April 22, 2010

A White Hat for Private Equity?

A growing body of evidence suggests that when private equity enters an industry, growth and productivity follow.

Does private equity wear a black hat or white hat? The black-hat view holds that private equity firms buy out other companies primarily to engage in financial engineering and pare down operational efficiency to ensure a quick turnover sale and profit. The white-hat view contends that private equity investors are driven not merely to generate operating efficiencies and short-term returns but to add value through increased productivity and other drivers of growth.

Private equity has long been the object of such scrutiny, and the recession has done little to provide definitive answers to these questions. That’s more true than ever as key market players and regulators cast around to identify just which institutions and investors were most responsible for introducing massive systemic risk and instability into financial markets. And so a larger question looms: Did private equity funds, with their highly-leveraged investments and opaque operations, contribute significantly to instability in financial markets?

Professor Morten Sørensen, working with Shai Bernstein and Josh Lerner of Harvard University and Per Strömberg of the Stockholm School of Economics, sought clues as to whether private equity played a role in introducing systemic risk into financial markets. In particular, they hoped to learn about the cyclicality of private equity: Do private equity investments smooth or amplify the economy’s up and down cycles?

Researchers face many challenges when trying to answer even elementary questions about the performance and operations of private equity–owned firms, because direct data from such firms is not readily available — as private companies, the firms are not required to file annual reports or financial disclosure statements. “It is hard to see what happens in terms of research and development, in terms of expenditures and in terms of a number of internal business decisions,” Sørensen says. “That makes it hard to understand what private equity investors are doing after they buy these companies.”

There are, however, sources of data that can provide indirect means to measure the economic impact of private equity. Sørensen and his coresearchers linked the Organization for Economic Cooperation and Development’s (OECD) structural analysis database, composed of statistics from across industries in dozens of countries from 1991 through 2007, to a database of worldwide private equity activity. The OECD data allowed the researchers to look at overall industry performance as a way to measure total production of private equity–owned companies.

The researchers found countries that had private equity investments in select industries and then compared the performance of industries without private equity investment in those countries to the same industries in other countries where there was private equity investment. The researchers looked most closely at productivity measures, which determine whether there are valuable gains in an industry in a given year, and employment growth and labor costs. By comparing and controlling for specific years and overall performance of industries, they were able to gauge whether private equity investment leads to more cyclicality and better performance.

To examine productivity measures, Sørensen and coresearchers looked at the amount of value added in an industry in a given year, comparing that with countries that had private equity investments in that industry and those that did not, finding that private equity investment is associated with a roughly 1 percent annual improvement in the growth rate. In other words, if overall productivity increased on average by 3 percent, productivity in industries with private equity investment increased on average by 4 percent, a fairly substantial increase, particularly when sustained over time, as the OECD data suggests is the case.

The researchers also compared the OECD measures of total labor costs and employment numbers by industry, again comparing data from those industries with private equity investment to those industries without. Here too they found that the growth rate improved substantially in industries with private equity investment by 0.5 to 0.8 percent. (This also means that in industries that are contracting, the contraction is less severe when private equity investment is present.)

“The overall picture we are getting is that private equity investors seem to be long-term investors, creating value in the industries where they invest,” Sørensen says.

The strong association between private equity and growth prompts the question, do private equity investors cause growth or are they simply good at selecting industries that are already on a growth trajectory? A range of analyses suggest that the direction of causality runs from private equity to productivity and employment growth. For example, the researchers found that private equity investments enter industries before employment or productivity starts to grow in those industries, suggesting that private equity investment prompts growth rather than the other way around.

The researchers also looked for evidence supporting claims that private equity investors are strictly interested in short-term returns, eschewing investment in fixed assets, maintenance and expansion in favor of financial engineering and quick turnaround. But declines in capital formation, smaller capital investments or higher consumption of fixed assets — typically signs of short-term investment — were neither higher nor lower in industries with private equity–owned firms. The researchers also looked at cyclicality and whether swings in industries where private equity is present are larger than those without private equity and concluded that there is little difference between private equity and other types of firms, Sørensen says.

In continental Europe, the regulatory environment for private equity is less friendly than it is in the United States and the UK (several new regulatory proposals targeting private equity and hedge funds are on deck in Europe), but the researchers found that the beneficial effects of private equity appear to be just as robust in Europe as in the United States and the UK.

The data sets Sørensen and his coresearchers used end a short time before the financial crisis hit, and it is unclear if their findings would have differed significantly had the data included the months leading into the crisis. Sørensen speculates that the conclusions would not have changed much. “Evidence is starting to accumulate that private equity–owned companies are fairly resistant to downturns despite their higher leverage, alleviating concerns that the high leverage would put these firms into distress during tough times,” he says. “That hasn’t happened to any extent we feared.” This is probably, he says, because leverage negotiated at the height of the boom came with relatively easy conditions and deferred interest, granting firms the means to ride out the recession.

Sørensen also attributes this resilience to the unique capital structure of private equity–owned firms, which allows them to renegotiate structure and debt with more latitude than publicly-traded companies, which must contend with shareholders. “That flexibility is probably what allowed private equity to weather the downturn.”

Morten Sørensen is the Daniel W. Stanton Associate Professor of Business in the Finance and Economics Division at Columbia Business School.

Read the Research

Shai Bernstein, Morten Sorensen, J. Lerner, Per Strömberg

"Private Equity, Industry Performance and Cyclicality"

View abstract/citation  Download PDF  

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