Private Equity Can Make Firms More Innovative

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There’s a longstanding debate about whether private equity investors create value for the firms they buy. The evidence shows that PE-backed firms generate strong returns for investors, but they’re often accused of 1) focusing too sharply on short-term results (hurting firms in the long run), 2) loading target companies with too much debt (increasing their risk of going bust), and 3) caring more about cost-cutting (eliminating jobs) than revenue growth. Maybe you remember how savagely the industry was portrayed during the 2012 U.S. election? Suffice it to say that a 2016 Mitt Romney campaign isn’t being championed on Wall Street.

PE’s proponents say this disparaging view doesn’t add up. First, the effects on employment are mixed. Second, the main goal of PE investors is to increase a firm’s value so that it can be sold for profit. This includes cutting unnecessary costs—but it also means finding ways to increase revenue. And a recent working paper out of the Dusseldorf Institute for Competition Economics (DICE), a think tank of sorts, focuses on the latter by exploring whether leveraged buyouts (LBOs) make firms more innovative.

According to Joel Stiebale, a professor at DICE and co-author of the paper, it’s becoming more difficult to ensure high returns from cost-cutting alone, so PE investors are seeking more entrepreneurial growth. To get a better picture of this trend, Stiebale, along with Kevin Amess from Nottingham University Business School and Mike Wright from Imperial College Business School, analyzed hundreds of PE-backed LBOs of UK companies from 1998 to 2008. (For a refresher on how PE works, see The Strategic Secret of Private Equity.) They found that LBOs not only led to an increase in firms’ patenting, but specifically, an increase in highly cited (a proxy for higher quality) patents.

PE investors don’t typically invest in firms known for innovation. If you ask someone who works in finance (as I had to) about PE and innovation, he or she will likely tell you that PE sponsors aren’t looking for the next big thing—they’re looking for companies that are dominant in a market, aren’t risky, and have a predictable and steady stream of cash to pay back debt. Startups, on the other hand, aren’t debt financed, because they’re too risky and unproven, and have no assets—not so appealing to lenders. It also takes a long time for returns on R&D investments to be realized—longer than the average five-to-seven-year period before the portfolio company is sold off.

At the same time, there are certain ways LBOs can actually make it easier for firms to invest in the long term. Because of their relationships with banks, PE funds can get financing much cheaper than target companies could under their current management. So investors can get companies more money, alleviating some financial constraints and enabling them to invest in growth. And it’s not as though public corporations are being praised for their long-termism—they’re also subject to shareholder pressure for short-term earnings. By taking firms private and “away from public scrutiny,” the authors said that LBOs allow companies to make more long-term entrepreneurial investments.

Amess, Stiebale, and Wright gathered information from three different databases—one on firm characteristics like sales and industry type, one on LBO deals, and one on patent applications and citations. Their sample included 35,081 firms and 407 buyouts that took place between 1998 and 2005. They looked at changes in patent activity from before the LBO to three years after the deal, and they analyzed this against a control group of comparable firms (similar size, sales, debt, etc.) that didn’t undergo buyouts. Looking at highly cited patents helped them rule out strategic patenting, or filing for patents to block a competitor or to use as a bargaining chip (e.g., Apple and Samsung have filed their share of presumably strategic design patents). And because they were compared against a control sample of non-LBO firms, they were able to identify the effects of an LBO on patenting, rather than the effects of PE investors buying firms that file a lot of patents.

The authors found that three years after an LBO, PE-backed firms had filed 40% more high-quality patent applications than regular firms. This is consistent with a 2011 article in the Journal of Finance, which also found that “patents of private equity-backed firms applied for in the years after the investment are more frequently cited.”

But when the authors distinguished between firms that were public or private pre-buyout, they found that the positive causal effect on innovation was statistically significant only in private-to-private transactions; there was no significant impact in other types of LBOs (public-to-private, secondary, and divisional buyouts). This suggests that the positive effects of buyouts are concentrated in private firms where financial constraints might be more pronounced, as publicly listed firms often have better and cheaper access to external finance. Further proving this, the researchers found that PE firms had the largest impact on innovation in industries and companies most likely to be financially constrained—industries, like manufacturing and pharmaceuticals, that are highly dependent on large outside investments, and firms that have a relatively low credit rating.

All of this adds to the contentious debate over whether PE investors sacrifice long-term growth for short-term profit. LBOs can help firms that are financially constrained invest in innovation. But whether those investments and patents actually pay off is another question. “ROI and other measures of firms performance were not the focus of our study,” Stiebale said. “It is likely that many of the patents in our sample only pay off for the target in the long run, after the end of our sample period.”

There were other limitations. Patents make a good proxy for innovation activity because they’re not self-reported, they’re costly, and they seem to be highly correlated with other common indicators of innovation. The downside is that not every invention becomes patented and some patents are more valuable than others. Stiebale also said their study was limited by data availability. “Most of the private firms in our sample do not publish R&D expenditures. But it would be very interesting to distinguish effects on innovation input (R&D) from innovation output (patents conditional on R&D) to analyze whether PE firms affect the efficiency of the R&D process, for example through organizational restructuring,” Stiebale said. “Since not all innovations are patented, it would also be interesting to analyze different types of innovation outputs, like new products and processes.”

Private equity has grown immensely over the past three decades. In 2014, exits from buyouts reached a new all-time high, exceeding $450 billion, according to Bain’s Global Private Equity Report. This might explain why MBAs continue to flock to the industry. But amid worries that leveraged buyouts could be disrupted (paywall) and calls to get rid of tax breaks on corporate debt—and with Bain’s head of Global Private Equity warning that “The challenge of how to make money investing in PE has never been greater.”—it seems wise that PE investors start exploring more opportunities for growth. Maybe this recent survey will abate concerns, as PE investors reported increasing revenue as their most important source for adding value, and reducing costs came in last.

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