Re-evaluating the innovation impact of public-to-private buyouts

September 30, 2019

Douglas Cumming

Story by Rob Rombouts

Conventional wisdom in the business world states that private equity investors risk institutional investor capital to add value to business, and bring innovation in the economy. Douglas Cumming thinks this conventional wisdom should be re-evaluated, particularly in the case of private equity public-to-private buyout transitions where a public company is delisted from a stock exchange.

Cumming is the DeSantis Distinguished Professor of Finance and Entrepreneurship at Florida Atlantic University. He will deliver the 2019 DAN Management Distinguished Lecture in Corporate Governance at Western University.

It is generally understood that publicly traded companies are focused on quarter-to-quarter value, making it difficult to make significant and strategic change. Private companies are not bound by the same restrictions. When publicly traded companies are bought by private equity investors, the new owners can make changes to be more innovative.

Writing in 1989, in Eclipse of the Public Corporation, Michael Jensen wrote that private equity is a better business model for the economy, as they are more active than publicly traded companies. Cumming also points to David Rubenstein, founder and co-executive Chairman of The Carlyle Group as a proponent of this view. Rubenstein argues that the United States is the strongest economy in the world because of private equity investment.

As it is commonly accepted that private equity creates value for the economy, private equity investors are taxed at a lower rate, paying capital gains tax on their income, not a high rate of income tax.

In his lecture, Cumming will re-examine this view and question the commonly held beliefs about private equity investors in the context of public to private transactions. Cumming argues that prior evidence on topic is limited to small single-country datasets and narrow time periods. In his study, Cumming uses a large data set, with data from more countries and over a longer time frame, focusing on the number and quality of patents created by the private equity companies. The data examined by Cumming indicates that private equity public-to-private buyouts do not lead to more patents and patent citations; on the contrary, they lead to fewer patents and patent citations.

“If you only look in boom periods, everything is going up,” said Cumming. “If you look at longer business cycles, you see other things.”

Cumming said the data indicate private equity public to private transactions are on average not focused on long-term value creation through innovation.

“Private equity firms don’t invest forever,” Cumming said, “They don’t invest to get dividends on equity. They invest to sell to someone else in an ‘exit’.”

The decrease in patents may also reflect changes to research and development focus, as private equity investors may sell off R&D departments, or as researchers may leave the company under new ownership.

In contrast to publically traded companies, private equity firms do not need to report on earnings, and many of the actions occur “in a black box” Cumming said.

As private equity public to private transactions are growing in the economy, Cumming said this may result in fewer patents and patent citations overall.

Cumming does not believe governments should take action to limit private equity firms, but said regulators should reconsider disclosure and information to shareholders of public companies prior to public-to-private transactions so that there is more informed voting on these deals. Moreover, the evidence in general brings into question the rationale for private equity fund manager taxation whereby carried interest performance compensation is taxed at the capital gains tax rate, not the higher income tax rate.

Cumming argued that the argument in support of taxing private equity fund managers at the capital gains tax rate is private equity investors create economic value and innovation for the economy. But in the case of private equity public-to-private buyouts, that doesn’t seem to be the case.

The 2019 DAN Management Distinguished Lecture in Corporate Governance will take place on Thursday October 17, at 2pm in the McKellar Theatre. The DAN Management Distinguished Lecture in Corporate Governance is made possible through the ongoing support of Aubrey Dan.