"I create nothing. I own." - Gordon Gekko, Wall Street, 1987
Gordon Gekko, the fictional poster-child of private equity in the 1980s, got rich through financial engineering; fracturing companies and selling them off for more than the sum of their parts. Oh, and there was also that insider trading thing he had going. The movie, Wall Street, and its main antagonist were emblematic of the destruction, not innovation, which was the order of the day on the Wall Street of 1987. Thirty years later, the question remains, “Do private equity firms provoke innovation or prevent it?”
On the one hand, if you are looking for uncommon innovation…the world changing, balls-to-the-wall, transformational kind…you probably won’t go searching in a private equity buyout fund’s portfolio of companies.
On the other hand, these days you might be missing something if you don’t.
LBOs and Oreos
On the heels of the movie, Wall Street, my impression of Private Equity was further shaped by the gargantuan buyout of RJR Nabisco by Kohlberg, Kravis, Roberts & Company (KKR) in 1988. The fate of Nabisco’s “Double Stuf Oreos” was at stake, so naturally the deal had my full attention.
The way I actually learned the salacious innards of the $24 billion buyout was through the gripping chronicle, Barbarians at the Gate: The Fall of RJR Nabisco. Still hailed as one of the best business books of all time, Barbarians was penned by two Wall Street Journal writers, Bryan Burrough and John Helyar. The book indelibly branded the LBO realm as a greed-fueled frenzy of over-leveraged alpha dogs. The RJR Nabisco deal marked not only the biggest private equity deal at the time, it marked the beginning of the end of RJR Nabisco.
Fast-forward thirty years and shift the scene from New York to a greasy spoon in Atlanta. John Helyar and I chase scrambled eggs around slippery plates as he recounts the KKR|RJR LBO and its impact on the company’s innovation. Helyar says, “The enormous pressure to service debt forced the company to slash and streamline. The focus wasn’t on innovation. Much of that was stopped – like the smokeless cigarette project they had was gone right away. In the 90s they were doing work on finding helpful pharmaceutical uses of nicotine but that R&D got spun out as a separate business. The main focus was on cost cutting and tightening operations. Meanwhile, arch competitor Philip Morris used that time to stretch its market share lead while the price of RJR stock dropped.”
A decade after the storming Barbarians, the reign of RJR Nabisco ceased for good. “End Of An Empire: The Overview; RJR Nabisco Splits Tobacco Ventures And Food Business,” read the March 1999 New York Times article announcing the break-up. Another ten years later, Burrough and Helyar wrote this in the afterward to the re-released version of their iconic book: “Be assured, that the Barbarians are (still) out there just beyond the gate, licking their wounds, biding their time, waiting for their next chance to storm the gates.”
Private Equity is a Buy-to-Sell Game
Firms mostly prefer to hold the companies they buy for five to six years (maybe up to ten years for the very patient) before hopefully exiting them for a tidy profit. That time compressed resale requirement might provoke think-fast innovation but too much pressure on management to perform under high debt anxiety may also fatigue a team and cripple new ideas.
“Since investment performance as measured by internal rate of return decreases with time, there is an urgency created that brings growth to the forefront and spurs innovation,” says Alex Mammen, founder of the PE firm, Heritage Growth Partners. “While all this sounds great, that same pressure for speed of innovation and rapid growth can also lead to short-term thinking and squelching innovation that requires big upfront or multi-year investment or may have a longer-term payoff beyond the investment window.”
Ira Genser is a Partner at Operating Advisory Group providing hands-on consulting and leadership support to Comvest Partners' portfolio companies. “Private equity may stimulate innovation immediately after the initial investment is made,” Genser says. “That’s when they are most likely to support new ideas, new markets, and new products. Once the hold period reaches three years or more, the appetite diminishes significantly as they prepare for an exit,” he says.
Is The Proof In The Patents?
Proponents of private equity say that time pressure provokes innovation. There is some relatively recent research that may corroborate the claim - that is, if you consider patents to be a proxy for innovation. Several European academics studied the quantity and quality of patents produced by PE-backed companies compared to others. They found that PE portfolio companies produced more high quality patents in the same time period relative to their non-PE peers. The researchers didn't draw direct conclusions as to what it was about PE investment that led to the profusion of patents. Correlation doesn't imply causality, as they say. But it doesn't NOT imply it either.
It is possible that the right amount of time pressure may just cause individual inventors in PE portfolio companies to produce more...because intelligent constraints can drive creativity. It is also possible that there's a different explanation. John Bacon is Chairman of the innovation consultancy IP2Biz and a faculty member for I-Corps, a national science foundation initiative which prepares scientists and engineers to extend their focus beyond the laboratory and into the commercial marketplace. "Private equity backed companies may file more patents, but they are not of high quality," Bacon says. "They are ammunition for litigation borne from culling through development efforts before the deal closed."
What happens to innovation when private equity firms hold their investments longer? We’re finding out now. Since the Great Recession, private equity firms are keeping their portfolio companies for longer periods. Middle market PE firms’ average holding periods rose to 6+ years following the Great Recession – up from a pre-downturn length of under 4 years. And, while hold times have dropped a bit recently, they remain much higher than pre-2008 numbers.
It is possible that longer PE holding periods will be the new normal. Actually, “Several big firms are raising new buyout funds that can invest in companies for up to 20 years — more than twice the period they've typically held onto investments in the past,” according to a recent Business Insider report. If you set aside the patent research (above) and assume that extreme time pressure is an innovation depressant, this trend bodes well since longer retention periods provide more opportunity for PE firms to provoke new ideas, products and processes in their portfolio companies.