Private Equity Might Be Like Shock Therapy, But it Does a Company Good, Study Finds

The World Economic Forum today released a new study that concludes that private equity-backed companies are more productive than their public, privately managed and government-backed counterparts.

For proponents of the “leverage creates discipline” school of thought, this news should come as no surprise. Companies with a heavy debt load are quicker to close inefficient plants or abandon a money-losing strategy. But in the world of public relations, this doesn’t necessarily make PE pros out to be heroes, especially since the study found that greater productivity doesn’t translate to higher wages for employees. I think it’s more important to determine whether private equity creates greater productivity and better discipline, and therefore, better companies, in the long term. No one studies what happens to PE-backed companies two or five years after their PE backers exit. I asked Josh Lerner, a Harvard Business School professor and co-editor of the report: Did the study address whether this productivity is sustainable?

He said no, because exit dates are sometimes numerous and difficult to track. He conceded that would make sense to look at.

“It would be asking, ‘Is this like shock therapy?’” he said. “Like when you take someone into rehab and for the next two years they are clean and sober, but then they start sliding back to their old habits? Or is it a permanent change?” Not a perfect metaphor, but it works.

The study is an extension of last year’s study, which noted that leveraged buyouts destroyed many jobs but ended up creating around the same amount through growth. “One reaction we had,” Lerner said, “was, ‘That’s fine, but what is the economic impact?’” PE-backed manufacturing companies were 2% more productive than public, government-backed and privately managed manufacturing companies, the report stated. A third of that was driven by the willingness of a PE backer to shut down unproductive facilities; two thirds was driven by doing less with more.

The part of the study that interested me most is the focus on economic downturns. During times of economic turmoil, PE-backed companies are even more productive than their counterparts, the report states.

It’s perplexing given the idea that PE-backed companies are supposedly running the leanest possible ships during good times (the whole, leverage creates discipline thing again). So when it comes time to cut, the company should have no levers left to pull. It seems that the less productive, less disciplined companies could better use the downturn to trim fat and perhaps “streamline their operations.” A turnaround expert suggested the reason for this finding is that since PE firms are so intensely focused on their covenants and debt, they may be ahead of the game on pending issues in portfolio companies and better able to address them in advance than its public counterpart.

View the full report here: Globalization of Alternative Investments Working Papers Volume 2: The Global Economic Impact of Private Equity Report 2009

5 Comments

  • I believe Warren Buffet has characterized this as the “driving with a knife taped to the steering wheel” effect. One is likely to drive more carefully when one knows the slightest bump could be fatal.

    I have not read the full study, but I wonder about a couple of potential issues. First, it would seem that companies that are performing well are less likely to be great candidates for buyouts, as the “operational improvements” that PE firms get paid to apply aren’t present (and the valuation multiples will likely reflect their already best-in-industry performance). So while PE-backed companies may show greater productivity improvements than non-PE-backed companies, it may be because they start from a lower baseline.

    Second, I wonder if the productivity effects are persistent. PE-backed companies are more likely, all other things being equal, to defer capex and under-invest in growth opportunities that are beyond the PE sponsor’s investment horizon. Does the productivity boost last after the sponsor has exited the investment? If not, PE firms who make significant operating improvements may still earn their keep, but the buyers for these enterprises should perhaps be less willing to pay up for the business going forward.

  • Well, “it does a company good” is questionable. It certainly gives its management the opportunity to become extraordinary rich in a much faster way, when servicing the debt in time and pursuing cost reduction wherever possible. Which management could resist in this scenario to cut jobs and increase the workload for the remaining employees.
    If this is the magic “increase in productivity…” – thanks a lot !!

  • I agree that “it does a company good” is very questionable. Productivity is usually a good thing because it increases a company’s profit, but if the increase in productivity is due to large amounts of debt, the increased profit is used to pay off loans, so it’s kind of a mute point. What’s more, portfolio companies are often forced to take on large amounts of variable-interest rate loans, and particularly now, when it is so difficult to refinance loans, this is a big problem for PE-owned companies. Erin, you have posted many times on the high default rate of PE-owned companies (2 out of 3 bankruptcies are PE-owned companies, right?).

    It seems like the only people who profit from the increased productivity are the banks, the PE firms, and possibly the top tier of the companies’ management, all at the expense of the other stakeholders (workers, the companies’ financial health, communities where the company shuts down underperforming factories, etc.).

  • BQ – The 2/3 figure comes from S&P, not me. Last year S&P claimed that 2/3 of all companies that defaulted on their debt had “traces” of “PE DNA.” Those reports have been disputed by myself and others because many of the companies weren’t backed by PE firms at the time of default. That doesn’t mean a large chunk of corporate bankruptcies don’t have LBO backers, but it is not a majority.

    The “Does a Company Good” headline reflects the purpose of the study. Whether it succeeded in proving that about private equity isn’t clear, but I think that is the the idea. That’s why the study evolved from just looking at job creation/destruction. My hope is that in the future, it will look at the company’s performance over time, including after the PE firm has exited.

  • I guess, a comparison makes only sense if one puts the number of defaults per segment into relation with the overall number of participants or their value per segment. Even if PE backed companies default in “only” 1/3 of all cases, this is likely to be an outperformance of the other (public) segment, if the public segment is not more than twice as large (which it certainly is). But this is not surprising at all: LBOs with lots of debt deliver higher returns in good times, and higher (relative) defaults in bad times (if the sponsor is not willing or able to inject additional equity).

    Whether PE is good or bad is one of the oldest questions. It certainly depends on the sub-asset class (VC, Growth, Turnaround is certainly a good and/or needed thing), and on the deal itself (see e.g. the case of nurse residents: http://gobnf.org/i/wog/nursinghomes.pdf ) – whether that is a reasonable increase in productivity, i don’t know. What I would like to see is a study that examines the treatment of “not involved” employees after an LBO…

    BQ: as far as I have seen, interest rates on leveraged loans are usually swapped floating to fixed after an LBO by -at least- 50%. However, with respect to current LIBOR levels, such a previous swap might be disadvantageous.

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