Corporate Raiders or Job Creators?
People often hold extreme and contrasting views on private equity (PE) and the leveraged buyout (LBO) acquisition method. Some people view it as a way to add value through providing growth capital, ideas and experience The proponents of this business model argue that this results in above-average returns to investors (which include college endowments and pension funds), improved products and increased employment. The naysayers view LBOs as a predatory tactic and the PE firms who employ it rapacious asset-strippers and barbarous job-cutters. With such diametrically opposing views propagated, I will examine the effects of PE buyouts on the economy.
This debate around LBOs became a publicised issue in the 2012 U.S presidential campaign as the Republican candidate Mitt Romney previously worked at PE firm Bain Capital. President Obama even opined that PE led to laying off workers, striping away benefits and profits for the PE firm.
The debate about Romney’s time at Bain and PE in general was highly politicised. Those cynical of Romney’s record and PE pointed to failures such as K.B Toys, GS Industries and more. The attacks on Mitt Romney culminated in a half-hour long polemic called “When Mitt Romney Came to Town”. Supporters of Mitt Romney and PE pointed to huge successes like Staples, Sports Authority and Steel Dynamics. However, this tit-for-tat method of debating Romney’s past and PE is problematic, especially when you consider Bain acquired 77 companies under Romney.
In economics, highlighting a handful of favourable data points or examples in a debate such as this is not overly helpful. It was the tactic used by political strategists and spin-doctors during the 2012 presidential campaign but it tells us very little. As economics students we prefer to construct whole datasets and look at the bigger picture. This requires aggregation.
Fortunately, there have been studies that do just this. Steven N. Kaplan of the University of Chicago, Robert S. Harris of the University of Virginia, and Tim Lenkinson of Oxford University published a paper on “Private Equity Performance: What Do We Know?” Their sample was comprised of 1400 U.S. PE firms assessed for the period of 25 years. They found that, on average, PE funds outperformed the S&P 500 by at least 3% per year. They took this as evidence that PE adds value and has a positive effect on the economy. Those critical of this study might argue that the dataset does not distinguish cleanly between venture capital firms and PE firms using LBOs. Secondly, they may argue that it doesn’t tell us about the net effects on employment.
Another famous study did directly analyse the net effect of PE on employment. It was conducted by Josh Lerner of Harvard Business School and four other authors and appropriately entitled “Private Equity and Employment”. They constructed a dataset of 3200 target firms and their 150,000 establishments (factories, offices, etc) involved in U.S. PE transactions from 1980 to 2005. They found that employment decreased by 6% over the 5 years following the buyout in existing establishments. However, target firms also create new jobs at new establishments and this leads to a net job-loss of less than 1% over the initial two years.
The study also looked at gross job flows and the purchase and sale of business establishments. They found that this activity was far greater in PE target companies than comparable companies that were not the target of PE buyouts. This provided evidence that PE buyouts catalysed the creative destruction process, with only a modest impact on employment.
Supporters of PE would argue that as this creative destruction process plays its course a net job-gain would result over the long-term. However, no studies have gathered sufficient data to assess this hypothesis. In any case, it would be difficult to assess the causal question of whether jobs added over the longer-term are attributable to the buyout or something else.
Perhaps the strongest piece of evidence that suggest PE buyouts are economically useful is the productivity gains that occur in buyout targets. Another paper authored by Josh Lerner of Harvard Business School and two other authors entitled “Private Equity and Long-Run Investment: The Case of Innovation” provides evidence of this. The authors studied the number and quality of patents generated by 495 buyout targets in the period from three years before to five years after being part of a private equity transaction. Their main finding was that “firms pursue more influential innovations, as measured by patent citations, in the years following private equity investments.” They stated, “these findings are largely inconsistent with the hypothesis that private equity-backed firms sacrifice long- run investments. Rather, private equity investments appear to be associated with a beneficial refocusing of firms’ innovative portfolios.”
This research runs against the thinking that PE firms using an LBO will be motivated by short-term profit-motives to the detriment of long-term investments and innovation. This is consistent with research conducted by Boston Consulting Group that identifies a shift in PE away from leverage arbitrage and tax concessions as a source of profit to improving operational performance and growing target companies.
It turns out that neither of the extreme views of PE or LBOs is quite correct. PE firms are not modern-day Vandals, Visigoths or Vikings but neither are they job-creating angels. As Bryan Burrough and John Helyar, authors of the New York Times Best Seller Barbarians at the Gate, put it “some companies are well-suited for the rigors of an LBO, while others are not.” Hence, when you aggregate many LBOs you find that their economic impact is modest in the medium-term.