“We should start by transforming the private equity industry — the poster child for financial firms that suck value out of the economy … But far too often, the private equity firms are like vampires — bleeding the company dry and walking away enriched even as the company succumbs,” stated Elizabeth Warren, in “End Wall Street’s stranglehold on our economy”, by Team Warren, Medium, in 2019.
Popular media spreads diverse and often even conflicting views on private equity investors. In the more extreme cases like the example above, PE is portrayed as a force of evil and, from the perspective of entrepreneurs or managers, something to be avoided at all cost.
Yet, academic research is more nuanced: PE investors generally advance sales efficiency and growth of the companies they back, and — in times of financial crisis — contribute to their financial stability. Part of this confusion around how value-adding PE investors truly are may be due to the fact we know relatively little about what they actually do — beyond investing money.
PE investors as active investors
PE investors typically acquire majority stakes in mature businesses, take on board seats and actively try to steer their portfolio companies towards shareholder value creation, striving to sell their stakes at much higher valuations five years after they entered the firms.
While in the past, the PE model was often portrayed as focusing on enhancing efficiency, for example, by streamlining operations and cost-cutting, PE investors are increasingly recognised for the entrepreneurial spirit they activate in their portfolio companies.
This means they now contribute more to growth as well. Such growth can be achieved internally, for example, through capital investments, or externally, such as through acquisitions. Yet, that does not mean PE investors push for internal or external growth equally nor in any circumstance.
Performance matters
Based on a study we conducted with a mid-sized, pan-European PE company, we showed that in the case of portfolio firms performing worse compared with their targets, PE investors were much more likely to push for capital investments, but yet against acquisitions.
Companies thus double down on improving existing operations when faced with significant performance shortfalls. As one of the PE investors we talked to put it: “If your company is in distress, the last thing you want to do is put another M&A target on top and add complexity and stress for the management team.” Acquisitions are not a great way to buy yourself out of trouble.
So what happens when portfolio companies over-perform? PE investors might intuitively think, “push for growth, regardless the type, no time for slacking”.
With returns in mind, this would indeed make sense – at least, at first sight. Value-creating internal capital investment opportunities are not endless, and capital investments take a significant amount of time to really materialise and yield increased sales, economies of scale or cost reductions.
Acquisitions, however, bring immediate sales and cash flows, together with an influx of resources which will help deal with any potential adjustment costs due to integrating the newly acquired firm. Hence acquisitions may boost shareholder value creation in the short term. So, PE investors should be more likely to push for acquisitions than capital investments in case of over-performance.
