Industry specialization of private equity firms: a source of buy-out performance heterogeneity

Abstract

This study sheds new light on the industry specialization of private equity (PE) firms as a source of buy-outs’ performance and on the conditions under which these firms can add value to the buy-outs in which they invest. Advantages to specialization are based on specific resources and capabilities that confer the PE funds advantages both in the pre- and post-transaction phases. We argue that the magnitude of the advantages to industry specialization will depend on the criticality of these specific resources for buy-outs’ performance improvements. Industry specialization will confer advantages when the target company is weakly or strongly performing before the buy-out because, in that context, performance improvements are more difficult to reach. The analysis is based on a sample of 217 PE-backed buy-outs completed in France between 2001 and 2007. The results show that relative specialization in the industry of the buy-out company results in profit increases of 7.5% greater than buy-outs backed by non-industry-specialized PE firms. Industry specialization also contributes to target company growth, especially when performance improvements are difficult to reach. Besides, the magnitude of the positive industry specialization effect varies between PE firms. This result emphasizes industry specialization as a strategic variable by illustrating heterogeneity in the ability to construct a competitive advantage.

Keywords:

• Industry specialization
• leveraged buy-outs
• operating performance
• private equity firms
• strategic entrepreneurship

Acknowledgement

The authors would like to thank Alina-Maria Cotoros (Msc) for gathering the data and two anonymous reviewers for their valuable comments.

Notes

1. In this paper, we define operating profit margin as EBITDA margin. Cash-flow is also a good proxy for value creation but we do not have access to cash flows of investee firms.

2. The paper does not focus on actual returns of PE firms.

3. In some cases, turnover growth will not lead to potential value creation if firm grows through acquisitions but EBITDA margin falls. Turnover growth is nevertheless important for buy-out’s performance because it can convert into market share, which in turn is highly valued by strategic investors at the time of an exit. We are grateful to an anonymous referee for pointing this out.

4. We allowed Deal leverage to change between PE firms because this variable plays a theoretical role in LBOs. The large amount of debt incurred in the typical LBO transaction should impose significant financial discipline on company management, thus becoming an important driver for efficiency gains post LBO (Cressy, Munari, and Malipiero 2007; Jensen 1989). It may be that the effect of deal leverage on LBO targets’ operating performance is PE firm-specific if PE firms are endowed with different level of (governance and financial engineering) capabilities that are complementary to deal leverage.

5. Figure 1 shows mean estimated values of change in performance metrics obtained from Model 2. In this study, we do not aim at measuring the effect on targets’ performance of LBOs in comparison with non-LBO companies. Our goal is to measure the extra growth or operating performance brought by the industry specialized LBOs compared to non-industry specialized LBOs. Our concern is on the differentiated effect between industry specialized and non-industry specialized LBOs, not on the absolute value of each effect.