Download The Impact of Private Equity on Job Growth

The Impact of
Private Equity on Job Growth
July 2012
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The Impact of Private Equity on Job Growth
John E. Surrette, Jr., CPA, CFE, MBA, Principal and Chair of the KLR Private Equity and
Venture Capital Services Group
July 2012
Over the past few years, the private equity industry has been thrust into the spotlight in a variety
of ways, many of which tend to be negative. For those who do not understand how the industry
works and what its purpose is, it is easy to see why it can at times be viewed in this fashion.
Given our extensive experience working with both private equity firms and their portfolio
companies, we thought it would be important to highlight some of the positive attributes of the
industry and the impact it has had on the economy.
One of the facts that is often overlooked is that private equity (PE) firms have been catalysts for
the turnaround of many well-known brands over the years. These are brands that were suffering
and on the verge of bankruptcy prior to being revitalized after purchase by a PE firm. These
companies would most likely not exist today without the investments made by these firms.
From Hertz to Continental Airlines to Staples to Snapple, previously fledgling businesses have
turned to PE firms for salvation, and because of certain incentives to succeed, PE-backed
companies are generally more successful at creating new jobs and increasing sales, as The Wall
Street Journal explains.
PE firms prefer to make investments in companies that underperform industry peers, because
they can generally be bought at a discount, which increases the probability of turning a profit.
Many times these businesses are on the brink of failure and need the PE firm to help facilitate
growth. Success rates among PE-backed companies are so high because firms only make money
if they improve the performance of the companies they invest in.
"Private equity firms don't make a profit unless their companies can meet their obligations to
workers and other creditors," the news source states. By facilitating economic growth and
providing crucial seed money, PE firms set the stage for these once-promising enterprises to
return to relevancy.
Much of the profit gained by PE firms comes after they revitalize a struggling company and take
it public, selling its shares and helping it grow even further, or selling it to a strategic or other
financial investor. Consider this similar to how "house flippers" revamp dilapidated buildings
and hope to resell them for profit.
PE investors generally employ a three-step process to "flipping" a business back into prosperity,
A. T. Kearny, a global management consulting firm, points out in a recent report.
First, after a purchase is made, there is what's called a "first 100 days" program that is launched
right after ownership transfer. Beyond moving on basic financial engineering strategies, PE firms
enact other performance-improving tactics such as salary restructuring, strategic sourcing,
general and administrative costs consolidation, production network optimization and inventory
management.
The next step is to reduce the complexity that may have led to muddled market value and poor
customer retention, and focus instead on a company's core competencies. For instance, on a
business level, this may include separating or integrating with other firms. On a value level,
firms may outsource noncompetitive processes. On a product level, successful products may be
pushed while weaker ones are discontinued.
Finally, the PE firm identifies add-ons (mergers and acquisitions, innovation and sales alliances,
etc.) and expands upon neglected resources, focusing on enhancing margins and improving
competitive position.
Although this process may initially lead to some job loss at the target company, it is a necessary
part of the process to bring a company back to prosperity. This generally leads to a company
regaining its competitive advantage, resulting in job growth and other positive economic
benefits.
Regarding risk, Bloomberg Businessweek explains that one of the reasons PE firms generate
better results than corporate executives is because the latter group fears failure. Failure generally
has a negative impact on the careers of executives and is awkward to explain to shareholders.
"Too often, executives forget to think like capitalists and look for opportunities to buy in at a low
point," Stuart E. Jackson writes for the magazine.
One specific example of where risk stunted the success of corporate buyers is Snapple's 1992
buyout by a Boston-based PE firm for $143 million, notes Businessweek. Snapple had become
moderately successful in its "cold channel" niche, laying the groundwork with a network of
independent distributors that placed the brand in thousands of mom-and-pop stores and coffee
shops. The PE firm took the company public.
Shortly after, it was purchased by Quaker Oats Co., the company that owned Gatorade. With the
intent to replicate Gatorade's "blueprint," Snapple was placed in supermarkets, but failed
miserably when it had to compete with larger brands such as Coca-Cola and Pepsi, costing
Quaker $100 million over three years. In turmoil, Quaker unloaded Snapple to another
investment firm for $300 million. The group placed Snapple back into its original cold channel
niche, eventually selling it to Cadbury Schweppes in 2000 for $1.4 billion, and turning a hefty
profit.
In the end, Snapple's corporate owners lost a combined $1.9 million, while its PE owners
realized a $2.6 billion gain. The two times it was sold to PEs (in 1992 and 1997), corporate
buyers considered the struggling brand too risky to invest in, so PE firms took the lead and
turned the company around.
Looking at a vast collection of data from between 1995 and 2009, GrowthEconomy.org - a
website recently launched by the Association for Corporate Growth - analyzed the impact of
private capital investment on middle-market businesses in the U.S. economy, finding that in
general, they vastly outperformed non private capital-backed companies.
For instance, PE-backed companies saw 81.5 percent job
growth over that time period – 24.1 percent of which came
from new openings, with 56.3 percent coming from expansion
- compared to 11.7 percent of other companies. By that same
token, sales grew for PE-backed companies by 132.8 percent
during the same period, compared to just 28 percent of others.
According to the site, PE-backed businesses also created more
than twice the number of new jobs than any other employment
stage, and showed more annual relative growth every year
except for one, compared to the general U.S. economy.
"Certainly when private equity firms play the role of turnaround specialists they can make
companies, and even whole industries, more competitive," USA Today explains. Citing a 2008
Government Accountability Office report, WSJ adds that companies in which PE firms invested
had low employee growth prior to being purchased, only to see it grow substantially after
acquisition.
"The GAO's private equity report observed that academic research generally suggests that recent
private equity LBOs [leveraged buyouts] have had a positive impact on the financial
performance of the acquired companies," the media outlet reports.
Other high-profile success stories of PE buyouts include office supply store Staples, which in
1986 used PE funding to grow beyond its first store to its current total of more than 2,000 - with
approximately 90,000 employees in all, as USA Today notes.
Continental Airlines, which was bought out in 1993 by a Texas-based PE group headquartered in
Fort Worth, was bankrupt at the time following labor disputes and recessive economic
conditions. Funding Universe explains that while many investors felt the investment to be too
risky, the Texas PE firm turned the company around by bringing in a new management team,
improving aircraft utilization and focusing on more lucrative routes. By 1997, Continental’s
operating income had reached $716 million – up from a loss of $108 million during the year
prior to the buyout.
There's also car rental business Hertz, whose parent company Ford sold it to private equity
investors for $14 billion in 2005, The New York Times reports. Less than one year later, Hertz
went public with an equity valuation of $17 billion.
In his analysis of the Hertz buyout, the author of the NYT article, Andrew Ross Sorkin, returns
to the idea that executives' inability to take risks ends up costing them in the long run.
"Perhaps most crucially, management often does not have the same incentives as a private equity
owner to pursue such drastic change," Sorkin states. "At public companies, which seek to deliver
steady returns to shareholders, executives are often rewarded for playing it safe. At a private
equity-owned business, the system favors risk-taking: Management can earn huge pay packages
if turnarounds succeed - and face quick dismissal if the status quo continues."
Earlier this year we wrote about the debate on carried interest, and the impact changes to the
current tax code could have on private equity investment. Changes to the tax code, as well as
other regulatory and governmental changes, are certainly components of the risks that private
equity firms analyze and accept on a regular basis. Not all investments made by these firms turn
into winners, but this asset class has consistently outperformed the general market. This is
directly attributed to the risks these firms take in their investments, and the ultimate reward for
their stakeholders. These stakeholders not only include the individuals and institutions investing
in their funds, but also every single employee who works at their portfolio companies.
Despite the fact that PE investment for 2011 was in line with 2010, the beginning of 2012 has
been a little quieter, according to PitchBook’s Private Equity Trends 2nd Quarter, 2012 report.
That doesn’t necessarily mean 2012 will be a down year, but it could certainly be pointing to an
uptick in activity in the third and fourth quarters of this year. Based on the data presented above,
increased PE investment would most likely have a positive impact on the economy as a whole.
Over the past several years, KLR has become a trusted advisor to the industry during all phases
of the transactional cycle. Our deep understanding of the financial markets and numerous
industries allows us to bring a level of experience that the industry requires. Please visit our
website at kahnlitwin.com to learn more about our Private Equity Services Group and the
services we offer.
Sources:
http://www.nytimes.com/2007/09/23/business/23hertz.html?_r=1&ref=business
http://online.wsj.com/article/SB10001424052970204124204577154521024107002.html
http://www.usatoday.com/news/opinion/editorials/story/2012-01-15/Mitt-Romney-BainCapital/52585400/1
http://www.atkearney.com/index.php/Publications/creating-new-jobs-and-value-with-privateequity-ea.html
http://www.businessweek.com/managing/content/may2011/ca20110523_371746.htm
http://articles.businessinsider.com/2012-01-10/wall_street/30610824_1_private-equity-patriotnational-bank-fdic
http://www.prweb.com/releases/2012/4/prweb9438817.htm
http://growtheconomy.org/growthsummary.lasso?state=US&year1=1995&year2=2009
http://www.fundinguniverse.com/company-histories/texas-pacific-group-inc-history/
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