The private equity deals that fail to justify ‘fast buck’ strategies

Debenhams: one of several quoted companies on the private equity merry-go-round. Karen Roe, CC BY

There is an ongoing and very heated debate between the unconditional supporters of private equity and their opponents. It’s not hard to see why. On the surface, these investors can often buy fragile companies, load on debt to fund strategic change and sack workers in a bid for efficiency. It can look ruthless, but the industry claims it simply works.

The British Private Equity & Venture Capital Association (BVCA), preach what they deem to be the undeniable benefits of private equity. For example, the trade lobby group wrote in 2010 that:

Private equity investment has been demonstrated to contribute significantly to companies’ growth. Private equity backed companies outperform leading UK businesses.

In contrast, Ed Miliband in his speech at the 2011 annual Labour Party conference accused private equity houses of “stripping assets for a quick buck and … [failing to represent] the values of British business.”

Horses for courses

To date, studies of private equity acquisitions of firms listed on the stock exchange disagree as to the effects on employment. A major issue is that the studies typically conflate very different forms of private equity acquisitions which are likely to vary significantly in terms of their impact. At the most extreme, some of this research fails to distinguish between private equity and venture capital, which typically provides equity financing to early-stage firms that are not yet listed on the stock market.

Such firms typically face severe difficulty raising cash to fund their growth. Banks are unwilling to lend them money given their high levels of risk and the firms cannot as yet tap into stock-market equity financing (and Dragon’s Den can’t or won’t fill the gap). For such firms, venture capitalists not only provide the much needed money, but also frequently provide strategic and management advice, which can be crucial for the survival of the firm. In short, there is very little doubt about the benefits, including those relating to employment, of venture capital financing.

In contrast, private equity typically targets mature firms that are already listed on the stock market and that offer well-established products or services. In the process of the private equity acquisition, the firm’s existing shareholders are bought out – often with the use of substantial amounts of debt, the firm is taken off the stock market (it is “taken private”) and then undergoes major long-term strategic and organisational changes. Such changes would not normally have been possible had the firm kept its stock market listing given the focus on the short term of most stock market investors.

Money, money, money

Is is important to realise that there are three main forms of private equity acquisitions which involve very different stakeholders and which are therefore likely to have very different effects on employment.

The most frequent form of private equity acquisition is a management buy-out or MBO. These involve management of a company taking the firm private, with the help of private equity houses which provide the cash. However, given that the existing management stays in place and carries on running the firm, the employment effects of MBOs are typically very positive or neutral at worst.

However, the other two main forms of private equity acquisitions – management buy-ins (MBIs) and institutional buy-outs (IBOs) – result in a change in the management. In the case of less-frequent MBIs, a new management team buys out the existing shareholders and takes the firm private and the input of private equity houses is typically limited to the financing. In the case of IBOs, the private equity house not only provides the financing, but also the management team. You can happily make the case for the positive employment effects of MBOs. The evidence on MBIs and IBOs, however, is much more mixed (see Goergen et al. 2011 for an overview).

A new study that we’ve published in the European Economic Review, sheds new light on the employment effects of UK IBOs. The study is based on 106 IBO acquisitions of UK listed firms between 1997 and 2006 (during the same period there were 139 MBOs and six MBIs). The sample included well-known companies such as Churchill China (check the bottom of your restaurant crockery), Fox’s biscuits and Goodfella’s Pizza maker Northern Foods and the high street department store Debenhams.

We compared the IBO targets with two control samples of firms which were not acquired. The first sample was matched by size and industry while the second was matched by pre-acquisition financial performance.

The IBO firms were followed for up to six years before and four years after the acquisition. The findings are stark reading. The most important thing is that there is a significant decrease in employment in the year following the acquisition in the target firms of IBOs, but not in two samples of control firms that we also had. And this drop in employment is combined with a drop in wages below the market rates for the target firms.

The IBO companies’ median employment growth was 11% five years before acquisition, falling down to –4.80% the year after the deal (see figure 1). Figures on salary suggest a similar trend with IBO companies seeing a salary reduction from a mean of £29,460 before the IBO to £28,520 following it.

Figure 1.

Stability pact

Those cynical about the industry might not be surprised by the above, but there is more. Importantly, despite what could be perceived as a much needed cull of the work force, the target firms do not experience an improvement in their profitability and productivity following the acquisition. The suggestion is clear: the increased insecurity inherent in the shedding of jobs and the downward pressure on wages outweighs any of the potential benefits from a change in management brought about by an institutional buy-out.

While this new study uncovers negative effects on employment of a particular type of private equity acquisitions – so called institutional buy-outs (IBOs) – it does not imply that all private equity acquisitions are bad for employment. What the results do suggest is that the debate on the effects of private equity acquisitions needs to be much more nuanced.

Importantly, it needs to distinguish between those types of private equity acquisitions that have undeniable positive benefits for employment – as well as the survival and competitiveness of UK businesses – and those that are likely to be mostly detrimental.