There is a constant and very heated debate between the unconditional supporters of personal equity and their opponents. It’s not hard to see why. On the surface, these investors can often buy fragile firms, take on debt to finance strategic changes, and lay off employees in the pursuit of efficiency. It could appear ruthless, but the industry says it just works.
The British private equity and enterprise capital association (BVCA) preach what they imagine are the undeniable advantages of personal equity. For example, a trade lobby group wrote in 2010 that:
Private equity investments have been shown to significantly contribute to business growth. Private equity-backed firms outperform leading UK firms.
By contrast, Ed Miliband in his speech at the Labor Party’s annual conference in 2011, private equity houses were accused of “disposing of assets in exchange for quick money and… [failing to represent] values of British business.
Horses for courses
Previous research on private equity takeovers of listed firms is inconsistent as to their impact on employment. A significant problem is that studies typically mix very different forms of personal equity takeovers, which might vary significantly in their impact. In the most extreme case, a little little bit of this tests does not distinguish between private equity and enterprise capital, which usually provides equity financing to early-stage firms that are not yet listed on a stock exchange.
Such firms normally struggle with serious difficulties in obtaining funds to finance their development. Banks do not need to lend them money because of the high level of risk, and firms cannot yet use equity financing on the stock exchange (and Dragon’s Den cannot or will not fill this gap). For such firms, enterprise capitalists not only provide much-needed money, but in addition they often provide strategic and management advice that might be critical to the company’s survival. In short, there is little doubt about the advantages, including employment advantages, of enterprise capital financing.
Private equity, on the other hand, typically targets mature firms that are already listed on the stock exchange and offer well-established products or services. In the private equity takeover process, the company’s existing shareholders are bought out – often with significant amounts of debt, the company delists from the stock exchange (“taken private”), and then undergoes major long-term strategic and organizational changes. Such changes would not normally be possible if the company remained listed on the stock exchange, given the short-term investment focus of most stock market investors.
Money, money, money
It is vital to understand that there are three essential forms of personal equity takeovers that involve very different stakeholders and can subsequently have very different impacts on employment.
The hottest form of personal equity takeover is a management buyout or MBO. These involve managing a company that takes the company private, with the help of personal equity houses providing the money. However, given that current management stays in place and continues to run the company, the employment effects of an MBO are typically very positive or, at worst, neutral.
However, the other two essential forms of personal equity acquisitions – management buyouts (MBI) and institutional buyouts (IBO) – result in management changes. In less common MBIs, the latest management team buys out existing shareholders and takes the company private, and the private equity houses’ contribution is normally limited to financing. In the case of IBO, the private equity house provides not only the financing but also the management team. You’ll be completely happy to make the case for MBO’s positive impact on employment. However, the evidence on MBI and IBO is much more mixed (see Goergen et al. 2011 for review).
A brand new study we published in the journal European Economic Review, sheds latest light on the impact of NPs on employment in the UK. The study is based on 106 IBO takeovers of UK listed firms between 1997 and 2006 (there have been 139 MBOs and 6 MBIs in the same period). The sample included well-known firms akin to Churchill’s China (check the bottom of the dishes in your restaurant), Fox’s cookies and Goodfella’s pizza machine Northern food and essential street Debenhams department store.
We compared IBO targets with two control samples of nonacquired firms. The first sample was matched by size and industry, while the second sample was matched to financial performance before the acquisition.
IBO firms were followed for as much as six years before and 4 years after the acquisition. The results make for clear reading. The bottom line is that there was a significant decline in employment in the goal IBO firms in the 12 months after the acquisition, and not in the two samples of control firms that we also had. And this decline in employment is combined with a drop in wages below market rates in goal firms.
The average employment growth in IBO firms was 11% in the five years before the acquisition and decreased to -4.80% one 12 months after the transaction (see Figure 1). Wage data suggests a similar trend. IBO firms saw their pay cut from an average of £29,460 before IBO to £28,520 after.
Stability pact
Those cynical about the industry may not be surprised by the above statement, but there is more to it. Importantly, despite what could also be perceived as much-needed workforce reductions, goal firms do not see their profitability and productivity improve post-acquisition. The implication is clear: the increased uncertainty associated with job cuts and downward pressure on wages outweighs any potential advantages from a management change driven by an institutional buyout.
While this latest research reveals the negative employment impact of a specific style of private equity acquisition – so-called institutional buyouts (IBO), it does not mean that all private equity acquisitions are bad for employment. The results suggest that the debate about the effects of personal equity takeovers must be much more nuanced.
Importantly, it is vital to differentiate between those sorts of private equity takeovers that have undeniable positive advantages for employment – in addition to the survival and competitiveness of UK businesses – from those that are prone to be largely detrimental.