Competitive Effects of Private Equity Investments

1. Competitive Effects of Private Equity Investments SCOTT HSU ADAM REED JÖRG ROCHOLL UNIV. OF WISCONSIN UNC-CHAPEL HILL ESMT MILWAUKEE National Taiwan University December 30, 2011

2. Why IsPrivate Equity (PE) Relevant? A Case Study • Mitt Romney, candidate for GOP president nomination, was the co-founder of Bain Capital, a PE firm. • His PE background was deemed as a liability, or at best irrelevant to the presidency. • But some disagree—his PE experience is relevant and valuable! • Value adding—PE funds earn 20% more than the market index; Under his tenure, Bain was the top performer. • Source: PE firms are good at cutting costs, making companies more productive, innovative, and efficient. • http://www.bloomberg.com/news/2011-12-15/romney-honed-right-skills-in-private-equity-commentary-by-steven-kaplan.html

3. Private Equity Investments (私募股權投資) • A form of investment in equity securities not publicly traded on the stock exchange. • Leveraged buyouts (LBOs): A deal acquired using a small portion of equity/a large portion of outside debts. • Who are private equity (PE) investors? • A specialized investment firm that builds several PE funds: • Limited partnerships with a 10-year contractual life. • General partners (GPs) run the fund; limited partners (LPs) provide capital. • The LPs include endowment funds, pension funds, insurance companies, and wealthy individuals.

4. Motivation • Academic attention on the performance of private equity (PE) investments. • Jensen (1989); Kaplan (1989); Guo, Hotchkiss, and Song (2009), among others. • What are the effects of private equity investments on existing firms in the industry? • Implications for investors and competitors. • Bernstein, Lerner, Sorensen, and Stromberg (2010) call for research into this question. • Competitive effects: PE-backed firms have competitive advantages over industry rivals.

5. What Makes PE Investments More Competitive? • The competitive advantages of PE investments over industry rivals: • PE investors’ industry expertise (Kaplan and Stromberg, 2009; Acharya, Hahn, and Kehoe, 2008). • Enhanced managerial incentives (Leslie and Oyer, 2009). • Better corporate governance (Acharya, Hahn, and Kehoe, 2008). • More innovative (Lerner, Sorensen, and Stromberg, 2011). • Better operating efficiency (Kaplan and Stromberg, 2009). These advantages affect the cross-sectional performance of industry competitors around and after the PE investments.

6. Main Results I • Industry competitors experience declining performance around and after the announcement of private equity investments: • Rivals experience negative abnormal stock returns around the announcement and completion dates, but positive abnormal stock returns around the withdrawal date of PE investments. • Significant deterioration in stock returns, M/B ratio and operating performance after the announcement of PE investments.

7. Main Results II • Factors that affect the cross-sectional underperformance of industry competitors: • Industry expertise of PE investors. • Managerial incentives. • Corporate governance. • Technological innovations. • Operating efficiency (cost savings). These factors impact both the announcement returns and values of industry competitors after the PE investments.

8. A Case Study: Aleris International Inc. CAR Aleris’ Competitors Event Date Aleris InternationalEvent Date:   Aug 7, 2006Bought by: Private Equity Firm Texas Pacific Group for 2.34 billion

9. Data Data on Private Equity Investments • Capital IQ • Identify deals whose acquirers are private equity investors; transaction values higher than $10 million. • For event studies:13,089 completed/212 withdrawn U.S. PE investments from 1980 to 2008 in 68 6-digit GICS industries. • For long-term analyses: 178 selected PE investments based on a rolling window selection mechanism described later. Data on Industry Competitors • Identify industry rival firms associated with the PE investments in the same 6- digit GICS industry. • 14,288 firms associated with 178 PE investments. • Firms’ accounting information from Compustat; Stock returns data from CRSP.

10. PE Sample Selection and Contamination • For analysis on competitors’ short-term reactions to PE investments, include as many PE investments as possible—13,089 completed and 212 withdrawn PE investments. • For analysis on competitors’ long-term reactions, the above sample creates a problem. • Observe multiple PE investments in a year in the same industry. • Analysis could be contaminated by the impact of other PE investments in the same industry.

11. Sample Selection: An Illustration 6-Year Rolling Window N=178

12. Selection for Rivals’ Long-Term Reactions • Identify the PE investments with the largest transaction value of the year in a given 6-digit Global Industry Classification Standard (GICS) industry. Bhojraj, Lee, and Oler (2003) find that the GICS classification is significantly better than other industry classifications such as SIC and NAICS. • Choose the largest PE investment that is the local maximum in a time-series sense. PE investments that are not preceded or followed by a larger PE investment in the same 6-digit GICS industry in a 3-year window before and after the announcement date. • Obtain 178 PE investments.

13. Selection for Rivals’ Long-Term Reactions Disadvantages Events not distributed evenly over time. Events not distributed evenly across industries. Small Sample Advantages Uncontaminated sample Maximum use of data No arbitrarily defined date ranges Relatively smooth distribution of events in time

14. Competitors’ CARs (around announcement, completion, and withdrawal)

15. Operating PerformanceRivals’ Reactions to 178 PE Events

16. Can We Add Controls? Yes: Panel regressions Control for clustered standard errors.

17. Hypotheses:What Makes PE Investments More Competitive?

18. Do Specific Competitive Pressures Explain the Cross Section of Rivals’ CARs? Dependent Variables: Industry Competitors’ CAR (-5, 10) Other control variables: Firm Asset, Firm Age, M/B ratio, Market Cap, Leverage, Sentiment Index, Herfindahl Index, M&A Dummy, Public Dummy, Majority Stake Dummy; Robust standard errors.

19. Do Specific Competitive Pressures Explain the Change in Rivals’ Market Value? Dependent Variables: Log(M/B After PE)-Log(M/B Before PE) Other control variables: Firm Asset, Firm Age, M/B ratio, Market Cap, Leverage, Sentiment Index, Herfindahl Index, M&A Dummy, Public Dummy, Majority Stake Dummy; Robust standard errors.

20. Calendar-Time Portfolio Approach • Rolling window approach reduces the number of PE investments that occur in clusters in time. • Form calendar-time portfolios that hold long the sample of 1,752 public PE investments (out of 13,089) and hold short their competitors. • Use the Fama-French Three Factor and Carhart Four Factor Model:

21. Robustness Tests • Alternative definitions of industry competitors. • Five alternative hypotheses that drive the main results. • PE investment premium. • Company visibility. • Industry visibility. • Financial strength. • Deep pockets. • Alternative definition of PE investments.

22. Conclusions This paper: • Documents the competitive effects of PE investments on their industry competitors. • Negative stock price reactions to announcements of PE transactions. • Deterioration in operating performance after the PE transactions. • Investigates the causes of underperformance of industry competitors after the PE transactions. • The specialization of PE investors • Corporate governance • Managerial incentives • Technological innovations • Operating efficiency • The results are robust to controlling for alternative hypotheses. • Has implications for investors in assessing the risk and return in industries with potential PE transactions.