Public to Private LBOs and Innovation

Public to Private LBOs and Innovation

A new study considers the proposition that indebtedness can reduce innovation. It offers support for the view that indebtedness in a particular context reduces patent flow. But whether patent flow should be considered a good surrogate for innovation remains open to question.

An argument that has long been aimed at the private equity industry is that it harms innovation by buying publicly traded firms, taking them private, restructuring them and putting them on the auction block. The restructured firms, burdened with debt by this process, don’t spend the money necessary for research and development, and indeed if they have a portfolio of patents to sell to raise cash.

Escaping Regulation

Authors Brian Ayash and Edward Egan say that in the 1980s the PE industry only narrowed escaped heightened oversight and regulation in the United States. It escaped largely because the targets of LBOs “were deemed not particularly innovative and so the concerns were moot.”

The PE industry has thrived since then, and it does a lot of business that bears little or no resemblance to the sort of deal that then made it notorious. But that leaves us with the question: was the original charge regarding the public-to-private deals accurate?

Brian Ayash is assistant professor of finance at California Polytechnic State University, Orfalea College of Business. He is also a certified public accountant, chartered financial analyst, and certified insolvency and restructuring advisor. Edward Egan is an assistant professor at Georgetown University, McDonough School of Business, as well as a venture capitalist and serial entrepreneur.

They begin their paper with an observation about the size of the industry. In 2018, PE funds raised more than $700 billion, which is “roughly equivalent to the annual gross state product of Pennsylvania.” Furthermore, since the 1980s PE firms have moved their activity into more innovative industries. So, if taking a company private does have a deleterious effect on innovation, that fact would be more harmful to the broader economy now than it would have been then.

Along with looking at the patent portfolios of PE/LBO targets, Ayash and Egan look at the related issue of research and development spending. They find that “there is no statistically significant change in R&D expenditure in our sample” as a consequence of the buyout. PE firms seem to target companies with low levels of R&D in the first place, and they keep those levels low.

Patent Flow

As to patents, these authors find the following:

  • LBO targets are neither more nor less likely than non-targets to hold patents;
  • Publicly traded LBO targets hold significantly more patents than other firms;
  • LBOs reduce patent flows—the acquired firms receive fewer grants, and also buy fewer patents, then in their pre-acquisition days;
  • The acquired firms do often sell off a large portion of their patent portfolio after buyout; and
  • They thereafter receive patents at a reduced rate.

What about private-to-private transactions? That is, do the same results hold true if a PE firm buys a portfolio company privately, restructures it, then sells it … again privately? No. Ayash and Egan favorably cite earlier work on this point to the effect that these transactions are typically associated with an increase in patent grants.

A Case for Regulation?

Before politicians run with this football, it should be said: this conclusion (assuming it holds up under scrutiny) will not establish that the reduction of innovation as measured via patents is a bad thing, that is: it will not require Congressional action to stop the buyout or get the patent numbers back up. Innovation might have to mean something other than, and sometimes at odds with, the size of the patent flow.

One hypothesis that might explain the Ayash/Egan data is this: some firms, inclusive of some of the smaller companies in the universe of public listings, acquire more patents than they have any use for, perhaps as an extension of the ego of the managers. This, if true, is an “agency” problem. It means that the managers of such a company are failing to serve as proper agents of the passive shareholders. Such firms (on this hypothesis) become ripe targets for takeover, precisely due to their agency problems as expressed in that overstocked patent portfolio.

Ayash and Egan find some support for the agency interpretation of their data. They conclude that the answer to their original question, whether PE-driven LBOs harm innovation, must be “nuanced” and “depends on the definition of innovation.”

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