In his bestselling 2009 book, “The Buyout of America,” New York Post columnist Josh Kosman paints a grim picture of private equity firms running amok, snapping up vulnerable companies and either pillaging every last crumb of value or making a killing off a quick-flip sale.
But is private equity really rife with high-finance larceny? Does it pose a significant threat to the economy at large?
Not in the mainstream, according to a new study by Jarrad Harford and Adam Kolasinski of the University of Washington Foster School of Business. Their exhaustive analysis of leveraged buy-outs finds that private equity firms, on average, actually add long-term value to the companies they purchase.
“There are always going to be some bad apples resulting in some scary cautionary tales,” says Harford, a professor of finance at the Foster School. “But on the whole, the industry is creating value.”
High risk, high reward
Private equity is a controversial practice, but not a terribly complicated one in concept. Investing firms find an under-performing company with good potential and predictable investment needs. They put up a small amount of equity against a large amount of debt to purchase the company. Then they operate the company for a fixed amount of time, gradually using profits to pay off the debt. Ideally, when it’s time to sell, the firms have vastly increased their equity holding and make a healthy profit at just about any sale price.
But to discern whether value is ultimately added or extracted, you have to know what happens to the purchased—or “target”—firms at and after the private equity sponsor exits the deal.
That’s the tricky part. While it’s easy to track the fortunes of the one-in-ten private equity targets that end in IPO, the other 90 percent present a significant challenge. In these cases, private equity targets remain private, are sold to a public operating company or another private equity group, or go bankrupt, among a range of possible conclusions.
Harford and Kolasinski examined 788 large U.S. private equity buy-out transactions—deals in excess of $50 million—that took place between 1993 and 2001. Using investigative accounting and analyzing numerous factors, they were able to track all of the deals to their various exits, and follow the target firms through 2009.
The picture that emerged was far more complete than any existing study of private equity exits. And it is a positive image. Private equity, on average, creates value.
Not so evil after all
“What is the economic role that private equity sponsors provide in our economy?” Harford poses. “If you take the cynic’s view, they’re locusts, hollowing out companies and dumping them on an unsuspecting public. If you take a supportive view, they are finding diamonds in the rough, fixing under-performing companies and finding a good fit with a new parent.”
The latter tends to be the case, the study finds. Harford says that the sample companies operated by private equity groups, post buy-out, exhibit a return on assets that is higher than those in a control group. Those target companies also tend to avoid over-investment. And the notorious private equity practice of extracting capital through special dividends that leave the target firm in distress—much maligned in the media—is rarely seen.
A sliver of the economy
Harford acknowledges that the study was not able to include the boom in private equity activity between 2005 and 2007, when the global economic crisis began. The jury is still out on that period’s flurry of deals made on the brink of worldwide recession.
But Harford says that even in 2007, the historical peak of leveraged buy-out activity, the total value of all private equity deals was around $1.2 trillion. This sounds like a lot until you put it into perspective against the larger economy. Even at its height, private equity represented an economic force less powerful than the top five firms of the Fortune 500.
“Though there are those who use private equity for wrongful purposes, we can say that the practice, on average, creates value rather than extracts wealth at the cost of long-term value,” Harford concludes. “Private equity is not a net force for evil. And even if it was, it’s simply not a significant enough piece of the overall economy to do much harm.”
“Evidence on how private equity sponsors add value from a comprehensive sample of large buy-outs and exit outcomes” is the work of UW Foster School of Business finance professors Jarrad Harford and Adam Kolasinski.