Hands Off Private Equity

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Commentary

In recent years, private equity (PE) and other “alternative” investments have been demonized in the popular press and by some academics, with growing calls for regulation. For example, state legislatures in California and Washington recently introduced new regulations to monitor private equity in healthcare.

Private equity refers to investing in companies whose shares are not publicly traded (hence, the word “private”), usually with the goal of enhancing firm value and, ultimately, selling the company for a profit. The PE industry grew substantially in the 1980s and reached $464 billion in the United States last year, and is expected to grow at least 10 percent annually for the next 10 years.

A key public policy question regarding PE transactions is whether these deals improve economic performance. There is also growing concern regarding how ownership changes affect workers and innovation, since any performance gains may be due to measures undertaken by the new PE owners to reduce wages, lay off workers, and reductions in investment in physical capital and research and development (R&D). 

The push for greater regulation is partly based on results from the standard empirical approach to assessing performance effects of PE deals: the impact of these transactions on stock prices and accounting profits. There are two major problems with such studies that focus on firm-level financial returns to PE investments. 

The first is that from a public policy perspective, it is more useful to assess the impact of PE transactions on measures of “real” economic performance, such as total factor productivity (TFP), which is generally regarded as a best metric of economic efficiency, or measures of innovation and R&D, which have been shown to enhance TFP. Public policy decisions related to PE should be based on their impact on the real economy, not exclusively on their financial effects. That is, academics and policymakers need to look beyond their financial impact on shareholders, to explore their impact on productivity and on non-financial stakeholders (e.g., employees). 

Another drawback of most PE studies is that the firm may not be the appropriate unit of analysis, given that many PE transactions occur below the firm level. That is, many PE transactions do not involve a change of ownership of an entire publicly-traded firm, but rather the divestment of a unit of a large company, or a transaction that affects only a few plants. Thus, full-firm transactions involving publicly-traded companies constitute only a small percentage of PE activity. A more desirable methodological approach is to examine the growth in TFP of plants and patterns of R&D investment before and after changes in ownership.

As a result, the most important studies of the real effects of PE transactions have been based on plant or establishment level data for TFP, as well as patent and project level data for innovation.

The end result is that there is now a substantial body of empirical evidence on the two key important indicators of real economic performance: productivity and innovation. There are seven key stylized facts about PE, as reported in a series of studies in leading economics and finance journals: 

1. PE investment, especially management buyouts, results in large, statistically significant improvements in TFP.
2. This improvement in performance could not be attributed to reductions in R&D or capital investment, wage reductions, or layoffs of blue-collar personnel.
3. Any downsizing that does occur in the aftermath of PE transactions tends to be focused mainly on white-collar personnel.
4. Such post-buyout productivity gains were pervasive across industries. 
5. PE investment leads to higher quality patents.
6. Entrepreneurial firms attracting PE investment are significantly more likely to license or sell their technology and engage in collaborative R&D. 
7. PE investment accelerates the commercialization of publicly-funded research and the diffusion of knowledge.

Taken together, these findings suggest that PE investment has positive real effects on the American economy. The evidence is fairly clear that PE transactions may be a useful mechanism for reducing agency costs and enhancing innovation and economic efficiency. Thus, policymakers should resist any attempts to regulate PE. 

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.