Are Private Equity Buyouts the Devil's Work?

Private equity deals have always had a bad rap.

The naysayers argue that PE-driven leveraged buyouts of public companies lose money for investors, victimize employees, lead to massive job cuts, and pretty much steal money from orphans and widows when given half a chance. It hasn't helped public relations that PE dealmeisters have become some of the fattest fat cats on Wall Street.

So there may be more than a few smiles over the severe financial pressure being felt at private equity firms these days, including big names Kohlberg Kravis Roberts & Company, Blackstone Group, and Carlyle Capital. Since many PE deals are fueled by debt, the subprime meltdown and resulting credit crisis is taking a toll on the industry.

PE acquisitions can work in any number of ways, but a common scenario is for a buyout firm to use borrowed capital to buy a public company, particularly one that is struggling, and take it private. In comes an experienced management team to either work with the existing team or replace it. The goal is to get the underperforming company focused on what it does best, improve its processes, and add hands-on board members/investors. The PE firm and its partners get their big pay day selling the revitalized enterprise to another company or launching it back into the public market with an IPO.

Most of the controversy around the industry has centered on the practice of quick flips. That's when the PE firm tries to cash out its investment after only a year or so, way before the company is really ready to stand on its own. These deals are the ones most likely to fail and damage shareholders.

But is PE really the devil's spawn?

Harvard Business School professor Josh Lerner argues just the opposite. Although there have been notable blowups and compensation scandals, over time private equity deals have been good for the economy and the parties involved, says Lerner, who co-authored The Global Economic Impact of Private Equity Report 2008, released in January for the World Economic Forum. The study looks at the results from 21,937 LBO transactions at 19,500 firms globally from January 1970 to June 2007.

Among the findings:

• Buyouts have a lower average default rate than US corporate bond issuers and significantly lower rates than US junk bond issuers.
• Firms that undergo a buyout pursue more economically important innovations, as measured by patent citations. In a baseline analysis, the increase in the key proxy for economic importance is 25 percent.
• There is no evidence that PE deals cause extensive job loss, nor is there huge amounts of domestic employment created.
• Private equity activity in emerging economies is expanding and maturing, particularly for minority and growth capital investments.

All this to say that amid the spectacular flops, private equity makes a lot of good things happen as well.