Angels or Demons?
Private Equity Insights
When Hugo Boss took the decision to close its Brooklyn, Ohio-based factory on the grounds that it was 'no longer globally competitive', its owners, Permira, will have known that it was going to spark controversy. Despite talks with unions and discussions with the local governor, the company was unable to make the numbers work, making the factory's 375 employees redundant.
Yet, Permira is unlikely to have expected what came next: a letter from one of its limited partners, the Ohio Public Employees Retirement System (OPERS), urging the firm to reconsider because the closure of the factory may have a 'deleterious long-term impact on the city of Brooklyn as well as an already depressed region of the state of Ohio'. The letter added that the OPERS board had concerns about 'future involvement' with Permira on the grounds of underperformance of Permira IV and claimed that Hugo Boss management had not bargained in good faith with state and local community partners over the closure.
For critics of private equity, this kind of story adds fuel to their argument that the industry destroys jobs and has a wholly negative impact on the economy. Given these types of criticism, there is a clear need for independent assessment of private equity's employment record. "Independent research is very important," says Wim Borgdorff, managing partner of AlpInvest Partners, which manages more than €40 billion of private equity investments. "It's difficult to get a true, independent story from association-led research – rightly or wrongly, people heavily discount the information coming out of these organisations. If you really want to influence society, the media and politicians, you need independent studies conducted by people from great universities".
So, an academic study that examines private equity's effect on employment should be of great interest to the industry itself as well as broader stakeholders. It was completed by Steven J Davis of the University of Chicago, together with John Haltiwanger of the University of Maryland, Josh Lerner of Harvard University and Ron Jarmin and Javier Miranda, both of the US Census Bureau. "There has been huge controversy over whether private equity, principally buyouts, destroys jobs," explains Davis. "I entered this project from a genuine position of curiosity to find out whether these claims were true. Over my career, I've conducted research that makes use of large-scale datasets on business outcomes and so was in a good position to determine the real story".
The result, Private Equity and Employment, finds that employment falls 2.7% at buyout targets relative to control companies in the first two years after buyout transactions. Yet, perhaps unsurprisingly, the research demonstrates that the interplay between buyout houses and their portfolio companies is rather more complex. "One of the most surprising things to come out of the study was the magnitude of private equity's creative destruction effect," says Davis. "We found a big difference between targets and controls in both the nature of job creation and destruction and the scale of it".
The findings present a picture of private equity acting as dynamic owners of businesses, taking them away from less profitable areas and removing inefficiencies, while directing them towards higher-value segments. They confirm that the role of private equity is often to reposition companies. In the wake of a buyout, targets shed jobs in parts of the original business only to create them in new areas through organic growth, acquisitions and disposals.
"We found that private equity acts as a catalyst for creative destruction," says Davis. "It's a bit like capitalism on steroids. Our evidence is broadly consistent with the view that private equity redirects resources from less productive to more productive uses, which is good for the economy as a whole.
There are, of course, losers in the process, but if you want market forces to improve living standards by encouraging efficient resource allocation, then private equity is a positive force on net".
It is a view shared by Katharina Lichtner, managing director at Capital Dynamics. "Private equity quite often cleans out structural problems that politics should be dealing with but can't because of conflicting demands from various constituents," she says. "Buyout firms take companies and act to make sure they are fit for survival in a global economy. Some of the actions they take may not be popular, such as moving low-skill jobs that shouldn't be based in, for example, Western Europe to lower-cost locations. However, at the same time, they create new, more highly paid and highly skilled jobs".
She adds: "While this can be a painful transition, overall, it often helps to put companies on a growth path. This not only allows companies to create more jobs in areas such as R&D, sales and marketing, but also fosters long-term employment security by building more sustainable businesses".
Yet, not everyone has agreed that the study's findings are so positive for private equity. A report put together by David Hall for the Public Services International Research Unit at the University of Greenwich, which looks into the Davis et al research points, takes issue with the concept of 'creative destruction'. It suggests that private equity's impact on companies is of creating greater job insecurity. "In two years following a private equity takeover, 24% of employees will have experienced their workplace being closed, sold or reduced – double the uncertainty compared with a firm which has not been the subject of a private equity takeover," the report says.
Janet Williamson, senior policy officer at the Trades Union Congress, agrees. "Putting private equity's impact down to creative destruction is misleading," she says. "Greenfield job creation [the creation of jobs in new areas of business] doesn't compensate for the job destruction. Whichever way you look at it, private equity destroys jobs on a net basis".
The use of leverage is one of the main reasons for this, she says. "The funding model means that buyout houses borrow heavily to finance deals and so it means that they and the management have a very different way of looking at the company," says Williamson. "The urgency of having to repay the debt encourages a slash-and-burn mentality. The owners see companies as a financial asset rather than an organic, working entity that has employees, customers and suppliers".
However, for the industry itself, the issue of whether private equity creates employment or not is something of a red herring. No buyout firms contacted for this piece were prepared to comment publicly on the issue, which speaks volumes about the political nature of this debate. But it is also indicative of firms' views on the subject. As one executive said: "We're not in the business of creating full employment. Our job is to generate the best returns for our investors by identifying the right companies and employing the right strategies for them". Another said: "It really depends on the industry you are investing in and the nature of the business. In some cases, you would have a great job-creation story; in others, the strategy has to be to strip away layers of inefficiency. It's impossible to generalise".
Indeed, as the Davis research suggests, employment is only one aspect of the overall picture. It is one of the reasons why Davis et al are now looking more closely at the issue of productivity. "When the employment paper came out, many people made comments about whether this was the right question to ask," says Borgdorff, who is on the World Economic Forum's advisory board for its series of papers on the global economic impact of private equity, the first of which featured the Davis et al employment study. "They said they had never seen an objective for private equity of creating jobs – employment is just a derivative outcome of what private equity does. Exploring productivity in addition to employment is a more meaningful study of the impact private equity has," Borgdorff continues.
The authors' research on productivity is still a work in progress, but early results suggest that private equity involvement increases productivity growth rates. In the first two years after a buyout, productivity grows by about 9% at target manufacturing companies as compared with 7% at control companies (those of a similar size, industry and age to the buyout targets), the research finds. Target companies are much more likely to shut down factories with low productivity, compared with other companies. While the study was unable to include 2008 data, it examined deals done in the 1980 to 2005 time period against variations in the credit market. It finds that the productivity growth differential between buyout-backed companies and the controls is greater in periods with an unusually high interest rate spread between AAA-rated and BB-rated corporate bonds. "The evidence is at least suggestive that private equity targets are better than controls in making the difficult choices needed to restructure businesses in times of financial crisis," the research says.
Clearly, the picture that emerges of private equity's impact on the economy is rather more complex than either the critics or the proponents of the industry tend to portray. This is reflected in the fact that the reaction to the Davis et al employment study was varied. "There was something in there for everyone," says Davis. "The critics honed in on the finding that net employment shrinks, while the private equity groups trumpeted the acceleration of new job creation in the wake of a deal".
However, what is apparent is that, in general, private equity should have a good story to tell. "Look at the whole picture of responsible investing," says Borgdorff. "You find that 95% of practitioners believe that they are acting responsibly and are not there to rob a company, strip out its value and fire the employees. They are there to create value. Yet, 95% of the wider world perceives private equity to be a negative force. I believe private equity's record of contribution to society overall is not bad at all. It just needs to ensure that better and more independent information is available to support its case".
This article first appeared in Private Equity Insights (Pg 17, Spring 2010, Issue 2).
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