By HEC Paris Professor, Stefano Lovo. This article appears originally on Knowledge@HEC.
Private equity firms have a reputation for hard-nosed business tactics, buying and reselling companies for profit.
A new empirical study shows that such firms tend not only to increase the value of divested assets much more than industrial buyers would, but also that they create additional wealth gains for the sellers.
Cookies, software, goldmines, over-the-counter drugs, or just a geographically isolated subsidiary: pretty much any type of business unit can wind up on the chopping block when a large company decides to sell an asset. There are many possible reasons, such as to achieve liquidity or to refocus on core activities. According to research, from 1970 to 2006, corporate asset sales comprise on average 38% of all merger and acquisition transactions.
And, until the mid-1990s, the divested unit was likely to be purchased by another company and possibly integrated into that company’s own cookie, software, pharmaceutical or mining operations. Since then, however, private equity (PE) firms have become more and more active in this area, garnering roughly one-third of the market for corporate asset sales. But why should they, considering that they are hardly going to integrate it into an existing business? Are PE investors just hunting for cheap deals or do they actually bring value to an activity? And do the sellers gain from offloading units to PE rather than to their competitors? A team of four researchers examined the role and performance of private equity sponsors in the acquisition of corporate subsidiaries and divisions.
The PE puzzle
The researchers approached the question of buyouts by private equity from both a theoretical and an empirical point of view. An industrial buyer can achieve economies of scale or create synergies through common patents, for example. By contrast, financial buyers will not create synergies or corner a market. In addition, their investment horizon is usually limited, since they typically resell within ten years. So why are PE firms increasingly active in the buyouts market?
In theory, as the researchers write, “there are two broad classes of explanations for the performance of private equity in asset sales. Private equity sponsors are either one, able to identify undervalued assets […] or two, have distinctive skills in managing and restructuring assets.” If private equity just buys underpriced assets, then on average they should pay less than industrial buyers and should have no effect on the assets’ performance. If, on the other hand, private equity’s strength is in their restructuring skills, then they can afford to pay more than industrial buyers and they should boost subsidiary performance.
In their empirical study, the researchers investigated sales of operating assets by listed US firms since the mid-1990s when private equity began to acquire divisional assets of substantial sizes. They compared the latter’s enterprise value to that of benchmark listed firms with similar characteristics, matched by size and industry, over identical periods. Also, they analyzed how the sellers’ revenues vary depending on the buyer being industrial or financial.
One can see private equity firms as restorers who are able to identify companies that ‘need fixing’ but have potential: they buy them, fix them, and resell them for a profit
Private equity firms add value
The team’s major empirical finding was that these investors were mostly successful. Over the period of private equity ownership, annual increase in enterprise value reached an average of 42.92% (and a median of 16.51%) when PE owners exited through an IPO or a sale to an operating firm, which occurred in more than 60% of the cases in the sample. This annualized growth in value was significantly higher than that of similar benchmark firms (mean difference 24.91%, median difference 11.52%), suggesting, as the researchers write, “that private equity contributes to the generation of asset value”.
Stefano Lovo says: “One can see private equity firms as restorers who are able to identify companies that ‘need fixing’ but have potential: they buy them, fix them, and resell them for a profit.” The fact that they are able to correctly anticipate gains also explains their competitive bidding behavior, during which they tend to pay more than industrial buyers would. He adds that he and his colleagues take no particular position for or against private equity firms. Their data points to the unique abilities of these firms to increase value, and was not consistent with the alternative explanation that PE firms buy undervalued assets.
However, the data reveals nothing about how the companies are improved under PE ownership. “Once PE investors buy a company, they usually delist it, and once it’s private, they don’t have to report to shareholders or anyone about employment or the structure of the capital. It becomes a dark room, and they have more freedom to run it,” explains Stefano Lovo.
Payoffs during sales processes
To fine-tune their results, the researchers also compared the different exit scenarios, since PE investors are always transitional owners and will ultimately resell, either going public, selling to a strategic buyer or to another investor. (And yes, about one sixth of the deals end with the company being closed down, for as Stefano Lovo points out, “this is a risky business after all!”) The systematic pattern formed by the subsequent gains in enterprise value suggest the following hierarchy with respect to business success: the highest growth rate occurs for IPOs, with an average of 108.51% (a median of 43.64%); the second highest is for exit by a sale to a strategic buyer, with 31.27% on average (18.92% median value). In both cases, the figures are significantly higher than for benchmark firms. The gains are less significant in the case of a secondary buyout (one fifth of the deals). The reason an IPO appears to be the best-case scenario, with typically fast and high returns is because of the transparency involved. “Potential buyers will look at the figures that you must disclose, so you can only afford to go public with a very good company, not with a lemon,” says Stefano Lovo.
Incidentally, in sales to PE, not only do the investors ultimately make money, but the original parent companies do too, as the researchers found that they obtained significant wealth gains from share price movements following deal announcements of sales to PE: the mean two-day abnormal return was 3.78% (median 2.06%). When selling to industrial buyers, original parent companies realize abnormal returns of about 1%. “These small differences in percentage translate into millions when looking at the total market capitalization of a company,” Lovo notes.
Based on an interview with HEC Paris Professor Stefano Lovo, and on the article “Divisional Buyouts by Private Equity and the Market for Divested Assets” by Ulrich Hege, Stefano Lovo, Myron B. Slovin and Marie E. Sushka.