Private equity can make companies more innovative

There’s an eternal argument about whether private equity investors create value for the companies they buy. The evidence shows that private equity backed organizations generate strong returns for investors, but they’re often blamed for three things:

1) The focus is on short-term results (hurting firms in the long run)

2) Loading target companies with too much debt (increasing their risk of going bust)

3) Caring more about cost-cutting (eliminating jobs) than revenue growth.

Private equity’s defenders say this negative view doesn’t quite make sense. First, the effects on employment are diverse. Second, the main goal of PE investors is to increase a firm’s value so that it can be sold for profit. This includes cutting unnecessary costs but it also means finding ways to increase competitive advantage and revenue. A research paper out of the “Dusseldorf Institute for Competition Economics” (DICE) explores whether leveraged buyouts (LBOs) make firms more innovative.

Globally, private equity firms are getting bigger. Much bigger. Even if Apollo Global Management (one of the largest firms)  hadn’t closed the largest buyout fund in history, 2017 would have represented a notable uptick in mega-funds compared to 2016. Though the aggregate value of buyout-backed exits globally dropped 23% in value and 19% in count from 2015, and even further from the record levels in 2014, making PE a more central player.

According to Joel Stiebale, a professor at DICE and co-author of the paper, it’s becoming more difficult to ensure high returns from cost-cutting strategy alone, so private equity are seeking more entrepreneurial growth – intrapreneurial processes for growth rather than the innovative outcome. To get a better picture of all this, the researchers analyzed hundreds of PE-backed LBOs (leveraged buyouts) of UK companies from 1998 to 2008. They found that LBO’s not only led to an increase in firms’ innovation but specifically, an increase in performance of the employees in new projects (innovative projects).

PE investors don’t typically invest in firms known for innovation. If you ask someone who works in finance about PE and innovation, they will likely tell you that PE sponsors aren’t looking for the next big thing, they’re looking for companies that are dominant in a market, aren’t risky, and have a predictable and steady stream of cash to pay back debt. The exact opposite of startups. Startups aren’t debt-financed, because they’re too risky and unproven,  have no assets, and are usually not appealing to lenders. It also takes a long time for returns on R&D investments to be realized, rather in big organizations and in startups too. At the same time, there are certain ways LBOs can create innovation in business models/services and other aspects of the company that can lead them to a quick and stable growth.

As Ahi Gvirtsman (Global VP of Innovation @HPE) writes in Spyre’s blog – “The only way for organizations to become innovative is by starting to execute innovative projects in a way that limits overall risk and overall cost.” Models such as CoNetwork offer an excellent foundation for an ecosystem that will build and execute innovative projects within 6 months.

All of this adds to the debate over whether PE investors sacrifice long-term growth for short-term profit. LBOs can help firms that are financially constrained, invest in innovation. But whether those investments actually pay off is another question. ROI and other measures of firms’ innovation performance are very difficult to define, which is why methodologies that measure the intrapreneurial process and its results have been recently developed.

With all roads leading to PE investment becoming a more central part of the market, it is crucial that PE investors start exploring more opportunities for growth.