Last year, the founders of the legendary investment firm KKR, or Kohlberg Kravis Roberts, resolved that they didn’t want to live with the unsavory parts of their past and launched an image makeover with a change at the helm.
For many of us, the world of private equity (PE) is defined by the best-selling 1989 book Barbarians at the Gate: The Fall of RJR Nabisco, by Wall Street Journal investigative journalists Bryan Burrough and John Helyar, and the eponymous 1993 HBO movie. The book captured the seemingly soulless ways by which PE investors like KKR raised money by selling junk bonds to buy companies — called leveraged buyouts — and in the process saddled those companies with ruinous levels of debt.
Leveraged buyouts gained notoriety in the 1980s and 1990s, when company management or outside investors financed corporate acquisitions predominantly by leveraging — or pledging as collateral — the assets of their target companies.
That visualization persists, but PE investors have in recent years undergone a makeover to secure a rightful and respectable place for themselves as responsible investors. Wharton management professor Paul Nary and University of Minnesota professor for corporate responsibility Aseem Kaul made that case in a recent paper published in the Academy of Management Review titled “Private Equity as an Intermediary in the Market for Corporate Assets.”
In their paper, Nary and Kaul discussed “why, and under what conditions, PE firms may thus have an advantage in buying, owning, and selling businesses.” They also drew up a set of propositions that predict which corporate targets PE firms are most likely to pursue.
They focused on “non-venture (or buyout) PE” firms that buy and sell entire companies, unlike venture capital firms, angel investors, or mutual funds that buy minority stakes in companies. “Non-venture PE firms … are different from the corporate raiders of the past, which generally engaged in one-off transactions, raising funds for each from a temporary consortium of private investors,” the paper stated.
“We may often still think of PE firms as primarily financial buyers and primarily as those barbarians at the gate that just do leveraged buyouts,” Nary told Knowledge at Wharton. “The reality is that the private equity industry has not only grown dramatically over the last three decades, but it has also changed dramatically. Private equity has been engaging in new types of deals and transactions, entering new markets and industries, and changing and evolving along the way.”
The New Colors of Private Equity
The world of PE includes firms that are “global financial powerhouses which are incredibly diversified” and others that are “ultra-specialized” in specific industries, such as high tech or life sciences, or novel types of deals, Nary said. In fact, PE acquisitions of high-tech companies increased from about four percent of all high-tech acquisitions in 2010 to more than a third by 2019, he said, referring to one of his ongoing research projects. He cited Blackstone, KKR, and TPG (formerly Texas Pacific Group) as examples of diversified PE firms and Thoma Bravo and Vista Equity Partners as those focused on high-tech industries.
PE firms have also made strategic shifts in their choices of target companies. Unlike a couple of decades ago, when PE investors typically bought similar companies (like waste-management companies or insurance companies) to create value from economies of scale, many have changed tack to develop better businesses through recombination of distinct pieces, to take advantage of synergies and complementarities, Nary said. For example, they may assemble a business by putting together a consulting business, a software business, or a different type of technology business, thus making a more complete suite of products that may better serve, for example, a specific customer market, he added.
In their paper, Nary and Kaul set a compelling backdrop for their study by citing prior research: In the U.S. alone, PE firms owned some 8,000 portfolio companies as of 2019, generating over five percent of U.S. GDP and employment — an eightfold increase compared to their holdings in 2000. Worldwide, in 2019, PE firms accounted for 40 percent of all private capital raised and made about 3,600 acquisitions, for a total deal value of $551 billion and 1,078 exits (sales) valued at $405 billion. The rise of PE has been accompanied by “a secular decline” in the number of publicly traded corporations over the past 20 years in the U.S.
Private Equity’s Unique Value Creation Strategies
Nary and Kaul said their study is an advancement over prior research in PE in that it explains “why PE has continued to grow over the past quarter of a century,” with an increasing dominance by large professional firms that often hold their investments for between five and 10 years “rather than going for a swift turnaround.” Such PE firms, they added, “bring a strong entrepreneurial orientation to bear.”
The authors made their case by first articulating why PE firms exist in the first place: A PE firm’s goal when buying a business is ultimately to profitably exit that investment, usually by selling the owned business to a corporate buyer that may realize operating synergies by combining the business with its existing operations or by taking that business public. In order to achieve that, PE firms must be able to buy the asset at a price greater than that offered by the best alternative corporate buyer today and then exit the asset at some point in the future (potentially in five to 10 years) while realizing a net profit and a sufficiently high return for their investors.
PE investors may be able to accomplish that task when they can leverage one or more of the value creation strategies in their arsenal, the paper stated. It defined the “value creation and capture” of the PE firm as the difference between the future sale price of a business and its present buying price, net of PE costs.
To create and capture value by buying established businesses and exiting them profitably later, PE firms must possess at least one of three potential advantages that the paper fleshed out. One is a “valuation advantage,” where they must be able to identify businesses that are currently undervalued by other market actors. This requires the ability to better assess the intrinsic value of a business at the point when it is bought, the paper explained.
The second is a “governance advantage,” whereby PE firms must be able to enhance the intrinsic value of the business during the ownership period. Here, PE investors can score as a source of patient capital and with “their ability to offer high-powered incentives to help correct governance problems, as well as to restructure stakeholder relationships,” the paper stated. With that combination, they can “bring medium-term investments to fruition, thus raising the intrinsic value of the business while it is under their ownership.”
The third potential plus is a “timing advantage,” whereby PE firms may be able to match the business to a more synergistic corporate owner in the future than is immediately available. PE investors have this advantage because they can “wait to sell the business until the best potential corporate buyer is ready to buy.”
“Those three categories can be thought of as three buckets of different but potentially related types of value creation mechanisms that private equity firms may use,” Nary said.
The paper pointed to other settings in which PE firms may be positioned to benefit. They could do well by buying businesses that are “relatively inscrutable or hard to value,” or those with underinvestment in strategic resources. Attractive PE targets also include businesses with any of these profiles: weak managerial incentives; a need for restructuring of stakeholder relationships; unrelated units of highly diversified companies; and those faced with difficulties in depressed markets or in financial distress. PE firms may also have valuation, governance, and timing advantages when pursuing targets for which there are no current corporate bidders as well as targets in industries where they have substantial prior experience or existing holdings.
According to Nary, PE firms may be able to align incentives in their acquired companies more precisely than many corporate owners, especially multi-business corporations. “In multi-business corporations, it’s very difficult to incentivize people in different businesses differently and precisely based on the performance of that specific business,” he said. Diversified corporations also tend to allocate capital to their different business units from a general pool, which makes that process inefficient, he added: “In private equity firms, you can very precisely align, for example, managerial incentives to create the most value at the point at which you sell the business. And everybody is very much aligned to the same goal, and the incentives are directly aligned to performance and not to the whims of corporate management that has 10 different businesses and different stakeholders and many different goals.”
PE Options for Corporations: Embrace or Compete
Nary identified some of the broader takeaways from the study: “For corporations and managers, one potential takeaway is that PE firms and the businesses they own are more likely to affect their own business and industries. PE firms are bigger and more prominent than ever. They are more sophisticated than ever. They can make powerful partners or formidable competitors.”
To be sure, the PE space mirrors the broader economic environment and has its ups and downs. For instance, the prevailing environment does not appear very helpful for PE investing: The number of PE deals declined in the second quarter of 2023 — the sixth quarterly decline — as debt servicing costs have risen along with interest rates.
Nary did not spot a trend there. “Business-as-usual for private equity firms has not seen major changes that are attributable to market cycles beyond what we would already expect, and PE firms will find ways to adapt,” he said. He pointed, for instance, to a recent $4 billion deal in which Vista Equity Partners bought payments software firm EngageSmart. He also dismissed the notion that higher interest rates are deterring PE deals entirely: “There are plenty of private equity firms that do deals that do not rely on a high degree of leverage and sometimes take on no leverage at all. They just do equity deals.”
Nary said he and Kaul embarked on their study because of a puzzling question: “What makes private equity able to capture value in buying and selling businesses consistently, over a long period of time, and across many settings, when so many companies and corporations fail to do so?” Their study provided the answer: “One overarching point of this paper is that when inefficiencies and frictions exist in the markets, if private equity can generate returns by exploiting those inefficiencies and frictions, [it] usually will.”
Published as “The Evolution of Private Equity” in the Spring/Summer 2024 issue of Wharton Magazine.
