relatively low cost, others are not. As a result, software firms—especially those developing internet applications—have debt that is only about 10% of book equity. By contrast, the debt-to-book value of restaurants is nearly 95%. Scientific research and development expenditure fits this pattern as well: software and pharmaceutical firms invest heavily in R&D, while restaurants and car dealers do almost none. For similar reasons, sectors with intangible assets are involved more in merger-and-acquisition activity than those with tangible assets. (You can find a wealth of sectoral finance data on the website of Stern Professor Aswath Damodaran.)
All of this leads to the judgment that the traditional system based on bank lending and marketable bonds is ill suited to financing the increased share of economic activity requiring intangible investment.
Fortunately, finance evolves. And, once we focus on the increased importance of business activities that are non-rival, have little market value, carry spillovers and exhibit synergies, it becomes easier to understand some important trends. In particular, we can explain the ongoing shift from public to private equity markets.
As we discussed in an earlier post, and as is further emphasized in a recent paper by Doidge, Kahle, Karolyi, and Stulz, the number of publicly traded firms in the United States has declined in nearly every year since 1997, and now stands at roughly 3,600, down from more than 7,500 in 1997. At the same time, the number of initial public offerings (IPOs) has fallen from more than 300 to just over 100 per year (see here).
Meanwhile, private equity (PE) has flourished. The value of assets under management by PE firms has risen by a factor of more than four since 2000, so that the total now stands at $2.5 trillion (see here). In addition, the number of mergers and acquisitions (M&A) remains strong. For example, the Institute for Mergers, Acquisitions and Alliances reports that M&A transactions averaged 12,000 per year since 2010, roughly double the average rate prior to 1995. To put the PE boom into perspective, PE finance has risen from 60% to 120% of commercial and industrial (C&I) loans.
The increasing importance of intangible assets helps us to explain this. Small- or medium-sized firms have an easier time protecting intellectual property when they are privately held. And, big firms (like Amazon, Google, Facebook, and Microsoft) with their economies of scale and scope can capture spillovers and exploit synergies more effectively, making it attractive for them to acquire private firms before they go public. The result is more equity finance, more M&A, and fewer public companies.
Aggregate data are consistent with the view that mature firms laden with tangible assets find debt finance relatively attractive. For example, according to the Financial Accounts of the United States, net equity issuance has been well below zero since late 2009. Importantly, S&P500 stock buybacks and dividends account for far more than this entire net decline (see Figure 7 here). The result is an increase in the ratios of debt to the book value of equity.
The shifting composition of investment poses a number of important challenges. For policymakers, one question is how to ensure that there is sufficient intangible investment. This raises a whole host of difficult issues about the government’s role in subsidizing and protecting the production of intangible assets. Here we have little to say.
On the structure of finance, however, we are guardedly optimistic. We view the increased reliance on private equity (relative to public equity and to C&I loans) as a natural consequence of the changing composition of the capital stock. Rather than signaling over-regulation of the public markets or of banks, it likely reflects a healthy evolution of the financial system in response to changing needs of the economy. And, with venture capital and private equity firms taking over the screening and monitoring functions of banks, there is no reason to believe that capital allocation is less efficient.
That said, we do have one concern: the behavior of banks. A recent paper by Dell’Ariccia, Kadysrzhanova, Minoui and Ratnovski documents that as the stock of intangible assets has increased, banks have shifted the composition of their loan portfolios. Specifically, they substitute a combination of residential real estate loans (with tangible collateral) and safe assets for commercial loans. Without proper monitoring and sufficient capital buffers, these common exposures (combined with a decline in diversification) can reduce the resilience of the entire financial system.
Finally, while it is important to ensure that healthy firms can finance projects that bring both private and social benefits, this need not mean either more debt or more public equity issuance. Indeed, just as we welcome the golden age of private equity, we are wary of proposals to increase the “access” of small and medium-sized business to debt finance. Greater reliance on debt typically makes the financial system more vulnerable.