Private Equity and Innovation

20 March 2008 at 2:45 pm 2 comments

| Peter Klein |

LBOs do not reduce patent activity, and the quality of patents may actually increase following a “going-private” transaction, according to a new paper by Morten Sorensen, Per Strömberg, and Josh Lerner.

A long-standing controversy is whether LBOs relieve managers from short-term pressures of dispersed shareholders, or whether LBO funds themselves are driven by short-term profit motives and sacrifice long-term growth to boost short-term performance. We investigate 495 transactions with a focus on one form of long-term activities, namely investments in innovation as measured by patenting activity. We find no evidence that LBOs decrease these activities. Relying on standard measures of patent quality, we find that patents applied for by firms in private equity transactions are more cited (a proxy for economic importance), show no significant shifts in the fundamental nature of the research, and are more concentrated in the most important and prominent areas of companies’ innovative portfolios.

I very much like this kind of work even though I’m a patent skeptic (1, 2, 3, 4).

Entry filed under: - Klein -, Corporate Governance, Innovation, Strategic Management, Theory of the Firm.

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2 Comments Add your own

  • 1. Joe Mahoney  |  21 March 2008 at 7:54 am

    Given the research talent of the authors of this paper, I have no cause to doubt the empirical finding. However, it is difficult to accept the proposition that LBOs — which some refer to as “large bankruptcy opportunities” — have no adverse effect on innovation in the long run. Are there any studies of LBO’s and subsequent long-term capital investments and/or R&D expenditures?

  • 2. John L. Chapman  |  21 March 2008 at 2:07 pm

    Joe Mahoney raises an interesting and important question. If his inference is in fact corrrect, it would certainly represent prima facie evidence that the LBO transactional form is harmful in a macroeconomic sense — which is the assertion of populist writers and critics in any case (e.g., books such as “Barbarians at the Gate” or movies such as “Wall Street”), as well as some very respected economists.

    To answer his query from what I know:

    (1) Across a survey of some 250 papers in the academic literature dating to 1984, I can recall none that directly address this issue, though some make allusion to the possibility in a qualitative sense. At the moment, however, an innovative study is underway using company-data from the US Bureau of the Census, led by Steve Davis of the University of Chicago and John Haltiwanger at the University of Maryland (Josh Lerner is also on this team). They have access to thousands of deals with LBO date flagged, and subsequent reporting leading to liquidity event. They do have some details of spending parameters in this data (though I do not know specifics), and their first paper out of this effort, at the World Economic Forum, caused controversy in terms of findings re: employment level changes.

    In any case the Census data is high-level too, and not perfect — it is also hard to get this kind of data directly from private investment firms. Other sources for at least anecdotal data on this topic from a handful of deals may be found from the Private Equity Council (Robert Shapiro of SonEcon did a study for them), Ernst & Young, and McKinsey.

    (2) From a proprietary data sample I have collected from 20-25 firms and some 500 transactions, in a study to be published with Peter Klein in 2009, we have asked for capital expenditure data, pre-deal and post-exit. A small percentage of the deal info had exact numbers, but most answered in binary fashion of up or down. 78% of these deals increased CapEx or held it steady, though the mean deal IRR of the 22% that decreased was insignificantly different. The entire data sample easily beat S&P 500 benchmarks, were mostly top-quartile firms, and all was self-reported, though; this is hardly a representative sample. But still highly interesting.

    (3) My conclusion though is this: it is useful to study these top-quartile performers because they are “best-in-class”, and hence have garnered success of the kind from which we can best learn. While I am not a Chicagoan or zealous adherent of perfectly efficient markets, I do think that these LBO deals are now bought and sold in highly competitive auctions, and to the degree R&D spending is a driver of firm value, it will not be curbed during private equity ownership. Good PE firms are, if anything, repositories of specific knowledge with respect to superior governance and strategy. And, to Joe’s question, they are adept at understanding what a good manager, who understands a given industry and the value creation mechanisms within it, tells them about what the pro forma P&L should look like to optimize value. That is to say, if R&D expenditures are cut, it may well mean that the prior owners were doing stupid things! Sir James Goldsmith raided Goodyear one time solely because the Goodyear management team was torching free cash flow on stupid oil pipeline projects of which they had no inherent knowledge.

    To say this still differently, PE investors are quintessential “capitalist-entrepreneurs”, who take significant stakes as active investors. They are compensated partly by how well they gauge what matters to future value, and to act to execute toward such an outcome of increased value. Cutting R&D per se is not a route to optimized value in industries where this matters.

    I therefore do not think that the empirical reality is that LBOs have adversely impacted innovation in the long run. Instead, I think that private equity is an institution which has greatly liquified the market for corporate control, and as such has provided a platform for entrepreneurship and the exploitation of superior market knowledge in the creation of value. The source of the value increase may come from changes in governance, strategy, execution, or all the above, but PE allows for the entrepreneurial foresight that apprehends this value creation opportunity to be funded and actualized. Trial and error and the market process then play out, and there are winners and losers in PE investing, but like any market, error is of course punished. And hence systematically, over time, “good R&D spending” is encouraged.

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