Private equity firms promote positive long-term activity for portfolio companies through leveraged buyouts, according to a study from Düsseldorf Institute for Competition Economics.
The working paper, titled ” The impact of private equity on firms' innovation activity ,” stems from a collaboration among Dr. Joel Stiebale of Universität Düsseldorf, Dr. Kevin Amess of Nottingham University Business School and Professor Mike Wright of Imperial College London. It argues that, unlike an existing perception that private equity firms pursue only short-term profit in buyouts, there is a positive impact on long-term innovation and financial constraints for the portfolio companies.
“What we find is, after a leveraged buyout, there is an increase in patent activity,” Amess told Private Equity International by phone, “but more specifically, we find it's concentrated among private-to-private transactions.”
The research looked at 407 LBOs that took place between 1998 and 2005 in the UK and discovered a six percent increase three years after the deal in quality-adjusted patent stock, meaning it was adjusted for the number of citations in patent proposals. Specifically in private-to-private LBOs, there was a fourteen percent increase three years after the buyout. The other categories observed in the study were public-to-private, secondary and divisional buyout deals.
These increases in innovation following a buyout are supported by the private equity firms' ability to relieve any financial constraints in portfolio companies, according to the paper. Private equity firms monitor the management of companies as active investors and their financial expertise earns trust – and therefore funds – from creditors.
Once the financial dependence is somewhat decreased, portfolio firms can then promote innovation, such as increased patenting. This causal effect, according to the paper, shows how private equity buyouts promote long-term growth for businesses.
To ensure buyouts and patent activity had a direct correlation, the researchers looked at other factors that could be driving innovation and ruled out management equity ownership, leverage, equity ratchets and firm's experience through analysis.
“PE firms will encourage innovation to occur in order to create value,” Amess said. “I think there's a case for saying leveraged buyouts by private equity firms that conduct these transactions look at creating sustainable long-term businesses.”
Amess said his team was “fairly agnostic” without any preconceived ideas about increases or decreases in innovation activity. Considering the results of the study, he said he thinks those who believe LBOs and PE activity is purely motivated by short-term profits will be surprised.