Figuring Out What Private Equity's Worth

Steven Davidoff Dealbook January 25, 2012

Controversy swirls around private equity as attacks on Mitt Romney and the entire industry mount. Amid the name-calling, little in the way of evidence has been cited. So let's take a look at some of the best research on this issue.

Does private equity "strip and flip" companies, leaving them for bankrupt? A paper last year by Edith Hotchkiss at Boston College, David C. Smith at the University of Virginia and Per Stromberg at the Stockholm School of Economics gives a qualified no.

The authors examined a sample of private equity firms from 1997 through 2010. They found that companies bought by private equity firms did not default on their debt any more than other firms in a control group with similar debt levels.

Private equity-owned companies that defaulted were less likely to be liquidated and remained in bankruptcy for a shorter time than the companies in the control group. Some 11 percent of private equity-owned companies that declared bankruptcy were liquidated, compared with 16 percent for those without private equity backing.

Private equity ownership not only helped keep companies from filing for bankruptcy, but these companies were better able to survive financial distress. The authors speculate that this is a result of private equity's deep pockets and its ability to obtain more financing to aid distressed companies.

The study has an important caveat: The point of comparison was confined to companies with similar levels of debt. Private equity firms often borrow large sums to buy companies, placing significantly more debt on them than they would have otherwise. The authors did not look at companies with lower levels of debt.

But in a separate paper, Steven Kaplan of the University of Chicago and Mr. Stromberg estimated that private equity-owned firms had a default rate of 1.2 percent a year from 1980 to 2002. That compares with Moody's Investors Service's reported default rate of 1.6 percent for all corporate bond issuers in the United States in the same time period.

Private equity-owned companies may have a lower general default rate because of the better debt terms that sophisticated private equity firms can negotiate. For example, Moody's has found that an outsize number of companies owned by private equity firms avoided default during the financial crisis because they had so-called covenant-lite debt, which had fewer terms that could be violated.

Beyond default rates, evidence of the private equity industry's ability to create value is still surprisingly uncertain, given that the industry has more than 30 years of history. One of the reasons is that private equity firms do not generally publicly disclose the performance of their buyouts.

A new paper, however, finds evidence that private equity firms do add value. Adam C. Kolasinski and Jarrad Harford of the University of Washington examined 788 large private equity buyouts in the United States. They found that private equity-owned companies invested more efficiently than other companies, a fact the authors attributed to private equity firms' greater access to capital. The authors also found that the payment of large dividends to private equity firms, a common practice, did not create future financial distress.

Other recent papers looked mostly at Europe, where private company data is required to be made available and so performance of private equity companies can be accurately measured. These European papers also found that private equity firms improved operating performance in the non-American companies they owned.

All told, the evidence on net value creation has yet to be firmly established. The large and consistent returns of firms like Kohlberg Kravis Roberts and the Blackstone Group show that money is being made, but not because private equity ownership creates better companies. At best, the evidence shows there may be value created, but it is not definitive.

Even if private equity firms do increase company performance, there is still the question of how.

One explanation may be better monitoring and supervision of management. Boards of private equity-owned companies have been found to be smaller and meet more frequently. One draft study of European companies, by Viral Acharya of New York University and Conor Kehoe of McKinsey & Company , found that about two-thirds of chief executives of private equity-owned companies were replaced in the first four years of ownership. And private equity-owned companies have been found to better align the compensation of management with good performance than public companies, which are often accused of overpaying executives.

While it appears that private equity may benefit some companies, this does not mean they always add value to them. Instead, private equity firms may make their riches by taking advantage of other debt holders, benefiting from tax arbitrage or firing employees. Evidence from the 1980s shows that private equity often took advantage of other debt holders.

As for taxes, private equity clearly benefits from the tax deduction that debt offers. Although the evidence is mixed, academics still argue that this tax benefit in part gives private equity its riches. And others have argued that private equity makes the bulk of its money by leveraging companies, thereby pumping up equity returns.

As for employees, again the evidence is uncertain. But the most important paper on this issue was made public in 2008, and revised late last year. The authors "” Steven J. Davis of the University of Chicago, John Haltiwanger of the University of Maryland, Josh Lerner of Harvard Business School and Ron S. Jarmin and Javier Miranda of the Census Bureau "” found that after a private equity acquisition, a company's work force shrank by more than 6 percent on average. Private equity-owned companies, however, appear to be more creative in building new businesses and adding jobs, which offsets that loss. As a result, the net job loss for the average private equity acquisition turns out to be only about 1 percent greater than at other companies. This study has been criticized for not examining what the growth of companies would have been had they remained independent.

The evidence shows that private equity is a minimal job destroyer, and there are some indications that value is created. Private equity firms do not live up to their 1980s reputation as vulture capitalists stripping companies and leaving them for dead. To be sure, questions remain about whether that value comes at the expense of tax arbitrage or is merely a trick of financial engineering and leverage.

This does not mean that private equity firms deserve all of their wealth. It may be that they are overcharging for their services. Andrew Metrick of the Yale School of Management and Ayako Yasuda of the University of California, Davis, found that private equity firms made about two-thirds of their money not from their 20 percent share of the profits but from the fees they charged to operate the companies. Another study by professors at Yale and Maastricht University that was reported by The Financial Times on Tuesday found that 70 percent of private equity's earnings from 2001 to 2010 were paid to the firms themselves, not their investors.

There are also questions raised by Victor Fleischer of the University of Colorado Law School, among others, concerning whether private equity deserves a 15 percent capital gains tax treatment for its profits because this is really disguised income.

There is still more research to be done, research that the private equity industry could make easier if it provided more information. And none of these papers look at individual firms like Bain Capital, Mr. Romney's former firm. It may be that in individual cases, private equity firms do take advantage of companies. And even if value is created, it is small solace for those who lose their jobs in the wake of a private equity acquisition. Still, a look at the research shows that private equity is far from the evil some are calling it.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the world of mergers and acquisitions.

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Figuring Out What Private Equity's Worth

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