37519

INNOVATION IN PRIVATE EQUITY LEVERAGED BUYOUTS

Fabio Bertoni

Introduction

Private equity (PE) leveraged buyouts (LBOs) are financial transactions through which an acquirer (i.e., a PE fund) buys a controlling stake in a company using a substantial amount of debt, with the objective of selling it after a few years for a profit (Kaplan & Strömberg, 2009; Wright et al., 2009). The objective of this chapter is to illustrate how LBOs affect innovative activity at target companies. Specifically, the aim is threefold: first, I want to illustrate how the effect of LBOs on innovative activity can be described using two complementary theories, and how these theories reflect the characteristics of different LBO waves. Second, I want to discuss how the literature has focused mostly on technological innovation, paying relatively less attention to managerial innovation. Third, I want to illustrate some possible avenues for future research on this topic.

A key objective of an LBO is to increase the valuation of the target company between the day on which the company is acquired and the day on which it is sold (e.g., at initial public offering, to an industrial acquirer through a trade sale, or to another LBO investor through a secondary sale) (Kaplan & Schoar, 2005). This increase in valuation, which is amplified by the use of leverage, is what makes the transaction profitable for an LBO investor (e.g., a PE firm). In order to obtain this increase in valuation, LBO investors will perform a number of activities including: changing the corporate governance of the company, restructuring its production process, changing the perimeter of its activities (e.g., liquidating unprofitable divisions), accelerating its expansion, boosting efficiency, and introducing new management practices (Cumming et al., 2007; Gompers et al., 2016). We can categorize these activities into three groups: financial engineering, governance engineering, and operational engineering (Kaplan & Strömberg, 2009). Most of these activities are likely to affect directly or indirectly, innovation in target companies in profound ways, which requires a multidimensional conceptual framework (Berg & Gottschalg, 2005). In order to conceptualize how LBOs may affect innovation, we need a theory linking these activities and their relative importance to the innovation process itself.

Two main theoretical frameworks link LBOs to the performance in general – and the innovation in particular – of target companies: agency theory and strategic entrepreneurship theory. The two theories differ both with respect to the relative importance and the role 376played by PE funds in performing to financial, governance, and operational engineering. The agency theory of LBOs stems from the seminal works on the relationship between shareholders and managers (Jensen & Meckling, 1976; Fama & Jensen, 1983; Jensen, 1986). According to this theory, the main value driver of an LBO is its ability to transform a company in which managers have weak incentives to maximize firm value and cash flows in excess of investment opportunities, into a company in which managers have high-powered incentives and no excess cash flow to spare. This transformation is performed mostly through a combination of a change in governance (especially management compensation) and an increase in leverage, which – according to this view of the LBO – is not only a mechanism to boost the return for LBO investors but also a factor that plays a fundamental role in the success of the transaction (Kaplan, 1989a, 1989b), especially for large LBO targets (Lahmann et al., 2017). According to agency theory, the result of the LBO will then be a better use of resources and an increased pressure towards efficiency. The renovated pressure on efficiency will also affect the innovation process. Accordingly, agency theory would predict that the process of technological innovation should focus on efficiency and become more efficient itself. It is important to notice that agency theory does not necessarily predict that a company will innovate more – or less – because of the LBO, but rather focuses on what type of innovative activity (efficiency-driven innovation) is being performed and on how efficient the innovation process is. The agency view is consistent both with more innovation being produced using the same resources and with fewer resources being used to produce the same amount of innovation. However, because LBOs in the period in which the agency theory was first formalized were mostly in low-tech sectors, where technological innovation was less crucial as a driver of competitive advantage, the prevalent view was that the LBO would not result in a boost of innovation activity, but rather in a more streamlined and efficient innovation process. As we will discuss later, some scholars have argued that the cost-cutting pressure of LBOs could actually cause short-termism and managerial myopia, which would hurt innovation (Hitt et al., 1991). This argument builds upon some elements of agency theory but does not descend directly from it. Interestingly, this argument has received very resonant media attention despite the fact that the empirical evidence largely rejects it.

The second theoretical framework that can be used to describe the impact of LBOs on innovative activity is strategic entrepreneurship theory (Wright et al., 2001a; Meuleman et al., 2009b). Both agency theory and strategic entrepreneurship theory view increased incentives as a fundamental aspect of LBOs. However, whereas in agency theory the focus is mostly on how this increase in incentives reduces inefficiency in firms with excess cash flows, the strategic entrepreneurship theory focuses on how it combines with the expansion of the firm’s resources and capabilities to boost the target firm performance. This difference in focus is partly due to the different theoretical underpinnings of the two theories, and partly due to a change in the prevailing characteristics of LBOs across different waves. Agency theory builds on the principal-agent theory, which studies the optimal mechanisms to reduce the inefficiencies arising from the delegation of a task from a principal (shareholders) to an agent (the managers), hence its focus on efficiency improvements. Strategic entrepreneurship theory is instead based on the resource-based view of the firm (Meuleman et al., 2009a). This theory focuses on how the competitive advantage of a firm depends on its unique resources and competences (Ireland et al., 2003). The role of an LBO is thus to enhance the resource and competence base both directly (e.g., managerial competences, financing), and indirectly (e.g., facilitating alliances). The historical reasons why the strategic entrepreneurship theory became increasingly more used is that targets of recent LBO 377waves were more often high-tech companies with underexploited growth opportunities rather than low-tech companies in mature industries and poor growth opportunities, which was the case in the early waves (Kaplan & Strömberg, 2009). Moreover, besides public-to-private buyouts, a number of different LBOs types (e.g., divisional LBOs, private-to-private) have become common in recent years (Alperovych et al., 2013).

Clearly, the perspective of strategic entrepreneurship theory is radically different when it comes to the expected impact of LBOs on innovative activity. The focus of this theory is more on the extent to which LBOs may boost innovation by providing additional resources and competences rather than on the efficiency of the firm and its innovation process. To this extent, the two views are complementary, because they focus on different aspects of the LBO process, and which one is most appropriate will depend on the circumstances and the object of the analysis (Makadok, 2003).

A second aspect that I want to highlight in this chapter is that whereas innovation is a very broad concept, the literature has paid a disproportionate attention to one specific aspect: technological innovation. A number of input and output measures of technological innovation have been proposed, each capturing a specific aspect of the phenomenon (Hagedoorn & Cloodt, 2003). In terms of output, we may define technological innovation as the introduction of new products or services or the improvement of the processes needed to produce products and provide services. In terms of inputs, technological innovation is often measured in terms of R&D expenses. Somewhere between inputs and outputs, patents are also often used to gauge technological innovation. Technological innovation is an extremely important form of innovation, especially in high-tech sectors. However, technological innovation is not the only type of innovation. Management innovation includes a number of significant changes in key non-technological aspects of the company, including its strategy, organization, management practices, or the design of its products (Birkinshaw et al., 2008; Mol & Birkinshaw, 2009, 2014). All these aspects are part of a broad definition of innovation; however, they have received limited attention in the literature. One possible explanation of this phenomenon is that, whereas technological innovation is relatively easy to measure (e.g., patents and R&D expenses can be obtained using commercial databases for a large number of companies across a large number of countries), managerial innovation can essentially only be gauged using survey data (OECD, 2005). However, the extent to which we understand the effect of LBOs on technological and management innovation is still very different.

This consideration naturally leads me to the third contribution of this chapter, which is to illustrate possible avenues of future research. One, of course, is to shed light on management innovation. However, there are several other aspects of the innovation process that have not yet been fully explored including: how LBOs affect the process of innovation to make it more efficient, how innovations differ (e.g., in how radical or incremental they are) in LBO companies, and how the path of innovation evolves after an LBO (e.g., if a company’s reliance on previous innovation is reduced after an LBO). This aspect can be particularly interesting because the effectiveness of LBOs can be particularly high when innovation is more about experimenting than exploiting (Ferreira et al., 2014). In summary, while we tend to know a lot about “how much” innovation LBO companies produce, we know relatively little about “how” they do that and “how effective” this innovation is.

In the rest of this chapter I will elaborate the concepts that I briefly illustrated in this introduction. I will begin, in the next section, by illustrating the different theoretical frameworks to analyze LBOs and the extent to which the empirical literature supports their predictions. Next, I will discuss differences between technological and managerial innovation 378and how LBOs can be expected to affect them according to the theoretical framework used. Finally, I will illustrate some possible avenues for future research.

Two complementary theoretical frameworks to study innovation in LBOs

Agency theory

We can trace the agency theory of LBOs back to the seminal works on ownership and governance (Jensen & Meckling, 1976). The theoretical framework describes a company owned by one shareholder who decides to sell part of her or his equity to an external shareholder. The reduced incentives of the incumbent shareholder because of the reduced stake in the firm cause an increased incentive to extract non-pecuniary benefits from the company at the expense of the new shareholder. A number of mechanisms (monitoring, bonding, incentives) may reduce but not completely offset this effect, leaving the company and its shareholders with a residual loss.

To some extent, we can think of an LBO as a transaction that is the reverse of what we just described. This is especially the case for public-to-private LBOs, in which a company that was previously listed (and hence with a high separation between ownership and control) is taken private by means of an LBO. The result is then the concentration of ownership and the reduction of the incentives for the controlling shareholder of extracting non-pecuniary benefits and hence causing an increase in the value of the company. The extent of the non-pecuniary benefits that can be extracted from a company depends on a series of characteristics, the most important of which is the presence of free cash flows, which are the cash flows from operations in excess of the investment opportunities of a company (Fama & Jensen, 1983; Jensen, 1986). When free cash flows are high, managers have more leeway for using them for investments from which they receive gratification, status, reputation, or visibility but that do not create value for shareholders. For this reason, we would expect LBOs to target profitable companies (i.e., high cash flow from operations) in mature industries (i.e., limited investment opportunities), with dispersed shareholdings (i.e., high potential gain from concentrating ownership through an LBO) (Harris et al., 2005). Put differently, efficiency-oriented buyouts generally occur in mature and stable industries where the lack of innovation is less likely to cause a competitive disadvantage (Wright et al., 2001a).

It is interesting to note that the agency theory of LBOs does not derive the efficiency focus from its theoretical underpinnings: the principal-agent theory. This theory discusses how, in a very general setting, contractual arrangements can be used to minimize the cost for a principal (in this case, external shareholders) of delegating a task to an agent (in this case, the shareholder-manager). Principal-agent theory provides a very broad set of recommendations and studies a large number of deviations from first-best equilibria. For instance, standard moral hazard models are typically described in terms of incentive for the agent to exert effort (Laffont & Martimort, 2009), which is a rather different setup than what is used by agency theory of LBOs, which focuses on how incentives affect the extraction of private benefits. In conclusion, the relatively narrow perspective of the agency theory of LBOs does not derive from its foundation on the principal-agent theory, but is rather the reflection of the historical development of the theory itself. When the agency theory of LBOs was developed, LBOs were mainly public-to-private transactions in low-tech industries (Kaplan & Strömberg, 2009). In this setting, the governance-improvement perspective of agency theory was appropriate to describe the key issues for value creation. As we will discuss in the next 379section, as LBOs changed their nature, new theoretical perspectives became an important addition to agency theory.

Leverage is a fundamental disciplining element in the agency theory of LBOs. Accordingly, it could be expected that changes in aggregate availability of credit affect the functioning of LBOs. This prediction is confirmed by Axelson et al. (2013), who find that buyout leverage is unrelated to the cross-sectional factors and is, instead, strictly related to variation in economy-wide credit conditions. This result suggests that cheap credit is a fundamental driver of the leverage decision in LBOs. Moreover the authors show that leverage is associated with higher transaction prices and lower buyout fund returns, suggesting that acquirers overpay when access to credit is easier.

We can identify several ways in which agency theory can be utilized to predict the impact of LBOs on innovative activity. The first and most direct application is with respect to the efficiency of the innovation process itself. To the extent to which LBOs reduce the incentive of managers to use cash flows for unproductive uses, including unproductive investment in innovation (e.g., pet projects), the innovation process should become more efficient. This means that more innovation output should be produced per unit of innovation input. Whereas there is a large literature studying increases in economic performance after an LBO (Lichtenberg & Siegel, 1990; Smith, 1990; Harris et al., 2005; Guo et al., 2011; Alperovych et al., 2013; Scellato & Ughetto, 2013), the specific evidence about innovation is limited but overall consistent with the hypothesis that innovation is more efficiently conducted after an LBO (Lerner et al., 2011).

The second way in which agency theory could be used to predict how LBOs affect innovation is by combining it with management myopia. After an LBO, the stress created by the increased leverage might lead managers to adopt a stricter regime for the use of capital, as confirmed by the fact that – contrary to what happens for venture capital (VC) – capital investments are more dependent on internal capital after an LBO (Bertoni et al., 2010a, 2013, 2015). Accordingly, even the productive expenditure in R&D could be foregone because managers care more about their short-term costs than their long-term benefits (Hitt et al., 1990). Moreover, LBOs may divert managers’ attention and distract them from other strategic matters, including innovation (Hitt et al., 1991; Long & Ravenscraft, 1993). Following this line of reasoning, one could argue that LBOs should cause a decline in innovation and, especially, a decline in capital-intensive technological innovation. Intriguingly, this view resonates with concerns commonly heard from the public opinion about PE being a “locust investor.”¹ Quite interestingly, the empirical literature largely rejects this view. Ughetto (2010) studies the patenting activity of European manufacturing LBOs between 1998 and 2004 using a panel dataset of 681 LBOs, 200 of which have patents. She finds that LBO targets file more patents per year after the LBO (1.59) than before the LBO (1.06).

Lerner et al. (2011) also examine patenting activity in LBO companies and find no evidence that LBOs sacrifice long-term investments. Conversely, and consistently with the view that LBO companies become more efficient, they find that LBO patents are more cited and become more concentrated in the important areas of companies’ innovative portfolios.

Finally, LBOs can affect the incentives to innovate in a more subtle way. Ferreira et al. (2014) show that the incentives to innovate, and the type of innovation they generate, depend on a company’s ownership structure. More specifically, their model can be used to contrast LBOs to public companies. The logic of their model is that LBOs are less transparent to outside investors than are public firms and that this lack of transparency essentially generates a put option for insiders (who can time the market by choosing an early exit strategy). This put option makes insiders more tolerant of failures and more inclined to invest in innovative 380projects. The consequence is that it is optimal for a firm to be public when exploiting existing ideas, whereas it is optimal for a firm to go private when exploring new ideas. Following this logic, exploitation/exploration phases of the innovation cycle (Benner & Tushman, 2003) should be reflected in LBO/IPO cycles.

Strategic entrepreneurship theory

Strategic entrepreneurship theory focuses on the role of LBOs as vehicles for facilitating innovation (Wright et al., 2001b). The theory is based on the resource-based view of the firm, which recognizes the role of resources and competences in exploiting growth opportunities and creating a sustainable competitive advantage (Barney, 1991; Mahoney, 2001; Ireland et al., 2003). It is important to note that strategic entrepreneurship and agency theories are not competing theories, but rather two theories that complement each other (Makadok, 2003). Whereas agency theory focalizes on the contractual aspects of an LBO, strategic entrepreneurship theory focuses on the provision of additional resources and competences (Hendry, 2002). Important synergies may exist between improved governance and additional competences (Makadok, 2003). These synergies may be so critical that governance improvement may not be sufficient, on its own, to guarantee a competitive advantage (Barney, 2002). It should also be highlighted that, to the extent to which governance engineering allows a better alignment of interests, it may also improve a firm’s ability to pursue competitive advantage (Gottschalg & Zollo, 2007).

A number of complementary resources can be provided to LBO targets by PE firms, including valuable intangible resources such as financial, strategic, and operational industry knowledge, reputation, and networks (Castanias, 1991; Coff, 1999; Arthurs & Busenitz, 2006). LBOs may also complement the existing competences of the management team (Zahra & Filatotchev, 2004). Due to these additional resources and competences, LBOs can stimulate strategic changes, enable growth opportunities, and create entrepreneurial opportunities that lead to revitalization and strategic innovation (Wright et al., 2001a; Meuleman et al., 2009a).

Strategic entrepreneurship theory offers a more direct framework for studying how LBOs affect innovation. One way LBOs may foster innovation is through the interaction between the managers of the target company and the investment team (Berg & Gottschalg, 2005). New products and services can be developed building on the improved ability to identify new markets (Meuleman et al., 2009a). Moreover, LBOs may improve the capability to take advantage of new technologies (Balkin et al., 2000). An LBO may also favor non-technological innovation (Schmidt & Rammer, 2007) because of the industry knowledge and business experience of PE (Kaplan & Strömberg, 2009).

A number of studies have embraced a strategic entrepreneurship perspective before the theory was formalized. Bull (1989) showed that the performance of LBOs increased after the buyout besides what could be explained by financial optimization and tax savings. Based on a number of interviews with LBO participants, the author concluded that no explanation for the increased performance of LBO targets was more persuasive than the introduction of entrepreneurial management. This conclusion is mostly based on anecdotal evidence that the introduction of entrepreneurial management contributed to creating value besides the reduction of agency costs alone. Malone (1989) studied smaller-company LBOs and showed that the target companies were typically in slow growth sectors, that layoffs and asset stripping were infrequently observed, and that the pressure due to the increased debt level actually 381more often caused a pronounced shift away from salaried compensation and a stronger focus on revenue-generation efforts (e.g., increased sales and marketing).

Table 19.1      Key features of agency and strategic entrepreneurship theories

Zahra (1995) was the first to explicitly document the changes in corporate entrepreneurship after an LBO and link them to changes in performance. The study compared pre- and post-LBO commitment to corporate entrepreneurship (innovation and venturing) and performance levels on a sample of 47 LBO companies. The results confirmed that LBO companies: increased their commitment to developing new products, placed greater emphasis on commercializing their technology, intensified their new venture efforts, and enhanced the quality and size of their R&D function without a significant change in R&D spending. The results also showed that post-LBO company performance was significantly higher than pre-LBO levels and especially so in companies in which corporate entrepreneurship was more pronounced.

More recent studies, such as the one by Guo et al. (2011), illustrate that whereas LBOs have changed over time, increase in operating performance is still as important and financially value-added. The authors show that LBO pricing and leverage were more conservative between 1990 and 2006 than in the 1980s, and that returns equally derive from increases in industry valuation multiples, realized tax benefits, and operating gains.

Boucly et al. (2011) study the change in corporate behavior following an LBO. They find that LBO targets become more profitable, grow faster, and increase their capital expenditures. Their results suggest that this evidence is consistent with the idea that PE creates value because it allows the exploitation of otherwise unexploited growth opportunities.

Link et al. (2014) find that PE investments in firms funded by the Small Business Innovation Research (SBIR) result in significantly increasing their licensing and selling their technology rights. Moreover, these firms are also more likely to do collaborative research and engage in development agreements. The results highlight the role of PE in accelerating the development and the commercialization of research-based technologies.

Davis et al. (2014), show that LBOs bring productivity gains at target firms, mainly through accelerated exit of less productive establishments and greater entry of highly productive ones.

Comparison of the two theories

In Table 19.1, I briefly summarize the main features of agency theory and strategic entrepreneurship theory.

382Technological and management innovation

So far, I have discussed the impact of LBOs on innovative activity, but I have been very generic about what type of innovation I was referring to. Innovation is a very broad concept that ranges from the development of new products using novel technologies (e.g., the use of 3D printing) to the introduction of new management techniques (e.g., lean production). A first basic distinction is the one between technological innovation and managerial innovation. Technological innovation is the introduction of new products or production processes that embody inventions from the industrial arts, engineering, applied sciences, and/or pure sciences (Garcia & Calantone, 2002). Generally speaking, the literature has predominantly studied technological innovation (Birkinshaw et al., 2008), especially in relation to early-stage VC investment (Hall & Lerner, 2010). The case for a link between VC and innovation is somewhat straightforward, especially when VC invests in high-tech start-ups for which technological innovation is a key value driver. The literature has highlighted that VC investment is positively related at the macro level to technological innovation in terms of patents (Kortum & Lerner, 2000; Popov & Roosenboom, 2012), total factor productivity (Hirukawa & Ueda, 2011), and R&D (Brown et al., 2009). Studies at the micro level generally confirm this evidence (Baum & Silverman, 2004; Engel & Keilbach, 2007; Bertoni et al., 2010b) but point out that different types of VC investors may have profoundly different effects on technological innovation, especially with respect to corporate VC (Dushnitsky & Lenox, 2005, 2006; Chemmanur et al., 2014) and governmental VC (Bertoni & Tykvová, 2015). Most studies argue that VC boosts innovation by alleviating firm’s financial constraints (Hall & Lerner, 2010).

PE targets, which tend to be larger and more mature than VC targets, should be less affected by financial constraints (Bertoni et al., 2013) and, if anything, financial constraints should be accentuated, rather than alleviated, because of the increase in leverage. The accentuation of financial constraints should be especially pronounced during times of crisis (Bertoni et al., 2014), amplifying the cyclicality of R&D cycles (Aghion et al., 2012). The literature on technological innovation by LBOs is hence mostly based on strategic entrepreneurship and on the ability of PE to revitalize firms’ innovative ability (Wright et al., 2001a, 2001b; Amess et al., 2016) and reinstate an entrepreneurial orientation in mature companies (Bruining & Wright, 2002). However, what is more interesting is that this set-up actually makes an even stronger argument if used for management, rather than technological, innovation. Using a narrow definition, management innovation can be defined as the invention and implementation of a management practice, process, structure, or technique that is new to the state of the art and is intended to further organizational goals (Birkinshaw et al., 2008). A somewhat broader definition is the one suggested by the Oslo manual (OECD, 2005) and implemented by the community innovation survey throughout Europe, which includes within management innovation any substantial change in the firm’s: strategy, management practices, organization, and marketing.

Four perspectives can be identified in the study of management innovation (Birkinshaw et al., 2008): the institutional perspective, the fashion perspective, the cultural perspective, and the rational perspective. The institutional perspective focuses on the socioe-conomic conditions in which management innovation is conducted. The fashion perspective focuses on the role of providers of management ideas and in their interaction with users of management ideas. The cultural perspective focuses on how the introduction of a new management practice generates a reaction in an organization. Finally, the rational perspective focuses on how management innovation results in performance improvement. Each of these perspectives 383can be used to study management innovation brought by LBOs. The institutional perspective can be useful to assess how institutional characteristics (Groh et al., 2010) result in different PE conducts (Meuleman & Wright, 2011) that in turn affect management innovation in target firms. The fashion perspective can focus on the extent to which the diffusion and propagation of management ideas (Abrahamson, 1996) are facilitated by the presence of PE. The cultural perspective may be used to understand how PE shapes and is shaped by the management culture inside an organization, starting from its board of directors (Acharya et al., 2009).

However, the rational perspective is probably the most natural starting point for analyses on management innovation and buyouts, because the motivation of the introduction of management innovation by PE follows a rational perspective. Mol and Birkinshaw (2014) examine the role of external involvement in the creation of management innovation. They argue that external involvement in the process of management innovating can occur in different ways. First, they describe the process through which internal change agents (the employees of the innovating company) and external change agents (independent consultants, academics, or management gurus) interact through the phases of management innovation (motivation, invention, implementation, and theorization). The role of external change agents is to give credibility to a management innovation in the invention phase, to act as a sounding board during the implementation phase, and to support the theorization phase. PE can directly promote management innovation by operating as an external change agent (because of its management competences) or indirectly accelerate management innovation by hiring external consultants it has close relationships with, a practice that has become more common in recent years (Kaplan & Strömberg, 2009). These sources of external knowledge can be used both to generate new ideas and to improve the chances of success of innovation effort (Weitz & Shenhaav, 2000). PE can thus be a very powerful external change agent in fostering management innovation in LBO companies because of their skills, their ability to complement managers with external support (Acharya et al., 2013), and the formal authority they acquire by sitting in – and often controlling – the board of directors (Cumming et al., 2007).

Wright et al. (2001a) were among the first to set up a comprehensive theoretical setting linking LBOs with management innovation. The authors argue that LBOs can create entrepreneurial opportunities, allow upside growth, and lead to revitalization and strategic innovation. More generally, PE can be seen as a facilitator for firms crossing a strategic threshold in their life cycle (Filatotchev et al., 2006), which will be accompanied by a change in the firm’s organization, management, and strategy. Management control systems will play a very important role in determining how the competitive strategy is formulated, implemented, and modified after an LBO (Bruining et al., 2004).

In summary, the case for a link between LBOs and management innovation is very strong, and possibly stronger than the link between LBOs and technological innovation. The empirical literature, however, has so far only paid marginal attention to this aspect, which naturally leads us to the next section, in which I discuss avenues for future research.

Avenues for future research

The academic literature started analyzing LBOs soon after they first developed in the US in the 1980s, which means scholars worldwide have now been studying LBOs for several decades. As a whole, LBOs are thus definitely not a frontier topic, as confirmed by the large number of studies surveyed by literature reviews on the subject (Kaplan & Strömberg, 2009; 384Wright et al., 2009). However, some aspects of LBOs are still poorly understood and require closer scrutiny. In general, the impact on innovative activity is among the lesser studied aspects of LBOs, especially by the finance literature.²

Within the general topic of LBOs and innovation, the literature has focused on quantitative aspects of innovation (e.g., how much innovation is produced by LBOs). One aspect that has received less attention is how this innovation is produced. First, the literature seems to suggest that innovation could be more efficient in LBOs, but we do not know how this is achieved. What are the key competences and practices that allow LBO targets to produce technological innovation using fewer resources? Second, how does this technological innovation differ from technological innovation before the LBO? We know from the literature (Lerner et al., 2011) that patents filed by LBO companies receive more citations and cover fewer core areas, but there are a number of other characteristics that we do not know about. Is radical innovation (as opposed to incremental innovation) less common in LBOs (Ferreira et al., 2014)? Are LBOs bringing new technological skills to their portfolio companies or rather changing the process through which these skills are combined? Relatedly, we know from the literature that recipients of SBIR grants accelerate the commercialization of research-based technologies (Link et al., 2014). To what extent do LBOs have a similar effect?

Relatedly, we know very little about how valuable and effective LBO innovation is. Generally, we know that the value of a patent is proportional to parameters such as citations and family size, but even after controlling for these factors, the value of patents varies enormously (Shane & Klock, 1997; Harhoff et al., 2003; Hirschey & Richardson, 2004; Trajtenberg, 2010). Clearly, innovation that is not patentable (or that, despite being patentable, uses a different intellectual property protection mechanism) is even harder to evaluate. As a result, our understanding of the actual value of innovation conducted by LBO firms is still limited.

Management innovation is, as I mentioned previously, a very interesting aspect of LBOs’ value-creation process and, yet, it is relatively under-researched. The few studies on this topic point out that LBOs are followed by a spree of management innovations, especially in strategy. But what types of strategic changes are caused by LBOs? To what extent, and under which dimensions, is the new strategy different from the pre-LBO strategy?

Another interesting topic for future research is how management innovation is identified and implemented in LBO companies. We know that PE partners have the business expertise and the experience in restructuring companies, and that they often partner with consultancy companies to complement their skill set. But how is this knowledge used to drive management innovation within LBO targets? How does the incumbent top and middle management of the company manage the interface between the inside (existing management practices) and the outside (now management ideas)? And how does the LBO company cope with the loss of this external knowledge source once the PE exits the company? Does the LBO leave an imprint on the company that lasts after the PE firm has left?

At an aggregate level, the role of PE as channel through which management innovation is diffused is an interesting avenue for research. We know PE waves are related to R&D cycles (Brown et al., 2009), but an equally interesting question is how they are related to the diffusion of management practices. The process can go both ways. On the one hand, a new management fashion can create business opportunities for LBOs, as was the case for the dismantling of conglomerates in the 1980s. On the other, PE can be an instrumental factor in accelerating the speed at which these new practices are adopted.385

Table 19.2      What we know and what we would like to know about LBOs and innovation

Finally, an interesting dimension that deserves attention by future research is the heterogeneity among LBOs, which I have not discussed here for the sake of brevity. Not only are LBOs conducted in companies with different characteristics (e.g., size, maturity, performance, technology intensity) but PE investors vary enormously in terms of their general and specific experience, assets under management, time horizon, and strength of their relationships with financial and non-financial partners. All these parameters may fundamentally affect their impact on innovative activity in a way that has not yet been fully addressed.

I summarize these avenues for future research in Table 19.2. For each macro-topic that I discussed in this section I identify the aspects we know more about, and those that I see as promising avenues for future work in this field.

Conclusions

In this chapter I gave an overview of the theoretical framework and the main empirical results about LBOs and innovation. Whereas I tried to give a comprehensive and coherent view about this topic, it is fair to acknowledge that the literature is neither comprehensive, as I pointed out in the previous section, nor entirely coherent. The reason is twofold. The first reason is the long time through which this literature extends. Since the late 1980s, the nature of LBOs, the characteristics of their targets, and the value levers used by PE firms have all evolved, making LBOs a moving target. Moreover, during the same period, our understanding of what we mean by – and how we measure – innovation has also evolved (Fagerberg, 2005).

The second reason is that, as is often the case with innovation, the literature is highly multi-disciplinary but, unfortunately, the existence of different perspectives results in a fragmented literature. Specifically, there seems to be a divide between the finance literature and the innovation literature. Part of this divide is due to the different emphasis given to the different terms in “LBO and innovation.” Simplifying, the finance literature mostly cares about “LBOs and innovation” because of “LBOs” whereas the innovation literature cares about it because of “innovation.” The result is that a finance paper and an innovation paper on the same aspects of “LBOs and innovation” will pay a substantially different attention to the two elements. The two fields also tend to have different narrative styles, reference journals, and – to a large extent – reference papers. Our understanding of the phenomenon 386is clearly not helped by this state of facts, which I hope will become less pronounced in the future.

On the positive side, the combination of the institutional differences across countries, the multi-faceted aspects of innovation, the differences among PE investors, the evolution of LBOs over time, and the moderating role of regional and temporal characteristics result in a very rich set of interesting research questions that are still only partly explored. I believe that studying innovation in LBO companies is an interesting, relevant, and far from exhausted topic for future research, and I hope that future scholars will answer some – if not all – of the questions that we still have on this subject.

Notes

  1    See e.g., The Economist (May 26, 2005), “Locust versus locust: German business and private equity.”

  2    The literature review by Kaplan and Strömberg (2009), for instance, does not have a specific section on innovative activity.

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