The private equity industry has come a long way since ‘Barbarians at the Gate’, the narrative of the rise and fall of one of the biggest leveraged buyouts in history first hit the shelves in the 1980s. Since then, the nature of these buyouts and their sponsors has been scrutinised and regulated. But far from this diminishing interest in them, their popularity has surged – PE firms in the US alone now hold some $4tn of assets. The industry has benefited from an unprecedented wave of investor interest, supported by exuberant equity markets, low rates and steady GDP growth. Dry powder (the jargon for unutilised raised capital) is at record levels globally, just waiting to be ignited…
This article is only available to Macro Hive subscribers. Sign-up to receive world-class macro analysis with a daily curated newsletter, podcast, original content from award-winning researchers, cross market strategy, equity insights, trade ideas, crypto flow frameworks, academic paper summaries, explanation and analysis of market-moving events, community investor chat room, and more.
The private equity industry has come a long way since ‘Barbarians at the Gate’, the narrative of the rise and fall of one of the biggest leveraged buyouts in history first hit the shelves in the 1980s. Since then, the nature of these buyouts and their sponsors has been scrutinised and regulated. But far from this diminishing interest in them, their popularity has surged – PE firms in the US alone now hold some $4tn of assets. The industry has benefited from an unprecedented wave of investor interest, supported by exuberant equity markets, low rates and steady GDP growth. Dry powder (the jargon for unutilised raised capital) is at record levels globally, just waiting to be ignited.
The Source of All Evil?
PE firms are often depicted as harmful due to their classic playbook move: acquiring a target by loading unsustainable amounts of debt on it, stripping it down of its assets, and squeezing the remaining life out of it in a matter of 3-5 years. Then, these firms pass their acquisition on to the public markets, unload it to a corporate buyer, or even to another private equity firm. In other words, little or no value is added – just cash to be made by the fund managers. Consequently, the industry has faced regulatory attention recently. The EU implemented the AIFMD, and the ECB now requires a stringent review of the types of debt loaded on. Democratic Presidential Candidate Warren has also lately declared a war on PE ‘vampires’, proposing a rule to end carried interest tax breaks for managers. But is it all bad in PE?
To speak to this backlash, a new, comprehensive study authored by S. J. Davis and J. Haltiwanger of the National Bureau of Economic Research et al., The Economic Effects of Private Equity Buyouts, aims to debunk the myths around whether leveraged buyouts are essentially good or bad and reveal what their real impact is on the targets.
The paper uses a highly comprehensive and clean set of buyout data from Capital IQ, matched to Census micro data. Carefully selected control firms are used for comparison to the buyout targets. The researchers go far to disentangle organic changes at firm level, which would have occurred regardless of the buyout. The results are significant.
Deal Volumes Depend Highly on Economic and Credit Conditions
It’s worth first exploring what drives PE deal volumes. Buyout levels are much higher when real GDP growth is above median and also when credit spreads (defined as the yield spread between below-investment-grade corporate bonds and one-month LIBOR) are narrow. Even more interestingly, high buyout level periods are usually followed by rising credit spreads and higher than average GDP growth over the next couple of years (Fig. 1, below). This pattern – most pronounced for public-to-private buyouts – indicates that target firms often face a tightening of credit conditions after the buyout. Also, the industry mix of PE buyouts differs by deal type. Consumer staples deals are largely public-to-private, whereas Industrials are private-to-public.
Figure 1: Quarterly Buyout Counts by Type, 1980 to 2013
Source: The Economic Effects of Private Equity Buyouts, Page 51
To gauge the impact of buyouts, the study estimates changes in employment, productivity, and wages on the target firms.
PE Firms Often Cut Staff
Results show that, overall, employment shrinks by 4.4% relative to controls when omitting post buyout acquisitions and divestitures, and only 1.4% otherwise (which isn’t significant). More importantly, employment rises by 3.1% after private-to-private buyouts and by 6.1% in secondary buyouts, but it shrinks by 10% in public-to-private. The key message is that the employment effects of PE buyouts vary greatly by type. Public firms have to deal with a highly dispersed ownership and could be suffering from poor corporate governance or bulky structuring prior to the deal, so they consequently require greater staff and division cuts.
Wages Suffer Too
Workers at target firms seem to enjoy a slight wage premium of 2.5% pre-buyout compared to controls, but 70% of that is wiped out after the deal is completed. The paper estimates a wage drop of 1.7% at target firms relative to controls over the two years post buyout.
If we disentangle individual data, this result once again varies highly by buyout type. Compensation per worker rises by 11% in divisional targets (when a division is carved out and bought by the PE firm) relative to controls over two years post buyout. Meanwhile it falls by 6% in private-to-private deals. This could be explained by ‘job title upgrading’: when a division is spun off as a separate entity, previous managers turn into CEOs and get an automatic pay rise. For public-to-private buyouts, wage impact is insignificant.
PE-backing Increases Productivity Across All Buyouts
PE firms have the most impact on improving target firm productivity levels, and this holds true across all industries. Labour productivity rises by 7.5% at targets relative to controls, and this is even more pronounced when the targets are larger and older. More than 80% of the estimated productivity gain reflects greater revenue growth at targets. Target firms in private-to-private deals experience a 14.7% productivity gain relative to controls. However, we note that if it is cheap debt fuelling deal-making, productivity increases much less, if at all, probably due to a lot of cash chasing lower quality assets.
Bottom Line: Regulation, If Any, Must Be Targeted
• Private-to-private deals exhibit high post buyout employment growth, wage reductions, and large productivity gains.
• Public-to-private deals suffer large job losses, often through facility closures and large productivity gains.
• Secondary deals exhibit high target employment growth (largely organic), high reallocation, and few discernible effects otherwise.
• Divisional buyouts involve large employment losses and massive reallocation effects alongside large gains in compensation per worker.
A one-size-fits-all type of regulation when it comes to buyouts is unlikely to work well. The real side effects of buyouts on target firms and their workers vary greatly by deal type and market conditions, such as ease and price of credit. The mix of probable consequences from the different types of deal makes a an effectively targeted policy difficult to implement. It also makes extreme views like Warren’s ungrounded.
Presiyana Karastoyanova is a Research Analyst at Macro Hive. Presiyana has previously worked at Nomura & Goldman Sachs, and has attained an MSc in Finance from Imperial College Business School.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)