From the well publicized takeover of tobacco-and-food giant RJR Nabisco by KKR (of Barbarians at the gate fame) to Blackstone's turning around of the hotel chain Hilton, leveraged buyouts are big business. Such big business, in fact, that the total value of leveraged buyouts conducted over the past three decades is calculated not in millions or billions, but in trillions of dollars. To be precise, some academics estimate that the more than 17,000 leveraged buyouts conducted by private equity firms between 1970 and 2007 work out to a total enterprise value of more than $3.6 trillion.
These buyouts, which affect thousands of companies and millions of employees across the world, are a major asset class for investors. But how much do private equity firms influence the performance of the companies they acquire? Although the academic debate about the impact of ownership on performance has been raging for decades, there has been surprisingly little research about the impact of private equity governance – or perhaps not so surprisingly, since data is scarce: “private” equity is so called for a reason. HEC Paris researcher Oliver Gottschalg, along with Francesco Castellaneta of the Catolica Lisbon School of Business and Economics, has co-authored a paper that provides insights into the “black box” of private equity value.
Definite, long-lasting ownership effect
So far, understanding of how ownership affects performance – the so-called “corporate effect” – was based largely on evidence from diversified corporations under public market ownership. But private equity governance differs from that of other organizations. For instance, private equity firms, even if they own a heterogeneous collection of businesses, tend to manage their investments independently from one another, in order to maximize the standalone market value of the buyout and eventually exceed the purchase price. In contrast, conglomerates are more concerned with synergies and tend to maximize performance across their portfolio. Oliver Gottschalg and his co-author are the first to fill the existing gap in research on the corporate effect. They collected data about nearly 7,000 buyouts and created the largest panel of private equity investment performance ever used in academic research.
By applying a statistical model, they found a significant private equity firm effect, which explains 4.6% of the variance in buyouts' performance. In other words, the nature of the buyer – its assets and knowledge – matters. “Leveraged buyouts are not trading, where the firm comes in, buys a company, and waits to sell, in which case performance would depend purely on the bought company,” points out Oliver Gottschalg. He adds that the skill of the private equity firm matters more and more as the industry matures: “Today the market is much more competitive than twenty years ago, when there were many good target companies, and with a 'normal' approach, it was easy to make a successful investment.” Another important finding is that the portion of variance in performance explained by the private equity firm increases over time, mainly because of the low mobility of resources across firms. In Oliver Gottschalg's words, “If out of ten private equity firms, seven are average and three are good, those three are likely to stay ahead; it's not as if there were a magic recipe [to boost performance of the buyout] that others could simply learn.”
Leveraged buyouts are not trading, where the firm comes in, buys a company, and waits to sell.
Stronger effect under challenging circumstances
The researchers next examined the contingencies under which the private equity firm effect was likely to be strongest. Their reasoning was that certain circumstances make some buyouts more challenging than others and thus increase the effect of the decisions made at the level of private equity firms. In other words, firms endowed with better resources, i.e., the necessary skills to create value from the acquired company, would have a greater impact.
A first contingency is the strategy chosen to add value. One strategy is to select high-potential target companies in the pre-investment phase (selection strategy). The second strategy is to add value in the post-investment phase (value-addition strategy), which tends to be a more complex, long-term process. As typical examples of actions taken by private equity firms during ownership, Oliver Gottschalg cites improving strategic alliances, reshuffling activities, going for international expansion, and so on. The study found that resource heterogeneity across private equity firms translated into more salient performance differences in contexts of value-addition strategies. Oliver Gottschalg attributes this to the fact that, in reality, most private equity firms act as coaches and step in to turn companies around over the course of several years, simply because there is no “recipe” to select the most suitable investment, buy it, and sell it off with minimal intervention.
The second contingency studied was the context of developed versus emerging economies. The researchers found support for their hypothesis that the private equity firm effect would be stronger in developed economies. Indeed, external factors (political instability, poorer infrastructure, less fluid markets, and so on) are likely to be more significant in emerging economies. In contrast, the marginal impact of private equity firms' unique abilities to implement value-creation strategies will matter more in developed economies, where more sophisticated institutions for facilitating transactions also mean more competition among potential acquirers.
Finally, following a similar logic – that owners' capabilities to turn around buyouts are most relevant in complex situations – the researchers found that private equity firms experience higher variance in performance in times of economic downturn.
