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THE EVOLUTION AND STRATEGIC POSITIONING OF PRIVATE EQUITY FIRMS¹

Robert E. Hoskisson, Wei Shi, Xiwei Yi, and Jing Jin

Introduction

General partners in private equity (PE) firms manage funds contributed by PE investors (limited partners, usually institutional investors) to acquire portfolio firms, most often using additional debt capital borrowed from banks or debt markets. As such, PE firms’ general partners, limited partner investors, portfolio firms (or acquired firms, often labeled buyout firms), banks, and other debt providers are the main players in PE transactions (Stowell, 2010; Gilligan & Wright, 2014). Among the above five players, PE firms’ general partners play the most important role as they solicit investor funds (limited partners), identify target portfolio firms, and initiate relationships with banks and other debt providers to finance buyout deals.²

Although PE firms’ general partners are the key players in PE transactions, the majority of academic research on PE (for reviews see Harris et al., 2005; Cumming et al., 2007; Renneboog et al., 2007; and Wright et al., 2009) has focused on explaining performance disparities between PE portfolio firms and their peer publicly traded firms. The lack of a systematic examination of PE firms’ strategies (when we speak of PE strategy we mean the overall portfolio strategy of general partners) hinders our understanding of competitive positioning among PE firms and its associated impact on buyout portfolio firms. To enrich our knowledge about PE firms’ strategies, this chapter aims to provide a conceptual configuration of PE firms’ strategic positioning (Doty & Glick, 1994).

To develop the foundation for our configuration model, we first review the evolution of PE firms through two historical waves of PE transactions (e.g., Kaplan & Strömberg, 2009). During the first wave, in the 1980s, PE firms focused on garnering the benefits of high financial leverage through leveraged buyouts (LBOs) of portfolio firms. In this wave, agency theory was foundational to explain the influence that PE firms had on buyout portfolio firms. After the first wave of PE transactions collapsed due to the over-issuance of junk bonds, the PE industry experienced a mild upward cycle in the 1990s. The second wave of PE transactions began at the end of the 1990s and peaked in 2007, but was interrupted by the 2008 global financial crisis. As the environment changed during the second wave and created a situation that goes beyond the explanations of agency theory, we argue that the combination of resource dependence theory and resource-based theory helps us better understand why 228PE firms need to cultivate distinctly different competencies and capabilities and reorient their strategies to cope with increased environmental uncertainties and complexities. We will introduce these perspectives more fully in the second section as we analyze PE firms’ strategic choices in relation to environmental changes and how such choices have resulted in divergent strategic positions.

Based on our review of the evolution of PE firms, we configure PE firms into four distinct strategic foci along two dimensions: financial structure emphasis and portfolio firm scope. The financial structure emphasis dimension refers to the level of financial leverage used by PE firms in restructuring the capital deployed among portfolio firms. This dimension indicates PE firms’ preference for using debt versus equity financing in the capital structure of portfolio firms and reflects PE firms’ short-term versus long-term investment horizon. To be clear, we are not talking about the central sourcing of overall capital, either debt or public equity, sought by general partners (for instance, Blackstone Group became publicly traded through an IPO in 2007). Rather, our focus is on how long- or short-term-oriented the overall deal structure that general partners apply to portfolio firms is.

The second dimension, portfolio firm scope, refers to the level of industry diversification among PE firms’ portfolios of business. This dimension demonstrates how PE firms utilize their distinct resources and capabilities to choose different strategies and establish competitive advantages. After justifying these two dimensions, we categorize PE firms into four types: short-term efficiency niche players, niche players with long-term equity positions, diversified players with focused groups of portfolio firms, and short-term diversified efficiency-oriented players. We analyze the strategic focus and competitive advantage of each type of player and provide examples of PE firms associated with each type in the third section of the chapter. In addition, we analyze the dynamic movement of PE firms between types along the two dimensions, given opportunity for portfolio expansion and response to environmental change. In the final section, we discuss theoretical implications and future research opportunities using our proposed conceptual framework as well as managerial and public policy implications in regard to emerging trends in the PE industry. We start, however, by briefly reviewing the evolution of the PE industry.

Evolution of the PE industry

In this section, we review the evolution of PE firms by examining the previously mentioned two waves of PE transactions and comparing their distinguishing characteristics. In doing so, we provide an understanding of the PE firms’ strategic advantages compared with other firms using agency theory in the first wave of PE transactions. We then apply resource dependence theory and the resource-based theory to explain how PE firms evolved to cope with environmental changes and external uncertainties during the second wave of PE transactions.

The first wave of PE firm transactions emerged during the 1980s. In 1981, Kohlberg Kravis Roberts (KKR & Co.) executed six LBO transactions, which encouraged other investors to engage in similar buyout transactions. Such investors typically acquired majority control of existing mature firms via increased financial leverage. Historically, the debt proportion of such portfolio buyout firms often ranged from 60% to 90% (Kaplan & Strömberg, 2009).

In regard to the first wave of PE firm transactions, the introduction of high leverage in PE portfolio firms as well as the adoption of incentive mechanisms as suggested by agency theory (Jensen & Meckling, 1976) better aligned the interests of portfolio firm managers to 229reduce agency costs (relative to publicly owned corporations) and thereby improved performance in buyout firms. In addition, high leverage results in capital structure changes and “tightens governance arrangements so as to reduce managerial discretion” (Wright et al., 1994: 217) and also boosts the return on equity for PE portfolio firms by deducting interest from profits before taxes (Kaplan, 1991; Wright et al., 2009; Lerner, 2011). According to agency theory, investors and owners are principals, and they hire managers to manage their businesses. To ensure that managers act in the interests of principals, firms establish boards of directors to monitor managers and use stock options to align the interests of shareholders and managers. A main conflict of interest between investors and managers in mature firms is managers’ frivolous use of free cash flow. PE firms’ prevalent use of high leverage is considered an effective strategy to discipline managers because the latter are obligated to meet interest payments. In other words, high levels of debt help reduce agency costs in portfolio firms (Jensen, 1986) because the need to pay back principal and interest compels managers to enhance firm performance and create value for shareholders.

While the use of high leverage has a number of advantages, it may also incur high risks. Later in the first wave of PE transactions, a large proportion of debt consisted of junior or unsecured loans financed by either high-yield bonds or “mezzanine debt” (Yago, 1991), which is subordinated to senior debt (Demiroglu & James, 2010). Issuing such junk bonds, while at first increasing capital liquidity and thereby stimulating a series of LBOs, generated high deal risks and finally led to the collapse of the first wave of buyout transactions.

Between the first and second waves of PE transactions in the early 1990s, as the PE industry gradually recovered from the junk bonds crisis, the industry experienced a mild upward cycle of LBO transactions. However, a second major wave of PE transactions emerged in the early 2000s. Specifically, from 1998 to 2005, PE buyouts increased at an annual rate of 13.22% (PricewaterhouseCoopers, 2006), primarily due to the low cost of capital. In the US, the value of PE transactions peaked in 2006, reflected in the delisting of many public firms. For example, the New York Stock Exchange (NYSE) recorded a net withdrawal of $38.8 billion in listed capital. NASDAQ recorded a net withdrawal of $11 billion as many public firms went private (Schneider & Valenti, 2010).

The second wave of PE transactions differs from the first wave in two ways. First, in the second wave the cost of being public became an additional reason for going private. Downward pressure on pay and the rising invasiveness of stakeholders decreased the attractiveness of being a public company for top executives (Kaplan, 2009). After 2002, the costs of being a public firm increased due to the requirements of the Sarbanes-Oxley Act (SOX). To avoid these costs and the short-term orientation caused by shareholder expectations associated with quarterly reports, PE firms took public firms private, allowing these firms to focus on better value creation, especially during periods of financial distress (Minns, 2010).

Second, in the second wave PE firms became more operations-oriented and focused on providing professional guidance (Matthews et al., 2009); in the first wave they had been keen on being “financial engineers,” creating value for the focal firm through cost-cutting measures (e.g., significant layoffs). Since short-term cost-cutting strategy caused public resistance to PE firms, in the second wave more and more PE firms changed their role from “financial engineers” to “operational engineers” by providing professional managerial guidance to buyout firms to improve value and profitability. As a result, an increasing number of PE firms established their own professional advice teams (e.g., KKR and Bain Capital) and built partnerships with buyout firms to help them implement their strategic plans.

The revitalization of PE transactions in the 2000s was due partly to the need to shelter public firms from excessive governance costs and short-term pressure from investors as well 230as the cheaper cost of debt, but this renaissance was impeded by the global financial crisis that began at the end of 2007. The massive credit market crisis engendered by the global financial crisis posed a significant challenge to PE firms because inexpensive and readily available debt sources dried up. In addition, PE firms faced increasing normative pressure from public and government oversight, creating legitimacy concerns as media exposure depicted PE firms as excessively greedy during deteriorating macro-economic conditions (Blundell-Wignall, 2007). Hence, these adverse economic conditions complicated the profitability of the second wave of PE transactions.

Theoretical background: establishing PE firm positioning

To analyze how PE firms cope with emerging challenges such as the credit squeeze and exit difficulties we turn to resource dependence theory. Resource dependence theory (Pfeffer & Salancik, 1978; Hillman et al., 2009) contends that organizations, constrained by a web of interdependencies with other organizations, attempt to manage their external dependencies to reduce associated uncertainty and risks. Given the unfavorable social and financial environments confronting PE firms, it would follow that they would want to reexamine their relationships with external parties. Since the unfavorable financial market restrains available debt sources, higher levels of equity investment (mostly private ownership) tend to replace the dominant use of high debt in the financial structure of PE transactions. An increase in equity investment is not only a response to changed hostile business environments, but also an intentionally managed endeavor by PE firms to reduce uncertainty and strengthen the firm’s independence from external parties. In addition, differentiated investment strategies reflect PE firms’ efforts to reduce direct competition between firms for deals. In sum, resource dependence theory explains why, following the collapse of the first wave of PE transactions, PE firms would employ more equity investment among portfolio firms’ capital structure instead of relying solely on riskier debt. In other words, some PE firms actively adapted their investment strategies to the changed external environment, as suggested by resource dependence theory.

This kind of environmental adaptation, however, is not the only means that PE firms have used to attract deals. Resource-based theory argues that sustained competitive advantages derive from the firm’s valuable, rare, inimitable, and nonsubstitutable (VRIN) resources (Barney, 1991) and emphasizes the role of firms’ embedded resources in shaping competitive advantage. From a resource-based perspective and in association with more competition for available capital, PE firms need to differentiate themselves and more clearly establish their competitive advantages to select targets and obtain capital. In addition, the shift from financial engineering that relied on retrenchment tactics in the first wave of PE transactions to operational engineering that emphasizes professional managerial guidance in the second wave of PE transactions also provides PE firms with the opportunity to consider their strategic identity. To comply with the trend to provide professional managerial guidance, some small- and medium-sized PE firms focus on a specialized field where their accumulated experience and professional teams can provide a competitive edge. Hence, the resource-based theory supports the emerging trend for PE firms to differentiate based on a narrow versus broad scope among portfolio firms. Also, PE firms that adopt more equity and less leverage may need to retain portfolio firms longer and develop skills to create value rather than relying on the short-term leverage effect coming primarily from a debt emphasis.

In sum, as PE firms intentionally manage environmental uncertainty and cultivate their core competencies, integrating resource dependence theory and resource-based theory 231into our conceptual framework will help unpack the theoretical rationales behind PE firm strategies.

Strategic configuration model of PE firms

As noted in the introduction, existing research regarding PE firms themselves has been rather limited, hindering our understanding of PE firms’ overall strategic positioning and the associated impact on portfolio performance. As such, we seek to configure PE firms into a more coherent typological framework (Doty & Glick, 1994). Derived from our description of the evolution of PE firms, we configure PE firms into four distinct strategic foci along two dimensions, as previously noted: financial structure emphasis and portfolio firm scope. The financial structure emphasis dimension reflects the level of financial leverage used by PE firms in structuring their portfolio firms. The portfolio firm scope dimension refers to the level of industry diversification among PE firms’ portfolios of business. We argue that these two dimensions capture configuration types among PE firms and that the combination of resource dependence theory and resource-based theory provides theoretical rationales for choosing these two dimensions.

For the financial structure emphasis dimension, the level of equity finance reflects PE firms’ long-range investment horizons, in that equity holdings enable PE firms to reap sustained long-term profits from their equity positions and likewise create potential long-term incentives for portfolio firm managers and other equity partners (e.g., long-term institutional investors). In contrast, relying on debt finance encourages PE firms to restructure and exit their invested firms through initial public offerings (IPOs) as soon as possible to garner momentum profits from improved performance and to avoid potential bankruptcy associated with high leverage. For the portfolio firm scope dimension, a focused portfolio firm allows PE firms to nurture expertise in-house and thus provide buyout firms with professional guidance. However, in a diversified portfolio, operational expertise is more difficult to apply because a wider range of knowledge is more difficult to acquire, rendering the PE firm more likely to maintain financial engineering as its dominant skill.

We believe these two dimensions motivate PE firms to adopt distinct strategic foci for two reasons. First, the PE industry is facing a dramatically changed business environment, making sole reliance on high leverage to generate profits for investors more and more challenging (Kaplan, 2009). PE firms are commonly attacked for taking advantage of provisions in US tax law that treat carried interest from debt and ordinary income differentially (Wruck, 2008; The Economist, 2012a). Accordingly, some PE firms tend to increase their equity investment to demonstrate a longer-term commitment to buyout firms. Moreover, PE firms face a weak equity market that has not fully recovered from the 2008 global financial crisis and hence have difficulties divesting highly leveraged portfolio firms through IPOs. Consequently, some PE firms have to operate a business longer than normal because exit opportunities are limited. In addition, the recent credit crunch has inhibited PE firms from obtaining cheap debt from banks and other financial institutions. As a result, some PE firms have changed from a conventional strategy hinging on high leverage to engaging in more equity investment and an increased operational focus.

Second, PE firms need to position themselves differentially to satisfy the needs of distinct PE investors and to compete for high-value buyout firms. The financial crisis makes PE investors as well as other financial investors more risk averse; accordingly, PE investors (limited partners) exhibit a high level of caution when making investment decisions and choosing PE funds in which to invest. Although the depressed world economy has led to low 232interest rates on borrowing, banks are becoming increasingly circumspect when assessing lending opportunities in the post-financial crisis era. Therefore, PE firms need to establish distinct competitive advantage to compete intensely for high-value investors, in particular pension funds (Nielsen, 2008) and lenders. Furthermore, given the large number of PE firms and limited number of buyout opportunities, PE firms face increased pressure in competing for portfolio firms with high potential (Gurung & Lerner, 2009; Lerner, 2011). Consequently, PE firms seek to differentiate themselves from one another to attract and retain institutional investors with comparable risk profiles and time horizons. Although most large PE firms have little difficulty raising funds thanks to their size and associated legitimacy and credibility, these firms (e.g., KKR and Blackstone) need to devote more attention to improving operational and managerial skills of portfolio firms (Rubenstein, 2010). For small- and medium-sized PE firms, the changed environment requires them to cultivate their core competitive skills and leverage their expertise in niche fields to compete for high-value PE limited partner investors and portfolio firms.

Figure 13.1      Strategic focus of PE firms: financial structure emphasis and portfolio firm emphasis

Source: Authors.

In sum, it is increasingly apparent that strategic choices of PE firms are diverging from each other to take advantage of their accumulated capabilities, expertise, and market power. Building on the dimensions of financial structure emphasis and portfolio firm scope, we illustrate our configuration framework in Figure 13.1. The horizontal axis differentiates PE firms by their portfolio firm scopes; the vertical axis differentiates PE firms by the financial structure emphasis of their portfolio firms. In the subsections that follow, we describe the four ideal types of PE firms and provide examples of PE firms associated with each quadrant in Figure 13.1.

Quadrant I: short-term efficiency niche players

PE firms in Quadrant I invest in a narrow scope of industry or firm types and have a typical financial structure that emphasizes debt over equity. This group of PE firms inherited the tradition of using high leverage as a tool to manage buyout firms and prefer to focus on a 233narrow set of industries and to provide professional performance improvement guidance for portfolio firms. In this chapter, we define this group of PE firms as short-term efficiency niche players. We will analyze strategic advantages of this group of PE firms from the two dimensions.

Using debt rather than equity in the financial structure refers to acquiring a company using a comparatively smaller portion of equity and a larger portion of external debt. As noted earlier, adopting high leverage as the financial structure of the portfolio firm has a variety of advantages. First, as mentioned, high leverage creates pressure on managers to fulfill the obligation to make principal and interest payments and improves the firm’s corporate governance by reducing agency costs. Second, in the US and many other countries, high leverage increases the value of the firm through tax deductions on interest (Kaplan & Strömberg, 2009). Third, while high leverage poses great risks for public firms, portfolio firms that become private face less pressure from governance requirements (through SOX) and less obligation to meet short-term investor expectations. Hence, high leverage greatly enhances the short-term efficiency of PE transactions by aligning the interests of managers and investors.

The preference for a focused portfolio firm scope represents a commitment to value creation for the acquired firm as a niche player. Focusing on certain industries enables PE firms to recruit experienced industry experts, accumulate important industry knowledge and experience, and cultivate the specialized capabilities necessary to deal with particular industry requirements. In addition, industry experts create additional value for the acquired firms by providing focused talent and accumulated experience in that industry. A focused PE firm is able to target its resources and attention on certain industries and hence concentrate resources on research in those industries, leading to important accumulated industry knowledge.

Starting in the 1980s most PE firms had strategies that fit well within this quadrant. A recent example of a short-term efficiency niche player is Bain Capital, an asset management financial services company headquartered in Boston, Massachusetts.³ Although Bain Capital has pursued deals internationally and now has subsidiaries in Europe, Asia, and India (Lopez-de-Silanes et al., 2009), it has relied mainly on capital raised from pension funds, insurance companies, endowments, high-net-worth individuals, sovereign wealth funds, and other institutional investors. The company is a typical short-term efficiency niche player, although it has traditionally focused on services industries (e.g., SunGard in business services and Dunkin’ Brands in the dining industry) (McCarthy & Alvarez, 2006; Rozwadowski & Young, 2005). Benefiting from its focused strategy, Bain Capital is able to successfully implement corporate capital restructuring, operating earnings improvements, and acquisition development across countries.

Quadrant II: niche players with long-term equity positions

Niche players with long-term equity positions are the PE firms with a focused portfolio firm scope that deploy more long-run equity holdings in the financial structure of the buyout firms. To develop in-depth strategic and operational insights and to cultivate networks in these industries, these PE firms concentrate on a limited number of industry segments (Harper & Schneider, 2004). We further explain the main features of investment strategies of niche players using SCF Partners as an example.

In recognition of his clients’ growing demands for PE investment, L. E. Simmons founded SCF Partners in 1989. Under Simmons’ leadership, the firm has made more than $1.6 billion 234in PE capital investments in energy services and equipment companies and has created more than 10 public companies listed on the US and Canadian stock markets. By the end of 2010, SCF Partners managed approximately $1.5 billion in assets (SCF Partners, 2012). Nevertheless, SCF Partners is a small PE firm when compared to KKR, which managed more than $60 billion at the end of 2010 (Eccles et al., 2011). Unlike a typical PE firm that emphasizes debt financing, SCF Partners attaches prime importance to providing equity capital to buyout portfolio firms in the energy services, manufacturing, and equipment industry segments. In addition, SCF Partners not only gives its portfolio firms consistent professional support for their strategic growth but also injects capital incrementally to buttress the strategic acquisitions and growth plans of its firms. Examining SCF Partners’ investment history reveals two features of its investment philosophy: the narrow investment focus and the reliance on equity investment.

First, the narrow investment focus enables SCF Partners to develop its expertise and cultivate its networks to build a solid reputation in its chosen industries. Its amassed experience and established reputation in these industries not only help SCF Partners provide portfolio firms with professional support but also aid in identifying future investment targets. Thanks to its industry knowledge, SCF Partners has a competitive edge in foreseeing industry trends and seeking firms with growth prospects in the energy services industry. Moreover, SCF Partners’ in-depth industry expertise allows it to attract and win the confidence of investors with long-run investment horizons. A second feature of its investment philosophy finds SCF Partners using more equity capital to conduct its transactions because a high leverage ratio obligates buyout firms to service the debt rather than foster growth.

Unlike conventional PE practices that emphasize drastic organizational changes in the post-buyout period, SCF Partners collaborates with entrepreneurial owners of buyout firms to implement incremental “reforms.” These owners, mostly private and often founder-dominated, have deep knowledge about and emotional connections with their ventures and are committed to growing their businesses. In other words, these entrepreneurial owners are the key to buyout businesses’ successes. As a result, in the post-buyout period, most top executives remain in the firm, and the role of SCF Partners is to assist these executives in improving firm performance and boosting future growth through appropriate acquisitions and fostering co-operation.

For example, the rapid growth of the tar sands industry in Canada requires increased investment in infrastructure (e.g., roads and metal buildings to accommodate workers), as most tar sands resources are located in the Canadian wilderness. Recognizing opportunities associated with this boom, SCF Partners established Site Energy Services Ltd. to acquire small energy services firms, consolidating local infrastructure services firms in Calgary by partnering with top managers of these firms. Other examples of SCF Partners’ investments include Rockwater Energy Solutions, which specializes in comprehensive fluids management services and environmental solutions, and Forum Energy Technologies (FET), which provides technologies and products to the energy industry.

Compared to Site Energy Services, FET is in a later stage of development. In partnership with SCF, FET has built businesses around deep-sea drilling services and sells remotely operated vehicles used for inspection and survey of associated deep-water well construction. In support of FET, SCF initiated an IPO in April 2012, not as an exit strategy but to provide continuing capital to pay down debt and support the growth of the company. Only about 20% of the company ownership was floated. SCF Partner has another portfolio company, Rockwater Energy Solutions, focused on services for horizontal drilling and associated hydraulic fracturing service where oil shale opportunities exist in the Bakken (North Dakota) and 235Eagleford (West Texas) fields. SCF also has other businesses focused on drilling and well completion service products, intervention products, and services to get wells flowing.

The role of SCF Partners in its investments is to provide financial and strategic growth support to the owners of each individual firm, and deploy the resources of these firms in aggregate to negotiate larger contracts and offer a wider scope of infrastructure and environmental services. In this sense, SCF Partners provides a platform for owners of these services firms to co-operate with and complement each other and jointly explore potential markets. In addition, SCF Partners builds portfolio firms through incremental acquisitions. SCF Partners not only provides portfolio firms with capital to acquire related assets, but also helps them identify acquisition targets and integrate acquired firms.

SCF Partners’ investment practices attest to a new trend in PE investments that departs from the emphasis on high leverage. The tenets of agency theory prescribe that high leverage leaves managers with little discretion and exerts pressure to avoid over-diversification (Wright et al., 2001). However, SCF Partners does not attempt to create value through reducing agency costs because most of its portfolio firms are small, private firms. Instead, it generates value by providing expertise and support to its portfolio firms. This position is supported by research by Castellaneta and Gottschalg (2016) who find the PE ownership fosters better performance the longer the portfolio firm is held, suggesting PE parent value-added rather than performance due to good target selection. We anticipate that more and more small- and medium-sized PE firms will adopt similar investment strategies and become niche players with long-term equity positions.

Quadrant III: diversified players with focused groups of portfolio firms

PE firms that emphasize relatively more equity investment and focus on a number of industries are defined as diversified players with focused groups of portfolio firms. Such PE firms are often relatively large PE funds with abundant resources and strong capabilities. These PE firms have developed expertise and knowledge in a number of related or unrelated industries and aim to exploit their expertise in chosen industries. Diversified players with focused groups of portfolio firms adopt relatively larger portions of equity investments because equity investments enable these PE firms to enjoy long-term returns associated with “patience capital” (Porter, 1992). In addition, facing a volatile equity market, highly leveraged buyout portfolio firms are subject to substantial bankruptcy risks, which is not in the interests of PE firms. Thus, diversified players with focused groups of portfolio firms have to adjust their profit-generating mechanisms from restructuring and a profitable quick exit to more consistent operational gains from equity holdings. In other words, consistent with the main principles of resource-based theory, diversified players with focused groups of portfolio firms proactively increase the portion of equity investment versus debt investment to exploit their capabilities in chosen industries. Diversified players with focused groups of portfolio firms choose to concentrate on a number of industries because having an in-depth understanding of a wide variety of industries is not only capital intensive but also consumes managerial time and energy. By nurturing expertise in a focused group of industries, PE firms in this quadrant develop their unique capabilities, providing a competitive distinction compared to other PE firms. To explain the uniqueness of PE firms in Quadrant III, we use Apax Partners as an example.

Apax Partners, headquartered in London, is an independent global PE firm that focuses solely on long-run investment in growth companies (Apax Partners, 2012). Although Apax managed $111.5 billion at the end of June 2011, it invests in only five industries (financial 236services, health care, media, retailing, and telecom). Apax believes that its experience, insight, and financial capital can help portfolio firms release their potential and generate significant growth. In spite of the dual roles that it plays – capital provider and catalyst for change – Apax attaches more importance to encouraging the growth of its buyout firms to maximize the value of its portfolios.

Its emphasis on growing buyout businesses is demonstrated by Apax’s investment selection criteria. If a targeted firm is not within the five aforementioned industries, is not sustainable, or is not a market leader with great growth potential, Apax will not invest in it. In addition, Apax aims to add value to existing management and governance instead of reshuffling management teams and governance structures. Therefore, as it often co-operates with incumbent management teams of target firms in buyout deals, Apax finds it easier to align its interests with those of current top executives. Moreover, Apax not only sends professionals to assist portfolio firms’ management teams but also sits on the boards of these firms to help top managers develop joint strategies. All these measures reflect Apax’s commitment to portfolio firms and its willingness to maintain long-term equity positions.

For example, Apax Partners, together with Permira (another large UK PE firm), took over private UK fashion retailer New Look in 2003. The top executives of New Look, pressured by expectations to meet short-term performance as a listed firm, felt that the public markets did not provide the right environment to ambitiously grow their business, so they partnered with Apax and Permira to privatize the firm. Apax and Permira each took 30.1% of New Look, the founder and other top executives of New Look took 36.7%, and Dubai-based retail giant Landmark assumed the remaining 3.1% (Achleitner et al., 2010). With the support of Apax and Permira, New Look established a new distribution center, enlarged store formats, and embarked on a path to internationalization. Apax and Permira chose not to exit New Look at the end of 2007 in spite of a bull IPO market because their focus was to work with the top management team of New Look to deliver better performance results (Achleitner et al., 2010).

The example of New Look shows that Apax prioritizes improving the full potential of its invested businesses and is willing to maintain equity holdings of buyout firms for a longer period than other PE firms in Quadrants I and IV. Apax’s long-term-focused, performance-oriented investment strategy is, in part, enabled by its own investors and relationships with banks. More than 46% of its funding comes from pension funds’ investments (Apax Partners, 2012), which often have long-run investment horizons (Ryan & Schneider, 2002). The Apax example is also supported by research by Castellaneta (2016) who found that PE firms that adopt a “carrot and stick” incentive approach “improve the alignment of managerial and firm interests and, in turn, encourage capability building. The model shows how incentives act on capabilities in three areas: the leveraging of existing capabilities, the sourcing of capabilities internally and the sourcing of capabilities externally” (2016: 41).

Quadrant IV: short-term diversified efficiency-oriented players

PE firms that invest in diversified industries and adopt a high-leverage financial structure are defined as short-term diversified efficiency-oriented PE firms. Because of their large size, PE firms in this quadrant are often well known to the public, and many are publicly traded on the stock exchanges (e.g., KKR and Blackstone). Research comparing diversified PE firms to unrelated diversified multidivisional firms has suggested that one of the main differences of this firm type is resource allocation between portfolio firms and headquarters (Baker & Montgomery, 1994). Short-term diversified efficiency-oriented players might have invested 237in a narrow scope of industries by employing high leverage when they were small; however, as they grow in terms of committed capital and resources, this type of PE firm faces increased opportunity costs and risks should they maintain a narrow business focus because of the high risk associated with a narrow portfolio of industries. Generally, the number of deals in a specific industry is reduced over time, and large, successful PE firms with a significant amount of funds to invest must move to other industries to find sufficient deals to use their available capital. To diversify their risks and expand their opportunity set, PE firms in this quadrant may gain minority control of larger buyout firms or acquire single business units of large companies in industries outside their usual deal focus.

In spite of strained debt markets after the recent financial crisis, short-term diversified efficiency-oriented players still rely on debt investments for three reasons. First, PE firms in Quadrant IV are large, have solid reputations, and have more credibility in accessing debt markets. Second, several firms in this sector are publicly traded, allowing such PE firms to access funds through the equity market. Hence, PE firms in Quadrant IV are capable of raising large amounts of capital; however, they need to diversify investment risks by enlarging their investment portfolios. Extensive use of debt allows these PE firms to make investments in multiple projects simultaneously and to leverage available capital. Third, as already noted, many PE firms in Quadrant IV are publicly traded and face pressure to meet investors’ short-term profit expectations; therefore, they need to exit portfolio firms as soon as possible through sell-offs or IPOs. Again, research by Castellaneta and Gottschalg (2016) suggest that these firms need to depend on selection (buy low and sell high) strategies because they take less time to restructure the portfolio firm and generally have less of an industry focus and expertise compared to Quadrant II and III players.

Similar to their counterparts, short-term diversified efficiency-oriented players have started to allocate more attention to operational improvements. However, unlike diversified players with focused groups of portfolio firms, short-term diversified efficiency-oriented players dedicate more efforts to operational enhancements to mitigate public criticism. In other words, diversified players with focused groups of portfolio firms proactively cultivate their expertise and knowledge in specific industries, whereas short-term diversified efficiency-oriented players attend to operational engineering as a reaction to external pressure to change the image of the PE industry as one based solely on financial engineering. Because they are the largest in the industry, short-term diversified efficiency-oriented players easily become targets of public criticism for using high leverage. In addition, relying solely on financial engineering cannot generate the expected benefits for PE firms (Kaplan, 2009); as a result, short-term diversified efficiency-oriented players need to pay more attention to operational improvements.

In sum, the motivation for PE firms in this quadrant to establish dedicated professional teams differs from that for PE firms in Quadrants II and III. PE firms with high-equity financial structures in Quadrants II and III establish professional teams to strategically and proactively pursue not only operational enhancements but also improved strategic positioning. Instead, PE firms with high debt in Quadrant IV use professional teams reactively because the exit option is limited; this is more in line with resource dependence theory.

Because PE firms have been perceived as burdening buyout firms with high levels of debt (The Economist, 2012b), some buyout firms may have used more equity than is typical, given the current social and economic trends (Bacon et al., 2013). Although this trend, as well as an increased operational orientation, may help deal with environmental pressure in the short run, once the depressed financial markets recovered these firms are seen to be refocusing on financial engineering.

238We use KKR as an example to illustrate the attributes of short-term diversified efficiency-oriented PE firms. KKR is an American-based global PE company, founded in 1976 by Jerome Kohlberg, Henry Kravis, and George R. Roberts, that specializes in leveraged buyouts. As its committed capital rose from $31 million in 1977 to more than $17 billion in 2006, KKR invested in 11 different industries. During the 1990s, a vulnerable market prompted PE firms to change their tactics, especially for high-leverage PE firms. In reaction to the market downturn in 2000, Kravis and Roberts envisioned developing a dedicated operations team for KKR, later known as KKR Capstone, that would partner with management to protect their investors’ interests (Eccles et al., 2011). KKR Capstone teams assist KKR deal teams during and after transactions. During a transaction, KKR Capstone teams help evaluate the operational efficiencies that could be achieved from a deal. More important, after the deal closes, two or more KKR Capstone professionals relocate to the portfolio company to achieve the improvements assumed in the pricing of the deal.

Although KKR uses industry expertise to help its portfolio firms, Capstone does not have deep specialized experience in a broad set of industries. Generally, given its diversified scope, KKR provides general management professionals to help restructure the portfolio firm in preparation for turnaround and exit. By consistently supporting and monitoring top executives in the portfolio firm, the on-site professional team makes sure the portfolio firm realizes the intended changes so the returns assumed in the pricing of the deal are achieved as soon as possible. In reaction to the environment change, KKR has to hold portfolio firms longer, consistent with the fact that privately owned holding periods have increased since the 1980s (Kaplan, 1991; Kaplan & Strömberg, 2009). However, compared to SCF Partners and Apax, which treat portfolio firms more as subsidiaries and exit less frequently, KKR, although it has become more operations-oriented because of environmental necessity, generally has shorter average holding periods.

Movements between quadrants’ strategic positions

Although our PE firm configuration model provides evidence of differential strategic positioning, there is also evidence that PE firms gradually reposition their strategic directions and seek different buyout targets because of changes in both the exogenous environments and endogenous resources and capabilities. As described in the example of KKR, there was an evolution to more operational expertise in the establishment of Capstone. Although this does not establish a change in quadrants, it does suggest incremental change. The shift from one quadrant to another is not dramatic but takes place progressively, and the shift across the two dimensions – financial structure emphasis and portfolio firm scope – can be propelled by PE firms’ attempts to maximize the value of their respective resources or to cope with new external uncertainties and risks. We propose that two basic strategic shifts capture the migration of PE firms across quadrants. The first shift is vertical movement caused by increasing equity investment; that is, from short-term efficiency niche players (Quadrant I) to niche players with long-term equity positions (Quadrant II) and from short-term diversified efficiency-oriented players (Quadrant IV) to diversified players with focused groups of portfolio firms (Quadrant III). The second shift is horizontal movement, which implies a more diversified portfolio; that is, from short-term efficiency niche players (Quadrant I) to short-term diversified efficiency-oriented players (Quadrant IV) and from niche players with long-term equity positions (Quadrant II) to diversified players with focused groups of portfolio firms (Quadrant III). These movements, whether vertical or horizontal, can appear the same but may be driven by different strategic intents: a proactive intent to utilize and to gain 239basic capabilities (using resource-based theory logic) or a reactive tactical logic in response to environmental change (using resource dependence theory logic).

The first shift suggests that short-term efficiency niche players (Quadrant I) and short-term diversified efficiency-oriented players (Quadrant IV) may increase their interest in equity investment. On the one hand, resource-based theory implies that PE firms in general need to cultivate their respective core competitive edges. For short-term efficiency niche players, they inevitably can deepen their insights into the focused set of industries in which they are heavily invested over time and accordingly nurture competitive advantages in these industries. For instance, one of Bain Capital’s investment approaches is to make full use of its business intelligence from a related set of service industries. In a similar vein, in spite of the wide scope of industries in which short-term diversified efficiency-oriented players invest, these PE firms also pay heed to fostering their capabilities and resources in certain industries. For example, KKR focuses its attention mainly on 14 industries, although it does not exclude investment opportunities beyond these 14.

The capabilities that short-term efficiency niche players and short-term diversified efficiency-oriented players have built up in their chosen industries enable these PE firms to hold longer-term equity investments in those specific industries – knowledge that imparts confidence in making longer-term equity investments. On the other hand, the first shift can also be explained by the resource dependence theory logic that suggests that PE firms are motivated to decrease their dependence on external environmental change and thereby mitigate external uncertainties. For short-term efficiency niche players, given the consequences of the 2008 financial crisis, exiting buyout firms through an IPO is now more challenging. This suggests that short-term efficiency niche players need to transform their business models characterized by short turnarounds, which is more difficult and less likely under their original financial structures. As such, in order to solve such problems, short-term efficiency niche players may need to increase their equity investments.

Likewise, short-term diversified efficiency-oriented players are also subject to scarcer exit opportunities due to the depressed equity market. Moreover, short-term diversified efficiency-oriented players face increased public criticism and scrutiny with respect to their reliance on capital restructuring of buyout firms and taking advantage of debt-associated tax deductions. As a result, short-term diversified efficiency-oriented players have started to establish dedicated professional service teams, as illustrated by the example of KKR. Although these professional service teams were built by KKR as a reaction to external environments, they allow KKR to cultivate expertise and capabilities in certain industries, enabling KKR to hold equity investments with more confidence. Thus, the changed environments call for short-term efficiency niche players and short-term diversified efficiency-oriented players to take further actions to cope with increased exogenous risks by the need to hold portfolio firms for longer.

The second shift, which concerns an increase in the level of diversification for short-term efficiency niche players (Quadrant I) and niche players with long-term equity positions (Quadrant II), occurs for two reasons. First, the resource dependence logic suggests that PE firms are likely to expand into new industries in order to reduce uncertainties associated with particular industries and diversify risks as they grow in size. Niche players with long-term equity positions may be compelled to expand into other industries to diversify risks associated with a single industry as their funds grow in size. Similar arguments hold for short-term efficiency niche players as their fund size increases. Second, the resource-based theory suggests that firms need to constantly develop capabilities that can help them cope with new challenges and risks in the environment. As PE firms in Quadrants I and II grow in 240size and accumulate slack resources (Penrose, 1959), these firms have an incentive to cultivate new expertise and capabilities to effectively utilize their dormant resources. Resource-based theory logic would suggest that short-term efficiency niche players and niche players with long-term equity positions would have the incentive to use these capabilities to pursue a wider portfolio firm scope (Chatterjee & Wernerfelt, 1991). Consequently, PE firms in Quadrants I and II might migrate respectively to Quadrants IV and III to exploit their augmented set of resources.

We posit that diagonal movements across quadrants are less likely because of organizational path dependence. Organizational path dependence (Sydow et al., 2009) states that the set of decisions firms can make in a given situation are restricted by decisions made in the past. Therefore, PE firms in Quadrants I and IV are less likely to migrate to Quadrant III and Quadrant II, respectively, because such movements imply that these PE firms need to discard their previous investment strategies. Furthermore, it is their experience and past reputation for particular types of deals that allow them to raise new funds. By the same token, PE firms in Quadrants I and II are less likely to deviate sharply from previous investments in familiar industries but may expand gradually to new industries so as to ameliorate uncertainties and risks related to these new arenas. Therefore, we anticipate that PE firms will take an incremental approach to increase equity investments and toexpand portfolio firm scopes instead of engaging in diagonal movements, which requires simultaneous moves in both funding and diversified scope repositioning.

Our discussion suggests that the first shift (from debt investments to equity investments) and the second shift (from focused firm scope to broader diversified firm scope) represent both PE firms’ proactive strategies and their reactions to external pressures. Taken together, the future landscape of the PE industry is jointly determined by external environments and the strategic choices among the four PE firm types.

Discussion

In this chapter, we argue that the PE firms are transforming themselves to embrace new challenges arising from changed business environments. Specifically, we contend that PE firms differentiate from each other in terms of financial structure and portfolio firm scope. As such, we argue that different types of PE firms develop heterogeneous capabilities and target different groups of investors and portfolio firms and have different debt provider relationships. The configuration of PE firms not only enables us to have a better understanding of the PE industry but also helps us to examine distinct ramifications of different PE firms. In this section, we first discuss theoretical perspectives that may facilitate and focus our research agenda on PE firms. We then address managerial and research implications that can be drawn from our configuration framework. Finally, we investigate public policy issues from the perspective we have put forward.

Theoretical implications

We have used agency theory, resource-based theory, and resource dependence theory to analyze the evolution of the PE industry. Generally, agency theory is the dominant theory to explain the emergence of PE transactions in the first wave. LBOs were the main form of the first wave of PE transactions. With a strong emphasis on financial leverage in these deals, the principles of agency theory suggest that with such leverage PE firms are able to constrain buyout firm managers’ discretionary power through the pressure of interest payments, 241and hence solve the “free cash flow problem” (Jensen, 1986). This logic is pertinent to PE firms in Quadrants I and IV. Characterized by using high leverage as the dominant financial structure, these types of PE firms aim to play the role of financial engineers and garner the benefits derived from reduced agency costs.

As the PE industry evolves and the external environment changes, resource dependence theory and resource-based theory provide us with a more comprehensive perspective to explain the strategic positioning of firms in the PE industry. First, as PE firms accumulate resources and the competition in the PE industry becomes fiercer, PE firms find that it is important for them to establish their unique identity and core competence through improved resource orchestration and utilization. This is in accordance with resource-based theory logic that valuable, rare, inimitable, and nonsubstitutable resources provide sustainable competitive advantages for firms. Therefore, PE firms accumulating specific industry knowledge and expertise tend to choose a focused strategy by providing detailed and professional guidance to portfolio firms to create value (e.g., PE firms in Quadrant II), while PE firms focused on financial engineering tend to choose a diversified strategy since they need to diversify their scope to use their dominant capabilities as deals become difficult to find in previous industries of focus (e.g., PE firms in Quadrant IV). Hence, the resource-based theory not only explains the important characteristics of why a PE firm chooses to be a diversified player or a niche player subsequent to the second wave of PE transactions but also addresses why diversified players with focused groups of portfolio firms (Quadrant III) proactively establish their own professional teams.

Second, as the PE industry evolved and the lack of exit opportunities created fierce competition in the industry, the previous dominant form of LBOs put huge pressure on PE firms because they had been dependent on the debt market. To adapt to the new environment and reduce the firm’s dependence on debt, as resource dependence theory suggests, PE firms in Quadrant I have used more equity investment. Likewise, Quadrant IV firms have received more capital from public equity markets and have used more equity investments in their portfolio firms as reactions to external environmental pressures. In addition, PE firms in Quadrant IV have been developing more operations-oriented teams to help manage the longer holding periods required by portfolio firms. Hence, resource dependence theory is useful in explaining PE firms’ increasing use of equity investments and a higher level of operational orientation in working with portfolio firms.

Dynamic capabilities theory is an extension of the resource-based theory and complements it by addressing why and how firms maintain their competitive advantages in situations of rapid and unpredictable changes (Teece et al., 1997; Teece, 2007). As the operations of PE firms are subject to rapid changes as social and economic conditions evolve, how different PE firms “integrate, build, and configure internal and external competencies to address rapidly changing environments” is likely to be critical to their future successes (Teece et al., 1997: 516). Therefore, future research on PE firms might adopt the dynamic capabilities framework to address PE firms’ migration among the four quadrants of our conceptual model to deal with changing environments.

Managerial and research implications

This chapter thus far has considered how changed social and economic environments have led PE firms to differentiate from each other and to develop their unique strategic foci. In this section, our discussion centers on how managers can better cope with the changing external environment from the perspectives of four key players (PE firms, investors, banks, 242and buyout firms) in PE transactions (Wright et al., 2010). Specifically, we examine the implications of globalization, the deal syndication among PE firms, the ramifications of institutional investors’ different investment horizons (as limited partners) on the PE industry, the influence of distinct types of debt on PE firms’ strategies, and the value of the PE industry for buyout firms’ CEOs. In this section, we also provide some suggestions for future research in exploring these implications.

First, all four types of PE firms are engaged in different levels of internationalization. For diversified players with focused groups of portfolio firms and short-term diversified efficiency-oriented players, globalization of their businesses inevitably broadens their opportunity pools. New opportunities in emerging economies invariably attract diversified PE firms in Quadrants III and IV to embark on the path of internationalization. For example, KKR has a presence in 13 metropolitan areas ranging from New York to Beijing, and Apax has 10 offices around the world. Niche players with long-term equity positions and short-term efficiency niche players also seek to exercise their dedicated capabilities in certain industries on a global platform. Although Bain Capital has been exploring investment opportunities as far as Asia, it focuses on the industries in which it has expertise when making investment decisions. Similarly, SCF Partners has offices in Calgary, Canada, and Aberdeen, Scotland, in addition to Houston, US, and its portfolio firms can be found in New Zealand and the Middle East as well, although it remains focused on its original energy services, manufacturing, and equipment industry segments. Future research can examine the distinctions among internationalization strategies adopted by different PE firms.

Second, deal syndication is another promising strategy for PE firms. The Apax example shows the prevalence of deal syndication in the PE industry. Deal syndication is an interfirm alliance in which two or more PE firms invest jointly in firms and share payoffs from such investments (Lerner, 1994; Lockett & Wright, 2001; Sorenson & Stuart, 2001; Meuleman et al., 2009b). The purposes behind PE syndication are to enable a PE firm to invest in more industries to diversify risks (Cumming, 2006), to make high-quality decisions (Lerner, 1994), and to generate new deal opportunities (Lockett & Wright, 2001) without unbalancing its portfolio due to deal size. Without deal syndication, too much of Apax’s capital might have been tied up with its investment in New Look. In this sense, alliances with Permira enabled Apax to make multiple deals at the same time and to reduce risks associated with relying on one particular deal.

Even though syndication may result in increasing agency and monitoring costs (Meuleman et al., 2009a), we suggest that it still could be a suitable strategy for all types of PE firms, but the underlying reasons and approaches may be different given the distinct strategic orientations. Future research can explore such syndication strategies from at least two aspects. First, syndications within the same quadrants allow PE firms with the same strategic orientations to reduce risks. It is of great importance for long-term-oriented PE firms (from Quadrants II and III) to diversify risks as they invest more equity capital in transactions. Risk diversification is also salient for short-term efficiency players (from Quadrants I and IV), especially when they invest in large transactions through high leverage. Second, syndications across quadrants might achieve complementary effects for both parties. For example, as it is difficult for short-term diversified efficiency-oriented players to have an in-depth understanding of a large number of industries, syndicating with niche players that focus on particular industries may be a plausible choice. Thus, it is likely that PE firms from different quadrants establish deal syndications to reduce risks, share operational expertise, and enhance short-term efficiency. More research is called for to untangle the different motivations behind PE firms’ deal syndications as well as the consequences thereof.

243Third, institutional investors should choose PE firms carefully by matching their investment horizons. As mentioned, PE firms have different preferences in terms of investment. Likewise, institutional investors adopt different investment strategies. For example, long-term institutional investors such as public pension funds favor long-run financial measurement of performance of their invested firms, whereas short-term institutional investors such as the majority of mutual funds and banks have more short-run financial parameters for their portfolio firms (Ryan & Schneider, 2002). Therefore, long-term institutional investors as limited partners should seek PE players with long-term-oriented positions – those in Quadrants II and III. In contrast, short-term institutional investors should focus on short-term efficiency players that turnover portfolio firms more quickly. Future research can examine how the compatibilities between PE firms and institutional investors influence strategic choices of buyout firms as well as of PE general partner firms.

Fourth, the changed landscape of the PE industry also has a significant impact on bank lending to PE firms. Managers of banks should be aware that PE firms with different strategic orientations have distinct strategies for debt and equity. Because short-term efficiency niche players rely on larger amounts of debt to finance deals but have short-term debt requirements, such PE firms may negotiate financing contracts with a number of banks to diversify their borrowing risks and to bargain for lower priced debt. Thus, when co-operating with short-term efficiency niche players, banks should carefully examine risks associated with short-term transactions and fast turnarounds. In contrast, banks can establish strategic partnerships with long-term-oriented PE firms (e.g., PE firms in Quadrants II and III) to reduce long-run transaction costs with these PE firms. Therefore, we suggest that banks should adopt different strategies to meet distinct borrowing needs of PE firms. More studies are needed to examine how PE firms’ strategic orientations influence banks’ lending behaviors. Likewise, more research is needed to study how different players would pursue public debt markets as an alternative to bank debt.

Last, the glamour of being a top executive of a public firm has reached a historically low level because of stakeholder pressure and public outcries about executive compensation (Kaplan, 2009). Simultaneously, a strengthening trend of privatization of public firms has emerged to allow potential portfolio firms to pursue opportunities not possible in public markets (Wright et al., 2001) and to maintain the value of their unique strategies (Shivdasani & Zak, 2007; Kaplan et al., 2011). In spite of the benefits of being a private firm and support from PE investors, top executives of buyout firms should be fully aware of vastly different strategies of distinct PE firms. Thus, we expect that managers of buyout firms with different foci (control rights versus long-term performance) may choose different types of PE firms. For example, if managers of buyout firms emphasize future control rights, they should collaborate with short-term efficiency-oriented players because they focus on relatively short-term investment horizons and seek “liquidity events” when the time is right (Wruck, 2008). However, if executives of buyout firms prefer long-term investors and do not attach much importance to control rights, they should seek investment from Quadrants II and III because these two types of PE firms are committed to buyout firms by assisting managers in developing the correct longer-term strategies. We believe that it is of the utmost importance to understand the implications of buyout firm managers’ perceptions of PE investments in their co-operative strategies with PE firms through further studies across different institutional environments.

The above discussion suggests that the new environment requires managers of different PE firms to understand the nature of a globalization strategy and to seek deal syndications that fit their strategic intent. Correspondingly, managers of PE investors, banks, and 244portfolio firms should also choose an appropriate PE firm to match their goals and align the interests of both parties. Different strategic orientations of PE firms not only have a profound impact on managers of both PE firms and buyout firms but also reveal important implications for policy makers.

Public policy issues

The previous section discussed how managers can better cope with the changing environment in the PE industry. In this section, we discuss the implications of our conceptual framework for public policy makers in developed and emerging economies. In developed economies, one of the many public policy issues regarding the PE industry is whether tax benefits generated from high levels of debt should be monitored by regulators, as high levels of debt also generate high risks for portfolio firms. The past few years have witnessed increasing public criticism about how PE firms saddle portfolio firms with debt to take advantage of the tax code’s treatment of debt (The Economist, 2012a) and may put portfolio firms at excessive risk. By revealing the variety and heterogeneity of PE firms, we suggest that public policy makers should avoid being overly influenced by public attitude and should be cautious relative to public accusations about PE firms. In fact, research by Wright et al. (2014) suggests that bankruptcies and recovery risks are no greater for PE firms than for other firms with similar capital structures.

As we revealed in the conceptual framework, PE firms differ from each other according to their financial structure emphasis and portfolio firm scope. For example, niche players with long-term equity positions (Quadrant II) and diversified players with focused groups of portfolio firms (Quadrant III) typically adopt a higher level of equity investments and are less likely to equip their portfolio firms with high levels of debt. Instead, they provide not only equity investment but also professional guidance to their portfolio firms. Therefore, public policy makers in developed markets should avoid succumbing to public pressures stemming from the belief that PE firms generate systematic risks for portfolio firms due to overuse of high leverage, and should avoid enacting restrictive regulation on PE firms. In fact, it is important for public policy makers in developed economies to realize that PE firms have in general shifted their focus from financial engineering in the 1980s to more focus on operational engineering. Also, recent research suggests that PE ownership and therefore involvement in a deal suggests deal quality to the market, especially in cross-border acquisitions (Humphery-Jenner et al., 2017). Not only PE firms in Quadrants II and III, which have relatively more equity investment, but also PE firms in Quadrants I and IV employ more professional talent to deal with environmental uncertainty. In sum, it is important for public policy makers in developed economies to conduct a thorough investigation and have a deep understanding of the heterogeneity of PE firms and their adaptation to the environment, and hence avoid making policy mistakes.

As an increasing number of PE firms embark on the path of internationalization, how public policy makers in emerging markets react to those large PE firms’ foreign entrants becomes an important issue. Again, we emphasize how important it is for public policy makers in emerging markets to understand the heterogeneity among PE firms’ strategic orientations (Klonowski, 2011). While they may be skeptical of PE firms in Quadrants I and IV, since these PE firms are short-term-oriented and focus on turning around distressed firms fast, we suggest that these policy makers need to consider the inherent advantages and disadvantages of each type of PE firm. For example, short-term efficiency niche players and short-term diversified efficiency-oriented players, due to their reliance on debt and their 245emphasis on reducing agency costs, play an indispensable role in “deepening and broadening the private sector” in emerging economies (Leeds & Sunderland, 2003: 113) and hence benefit mature firms in traditional manufacturing industries by enhancing the portfolio firms’ corporate governance and reducing agency costs. They also need to be aware that some PE players are more long-term-oriented, with distinct operational capabilities in their specific or narrowly scoped industries (PE firms in Quadrants II and III). As such, they may provide more benefits for new ventures or growing firms in high-tech industries in emerging economies. By enacting policies that are flexible and therefore favorable to all PE firm types, their associated functions would be effective in realizing public policy makers’ goals to stimulate healthy growth of domestic PE investments.

Another issue that needs further research is the influence of monetary policy on interest rates and how interest rates foster more or less development of the PE industry and their relative strategic positions. Given the different financial structures used by PE firms, easy money may not always foster PE firm demand with lower interest rates because some PE firms have a relatively high emphasis on equity versus debt.

Conclusion

Although a significant number of studies on PE investments have examined PE firm impact on portfolio firm performance, an assessment of the strategies pursued by independent PE firms was lacking. Therefore, the intent of this study was to examine the evolution of PE firms and specify the current nature of PE firms’ strategic positioning. At the same time, we have sought to describe four ideal types of PE firms and provide examples of PE firms that represent positioning along two dimensions: financial structure emphasis and diversified portfolio firm scope. We also reviewed and discussed what theoretical perspectives might be helpful to enrich our insight into PE firms. In addition, we addressed the importance of considering heterogeneous strategic positioning among PE firms, for managers of PE firms and buyout firms as well as for public policy makers in developed and emerging economies. We hope that our treatise can represent a further step to enrich the understanding of PE firms as a financial service sector that is unique and critical to the global economy.

Notes

  1    The chapter is adapted from an article originally published in the Academy of Management Perspectives (Hoskisson et al., 2013).

  2    Note that we are focused on later-stage PE firms (formerly known as LBO associations) rather than on early-stage PE firms (often labeled venture capital firms).

  3    In addition to PE business, Bain Capital has other investment businesses, such as early-stage venture capital. In this chapter, however, we focus on its late-stage PE business.

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