Boom In Timely Research

Do buyout firms hurt the industries in which they invest? Is it risky to let investment banks have private equity arms? Is there another incentive, apart from carried interest, that could motivate buyout shops to earn exceptional returns on behalf of limited partners?

Inquiring buyout minds, not to mention members of Congress, want to know. And, thanks to a boom in academic output from colleges, universities and research institutes, they’re starting to get answers—or at least thoughtful attempts at answers. In the case of the questions above, No, Yes and Yes are the principal conclusions of three research papers available to the public but not yet published in journals.

That these papers are particularly topical stems in part from changes in how academic research gets circulated. More than 10 years ago, said Michael S. Weisbach, a professor at The Ohio State University, the public would typically learn about papers after they appeared in financial journals, sometimes several years after the original research was done. A reporter like me would have had to rely on the largesse of the author to send a pre-publication draft. Today, academics often post working papers on their latest research on Web sites, and go on road shows to present the results and gather feedback. “We want to circulate our ideas and talk to people like you,” Weisbach told me. “That’s the way to get the word out.”

Indeed, Congressmen still on the fence about whether buyout shops pose a systemic risk to the economy can download a copy of “Private Equity and Industry Performance,” a working paper published in January by Shai Bernstein, a student at Harvard Business School, Josh Lerner, professor at Harvard Business School, Morten Sorensen, an associate professor at Columbia Business School, and Per Stromberg, of the Institute for Financial Research, as part of the World Economic Forum’s ongoing study of global private equity. In looking at the impact of buyouts in 20 industries, in 26 countries from 1991 to 2007, the paper finds that industries in which buyout firms invested grew more rapidly than did others. At the same time, they experienced no more volatility, and sometimes less volatility.

Meantime, merchant banks facing new regulations can take far less comfort in another working paper co-authored by Lily Fang, an assistant professor at INSEAD, Lerner, and Victoria Ivashina, assistant professor at Harvard Business School, and released this month: “’An Unfair Advantage’? Combining Banking with Private Equity Investing.” This research finds that bank-sponsored deals “have slightly worse outcomes” than do other buyouts, while “investments during market peaks by commercial banks have significantly higher rates of bankruptcy.” Ouch. Not exactly the kind of material banks want Congressmen to be reading while they contemplate the proposed Volcker Rule banning them from having private equity arms.

And perhaps you thought nothing new could be added to the ongoing carried-interest taxation debate? Well, Ohio State’s Weisbach, along with three colleagues, released a working paper in February titled “Incentives of Private Equity General Partners from Future Fundraising.” It argues that, contrary to common thinking, carried interest isn’t the only big performance-tied incentive motivating buyout partners. Consider this cascade of cause-and-effects: Fund performance influences future fundraising, bigger funds produce more management fees, more fees translate into higher salaries and bonuses, higher compensation creates partner wealth. The paper concludes: “Our estimates suggest that implicit incentives from expected future fundraising are about as large as explicit incentives from carried interest in the current fund.” The implications are mind-boggling, if unsettling. Is it possible that, like ordinary mutual fund managers, buyout pros would show up at work without the prospect of earning carried interest?

Such research appears to be having a growing impact—on industry practice, regulation, and reputation. In early 2008, with Congress already threatening the industry with higher taxes, Lerner and Steven J. Davis, a professor at the University of Chicago Booth School of Business, released a study on the pace of job creation at some 5,000 companies acquired through LBOs from 1980 through 2005. Both supporters and critics of the industry found things to like in the research, sponsored by the World Economic Forum. Employment, the study found, tends to drop more rapidly than at other companies in the first few years of buyout ownership. Still, those losses appeared to get offset in later years as the companies opened new plants and offices. The results got play in The New York Times, The Wall Street Journal and elsewhere, and Lerner testified later that winter before the House Energy and Commerce Subcommittee on Telecommunications and the Internet.

Steven N. Kaplan, professor at the University of Chicago Booth School of Business, believes some of the most influential research took place in the mid-1980s. Work he and other academics did back then helped to establish buyouts as a particularly efficient form of ownership that led to improvements in operations and shareholder value. Kaplan pointed to a 1989 article in the Harvard Business Review, “Eclipse of the public Corporation,” by Michael C. Jensen, then professor of business administration at Harvard Business School, as particularly influential. True, the paper went a little far in suggesting that “by the turn of the century, the primacy of public stock ownership in the United States may have all but disappeared.” Still, said Kaplan, the article “got a huge amount of attention and clearly there was some truth to what he had to say.”

Below is list of some of the more interesting research papers I came across in researching this column:

“Do Buyouts (Still) Create Value?” August 2009 by Shourun Guo of Duke Energy Corporation, Edith S. Hotchkiss of Carroll School of Management at Boston College, and Weihong Song of College of Business at University of Cincinnati

“Eclipse Of The Public Corporation” September-October 1989 by Michael C. Jensen of Harvard Business School

“Economics Of Private Equity Funds” July 1 2009 by Andrew Metrick and Ayako Yasuda of The Wharton School

“Incentives Of Private Equity General Partners From Future Fundraising” February 2010 by Ji-Woong Chung, Berk A. Sensoy, Lea H. Stern, Michael S. Weisbach of The Ohio State University

“Leveraged Buyouts and Private Equity” June 2008 Steven K. Kaplan of University of Chicago Graduate School of Business and Per Stromberg of Stockholm School of Economics

“Private Equity And Industry Performance” January 2010 Shai Bernstein of Harvard Business School, Josh Lerner of Harvard Business School, Morten Sorensen of Columbia Business School, Per Stromberg of Stockholm School of Economics

“Private Equity Performance: Returns, Persistence, And Capital Flows” August 2005 (The Journal of Finance) Steven N. Kaplan of University of Chicago Graduate School of Business, Antoinette Schoar of Sloan School of Management at MIT

“Risk and Expected Returns Of Private Equity Investments: Evidence Based On Market Prices” March 2010 Narasimhan Jegadeesh of Goizueta Business School at Emory University, Roman Kraussl at VU University Amsterdam, Joshua Pollet of Eli Broad College of Business at Michigan State University

“Value Creation In Middle-Market Buyouts: A Transaction-Level Analysis” April 2009 John L. Chapman of American Enterprise Institute, Peter G. Klein of University of Missouri

“Why Are Buyouts Levered? The Financial Structure Of Private Equity Funds” August 2009 (The Journal of Finance) by Ulf Axelson of Stockholm School of Economics, Per Stromberg of Stockholm School of Economics, and Michael S. Weisbach of Ohio State University

“Which CEO Characteristics And Abilities Matter?” August 2009 by Steven N. Kaplan of University of Chicago Graduate School of Business, Mark M. Klebanov of Ziff Brothers Investments and Morten Sorensen of Columbia Business School

“An Unfair Advantage? Combining Banking With Private Equity Investing” March 15, 2010 by Lily Fang of INSEAD, Victoria Ivashina of Harvard Business School, and Josh Lerner of Harvard Business School