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By M. Isi Eromosele
There are several alternative perspectives that can be offered as to how Private Equity investments can affect the prospects of an industry.
The first area of focus should be on the performance of industries where Private Equity funds have been active relative to industries where these investors have not been active.
A central hypothesis since in business has been that private equity has the ability to improve the operations of firms. By closely monitoring managers, restricting free cash flow through the use of leverage and giving Managers equity incentives, it is argued, private equity-backed firms are able to improve operations in the firms they back.
These leveraged buyouts (LBOs) may not only affect the bought-out firm itself but may also increase competitive pressure and force competitors to improve their own operations.
Recent studies have used large samples and a variety of performance measures to more directly assess whether private equity makes a difference in the management of the firms in which they invest.
They show that private equity-backed firms are on average the best-managed ownership group in the sample, though they cannot rule out the possibility these firms were better managed before the PE transaction.
They show that private equity-backed firms experienced a substantial productivity growth advantage (about two percentage points) in the two years following the transaction. About two-thirds of this differential is due to improved productivity among continuing establishments of the firms.
Reversed Leverage Buyouts (RLBOs) appear to consistently outperform other IPOs and the stock market as a whole. Large RLBOs that are backed by PE firms with more capital under management perform better, while quick flips - when PE firms sell off an investment soon after acquisition, underperform.
There are several alternative perspectives that can be offered as to how Private Equity investments can affect the prospects of an industry.
The first area of focus should be on the performance of industries where Private Equity funds have been active relative to industries where these investors have not been active.
A central hypothesis since in business has been that private equity has the ability to improve the operations of firms. By closely monitoring managers, restricting free cash flow through the use of leverage and giving Managers equity incentives, it is argued, private equity-backed firms are able to improve operations in the firms they back.
These leveraged buyouts (LBOs) may not only affect the bought-out firm itself but may also increase competitive pressure and force competitors to improve their own operations.
Recent studies have used large samples and a variety of performance measures to more directly assess whether private equity makes a difference in the management of the firms in which they invest.
They show that private equity-backed firms are on average the best-managed ownership group in the sample, though they cannot rule out the possibility these firms were better managed before the PE transaction.
They show that private equity-backed firms experienced a substantial productivity growth advantage (about two percentage points) in the two years following the transaction. About two-thirds of this differential is due to improved productivity among continuing establishments of the firms.
Reversed Leverage Buyouts (RLBOs) appear to consistently outperform other IPOs and the stock market as a whole. Large RLBOs that are backed by PE firms with more capital under management perform better, while quick flips - when PE firms sell off an investment soon after acquisition, underperform.
The impact of economic cycles
Numerous practitioner accounts over the years have suggested that the Private Equity industry is highly cyclical, with periods of easy financing availability (often in response to the successes of earlier transactions) leading to an acceleration of deal volume, greater use of leverage, higher valuations and ultimately more troubled investments.
The level of leverage is driven by the cost of debt, rather than the more industry- and firm-specific factors that affect leverage in publicly traded firms. The availability of leverage is also strongly associated with higher valuation levels. The 1980s buyout boom saw an increase in valuations, reliance on public debt and incentive problems (for example, parties cashing out at the time of transaction).
Moreover, in the transactions done at the market peak, the outcomes were disappointing: of the 66 largest buyouts completed between 1986 and 1988, 38% experienced financial distress, which they define as default or an actual or attempted restructuring of debt obligations due to difficulties in making payments. 27% actually did default on debt repayments, often in conjunction with a Chapter 11 filing.
These findings corroborate the suggestions that availability of financing impacts booms and busts in the Private Equity market. If firms completing buyouts at market peaks employ leverage excessively, we may expect industries with heavy buyout activity to experience more intense subsequent downturns.
Moreover, the effects of this overinvestment would be exacerbated if PE investments drive rivals, not backed by private equity, to aggressively invest and leverage themselves.
Private equity-backed firms may do better during downturns because their investors constitute a concentrated shareholder base, which can continue to provide equity financing in a way that might be difficult to arrange for other companies during downturns.
M. Isi Eromosele is the President | Chief Executive Officer | Executive Creative Director of Oseme Group - Oseme Creative | Oseme Consulting | Oseme Finance
Copyright Control © 2012 Oseme Group
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