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The Impact of Private Equity on Job Growth July 2012 www.KahnLitwin.com Boston ♦ Newport ♦ Providence ♦ Waltham 888-KLR-8557 ♦[email protected] 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/ This publication contains general information only and is based on the experiences and research of Kahn, Litwin, Renza & Co., Ltd. (KLR) practitioners. Any statements contained herein are not intended or written by KLR to be used, and nothing contained herein can be used, by you or any other person, for the purpose of avoiding penalties that may be imposed under federal tax law. KLR is not, by means of this publication, rendering business, financial, investment, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified trusted advisor. KLR, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication. Please see www.kahnlitwin.com for a detailed description of Kahn, Litwin, Renza & Co., Ltd. Copyright © 2012 Kahn, Litwin, Renza & Co., Ltd. All rights reserved.