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date: 03 December 2022

The Governance Roles of Private Equityfree

The Governance Roles of Private Equityfree

  • Sophie Manigart, Sophie ManigartVlerick Business School, Ghent University
  • Miguel MeulemanMiguel MeulemanVlerick Business School, Ghent University
  •  and Tom BeernaertTom BeernaertFaculty of Economics and Bussiness Administration, Ghent University

Summary

Private equity (PE) investors enhance the governance of portfolio companies by installing high-powered boards, structuring the senior management team, installing reward and performance management systems, and advising the portfolio company. The aim is to reduce agency risks and to increase shareholder value. A growing body of literature investigates the real effects of PE buyouts on their portfolio companies. Empirical evidence suggest that PE buyouts do not consider efficiency improvements as their main value-creating strategy, but PE enhances growth rather than efficiency. Researchers’ understanding of PE’s entrepreneurial growth approach to increase shareholder value is limited to date, although it is known that PE portfolio companies are active innovators and that PE portfolio companies extensively engage in acquisitive growth.

Financial performance of PE investors can also be driven by transferring value from other stakeholders to the portfolio company after buyout. Does PE buyout’s shareholder value creation come at the expense of other stakeholders, such as employees or customers, or do they also benefit? PE’s impact on employment and wages in portfolio companies has received considerable attention. The effect depends on the institutional setting and macroeconomic conditions and differs across PE groups and by type of buyout. PE buyouts do improve employees’ safety, well-being, and human capital. Research on the impact of PE on stakeholders other than employees is limited. Industry-specific studies uncovered fine-grained actions and mainly negative effects on various stakeholders beyond shareholders and employees. This highlights the tension between enhancing shareholder value at the expense of stakeholder value. Given the continuous development of practices in the PE industry, the governance roles of PE will remain a fertile ground for academic research.

Subjects

  • Entrepreneurship
  • Finance

Setting the Stage

Invest Europe, the European industry association of the private equity (PE) industry, defines PE as “a form of professional investment that involves taking an ownership interest (equity) in a company and holding it in private hands. . . PE is typically a medium to long-term investment” (Invest Europe, 2021). This form of investment originated after World War II in the United States (Sahlman, 1990) and has since spread over the globe, managing close to $5 trillion in 2021 (Preqin, 2021). Independent PE management teams, or general partners (GPs), typically set up a 10-year fund in which they collect money from investors or limited partners (LPs) like high-net-worth individuals or families, corporates, institutional investors, or governments (Sahlman, 1990). During the first three to five years of the life of the fund—the investment period—investment opportunities are scouted, and equity investments in some 10–20 portfolio companies are carried out. In a second phase, GPs work together with the management teams of their portfolio companies to enhance the value of the equity investment. Finally, the equity stakes are sold—or the investments are exited—some three to seven years after the initial investment.

PE can be broadly defined as any equity investment in an unquoted opportunity, including young, high-growth-oriented companies, typically referred to as venture capital, infrastructure, or real estate. Following Gompers et al. (2016), the narrow definition of PE is used in this article, referring to investors who focus upon equity investments in mature companies (in contrast to venture capital investors, who focus upon equity investments in young, high-growth-oriented companies). While historically PE mainly focused on acquiring majority stakes in buyout or buy-in transactions, taking a minority stake has become more accepted in the 21st century.

An independent PE fund has a purely financial goal: generating a financial return for LPs and GPs that compensates for their investment and liquidity risk. While the independent investment structure with GPs professionally managing investments from several LPs is still the most prevalent organizational form in the PE industry, alternatives have emerged, such as sovereign wealth funds, family offices, or corporate investors who manage their own funds. These alternative forms of PE investors may have different investment goals, such as strategic objectives, and time frames (Neckebrouck et al., 2021). This article begins by discussing the vast literature on independent PE investors and thereafter focuses on alternative PE investors, for whom the insights are more limited.

PE investors create shareholder value through financial, operational, and governance engineering (Kaplan & Strömberg, 2009). Financial engineering refers to the use of leverage to buy out a company and installing management incentive schemes that align the interests of the PE investors and management, such as through equity and stock option plans (Jensen, 1986). Operational engineering focuses on providing industry and operating expertise to the management teams. Governance engineering focuses on PE investors’ role as directors of their portfolio companies, for example, by replacing poorly performing management.

The purpose of this article is to explore how PE enhances the governance of portfolio companies, taking a broad definition of corporate governance as advanced by the Organisation for Economic Co-operation and Development (OECD): the

procedures and processes according to which an organization is directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among the different participants in the organization—such as the board, managers, shareholders, and other stakeholders—and lays down the rules and procedures for decision-making (OECD, 2015).

Next, the impact of PE investors’ actions on the financial performance of their portfolio companies is discussed. However, enhancing financial performance may come at the expense of other stakeholders, such as employees or customers. The limited literature on how other stakeholders are treated when PE invests is reviewed thereafter. The article’s conclusions identify gaps in the current knowledge, leading to promising avenues for future research.

How Do PE Investors Enhance Corporate Governance in Their Portfolio Companies?

Agency theory highlights how goal incongruencies and information asymmetries between managers and shareholders create agency costs, thereby impeding value creation (Eisenhardt, 1989; Jensen & Meckling, 1976). This is especially the case in public firms with widely held ownership. PE investors are experts in reducing agency costs through aligning the objectives of the management team with those of the investors (Jensen, 1986), thereby reducing goal incongruences. Next, they engage in intensive information production through thorough due diligence before investing and by monitoring after their investment (Gompers et al., 2016). Overall, PE investors install different governance mechanisms to align their interests with the interest of managers.

Installing High-Powered Boards

One central governance instrument PE employs is the board of directors (Gompers et al., 2016). By structuring the board of directors, PE firms can exert control and influence important company decisions, including assigning the CEO and recruiting the senior management team, developing reward and performance management systems, and more generally advising the portfolio company. PE firms generally install small, independent, highly competent boards dominated by outsiders, thereby enhancing their effectiveness (Coles et al., 2008; Hermalin & Weisbach, 1998). The aim is to enhance board performance through rightsizing the board and adjusting its composition to the needs of the company. PE investors prefer small boards of directors, with more than 90% having between five and seven members, while larger PE firms tend to have portfolio companies with larger boards (Gompers et al., 2016). PE investors take roughly three of the board seats, while allocating one or two to management (Gompers et al., 2016). Compared with boards of non-PE-backed companies, boards of PE-backed companies include more outside experts who are not affiliated with the PE firms (Cornelli & Karakas, 2008; Marini et al., 2021). Outside board members are more often experienced in finance or in the target industry, especially when the need for either advice or oversight is higher, such as in poorly performing portfolio companies or in companies with high R&D intensity (Chen, 2014). The expert boards installed by PE investors hence create a culture where risk is more strongly mitigated, such as through lower coordination or director free-riding problems (Lipton & Lorsch, 1992). The positive impact is highest when the new boards are smaller or have busier industry expert directors (a sign that PE investors are effective in allocating multiple roles across directors; Marini et al., 2021). This ultimately creates more financial value (Chen, 2014).

Structuring the Senior Management Team

PE investors play an active role in recruiting senior management teams: roughly 58% of PE firms recruit their own senior management team before or after investing (Gompers et al., 2016). Slightly more than 30% of PE firms recruit their own senior management team before investing. This provides a friendly signal toward different stakeholders involved. However, PE investors intend to replace the CEO in about one-third of the investments after having invested (Gompers et al., 2016). Taken together, this is broadly in line with an empirical study based upon data from a sample of 126 PE-backed leveraged buyouts (LBOs) in the United States between 1990 and 2006, which documented a CEO turnover rate of 51% in the 2 years after the buyout (Gong & Wu, 2011).

Replacing the incumbent top management team is triggered by underperformance, either prior to the investment or ex post the investment (Cornelli et al., 2013; Jensen & Ruback, 1983): the likelihood of CEO replacement is higher when prebuyout profitability is lower and when potential agency costs of free cash flow are higher (Gong & Wu, 2011). Nevertheless, there is significant heterogeneity in the way PE investors deal with the top management team of their portfolio firms. For example, larger and more international PE investors are more likely to install their own management team throughout the investment period (Gompers et al., 2016).

Installing Reward and Performance Management Systems

Installing high-powered reward and performance management systems constitutes another important governance mechanism to align the incentives of the PE investor and the incumbent management team. Setting performance targets and designing reward packages aligned with these performance targets are crucial to the overall deal-structuring and negotiations with the management team (Gottschalg & Zollo, 2007). A key aspect of reward management is the “carrot and stick” mechanism (Castellaneta, 2016). The carrot refers to the upside financial reward for the management team if a company performs well. On the other hand, if the company performs badly, the management team bears negative downside risks. The downside risk is a financial stick that incentivizes the managers to perform well. Positive and negative financial incentives are key to incentivizing managers to maximize a firm’s potential performance.

The literature identifies three different types of incentive mechanisms installed by PE investors (Leslie & Oyer, 2008). First, the management of the acquired company acquires an important equity stake, thereby aligning their goals with those of the investors. This incentivizes management to maximize firm value (Kaplan, 1989; Leslie & Oyer, 2008; Muscarella & Vetsuypens, 1990) and aligns managers’ and investors’ attitudes toward risk-taking (Eisenhardt, 1989). The fraction of equity owned by the highest-paid executive at a PE-owned firm is twice as large as its counterpart in publicly traded companies (Leslie & Oyer, 2008). This feature is considered to be one of the cornerstones of the PE model because it effectively transforms managers-as-agents into managers-as-owners. An important characteristic of this equity incentive plan is that managers are typically required to purchase a significant amount of shares at the start of their tenure with their own personal funds, to ensure that they have skin in the game and are at risk to lose if they underperform. Since their equity share is defined at the start, the management team does not suffer from the systematic performance penalty of a competitive pay policy. In the latter system, granting the management team a fixed value of new shares each year rewards past poor stock performance with more shares and penalizes good performance with fewer shares (O’Byrne, 2020). Because CEOs in PE-owned companies are restricted from selling their stock holdings and must keep them for a longer period than is required of CEOs of stock-listed companies, the PE investor creates a stronger incentive to increase long-term shareholder value (Jackson, 2013).

Second, stock options are granted to the management team, and a broader employee stock-option plan is put in place (Leslie & Oyer, 2008). Stock options usually vest over 5 years. Finally, buyout funds implement strong cash-bonus structures for the managers. The CEO in a PE-owned firm typically earns 12% less in base pay but receives a substantially larger share of cash compensation through variable pay. Taken together, there is no statistically significant difference in total compensation levels between CEOs of PE-backed companies and those of stock-listed companies after adjusting for differences in company size (Jackson, 2013). Therefore, PE investors can more strongly align the goals and reduce agency risks through adequate compensation packages, without having to resort to higher cash compensation.

Yet, despite all the advantages, PE executive compensation packages generally do little to isolate the management’s contribution to value creation and the market or industry multiple growth. Consequently, managers benefit in rising markets, but are penalized in declining ones (O’Byrne, 2020).

Next to installing high-powered reward management systems, PE boards take up an active role in driving performance management. PE firms’ focus on installing a high-performance management culture might well be one of the most striking differences between PE-backed companies and their public counterparts (Acharya et al., 2009; Bloom et al., 2015). By defining clear goals before investing and installing dashboards, including idiosyncratic key performance indicators, PE firms monitor managements’ progress in executing strategic initiatives and in realizing different value-creation levers. The dashboards strongly focus on cash-flow metrics (as opposed to earnings) and speed of delivery. They enable PE boards to monitor progress more intensively and to intervene quickly and decisively when portfolio companies underperform. Using an extensive international survey spanning 10,000 manufacturing plants across 34 countries, Bloom et al. (2015) showed how PE firms—in comparison to other types of firms—more frequently employ continuous performance management, improvement, and feedback systems. Moreover, enhanced monitoring not only is pushed by the PE investor, but also arises within management because managers are now also shareholders and therefore more strongly monitor fellow managers (Meuleman et al., 2009).

A key question, then, is what actions PE firms take when performance doesn’t match expectations. Cornelli et al. (2013) provided evidence with respect to PE investors’ monitoring of the performance of their portfolio companies and the likelihood that the CEO will be fired. They showed that boards collect two types of performance data: “hard” (i.e., verifiable) performance data are collected to assess deviance from agreed performance targets and “soft” data (i.e., nonverifiable) are collected about the firm’s operations and the CEO’s competence. Even if hard performance data play a key role in firing decisions, soft data are much more influential in decisions to fire the CEO. Replacing the CEO ultimately also improves firm performance. Importantly, the findings by Cornelli et al. (2013) indicated that PE investors (as compared to the boards of companies with dispersed ownership) are active monitors who collect fine-grained, soft information about the competence of the CEO—rather than purely relying on hard, financial data—and hence learning about the CEO’s true ability plays an important part in effective corporate governance. Bourgois et al. (2021) showed that PE investors push their portfolio companies to engage in acquisitions when they slightly underperform, in order to catch up and ultimately to reach their targets. This is especially the case when PE investors have more money invested or when they have appointed more experienced board members.

Overall, the limited academic evidence indicates that PE boards play a highly active role in monitoring and driving performance management in their portfolio companies, and that they do act when portfolio companies underperform, such as by replacing the CEO or through acquisitions.

Advising the Portfolio Company

An important element of the effective governance of portfolio companies is the human capital the PE firm employs or the so-called GP effect (Castellaneta et al., 2019). The accumulated experience of PE partners, the cross-utilization of industry expertise and management within portfolio companies, and PE firms’ extensive industry networks enable them to apply unique knowledge across the investment cycle (Acharya et al., 2013; Braun et al., 2019; Hite & Vetsuypens, 1989; Kaplan & Strömberg, 2009). As PE partners gain more experience, they become more effective in conducting various tasks, including deal selection, monitoring, and advising portfolio companies, which adds value to the governance role of PE firms and increases their impact on portfolio companies. For example, Acharya et al. (2013) showed how the heterogeneous background of a PE firm’s partners correlates with deal-level abnormal returns. More specifically, PE partners with strong operational capabilities (e.g., ex-consultants or former industry managers) seem to be more effective in “organic” deals that focus on operational improvements and organic growth strategies (e.g., adding new products, customers, or geographies), whereas partners with a financial background are more successful in buy-and-build strategies. Moreover, industry specialization of PE firms is associated with higher postbuyout profitability, which highlights how industry-specific experience can contribute to better PE governance (Cressy et al., 2007). More generally, the accumulated investment experience of the GP has a positive and persistent effect on the returns generated by a PE fund (Kaplan & Schoar, 2005; Korteweg & Sorensen, 2017). However, the persistence of fund-level returns may have declined in the 21st century as competition has increased and best practices with respect to governance engineering have become assimilated across PE firms (Braun et al., 2017). Overall, significant heterogeneity exists with respect to the reputation and experience of PE firms and the partners they employ, which has become a prominent topic in explaining performance differences at the level of the portfolio company as well as the fund level (Braun et al., 2019; Tykvová, 2018).

The Real Effects of PE Governance

The enhanced governance mechanisms installed by PE firms in their portfolio companies aim to reduce agency risks and to enhance upside potential. It is therefore expected that companies backed by PE investors behave differently than non-PE-backed companies or exhibit post-PE performance that differs from their pre-PE performance. Numerous studies have examined the real effects of PE on their portfolio companies and stakeholders. This section first reviews the literature on the impact of PE firms on the performance of their portfolio companies, including operational efficiency and growth. Thereafter, it focuses on the effects on the employees of the portfolio companies and on other stakeholders.

The Impact on Company Performance

The alignment of interests between shareholders and managers through strong governance mechanisms installed by PE investors should increase shareholder value in the portfolio companies. However, the academic evidence on whether PE has a real impact on their portfolio companies is mixed (Morris & Phalippou, 2020). The traditional agency approach to PE-backed buyouts has largely focused on value creation through prevention of managerial perquisites and other value-destroying investments (Bruton et al., 2010; Klein et al., 2013; Meuleman et al., 2009). Moreover, the disciplinary nature of high debt levels and vigilant monitoring hinders managerial discretion and overly high risk-taking (Jensen & Meckling, 1976; Wright et al., 2000). Thus, this agency perspective on PE-backed buyouts predicts an improvement in efficiency in the target company once acquired by a PE investor. Empirical evidence on operational improvement and efficiency gains is mixed, however. While some studies report a positive impact of PE on their target’s operational efficiency (Alperovych et al., 2013; Meuleman et al., 2009), others report negative (Antoni et al., 2019; Cressy et al., 2011) or no effects (Davis et al., 2021). A meta-analysis by Verbouw et al. (2021), synthesizing 452 empirical samples from 69 independent studies covering 47 years of data and 546,002 portfolio companies, suggested that the efficiency of the portfolio company does not significantly change after the buyout, although the effect was slightly more positive in the 1980s than in the 21st century. This suggests that PE buyouts do not focus on efficiency improvements as their main value-creating strategy.

More recently, scholars advanced the idea that traditional agency theory has depicted only a partial view of PE-backed buyouts, as it attaches little importance to their upside potential (Wright et al., 2000) and it overlooks the impact that PE may have on the targets’ entrepreneurial growth potential (Klein et al., 2013; Meuleman et al., 2009). The stringent governance structures under agency theory imply that cost-cutting and short-termism could occur under PE ownership and that long-term investments, such as R&D investments, would be postponed, thereby sacrificing organizational growth (Wright et al., 2019). Furthermore, the LBO structure has shortcomings because higher debt levels are likely to increase insolvency risk (Wilson & Wright, 2013) and limit managers’ flexibility to undertake risky innovative activities (Wright et al., 2000), both conditions detrimental to long-term growth. As there is little academic support for an enhanced focus on costs and efficiency after PE investment, a key question is whether PE does enhance growth, rather than efficiency. In line with this view, PE would encourage entrepreneurial initiatives that lead to corporate revitalization and organic growth (Ireland et al., 2003; Meuleman et al., 2009), foster strategic innovation (Amess et al., 2016), and cultivate managerial opportunity recognition and exploitation—for instance, through buy-and-build strategies (Bansraj et al., 2020; Hammer et al., 2022). The managerial expertise of PE investors is a catalyst to boost growth and is transferred through the PE investors’ active involvement in their portfolio companies (Barney, 2001; Castellaneta et al., 2019; Manigart & Wright, 2013). This is consistent with evidence that, after buyout, PE-backed companies experience higher growth rates than similar non-PE-backed companies (Cohn, Hotchkiss & Towery, 2021; Jelic et al., 2019), especially in the 21st century (Verbouw et al., 2021). PE’s value-creating strategy has shifted from a cost-reduction approach to a more entrepreneurial growth approach.

Our understanding of the mechanisms PE portfolio companies employ to realize this enhanced growth is limited. One channel that has been extensively researched is whether they are active innovators. The empirical evidence is positive: PE portfolio companies enhance innovation (Amess et al., 2016; Le Nadant & Perdreau, 2011). PE investors are associated with higher-quality patents that become more concentrated in important strategic domains, and this is true both in the United States (Lerner et al., 2011) and in Europe (Popov & Roosenboom, 2009). Compared with independent PE investors, corporate PE investors focus even more strongly on innovation output (Ughetto, 2010). This evidence again suggests that PE investors value a growth strategy more than a cost-reduction strategy, under which innovation and R&D spending might suffer. Next to enhancing the portfolio company’s innovation capacity, PE portfolio companies also extensively engage in acquisitive growth. Hammer et al. (2022) reported that the probability of an acquisition almost doubles after PE entry, as evidenced by PE’s focus on so-called buy-and-build strategies, in which a portfolio company serves as a platform for add-on acquisitions.

Beyond Shareholder Value: The Impact on Employees

Financial performance of PE investors can be driven by value creation within the portfolio company, such as by enhancing operational efficiency or growth, but also by transferring value from other stakeholders to the portfolio company after buyout. As Nobel Prize winning economist Stiglitz (2019) put it, PE’s goal is to “take advantage of others through market power, through individual vulnerabilities, and through inside or unequal information.” Recently, research has investigated whether PE investors indeed transfer value from stakeholders like employees, customers, or suppliers, and as such would create financial value for their shareholders at the expense of other stakeholders. In doing so, PE firms would breach implicit contracts with stakeholders (Fama & Jensen, 1983; Shleifer & Summers, 1987). PE investors might be more disposed than the preexisting owners to breach those implicit contracts because they are new shareholders and therefore do not have the same established relationships with the stakeholders as the former owners (Eaton et al., 2020). Next, they are less exposed to the potential long-term effects of the contract violations because they intend to exit the firm 3 to 7 years after the initial investment. Consequently, in their quest to rapidly increase firm value, they might violate implicit contracts to increase the financial return for their shareholders, which may in turn result in stakeholder wealth losses (Eaton et al., 2020).

A growing number of empirical studies have extended research on the effects of PE buyouts by incorporating multiple stakeholders in the analysis (Brown et al., 2020). These studies investigate, for example, effects on employees, but also nonfinancial effects in various specific industries like education (Eaton et al., 2020), healthcare (Gupta et al., 2021; Pradhan et al., 2014), the hotel industry (Spaenjers & Steiner, 2021), and the restaurant industry (Bernstein & Sheen, 2016).

Zooming in on the effect of the buyout on the employees of the newly acquired company, the literature mainly investigates the impact on employment and on wages. Critics of the PE model assert that PE investors push portfolio companies to lay off employees to enhance profits (i.e., value transfer), whereas advocates of the model claim that PE firms create jobs by pursuing profitable growth strategies (i.e., value creation). Empirical evidence on the matter is mixed.1 For example, Scellato and Ughetto (2013) reported that total employment in portfolio companies grows more after a buyout than in comparable companies, while Lichtenberg and Siegel (1990) showed a decline in nonproduction worker employment after buyout, and Amess and Wright (2012) concluded that LBOs do not result in significantly different employment levels. The effects of U.S.-based PE buyouts on employment, wages, productivity, and job reallocation vary tremendously with macroeconomic and credit conditions, across PE groups, and by type of buyout (Davis et al., 2021). Davis et al. (2021) reported that employment shrinks on average 13% over 2 years after buyouts of publicly listed firms but expands 13% after buyouts of privately held firms, resulting in large postbuyout productivity gains, especially for deals executed amid tight credit conditions.

To shed light on these inconclusive findings, Verbouw et al. (2021) performed a meta-analysis to quantitatively assess the impact of PE-backed buyouts on employment levels of portfolio companies and found a zero average effect. However, they found substantial variation in effect sizes depending on the institutional setting. More specifically, employment increases in countries with strong employment protection laws but decreases in countries with more individualistic cultures.

While the average effect of a PE investment on employment levels may be zero, studies have investigated which employees have the highest chances of being fired. For example, evidence exists of a reduction in administrative staff and more hiring for jobs that require IT skills (Antoni et al., 2019). Olsson and Tåg (2017) showed that unemployment doubles for workers in less productive firms who perform routine or offshorable tasks. Interestingly, employees with lower health status before the buyout have a higher probability of job loss after the buyout (Garcia Gomez et al., 2020). These fine-grained insights suggest that PE investors face ethical dilemmas between enhancing shareholder value and caring for stakeholders.

The effect of PE on employees goes beyond mere hiring or firing policies and may also impact wages and other types of employee compensation (Bacon et al., 2013). How PE buyouts affect wages is controversial (Davis et al., 2021). While some studies show a positive effect on compensation (Agrawal & Tambe, 2016; Boucly et al., 2011; Gurung & Lerner, 2009), others show a negative effect (Amess et al., 2008; Antoni et al., 2019; Goergen et al., 2014) or no effect (Davis et al., 2021). Tåg (2012, p. 287) concluded that the evidence overall suggests “slight positive effects on wages” after buyouts.

Bacon et al. (2013) highlighted that the effects may vary between buyout types and that it is inappropriate to regard most PE buyouts as a zero-sum game with value transferred to shareholders at the expense of employees. However, the extent of this effect appears to vary by national context and deal type. For example, in the United States, compensation per worker rises by 11% in divisional buyouts relative to controls over 2 years after buyout, while it falls by 6% in private-to-private buyouts (Davis et al., 2021). The higher wages in divisional buyouts may reflect that formerly divisional managers now have firmwide responsibilities. Some employees may be more strongly hit than others. For example, Garcia Gomez et al. (2020) showed that employees with lower health status before the buyout face a higher probability not only of employment loss, but also of income loss, and they concluded that buyout-related restructuring has a stronger negative impact on the careers and human capital of employees with health problems. Again, shareholder value creation comes at the expense of stakeholder value. More emphasis should be given to corporate social responsibility (CSR), including all stakeholders. LPs could play an important role in the transition toward a PE model that benefits society at large.

Recently, scholars have extended the stream of research by investigating the impact on employees of portfolio companies beyond employment levels and wages. For example, Agrawal and Tambe (2016) documented that a PE buyout has a positive effect on the quality of the workforce in the IT industry: employees gain transferable, IT-complementary human capital and thereby experience heightened long-run employability. PE buyouts of publicly traded U.S. firms are associated with a large, persistent decline in workplace injury rates, and the firms have fewer safety inspection violations after buyout (Cohn, Nestoriak & Wardlaw, 2021). Finally, there is no evidence that the strategies of PE buyout funds—such as streamlining the operations and strengthening the incentives for management, which might result in a more demanding and stressful work environment—negatively influence the employees’ health (Garcia Gomez et al., 2020). Taken together, these findings suggest that the impact of PE buyouts on employees extends well beyond employment levels and wages, as PE also affects their safety, well-being, and human capital. PE’s impact on employees is hence complex, highly nuanced, and context-specific, but not yet fully understood.

The Impact of PE on Other Stakeholders

There is little evidence of the impact of PE on stakeholders other than employees, and the evidence is mixed as to whether the PE buyout fund’s (shareholder) value-creation actions come at their expense, or whether they benefit. In an analysis of restaurant chain buyouts in Florida between 2002 and 2012, Bernstein and Sheen (2016) argued that the takeover of restaurants by a PE fund is beneficial for the customers: restaurants become cleaner, safer, and better maintained after a PE buyout. In contrast, there is increasing evidence that stakeholders in other industries are worse off after a PE investment. For instance, PE-backed buyouts in for-profit college education are associated with worse outcomes for students, including higher tuition and per student debt, and lower education inputs, graduation rates, and per graduate earnings (Eaton et al., 2020). Similarly, hotels owned by PE investors experience improvements in operating efficiency and significantly higher bottom-line profits, but at the expense of lower guest satisfaction (Spaenjers & Steiner, 2021). In the healthcare industry, PE ownership is associated with a decline in patient well-being, including an increase in the short-term mortality of Medicare patients (Gupta et al., 2021), while PE-owned nursing homes have fewer and less-skilled registered nurses, more deficiencies, and worse health outcomes than their non-PE counterparts (Pradhan et al., 2014). This suggests that a PE buyout fund’s incentives are not always aligned with those of other stakeholders, and shareholder value creation might come at the expense of the other stakeholders, as suggested by Stiglitz (2019).

Finally, some studies also include the government as a stakeholder in their analysis. Eaton et al. (2020) showed that PE-backed companies obtain higher profits through superior capture of government aid. PE ownership of nursing homes leads to an increase in taxpayer spending per patient (Gupta et al., 2021). This rent-seeking behavior is clearly not in the taxpayers’ interest.

The growth in empirical studies of the nonfinancial effects of PE has been driven by the rise of stakeholder capitalism, broadening the scope of financial responsibility beyond shareholders only. The finance community’s interest in stakeholder capitalism has multiple sources: asset managers (e.g., BlackRock CEO Larry Fink’s 2020 statement on “A Fundamental Reshaping of Finance”), regulations (e.g., EU’s Sustainable Finance Disclosure Regulation 2019/2088), academics (see Henderson, 2021), and the general public (e.g., a surge in demand for environmental, social, and governance [ESG] funds). Overall, appetite among PE firms for integrating ESG considerations is increasing (Indahl & Jacobsen, 2019). Multiple PE firms have voluntarily signed the United Nations Principles for Responsible Investment. This includes inter alia committing to incorporation of ESG considerations into their investment-analysis and decision-making processes and to being active owners and incorporating ESG issues into their ownership policies and practices.2 Our understanding of the effects of stakeholder capitalism on the functioning and effects of PE investors is limited to date. PE firms adopt ESG considerations because of pressure from their investors. They focus on ESG aspects primarily during the due-diligence phase and monitor and integrate ESG factors mainly to cover risks (Zaccone & Pedrini, 2020). In their investment decisions, PE investors react more negatively to bad ESG practices, especially those related to governance issues, than to good ESG practices (Crifo et al., 2015). Clearly, academic research needs to catch up with PE practices to enhance our understanding of the effects of adhering to the UN Principles for Responsible Investment and a focus on ESG.

Contextualizing Buyouts

While early research treated all PE-backed buyouts as similar, researchers increasingly acknowledge the importance of the context in which buyouts take place in getting a richer understanding of mechanisms employed by PE investors and outcomes thereof. One widely researched contextual factor is the type of target company, or the source of the buyout deal. A second important factor is the institutional context in which either the target company or the PE investor operates.

Sources of Buyouts

An important source of buyout targets are public companies that are taken private in a so-called public-to-private transaction, and this setting constituted the context of early PE studies (Jensen & Meckling, 1976; Kaplan, 1989). In this context, ownership and control are separated in a public corporation with diffuse ownership before the buyout, thereby offering ample opportunities to reduce traditional agency problems through concentrated ownership and appropriate incentive systems after buyout (Jensen, 1989). While highly visible, public-to-private transactions are not the dominant source of buyouts, and most buyouts involve private targets with concentrated ownership. In a family-led buyout, a family firm is sold to a PE investor, for example to solve succession problems. In a divisional buyout, a division of a conglomerate is sold to increase the strategic focus of the parent company. In a secondary buyout (SBO), a portfolio company is sold by one PE fund to another. As the prebuyout situation is fundamentally different across buyout types, so are the value-creation mechanisms and the outcomes of PE ownership. Studies have indeed indicated that the magnitude of the real impact of PE is contingent upon the buyout type.

Private-to-private buyouts show higher postbuyout growth compared to public-to-private buyouts (Davis et al., 2021; Lavery et al., 2021; Verbouw et al., 2021). Target selection is an important driver of this result, as private-to-private transactions are disproportionately focused on poorly performing firms or on firms with substantial growth potential, offering large value-creation possibilities. Alternatively, by relying on the extensive PE network of credit providers, private-to-private targets can grow more strongly by relaxing their financial constraints (Bernstein et al., 2019; Boucly et al., 2011). Patenting activity is also stronger in private-to-private buyouts (Amess et al., 2016).

SBOs provide an interesting context for examining the sustainability of the organizational structure of a buyout and allow testing of whether the governance benefits of the buyout model are exhausted after the primary buyout stage. There is limited, mixed empirical evidence that governance benefits of the buyout model may not be exhausted after the primary buyout stage (Wright et al., 2019). Some studies report that the target’s operational performance (Achleitner & Figge, 2014) and growth of sales and employment increase up to 5 years after SBOs, but the performance of the SBO depends on PE directors’ human capital (Jelic et al., 2019). In contrast, Bonini (2015), Zhou et al. (2014), and Alperovych et al. (2013) found that performance deteriorates during an SBO. Degeorge et al. (2016) additionally showed that SBOs underperform when buyers are under pressure to invest, whereas SBOs perform equally well as other buyouts when buyers are not under such pressure to invest.

Finally, studies have indicated that management buyouts (MBOs; buyouts in which the incumbent management takes over the company together with the PE investor) especially enhance growth and efficiency (Kaplan & Strömberg, 2009; Meuleman et al., 2009; Watt, 2008). In contrast, management buy-ins (transactions in which the incumbent management is replaced by an outside management team) have been shown to harm employment levels (Amess & Wright, 2007) and increase insolvency risk (Wilson & Wright, 2013) and are associated with smaller effects on efficiency than MBOs (Wilson et al., 2012).

The Institutional Context

Evidence is growing that the mixed findings reported in empirical studies on the impact of PE on portfolio companies are partially driven by the different national institutional contexts in which the studies are conducted. More specifically, strong investor protection is important, because it ensures the investment’s value at exit and minimizes transactions costs, such as information asymmetries, which ultimately makes growth-enhancing investments worthwhile (Groh et al., 2010). Verbouw et al. (2021) confirmed that postbuyout growth increases most in countries with strong investor protection laws. Next, cultural institutions also matter. For example, relying on the GLOBE framework, Hammer et al. (2018) found that performance orientation in portfolio-company countries is negatively related to postbuyout operating performance gains. Individualism is positively related to portfolio companies’ growth and efficiency, which can be explained by increased organizational risk-taking and a focus on investment returns (Verbouw et al., 2021). Nevertheless, the decrease in employment in these cultures could suggest that a value-transfer mechanism is fueling the efficiency gains.

Gaps in Our Knowledge

PE investors employ corporate governance mechanisms that all shareholders and all companies can install (Jensen & Meckling, 1976). Nevertheless, there is ample evidence that PE investors have, on average, a positive impact on the growth of their portfolio companies. This growth is achieved by aligning goals through contracting and enhanced governance. Clearly defined ambitious objectives are enforced by highly engaged boards and shareholders. This leads to, among other things, heightened innovation and acquisition activity, for example through buy-and-build strategies. Additionally, barriers to change are reduced, which might lead to breach of implicit contracts with stakeholders (Eaton et al., 2020), such as CEOs, managers, employees, or taxpayers. If so, PE ownership is detrimental to these others (Stiglitz, 2019).

Despite decades of research on the functioning of PE investors, specifically how they create shareholder value remains a black box. Recent research has just started to scratch the surface. For example, Biesinger et al. (2020) showed that ex ante value-creation plans mainly focus on operational improvements, top-line growth, and corporate governance. Given the focus on operational improvements, it is puzzling that portfolio companies do not systematically show operational efficiency gains, although they do show higher growth (Verbouw et al., 2021). Returns to shareholders are mainly driven by successful execution of the plan, rather than the ex ante selection of specific actions, with specialized PE firms being systematically better at execution (Biesinger et al., 2020).

Another promising stream of research that opens the black box of PE impact focuses on a single industry, like education (Eaton et al., 2020), healthcare (Gupta et al., 2021; Pradhan et al., 2014), the hotel industry (Spaenjers & Steiner, 2021), or the restaurant industry (Bernstein & Sheen, 2016). This enables the uncovering of fine-grained actions and impacts on various stakeholders beyond shareholders and employees, such as customers in hotels and restaurants, patients in hospitals, or students in schools. Some of these studies strongly suggest that there is a transfer of value from stakeholders to shareholders. The recent trends toward more responsible investment practices and impact investing might limit these transfers, however. Considering the societal push toward sustainability and CSR, it will be important to understand whether and how PE investors balance shareholder value with stakeholder value (Chen et al., 2021). In this perspective, GPs can be an important factor in pushing for change.

Whereas PE investors initially almost exclusively focused on transactions in which they acquired a majority stake, they increasingly invest in minority stakes. This is driven by both an increasing demand for (Tappeiner et al., 2012) and an increasing supply of (Chen et al., 2014; Puche & Lotz, 2015) minority PE stakes. A growing number of PE funds, driven by increased competition for deals, allow more flexibility in engaging in minority investments in their investment strategy and some even specialize in minorities. Investing in minority stakes raises new challenges for PE investors, however. While buyouts provide PE investors with full control over a firm’s major operational and strategic decisions (Chen et al., 2014), PE investors taking minority positions have to compromise with majority shareholders. Therefore, agency risks may arise not only between owners and managers but also among owners. Indeed, when ownership is shared among different principals and preferences vary across the principals, one principal cannot unilaterally force its particularistic agenda on the others based on its idiosyncratic problem-framing, and principal–principal agency problems may arise (Villanueva & Sapienza, 2009). The scant research on how principal–principal agency problems affect outcomes in PE minority investments is inconclusive. Some researchers document worse outcomes for PE minority investments compared with PE majority investments where no principal–principal problems exist (Neckebrouck et al., 2021; Puche & Lotz, 2015), and some document equal (e.g., in developing countries; see Lerner et al., 2016) or even better outcomes (e.g., in Italy, see Battistin et al., 2017). This suggests that more insight is needed into how PE minority investments impact portfolio companies. A particular type of PE minority investment is when PE investors hold an equity stake in a public company—such as through a private investment in public equity (PIPE) transaction or through holding onto (a fraction of) their stake after a portfolio company has been exited through an IPO. The motives for, and outcomes thereof, are not well understood, but there is evidence that public firms with PE backing perform significantly better when making acquisitions (Matanova et al., 2022).

In addition to diversification in PE investors’ investment strategies, the PE industry as a whole has become more diversified in the 21st century, as new types of investors have emerged. Besides the traditional, independent, PE limited partnership on which most research has focused, corporate investors, family offices, or sovereign wealth funds emerged. On the one hand, they compete with the traditional investors for deals; on the other hand, they often invest together in syndicates. This raises interesting governance problems, because the new players may not have the same objectives as traditional investors, giving rise to principal–principal problems in heterogeneous investment syndicates, a condition suggesting the importance of the following questions: How are these problems solved? Or are the different, complementary approaches and resources of different players value enhancing? Under which conditions?

There is also a need for contextualizing PE research. While most of the academic research on PE has focused on the United States and Europe, insights into PE practices in other parts of the world are limited. Nevertheless, the institutional context in which PE operates is important in shaping practices and outcomes (Verbouw et al., 2021). The legal context, for example, shapes contracting practices and enforcement as well as formal employee relations. The cultural context shapes attitudes toward entrepreneurship and risk-taking. While the dominant PE model has been exported from the United States to the rest of the world, it has been adapted to thrive in different contexts. Understanding this more deeply is important. In addition to the formal or informal institutional context, other contextual dimensions are important, such as the type of target company (e.g., investments in family firms, public-to-private transactions, or divisional buyouts).

Finally, most of the academic research, including this article, has focused on the relationship between PE investors and their portfolio companies, as drivers of returns for the shareholders in PE funds. An underresearched area is the relationship between PE GPs and their LPs. GPs act as agents of LPs, leading to potential agency risks. How are these managed? From a theoretical perspective, Batt and Appelbaum (2021) developed a conceptual framework to assess the asymmetric conditions that may undermine the interest alignment of GPs and LPs. Empirical studies, on the other hand, remain scarce because available data are thin due to the lack of transparency in PE transactions. A fascinating development in the PE industry in the 21st century is the departure of major investors from the dominant dual model with PE managers as GPs and investors as LPs in closed-ended funds. Some large PE investors have become publicly listed, such as KKR and Blackstone (Cumming et al., 2011). But not all listed entities are the same: some list the management company, while others list individual funds. What is the impact of having a dispersed ownership base in some of the legal entities of a PE conglomerate? Alternatively, Sequoia has announced that it will establish an open-ended entity, rather than a closed-ended fund (Kruppa, 2021). Again, this should have important governance implications. Given the continuous development of practices in the PE industry, this will remain a fertile ground for academic research.

To conclude, there is a vast body of research on the relationship between PE investors and their portfolio companies. Although numerous studies have examined different value-creation strategies, there is also a need for more fine-grained, contextualized research to understand heterogeneous practices of PE firms and the impacts they generate for different types of stakeholders in society. Moreover, understanding how the principal–agency relationship between LPs and GPs affects the performance of PE funds and the underlying portfolio companies is a fruitful avenue for future research.

References

Notes

  • 1. For an overview, see Lutz and Achleitner (2009) and Wright et al. (2019).

  • 2. Note that there is a close link between ESG and corporate social responsibility (CSR), because the CSR themes that are high on corporate agendas today are roughly the same themes that investors look at under the header of ESG.