Last week, members of the private equity community and beyond were captivated by a new study—The Economic Effects of Private Equity Buyouts—from researchers at Harvard University and the University of Chicago. It tries to uncover the real side effects of buyouts by examining more than 9,000 private equity buyouts over the 30-year period from 1983 to 2013.
Here are five things we learned:
PE firms are opportunistic
When credit was cheap, PE firms mostly chose to deliver returns via financial engineering rather than operating improvements—for instance, by issuance of new debt to fund additional dividend returns for equity. But when credit was costly, private equity firms indulged in less financial engineering and focused on operational improvements.
When the economy booms and credit spreads narrow, private equity deals take on more leverage and have higher valuations—and investors receive lower returns.
Labor productivity rises 8 percent in public-to-private buyouts—“a striking impact given that targets tend to be mature firms in mature industries,” the study said. Productivity also increases by 8 percent in private-to-private buyouts.
“I expected that PE buyouts would yield productivity gains in the acquired firms (relative to controls) but I am surprised by the large size of those gains,” said one of the authors of the study, Steven Davis, professor of international business and economics at the University of Chicago Booth School of Business.
The study didn’t explore how buyouts generate productivity gains in the acquired firms, Davis said. One of the levers, however, was reallocation of resources, including manpower to more productive parts of the firm—for instance, from less productive manufacturing plants to more productive ones.
Impact on employment is negative
While employment expands in buyouts of privately-held firms and secondary buyouts by 13 percent and 10 percent respectively, public companies and carve-outs see employment drop by 13 percent and 16 percent, respectively.
Many public-to-private deals involve firms that suffer from poor corporate governance and “face an intense need for cost-cutting,” including closing down some facilities, the study noted. In carve-outs, the parent company may recognize the need for downsizing but resists in order “to shield its public image and preserve employee morale in the rest of the firm.”
On the other hand, employment rises in private-to-private transactions because the motivation behind such buyouts is generally a desire to improve access to financing or professionalize management. Similarly, secondary sales reflect “an incomplete, ongoing effort to improve operations and profitability in the target firm or a hasty, but successful exit by the first PE owner to pave the road to raising a new buyout fund,” the study said.
Buyouts lead to wage losses
Average earnings per worker fall by 1.7 percent and buyouts erase 70 percent of the modest pre-buyout wage premium over the two-year period post transaction. The mix of buyouts leading to large productivity gains on the one hand and job and wage losses on the other “presents serious challenges for policy design, particularly in an era of slow productivity growth (which ultimately drives living standards) and concerns about economic inequality,” the study notes.
However, “PE buyouts are a potentially powerful tool for raising productivity and making the pie bigger,” Davis said. Therefore, “further exploration would address harnessing the power of private equity to drive productivity growth in a way that is socially beneficial.”
The PE-multiplier effect
The effects of buyouts on employment growth suggest a “PE-multiplier effect” that resonates with concerns that private equity magnifies the effects of economic shocks. In particular, public-to-private deals proliferate before the tightening of the credit market. Later, these buyouts exhibit large employment losses and poor productivity performance during aggregate downturns.
Action Item: Reach Steven Davis here: Steven.Davis@ChicagoBooth.edu