39020

BUYOUTS AND INVESTMENT

Dirk Engel and Joel Stiebale

Introduction

The effects of buyouts on investment of portfolio firms are a central topic in the literature on private equity (PE). Seminal theoretical contributions argue that public corporations characterized by a separation between ownership and control are inefficient due to over-investment by managers which tend to waste free cash flow on unprofitable investment projects (e.g., Jensen, 1986). Debt bonding, managements’ equity stakes, and the presence of active investors often contribute to overcome this problem (Jensen, 1986, 1989), and PE firms can induce empire-building managers to reduce over-investment after buyouts and focus on profitable investment opportunities (e.g., Kaplan & Strömberg, 2009). While the literature focusing on buyouts of large public firms has also emphasized cost-cutting more generally (e.g., Kaplan, 1989; Smith, 1990; Aslan & Kumar, 2011), a more recent literature (e.g., Wright et al., 2001) argues that some buyout transactions can also accelerate entrepreneurial activity and contribute to identifying investment opportunities.

Although PE firms play a prominent role in several efforts to accelerate entrepreneurial activity as well as to reduce over-investment (e.g., Gorman & Sahlman, 1989; Gompers & Lerner, 1998), their growing importance as financiers in many countries has led to controversial debates among practitioners, policy makers, and researchers. Examples are the US Dodd-Frank Act from June 2010, a White Paper by the European Commission (2006), the UK Financial Services Authority’s 2006 paper (FSA, 2006), and a famous speech by Germany’s former vice chancellor Franz Müntefering, who equated PE investors with locusts and stated that these investors hollow out companies for their own benefit (e.g., Ferran, 2007). Most of these concerns are implicitly due to the perception that PE firms amplify financing constraints or have a negative impact on long-run investment. Portfolio firms are typically acquired via a leveraged buyout (LBO) in which the PE firm will raise debt finance, secured by the portfolio firms’ assets and future cash flows, in order to facilitate the transaction (Gilligan & Wright, 2014). Policy makers are often concerned that these LBOs make portfolio firms over-indebted. They are also concerned that PE investors have a short-term planning horizon and therefore cut investments, especially those with a long-term character.

In this chapter, we discuss the existing empirical evidence on the effects of buyouts on investment and financial constraints. Particularly, we assess the following questions:

i)     What do we know about the impact of PE firms on portfolio firms’ investment and financial constraints?

ii)    Do the results differ across different types of portfolio firms and investors?

iii)   What are the methodological problems of empirical studies?

iv)    Which are the most promising areas for future research?

A growing number of empirical studies analyze post-buyout performance with respect to productivity (Harris et al., 2005), firm growth (Amess & Wright, 2007) and other outcome variables and provide mixed results which seem to differ across countries (e.g., Davis et al., 2011; Amess & Wright, 2012). In this chapter, we focus on the part of this literature that has analyzed the effect of buyouts on capital expenditures (Kaplan, 1989; Smith, 1990), other types of investment (e.g., Lerner et al., 2011), and financing constraints (e.g., Boucly et al., 2011). We discuss the theoretical background, methodology, and data used by these empirical studies and the results they have produced.

The rest of this chapter is organized as follows. In the next section we summarize the effects of buyouts on investment from a theoretical point of view. Then we introduce the empirical methodology employed by empirical studies and present related findings. Thereafter, we discuss methodological problems in the existing literature and suggestions for future research, and the final section concludes.

Buyouts, investment, and the role of PE firms from a theoretical point of view

The role of PE investors in buyouts

The role of PE firms in buyouts has mainly been developed from the perspectives of agency theory (e.g., Jensen, 1986, 1989) and entrepreneurship theory (e.g., Wright et al., 2001). Agency theory analyses over-investment in targets of buyouts and how PE firms reduce this problem. The entrepreneurship perspective argues that buyouts induce entrepreneurial investment and growth in portfolio firms. In contrast to these positive views, PE firms might have an incentive to cut investment in order to increase short-term profit because they usually have to repay fund investors’ capital, along with any profit generated, about 5 to 10 years after a buyout. Further, due to the high amount of leverage typically used to finance the transaction, which is usually secured by portfolio firms’ assets or future cash flows, cash is used to service the debt rather than make investments that yield a longer-term payoff (e.g., Rappaport, 1990; Kaplan, 1991).

It is well documented that capital markets are characterized by information asymmetries, and suppliers of finance are confronted with an adverse selection problem leading to the rationing of finance and under-investment (Stiglitz & Weiss, 1981; Hubbard, 1998). Whether leveraged buyouts have positive or negative effects on portfolio firms’ ability to exploit profitable investment opportunities therefore depends on PE firms’ ability to deal with these capital market imperfections. Several theories argue that PE firms’ activities, which include screening, contracting, monitoring, providing financial expertise, hands-on management, providing access to external finance, and their indirect signaling effects towards external investors, reduce information asymmetries (e.g., Gorman & Sahlman, 1989; Berger & Udell, 1998; Gompers & Lerner, 1998). The improvement in corporate governance via LBOs can help to overcome moral hazard problems, providing creditors with the confidence that funds are used productively. Further, PE firms’ financial expertise is a reassurance to creditors, making it more likely they will provide funds for investment. Consequently, 392PE firms might relax growth barriers and financial rationing in their portfolio firms. Corporate governance structures implemented by PE firms and the necessity to service debt generated by the buyout transaction can induce managers to focus on the most profitable investment projects (e.g., Jensen, 1986). Therefore, PE firms can contribute to reducing under-investment in firms with growth perspectives and reducing over-investment in firms with managers that tend to waste free cash flow.

PE firms’ heterogeneity with respect to their active role

Different types of PE investors might have different strategic goals and incentive structures, which can result in different monitoring and governance activities (see, for instance, Chen et al., 2007). Further, PE firms are a heterogeneous group of financial intermediaries, and it is an important question which characteristics of PE firms and deals are favorable to achieve economic efficiency and to exploit growth opportunities. The literature of financial intermediation postulates that active involvement of PE firms can be identified along several dimensions (e.g., monitoring, hands-on management) which affect the behavior of portfolio firms (e.g., Hart, 2001) as well as their performance (e.g., Amit et al., 1998).

The role of PE investors is also influenced by country-specific conditions. As argued by La Porta et al. (1998, 2000), there are considerable differences across countries in governance mechanisms dealing with agency conflicts. Bottazzi et al. (2009) develop a theoretical model to link investor protection to the extent of PE firms’ involvement in portfolio firms. In this model, PE firms have stronger incentives to provide value-added support and to develop value-adding competencies in a legal system with higher investor protection. This arises because low investor protection implies a higher probability that portfolio firms’ managers will find a weakness in the legal system that allows them to divert cash into their own pockets, which reduces the expected return for PE firms’ efforts. The empirical results of Bottazzi et al. (2008, 2009) are in line with their theoretical predictions. The frequency of interactions with portfolio firms, as a proxy for the extent of value-added support, is higher for companies in countries characterized by a common law than for companies in countries characterized by civil law. Further empirical studies confirm this pattern. Schwienbacher (2008) shows that US investors are engaged in syndicated deals and replace the management team in their portfolio firms more often than European PE firms. Different activity levels of PE firms in their portfolio firms therefore potentially lead to heterogeneous buyout performance across countries.

Buyout firm characteristics and their role in the extent of agency costs and entrepreneurial opportunities

Portfolio firms are arguably not uniformly affected by over- and under-investment before buyouts take place. They are heterogeneous with respect to several characteristics which affect the extent of agency costs and entrepreneurial opportunities. Meuleman et al. (2009: 8) point out that “the vendor source of the buyout may also vary, with consequences for pre-buyout agency issues”. Two main agency problems matter: (1) agency problems between owner and manager and (2) agency problems between different owners, particularly blockholders versus shareholders with small equity shares. Several studies differentiate between family-controlled and non-family controlled firms to operationalize the relationship between agency costs and investment patterns. Family firms are characterized by the entity of ownership, management, and control, which allows them to avoid over-investment in a better way than in public firms (e.g., Villalonga & Amit, 2006 for details). Listed corporations should experience few financing constraints due to relatively high collateral, strict 393reporting requirements, which reduce information asymmetries between firms and financiers, and access to equity markets. In contrast, the difficulty in conveying information to providers of finance make it more likely that private firms have to rely on internal financial resources and have limited access to bank loans, which can imply under-investment due to financing constraints (Carpenter & Petersen, 2002; Behr et al., 2013). Similarly, financing constraints are usually more severe for small firms with low levels of collateral and younger firms which do not have an established track record (Carpenter & Petersen, 2002). Hence, PE firms have higher potential to reduce financing constraints in private-to-private rather than in public-to-private transactions and in portfolio firms of relatively low size and among young firms.

Another theoretically interesting issue is the case of divisional buyouts. On the one hand, a divisional organization structure might be more effective in allocating financial resources than the financial market (Williamson, 1975, 1985). On the other, divisional structures in conglomerates can be affected by information asymmetries between divisional managers and headquarters, which have control over financial resources (Williamson, 1985; Seru, 2014). This problem is arguably particularly severe for investments with uncertain payoffs such as innovation activities. Roth and O’Donnell (1996) point out three important factors for the extent of agency costs. Agency costs rise with the cultural distance between headquarters and division, the level of decision-making authority of divisions, and the goal incongruence between headquarters and division. The net effect of divisional buyouts by PE firms on investment is therefore ambiguous from a theoretical point of view.

The type of investment in portfolio firms is also likely to play a role in the severity of financial constraints. For instance, research and development (R&D) and other types of intangible investments are typically associated with lower collateral value but higher riskiness and asymmetric information problems compared to tangible investment. This implies that financial constraints are particularly severe for the financing of innovation (e.g., Brown et al., 2012; Hsu et al., 2014), which has been confirmed by robust empirical evidence (see, for instance, Stiglitz & Weiss, 1981; Aghion et al., 2012; Hottenrott & Peters, 2012). The potential of PE firms to reduce financing constraints is therefore arguably higher in firms with innovation potential.

The literature has also differentiated between management buyouts (MBOs), where the incumbent management team buys shares, management buyins (MBIs), where an external management team takes over the portfolio firm, investor-led buyouts (IBOs), which include friendly or hostile takeovers, and hybrid forms between MBO/MBI and IBO. There is evidence that MBOs are associated with higher involvement of the existing management in succession planning compared to MBIs (see Scholes et al., 2008: 19). This implies that information asymmetries might be lower and entrepreneurial opportunities are more likely to be exploited through MBOs. Therefore, MBOs might induce higher investment levels than MBIs.

Main empirical findings

Existing empirical studies on the effects of PE on investment and financial constraints can be broadly divided into three groups. First, direct measures of financing constraints in PE-backed firms via investment cash flow (ICF) sensitivities (e.g., Bertoni et al., 2013; Engel & Stiebale, 2014; Ughetto, 2016). Second, empirical analyses providing indirect evidence by estimating heterogeneous effects of buyouts among firms that are likely to face financing constraints (e.g., Boucly et al., 2011; Chung, 2011; Amess et al., 2016) or during 394periods of financial distress (e.g., Hotchkiss et al., 2014). And third, evidence on (different types of) investment in general (e.g., Smith, 2015; Agrawal & Tambe, 2016).

Investment cash flow sensitivities

Since portfolio firms might not be selected randomly, descriptive patterns of pre- and post-buyout levels of investment might not tell us much about the causal effects of buyouts. Empirical analyses in the first group exploit investment theory and knowledge about determinants of investment to model an investment equation. According to Bond and van Reenen (2007), financial constraints describe a situation where a “windfall” increase in the availability of internal funds, i.e., an increase which conveys no information about the profitability of investment, causes higher investment spending. Researchers measuring financial constraints have mostly operationalized this definition by regressing firm-level investment on a measure of investment opportunities and a measure of internal finance, usually a firm’s cash flow:

where Iit measures investment of firm i in period t (sometimes normalized by the capital stock), x is the vector of control variables, CF denotes a measure of cash flow, α captures unobserved firm heterogeneity, and ε is an error term. If investment opportunities are sufficiently controlled for via F(xit), the coefficient β, the ICF sensitivity, measures the degree of financial constraints. The reasoning is as follows. In neoclassical investment models, firms choose investment such that the marginal product of capital equals its user costs. In a perfect capital market, the user costs of capital are constant and independent of the source of financing according to the Modigliani-Miller theorem. In contrast, in imperfect capital markets, firms have a preference for internal financing since there is a cost premium for external finance. Hence, firms with limited internal finance might not undertake some investment projects with an expected return that lies between the costs of external and internal finance but will increase investment if additional cash becomes available. The higher the cost premium for external finance, the more financially constrained are firms with profitable investment projects, and the higher is their preference for internal finance. The sensitivity of investment to cash flow is thus associated with the degree of financing constraints. To evaluate effects of buyouts on investment, researchers have augmented equation (1) to include an indicator of post-buyout periods and an interaction term with cash flow:

where PEit takes on a value of 1 for portfolio firms after a buyout. Scholars have based their estimates on various theories which imply different controls for investment opportunities, F(xit), related to different specifications of adjustment costs and expectation formation. The investment literature mostly applies standard neoclassical models with convex costs of adjustment (see, for instance, Cooper & Haltiwanger, 2006). The Q-model and the Euler equation specification are structural models which are explicitly derived from this theory.

The Q-model is based on the idea that investment equals the ratio of the shadow value of capital to its purchase price for an additional unit, known as marginal Q. In empirical applications, marginal Q is often approximated by the observed market-to-book ratio known as average Q or Tobin’s Q. This measure is usually constructed from stock market valuations and, thus, unquoted firms are not the subject of these studies. Since targets of buyouts 395are often not listed on the stock market, this model is not very well suited for studying the effects of LBOs. The empirical implementation of the Q-model critically hinges on the assumption that stock market prices reflect expected discounted future profits. Among others, Schiantarelli (1996) and Hubbard (1998) argue that stock markets might not be efficient and stock price data could therefore be a very imprecise proxy of investment opportunities.

Due to the potential problems of the Q-model (see Bond & van Reenen, 2007 for further details) and its non-applicability to unquoted firms, many researchers prefer alternative econometric approaches which avoid the use of stock price data. One example of such a model is the Euler equation which can be constructed from standard balance sheet items and usually assumes convex adjustment costs (see Bond & Meghir, 1994 for an empirical application). Many empirical studies find, however, large and extremely complex adjustments in firm-level data and, thus, this assumption might be violated (Cooper & Haltiwanger, 2006; Bond & van Reenen, 2007). Flexible accelerator models (e.g., Harhoff, 1998; Mairesse et al., 1999) overcome this limitation by specifying dynamic models with simple partial adjustment – usually based on lagged values of investment, capital, and sales – which can be seen as an approximation of a more complex adjustment process (Bond et al., 2003). The model can be applied for investments in tangible fixed assets or for R&D spending as an indicator for long-run investments (e.g., Bond et al., 2005). The validity of all these specifications critically depends on their ability to control for investment opportunities and adjustment costs.

Bertoni et al. (2013) estimate a Euler investment equation extended by interactions between cash flow and pre- and post-buyout dummies. The authors estimate their model for a sample of 78 buyouts in Spain between 1995 and 2004. They estimate a statistically insignificant ICF sensitivity for pre-buyout periods and a significantly positive ICF sensitivity in post-buyout periods. The authors interpret this finding as evidence that buyouts create growth opportunities and portfolio firms lack internal funds to exploit these opportunities. However, they do not analyze how the level of investment changes.

Engel and Stiebale (2014) apply a dynamic version of a sales accelerator model with indicators of buyouts and their interaction with cash flow. They estimate their empirical model separately for a sample of 7,543 UK firms including 315 buyout firms, and 18,095 French firms subject to 277 buyouts that take place between 1999 and 2007. The authors find that the ICF sensitivities of portfolio firms are positive and similar to other firms before PE financing starts but are reduced significantly after buyouts in the UK. These firms also display higher levels of investment in post-buyout periods. The increase in investment and the reduction of financial constraints is concentrated among small firms, which are arguably more likely to face financial constraints a priori. In contrast, they find that the level of investment and financial constraint are not significantly affected by buyouts in France.

Some empirical studies have also analyzed differences in distinctive characteristics discussed in the previous section (vendor source, type of buyout, and investor), and estimated heterogeneous effects. For instance, Crocea et al. (2013) address family-controlled businesses and differentiate between first generation venture capital (VC) backed firms (i.e., founding firms acquire VC) and descendant generation PE-backed firms which include both expansion financing as well as buyout financing. The authors estimate a Euler equation for a sample of 469 privately-held Spanish firms including 151 firms with initial VC investment between 1995 and 2006. They find that descendant generation PE-backed firms do not show a statistically significant ICF sensitivity in the pre-investment period and, in contrast to other studies, find no significant change in the post-investment period. However, the heterogeneity 396of Crocea et al.’s sample might explain these findings, since changes in ICF sensitivities might differ between expansion financing and buyouts.

Ughetto (2016) also applies the Euler equation methodology and takes characteristics of PE firms and buyouts and interactions with cash flow into account. The equation is estimated on a sample of 206 low- and medium-technology firms (including 108 buyouts) from the UK, France, Italy, and Spain. In contrast to Engel and Stiebale (2014), she estimates a significantly positive effect of buyouts on ICF sensitivity for French legal origin firms (France, Italy, Spain). For UK firms, the effects on ICF sensitivities are even more pronounced, and she also finds negative effects on the level of investment independent of cash flow. Further, the estimates suggest that higher cash flow sensitivities and lower investment levels are concentrated in buyouts with independent rather than captive investors. This finding is in principle in line with the view that independent PE firms are more active investors than non-independent ones.¹

In contrast to the role of independent versus captive investors, we know relatively little about the effects of governmental buyouts on investment. Most studies focus on new-technology based firms (e.g., Grilli & Murtinu, 2011; Bertoni & Tykvová, 2015) whereas the role of governmental PE buyouts has so far been neglected.

With respect to the vendor source, Pindado et al. (2011) show that family-owned firms have lower ICF sensitivities than other firms. The result suggests that family control reduces both financing constraints as well as unproductive use of free cash flow due to managerial discretion. Ellul et al. (2010) find that investments in family-controlled firms are lower in countries with strict inheritance laws after a succession. As pointed out by Jaskiewicz et al. (2015), imprinting the entrepreneurial legacy helps such that the successor does not fear the paying out of other heirs and, thus, entrepreneurial opportunities can be exploited to a greater extent.

Indirect evidence on PE firms and financing constraints

A small but growing literature investigates the effect of PE firms on investment and financial constraints indirectly without specifying an investment equation. The idea behind this strand of literature is that if buyouts affect investment via affecting credit constraints, the effects of buyouts should be most pronounced in industries in which financial constraints potentially play a more important role and among firms which are a priori more likely to be financially constrained. The most common industry-level indicator of the importance of external finance across industries is the Rajan and Zingales (1998) measure of financial dependence. It measures the share of investment that cannot be financed from internal cash flow for the median listed US firm within industries. This measure is based on the assumption that listed firms in the US operate in a relatively unconstrained financial environment, and therefore this figure captures the technological dependence on external finance across industries. Boucly et al. (2011) investigate the effects of LBOs on French portfolio firms allowing for heterogeneous effects of PE firms across industries that depend on external finance to a different extent. For this purpose, they estimate difference-in-differences (DiD) regressions comparing the performance of firms that have been taken over in an LBO to other firms:

Yijt=β1⋅postt+β2⋅postt⋅LBOi×β3⋅postt⋅FDj+β4⋅postt⋅FDj⋅LBOi+ηi+uijt

In this specification, Yijt indicates the outcome of firm i active in industry j at time t. post takes on a value of 1 in post-buyout periods for portfolio firms and their control observations, FDj, 397is the measure of financial dependence and LBOi indicates buyout firms. postt×FDj×LBOij thus measures how the effects of buyouts vary across industries with different levels of financial dependence. The authors use various outcome variables to show that positive growth effects of buyouts are indeed higher in industries with high levels of dependence on external finance, which is in line with buyouts alleviating financial constraints. They also provide evidence that positive effects of buyouts are concentrated among initially private firms and small firms which are arguably more likely to be credit constrained.

Amess et al. (2016), who investigate the effect of buyouts on innovation in UK portfolio firms, use a related identification strategy. To control for endogeneity of buyouts, the authors use propensity score matching to identify an adequate control group. Using the matched sample, they estimate a DiD specification allowing for heterogeneous effects for firms which are a priori more likely to be financially constrained. The case of innovation is of particular importance for assessing financial constraints since R&D is typically associated with lower collateral value but higher riskiness and asymmetric information problems compared to tangible investment. This implies that financial constraints are particularly severe for the financing of innovation (Brown et al., 2012; Hsu et al., 2014), which has been confirmed by robust empirical evidence (e.g., Stiglitz & Weiss, 1981; Aghion et al., 2012; Hottenrott & Peters, 2012). In line with PE firms relaxing credit constraints for innovation, Amess et al. (2016) indeed find that buyouts have more pronounced effects among portfolio firms which are a priori more likely to be financially constrained, such as private firms, firms with low pre-buyout credit ratings, and firms operating in financially dependent industries. Chung (2011) also estimates positive effects of buyouts on firm growth for private but not for large public firms which are characterized by a separation of ownership and control.

Buyouts and different types of investment

A growing literature investigates the effects of buyouts on different types of investments. Early studies focused on the effects of buyouts on capital expenditures and have provided evidence that these expenditures fell after buyouts of large publicly listed firms (Kaplan, 1989; Smith, 1990). In contrast, Boucly et al. (2011) and Smith (2015) find that capital expenditures increase after buyouts in France and India and that these effects are concentrated in relatively small private firms. In line with these results, a recent study using industry-level data by Bernstein et al. (2016) finds evidence for increasing capital stocks in industries that attract high levels of PE across many different countries.

Meuleman et al. (2009) focus on the role of distinctive characteristics of PE firms to explain performance differences within a sample of 238 PE financed buyouts in the UK. One of their main findings is that experience of PE funds, measured by the cumulative number of buyout investments from the early 1980s onwards, is positively related to the growth of PE-financed buyouts. Furthermore, PE-financed buyouts of independent PE firms also achieve significantly higher growth rates in sales and employment. However, the level of growth is significantly negatively related to the number of investments which are handled by one investment executive. While Meuleman et al. (2009) do not directly analyze investment outcomes, their results indicate that distinctive characteristics of PE firms accelerate the exploitation of entrepreneurial opportunities and, thus, they are likely to enhance investment activity as well.

Of particular interest has been the effect of buyouts on investment with a long-run character such as innovation, as this measure is directly related to the concern that PE firms focus on short-term performance. Tåg (2010) summarizes the empirical evidence and points 398out that results of studies in the 1990s are rather mixed. For instance, Long and Ravenscraft (1993) estimate negative effects of buyouts on R&D intensity, Lichtenberg and Siegel (1990) find insignificant effects, whereas the study of Wright et al. (1992) provides evidence for positive effects which are in accordance with the view of strategic entrepreneurship. Earlier studies were mostly limited to buyouts of large listed companies and may thus not be representative of the market for LBOs.

More recently, Lerner et al. (2011) study 472 PE-based US LBO transactions between 1986 and 2005 and find that patents of portfolio firms are more cited after a buyout occurs, which suggests that the quality of innovation output increases in post-buyout periods. The evidence with respect to the level of patent activity shows a decline in patenting activity after a buyout, although the authors suggest interpreting the result with caution. For instance, the time lag from application to patent filing is about 30 months and the possibility that the decline is mainly driven by innovation activity before the buyout occurs cannot be ruled out. Ughetto (2010) provides first evidence for Western Europe based on a sample of 681 buyouts in manufacturing between 1998 and 2004. She finds that the average number of patents increases by around 50% after a buyout relative to the pre-buyout period. The estimated change in patenting varies with characteristics of the LBO. In particular, syndicated buyouts and buyouts with a specialized or experienced lead investor, tend to be buyouts where patenting activity increased the most. Both studies are, however, rather descriptive, as their evidence is based on a before-after comparison of buyout firms without a control group. Thus, it is not clear whether the results reflect the causal effect of buyouts or rather the selection of portfolio firms with certain innovation performance.

Amess et al. (2016) use propensity score matching to identify a suitable control group from a large sample of firms in the UK which they compare to their sample of 407 portfolio firms. They combine their matching approach with a DiD estimator to estimate the causal effect of buyouts on innovation measured by patenting. The results show that the absolute number of patents as well as citation-weighted patents increase upon buyouts. There is also evidence that buyouts can induce other types of investments and technology upgrading. For instance, Agrawal and Tambe (2016) show that post-buyout, portfolio firms increase their investment in information and communication technologies. Further, evidence suggests that PE firms induce divestment and investment in subsidiaries (e.g., Davis et al., 2011).

Discussion and suggestions for future research

All in all, our overview of the existing literature shows that while an increasing number of studies investigates the relationship between buyouts and investment of portfolio firms, the evidence is far from conclusive. The relationship between buyouts and investment is ambiguous from a theoretical perspective. On the one hand, leverage ratios of portfolio firms usually increase after a buyout transaction, which might limit their ability to exploit investment opportunities. On the other, several studies point out the potential for the creation and exploitation of entrepreneurial opportunities. We believe that a conceptual framework with respect to (1) the type of buyout, (2) the vendor source, and (3) the main characteristics of acquirer/financier might be helpful to understand under which circumstances the exploitation of entrepreneurial opportunities, the alleviation of financial constraints, and the reduction of investment are most likely to occur.

Given the mixed results of previous studies on buyouts and investment, it is natural to ask whether results of some studies are more reliable than others. As discussed in Chapter 19, a significant part of previous studies have relied on ICF sensitivities to identify financial 399constraints in portfolio firms. The validity of ICF sensitivities as a measure of financial constraints is controversial in the literature. For instance, Kaplan and Zingales (1997) point out that ICF sensitivities may not increase monotonically with the cost premium for external finance. They show that in a static demand setting, the sensitivity of investment to (a windfall change in) the availability of internal funds may be lower for firms with a higher cost premium for external finance if the marginal product of capital is sufficiently convex. Bond and Söderbom (2013), who show that this result only applies to unconditional sensitivities in a static setting without adjustment costs, have recently challenged this conclusion. They argue that ICF sensitivities increase monotonically conditional on investment opportunities in the presence of adjustment costs. However, the interpretation of ICF sensitivities still relies on a correct specification of the adjustment cost process and adequate control for investment opportunities. For instance, Cummins et al. (2006) show that ICF sensitivities among US listed firms are affected by a measurement error in investment opportunities when these are proxied by stock market valuations, and that sensitivities disappear once this measurement error is assessed by using analysts’ earnings forecasts as a measure of investment opportunities. This result has, however, been obtained from a sample of US listed firms, which are arguably not the most likely to be financially constrained.

Another critical aspect of ICF sensitivities is that cash flow is arguably endogenous to investment and not all studies have accurately controlled for this issue. Due to a lack of external instrumental variables, the more convincing analyses have used lagged variables as instruments in a system- or difference-generalized method of moments (GMM) framework. The validity of lagged variables as instruments, however, critically hinges on correct model specification and the validity of the assumed autocorrelation structure. Overall, the validity of ICF sensitivities remains controversial, and results of existing studies have to be interpreted cautiously. Given the difficulties in measuring financial constraints, it will be interesting to see whether different measures of financial constraints will yield different results in future studies.

The few empirical studies that have estimated heterogeneous effects of LBOs on firms that are a priori likely to face financial constraints to a different extent seem to have produced a more consistent picture. Although they are less sensitive to the econometric and measurement issues affecting ICF sensitivities, they critically hinge on assumptions about which firms are a priori likely to be financially constrained. However, the results obtained by these studies so far are quite intuitive. PE firms seem to induce growth, investment, and innovation mainly in external finance-dependent industries, in private firms, small firms, and firms with relatively low initial credit ratings, hence, in situations where financial factors arguably play an important role. Most estimates of negative effects on the level of investment largely stem from earlier studies that were limited to a sample of large public corporations. Future research will show whether these results remain robust in different contexts and samples studied.

Another important issue in research on PE and investment (and other outcome variables) is the lack of exogenous variation in buyouts. Many studies compare post-buyout performance of LBO firms to non-PE backed firms, controlling for some observable industry or firm-level characteristics. These studies therefore implicitly assume that targets of buyouts are randomly selected. However, PE firms have industry expertise and might base their investment decisions on firm characteristics unobservable to the researcher. Similar to studies of other acquisition events, it is extremely difficult, to obtain valid instrumental variables or sources of (quasi-)experimental variation (e.g., Braguinsky et al., 2015). Some empirical analyses have partly addressed selection issues using a (propensity score) matching 400approach combined with a DiD estimator which controls for observed time varying and unobservable time-invariant characteristics. The approach can be convincing if the relevant determinants of the outcome variables, including past growth rates of outcomes, are adequately controlled for. Nevertheless, time-varying unobservable characteristics would bias the estimated effects of buyouts. Furthermore, matching procedures seem to be the best one can do to circumvent the problem that acquired firms are not a random subset of the population. For this reason, this method is also frequently used in M&A research (e.g., Guadalupe et al., 2012).

Another approach, frequently used in the finance literature, is to compare acquired firms to targets of announced M&As that were not completed for reasons that are unlikely to be related to the outcome variables of interest (e.g., Bena & Li, 2014; Seru, 2014). A similar idea is exploited by Smith (2015) who analyses a sample of PE-backed firms in India which he compares to the performance of firms that will receive PE in the future. The author complements this evidence with data from a specific PE firm that enables him to identify firms initially selected for PE investments that were finally not acquired. This reduces endogeneity concerns, which potentially affect many studies on buyouts and investment. The results obtained from this identification strategy suggest that, among other things, portfolio firms increase their investments, indicated by a growth of assets, after buyouts. Studies that exploit a similar empirical strategy as Smith (2015) are a promising area for future research. Since this study is limited to Indian firms, it will be interesting to see whether a similar identification strategy affects results obtained for portfolio firms in the US and Europe which have been the subject of most empirical research on buyouts.

Besides methodological issues, a potential explanation for varying results across studies and countries are differences in the share of family-controlled firms and divisional buyouts as well as differences in entrepreneurial legacy and inheritance laws. Another interesting direction for future research is thus to investigate these issues in more detail.

Meuleman et al. (2009) address differences between divisional and non-divisional buyouts in the UK. They find that divisional buyouts are characterized by significantly higher changes in profitability and employment growth compared to non-divisional buyouts. A study which addresses the effect of buyout transactions on investment and financing constraints in divisional and non-divisional buyouts by considering different investors, is still missing however.

Many divisions of large (industrial) multinational enterprises (MNEs) were targets of buyout transactions. Questions remain about the role of corporate investors in these transactions compared to PE firms. It is a well-documented empirical fact that subsidiaries of MNEs outperform other firms with respect to many indicators (e.g., Helpman et al., 2004; Chang et al., 2013). Further, MNEs are usually active investors that often shift resources and economic activity across different locations (e.g., Berry, 2010, 2013). Some of these shifts might also include buyout transactions at the location of divestment, and we know little about the evolution of these entities after divestments such as their growth, productivity, investments, and innovation performance.

As we have discussed in the previous section, there is evidence that buyouts can induce R&D and patenting and that some of this increase seems to stem from PE firms relaxing financing constraints. While the level of R&D expenditures and patenting are interesting outcomes, they do not tell us much about the efficiency with which innovation activity is performed if they are studied in isolation. An important question for future research is thus whether portfolio firms are able to generate higher innovation output conditional on innovation input.

401Although patents are a commonly used measure of innovation output, it is well known that they only capture part of firms’ innovation activities and sometimes reflect a firms’ innovation strategy (e.g., Ziedonis, 2004). To gain a more complete picture on the effects of buyouts on innovation it would thus be interesting to study additional variables such as process innovations and the introduction of new or improved products. Another important question in this context is whether buyouts lead to changes in the management of innovation processes and whether these contribute to higher innovation efficiency. Further, an interesting area for future research is whether buyouts affect other variables that reflect productivity-enhancing investments in a broader sense such as vertical and lateral integration and investments in product quality.

Conclusion

In this chapter, we have summarized the literature on the effects of buyouts by PE firms on the investments and financial constraints in their portfolio firms. From a theoretical point of view, the net effect of PE firms on investment is ambiguous. The earlier literature has focused on buyouts in large public organizations in which PE firms are likely to reduce the over-investment by empire-building managers and improve investment efficiency. A newer strand of literature has, in contrast, focused on entrepreneurial buyouts, which might relax growth constraints in portfolio firms. However, since higher leverage after buyouts might limit portfolio firms’ ability to exploit investment opportunities, the net effect of PE firms ultimately boils down to an empirical question.

While overall the findings of empirical studies are mixed, a significant part of the more recent literature has found that buyouts can induce both tangible investment as well as investment in innovation and new technologies. One of the channels that seems to drive this result is a reduction of financing constraints, especially in private firms, small firms, and firms operating in industries with high dependence on external finance. Our survey shows that the effects of buyouts is not uniform but depends on portfolio firm characteristics, the type of investor, country characteristics, and time periods studied. Evidence on investment and financial constraints of PE-backed firms during the financial crisis is still limited.

We have also discussed methodological issues of existing empirical studies and argued that more evidence on investment and financing constraints is needed that is based on credible control groups of firms that are unaffected by buyouts. Given the difficulty in measuring financing constraints, it will also be interesting to see whether the results of existing studies are robust if new and different methods for identifying credit constraints are applied.

From a policy point of view, it seems that the perception that PE firms over-indebt portfolio firms and negatively affect their investment activities, seems on average not to be supported by empirical evidence. The results of studies surveyed in this chapter, however, suggest that the benefits of buyouts crucially depend on the type of investor, portfolio firms, and country characteristics.

Note

  1    The differentiation between independent and captive investors results from the fact that detailed information about the activity level is missing. Bottazzi et al. (2008) find that independent VCs have a higher probability of being involved in recruiting senior management, in hiring outside directors, and in raising external funds. The major implication of Bottazzi et al.’s result is that differentiation between independent and captive funds is a suitable proxy to differentiate between more and less active PE firms.

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