Who does private equity buy? Evidence on the role of private equity from buyouts of divested businesses

• Date: 01 May 2018
• DOI: http://doi.org/10.1002/smj.2759
• Published date: 01 May 2018
• Author: Harbir Singh,Aseem Kaul,Paul Nary

RESEARCH ARTICLE

Who does private equity buy? Evidence on the role

of private equity from buyouts of divested

businesses

Aseem Kaul

1

| Paul Nary

1

| Harbir Singh

2

1

Strategic Management and Entrepreneurship

Department, Carlson School of Management,

University of Minnesota, Minneapolis, Minnesota

2

Management Department, Wharton School,

University of Pennsylvania, Philadelphia,

Pennsylvania

Correspondence

Aseem Kaul, Carlson School of Management,

University of Minnesota, 321, 19th Avenue South,

Minneapolis MN 55455.

Email: akaul@umn.edu

Research Summary: We examine the role of nonventure

private equity firms in the market for divested businesses,

comparing targets bought by such firms to those bought

by corporate acquirers. We argue that a combination of

vigilant monitoring, high-powered incentives, patient cap-

ital, and business independence makes private equity

firms uniquely suited to correcting underinvestment prob-

lems in public corporations, and that they will therefore

systematically target divested businesses that are outside

their parents’core area, whose rivals invest more in long-

term strategic assets than their parents, and whose parents

have weak managerial incentives both overall and at the

divisional level. Results from a sample of 1,711 divest-

ments confirm these predictions. Our study contributes to

our understanding of private equity ownership, highlight-

ing its advantage as an alternate governance form.

Managerial Summary: Private equity firms are often por-

trayed as destroyers of corporate value, raiding estab-

lished companies in pursuit of short-term gain. In

contrast, we argue that private equity investors help to

revitalize businesses by enabling investments in long-

term strategic resources and capabilities that they are bet-

ter able to evaluate, monitor, and support than public

market investors. Consistent with these arguments, we

find that when acquiring businesses divested by public

corporations, private equity firms are more likely to buy

units outside the parent's core area, those whose peers

invest more in R&D than their parents, and those whose

parents have weak managerial incentives, especially at

the divisional level. Thus, private equity firms systemati-

cally target those businesses that may fail to realize their

full potential under public ownership.

Received: 14 November 2015 Revised: 4 December 2017 Accepted: 5 December 2017 Published on: 30 January 2018

DOI: 10.1002/smj.2759

1268 Copyright © 2017 John Wiley & Sons, Ltd. wileyonlinelibrary.com/journal/smj Strat Mgmt J. 2018;39:1268–1298.

KEYWORDS

buyout, corporate governance, divestiture, private

equity, underinvestment

1|INTRODUCTION

Buyouts by private equity (PE) firms are an increasingly important phenomenon of the contempo-

rary corporate landscape, one that has attracted growing interest in the strategy literature

(Castellaneta & Gottschalg, 2016; Hoskisson, Shi, Yi, & Jin, 2013; Seth & Easterwood, 1993; Wier-

sema & Liebeskind, 1995). Early accounts of buyouts highlighted their role in disciplining managers

(Jensen, 1986; Williamson, 1988) and correcting value-destroying diversification (Berger & Ofek,

1996), and warned that the short-term focus of private equity buyers might have adverse long-term

consequences (Fox & Marcus, 1992; Long & Ravenscraft, 1993). In contrast to this view, private

equity investors themselves identify “growth in the value of the underlying business”as the most

important driver of the deals they make (Gompers, Kaplan, & Mukharlyamov, 2015), and

researchers have found little evidence of a short-term orientation among PE investors (Harford &

Kolasinksi, 2014; Smith, 1990), with studies showing that many buyouts, especially those involving

smaller targets, are held for substantial periods of time (Kaplan & Stromberg, 2009; Wright, Robbie,

Thompson, & Starkey, 1994). This has led scholars to argue for an entrepreneurial role for buyouts

(Berg & Gottschalg, 2005; Wright, Hoskisson, Busenitz, & Dial, 2000), with empirical evidence

confirming that the positive effects of buyouts are associated with long-term improvements in pro-

ductivity (Harris, Siegel, & Wright, 2005; Lichtenberg & Siegel, 1990), performance (Cumming,

Siegel, & Wright, 2007; Palepu, 1990), monitoring and incentives (Guo, Hotchkiss, & Song, 2011;

Holthausen & Larcker, 1996), and innovation (Holthausen & Larcker, 1996; Rubera & Tellis, 2014;

Zahra, 1995). There is thus a need for a stronger theoretical account of the role of PE firms.

Existing research has also paid relatively little attention to the nature of targets that PE firms pur-

sue, focusing more on the performance consequences of buyouts. A few early inquiries (Maupin,

1987; Singh, 1990) aside, hardly any studies have looked at the antecedents of buyouts. There is

also limited work examining divisional buyouts, that is, buyouts of businesses divested from a larger

firm (Hite & Vetsuypens, 1989; Meuleman, Amess, Wright, & Scholes, 2009), with most studies

focusing on buyouts of stand-alone firms. Yet empirical evidence shows that divisional buyouts are

the modal transaction type (Cumming et al., 2007; Kaplan & Stromberg, 2009), and that PE firms

account for a substantial proportion of acquisitions of divested businesses (Berger & Ofek, 1996).

Understanding which businesses PE firms target may thus help enhance our understanding of the

strategies of PE firms, and the role they play relative to corporate acquirers.

Our study is an attempt to explore the attributes of businesses bought by private equity firms,

and to compare target choices of PE firms versus corporate buyers. Theoretically, we contend that

PE ownership is a unique governance form designed to address situations where incentive alignment

with public equity markets may fail to ensure adequate investments in long-term specialized assets

(Williamson, 1988, 1990). Publicly owned firms may suffer from problems of coordination costs,

myopia, and low-powered incentives (Graham, Harvey, & Rajgopal, 2005; Markides, 1992; Wil-

liamson, 1985; Zhang & Gimeno, 2010), which may cause them to underinvest in potentially

KAUL ET AL.1269