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Finding the Virtue in Private Equity Firms

Private equity firms have long been seen as villainous actors intent on the singular goal of profit. But new research from Wharton management professor Paul Nary provides better insight into the benefits of private equity buyouts. Nary has co-authored a paper with Wharton management professor Harbir Singh and Aseem Kaul, associate professor at the Carlson School of Management at the University of Minnesota, titled, “Who Does Private Equity Buy? Evidence on the Role of Private Equity from Buyouts of Divested Businesses.” The paper was published in Strategic Management Journal. Nary recently joined Knowledge@Wharton to discuss the paper and its findings.

An edited transcript of the conversation follows.

Knowledge@Wharton: Private equity firms are often viewed as destroyers of corporate value, but your paper argues that the opposite may be true.

Paul Nary: Yes, correct. It’s really fascinating because, even though the 1980s are far gone now, we still often think about private equity firms as these greedy destroyers of good businesses, always willing to strip away corporate value in pursuit of short-term gains. Aside from some anecdotal evidence from a few cases, we really don’t know much about their actual behavior when it comes to, for example, acquiring businesses that publicly owned corporations divest. We simply don’t have enough research that looks into this. In our study, we do find that private equity investors may, in fact, play an important role that helps revitalize businesses by taking a longer-term approach to creating value.

We find that private equity firms tend to acquire businesses that may fail to realize their potential under public ownership – essentially, divisions of firms that may have been neglected or under-incentivized by their parent corporations. PE firms then play a more important role in markets for businesses than we previously thought, as they may acquire mismanaged or neglected businesses and invest time and resources into nurturing them in a way that would have been impossible under public ownership.

Knowledge@Wharton: How did you test this?

Nary: We did an empirical study of about 1,600 acquisitions of divested business units that PE firms or other corporate acquirers bought from their publicly owned parent firms. We were interested to get to the real basics and understand what the PE firms were doing, so we were looking at the behavior of private equity acquirers as compared to other acquirers — for example, other corporations that may be buying similar types of divested assets.

Knowledge@Wharton: What set the private equity firms apart?

Nary: They seemed to be much more likely to buy businesses that were unrelated to their parent’s core businesses as well as businesses that tended to be potentially neglected — for example, those that may have required higher investment than their parents were able to provide or that required better-aligned incentives for their managers.

“PE firms … play a more important role in markets for businesses than we previously thought.”

Knowledge@Wharton: Does this paper suggest that private equity firms have changed their practices since the 1980s in terms of what they target?

Nary: It may very well be the case. We do observe — not in our study, but in general there is a lot of evidence for this — that private equity firms tend to be more professional now. They have institutional investors that expect certain types of behavior and certain types of stability, so I do think that the private equity firms of today are much different from the private equity firms at the beginning of the industry, say the 1970s or the 1980s.

Knowledge@Wharton: What lesson does this paper provide for private equity firms? Should they be marketing their value a little bit better?

Nary: I do think there is a case to be made for that. I’m not sure if they would care, though, because I think they are professional players in the market that are very comfortable with their position and the type of business that they do. However, there is a case to be made for perhaps some PR initiatives.

Knowledge@Wharton: What are some other practical applications for this paper?

Nary: That’s a really interesting question, considering that today so many public firms are choosing to go private — for example, Dell — while promising new ventures — for example, Uber — are choosing to stay private longer. We’ve heard about Elon Musk’s dissatisfaction with the public markets. He has a desire to take Tesla private.

“I do think that the private equity firms of today are much different from the private equity firms at the beginning of the industry.”

First, we may want to reconsider the image of private equity firms as greedy and ruthless corporate raiders, even aside from the PR, and instead allow that they may, in fact, play a positive role in the markets and be great partners for firms and business units that benefit under private ownership more than they would under public ownership. For example, a good business may require a more long-term perspective, a long-term investment that may not be appreciated by public market stockholders or equity analysts.

And second, consider all of this recent talk about short-termism of public markets, all this focus on quarterly earnings or the rule that investors — whether institutional or retail — should take on the governance of public firms. We may want to think about ways to improve and modernize corporate governance, regulations or even investors’ expectations to better align with the way some modern firms may create value so that not just the private but also public investors can benefit from ownership of high-potential businesses.

Knowledge@Wharton: What are some future lines for this research?

Nary: I want to investigate the different facets of performance implications of PE buyouts. We know that private equity firms and their limited partners — their investors — generally seem to benefit when private firms engage in their business, especially as they become more professional about it. However, what happens to the parent companies that sell their divested business units to private equity acquirers? Do they benefit from these divestitures, or is it a strategic move on their part to sell to a private equity firm rather than a competitor? It would be interesting to see the performance implications of this.

On the other hand, private equity firms are also becoming much more active in Silicon Valley and the technology sector in general. That’s fascinating because that’s a little bit different from the business that they used to engage in. We already know quite a bit about how firms like Facebook or Google engage in technology acquisitions or in investing in promising startups. Some of my other research looks at that, but we know very little about how private equity firms operate in those settings, about how they create and capture value, what they actually do in high-tech industries, and whether that’s different from their typical approach from their core business that’s focused on the financials. So, that’s also on the project list.

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