In a one-page paper, answer the following: What is the function of venture capital in the United States and why is it important and/or needed? Describe the seven constants that apply across any market condition or time.

In a two-page paper, answer the following questions at the end of Chapter 10 on page 324.

Questions 1, 4 (venture capital related), 7, 8, 12, and 13

Note: Questions 12 and 13 can be combined into one answer.

Chapter 10: The Impact of Private Equity on SocietyDoes This Really Matter Anyway?

Clearly, venture capital (VC) and private equity funds exert a major impact on the fates of individual companies. But to what extent does all this fund-raising, investing, governance, and exiting influence the overall economic landscape as well?

Part of the challenge in assessing this question is the sheer amount of activityand the many variables that affect and outcome. Because the activity of private equity firms affects the outcome of their investments, it is easy to hold them responsible for outcomes both good and bad. We can certainly find many illustrations of venture and buyout groups adding value to the firms they financed, and others for which the outcome was far less happy, as shown in this chapter.

On the one hand, many case studies illustrate situations where venture investors have allowed entrepreneurs to realize value that they would otherwise not have been able to garner. Consider, for example, the story of Lingtu.1 This Beijing Company, which makes digital maps for both individual and corporate applications, provides a particularly important service in China, where city streets are frequently a maze of winding, tiny lanes and breakneck growth renders paper maps obsolete soon after they are printed. By January 2003, Lingtus founders decided they needed help in thinking about strategic choices. Lingtus team met Gobi Partners, a fund that from its inception in 2001 has focused single-mindedly on financing early-stage Chinese digital media and information technology companies. After an exhaustive due diligence process, Gobi invested a little over $2 million in Lingtu. Gobi assisted the firm in a variety of ways in the next few years:

First, it helped the firm prioritize the allocation of resources.

Second, Gobi introduced Lingtu to a number of corporations that were its own limited partners (LPs). These included IBM, which partnered with Lingtu to develop navigation and web map-search programs and supported the young firm in its winning bid for a project with telecommunications provider China Unicom, as well as NTT DoCoMo, which also served as lead investor in a subsequent financing round.

Finally, the initial and subsequent financing rounds allowed the company to expand its investment in technology and marketing.

Similarly, case studies of private equity deals note situations in which target companies achieved substantial productivity gains, often in the form of improvements to existing operations. For instance, in the Hertz buyout, the Carlyle Group, Clayton, Dubilier & Rice, and Merrill Lynch Private Equity addressed inefficiencies in preexisting operations to help increase profitability.2 Specifically, the investors reduced overhead costs by shrinking inefficient labor expenses and cutting noncapital investments to industry-standard levels. The owners also aligned managerial incentives more closely with the return on capital. Similarly, the buyout of O.M. Scott & Sons led to substantial operating improvements in the firms existing operations, partly through powerful incentives offered to management and partly through specific suggestions made by the private equity investors.3 In examples like these, profitability enhancement and creation of private value are likely to go hand in hand with productivity gains.

But other cases suggest that private equity transactions generate few lasting gains for the companies they invest in, much less for society as a whole. In several cases, and for various reasons, private equity groups sometimes fail to achieve their goals for target companies. For instance, when Berkshire Partners bought Wisconsin Central Railroad, it had an ambitious plan to increase productivity.4 Technological problems arose soon after the buyout transaction, however, and prevented the deployment of a computerized control system that was crucial to the plan. Moreover, the original business plan overlooked certain costs and greatly overestimated the targets ability to cut expenses. As a result, the numbers in the ambitious business plan were never met and the company went into technical default on its loan covenants.5

In other cases, such as the Revco transaction, a crippling debt load, along with management disarray, a weak and inexperienced leveraged buyout (LBO) sponsor, and a disastrous midstream shift in strategy led to a failure to achieve performance goals.6 Inasmuch as this transaction created private value, it seems to have sprung from tax savings rather than operational improvements, and thus it is unlikely to have led to any lasting social benefits. Many other cases will doubtless emerge from the most recent buyout wave.7

Clearly, looking at individual case studies only takes us so far. To be able to really answer the questions of the broader impact of VC and private equity, we need to grapple with the systematic evidence. While less thrilling than single company studies, such a wider assessment is a crucial step in understanding the impact of venture and buyout funds. This wider appreciation is important for two reasons: (Page 304)

1. On a personal level, choosing to invest in a career in a venture or buyout firm makes sense only if the industry is likely to have real staying power for the decades to come. If the industry just makes money by shuffling assets, its long-term prospects are fairly limitedconsider the situation of the long-term career prospects for the investment bankers who made tons of money in 2006 by securitizing subprime mortgages. Moreover, though we may be accused of idealism, there is a natural and commendable desire to pursue a career that does more than simply provide a paycheck. It is natural to ask whether private equity can be said to provide a benefit to society.

2. Policymakers are intensely interested in private equity. Whether seeking to regulate problematic practices by buyout funds that may endanger the economy or encouraging more venture funds to finance young firms, their decisions are likely to profoundly shape the industry. But without a clear understanding of how the industry shapes the economy, it is unclear that the proper policy decisions will be made.

In this chapter, we explore these important issues. We begin by seeking to understand what the literature has told us about the impact of VC for economic growth and innovation. We then explore the consequences of later-stage private equity investments. Finally, we consider the consequences of these findings for public policy because policymakers seek to restrain possible abuses by private equity firms by imposing regulations that will affect the industryand the economyfor years to come.

THE CONSEQUENCES OF VENTURE CAPITAL

To assess the impact of VC, we must look at studies of the experience in the market with the most developed and seasoned VC industry, the United States. (Given the much smaller representation of VC in other nations, as discussed in Chapter 8, we have limited ability to say much about its influence elsewhere.⁸) Even though venture activity is most developed in the United States, the reader might be skeptical as to whether this activity could noticeably affect innovation: for most of the past three decades, investments made by the entire VC sector totaled less than the research and development (R&D) and capital expenditure budgets of single companies (such as IBM, General Motors, or Merck).

We can begin this exploration by examining the cumulative impact of venture investing on wealth, jobs, and other financial measures across a variety of industries. Though it would be useful to track the fate of every VC-financed company and find out where the innovation or technology ended up, in reality we can only track those companies that have gone public. Consistent information on venture-backed firms that were acquired or went out of business simply doesnt exist. For instance, how much of the growth in Microsofts revenues and profits should we attribute to the web-mail service Hotmail (a company originally funded by venture firm Draper Fisher Jurvetson, which was integrated into Microsofts MSN service, after its acquisition) and Visio (a diagrammatic software firm funded by Technology Venture Investors and Kleiner Perkins, which was incorporated into the Microsoft Office suite of software)? But in general, investments in companies that eventually go public yield much higher returns for venture capitalists than those in firms that get acquired or remain privately held, so focusing on this subset may paint a reasonable picture of the collective impact of VC. (Page 307)

Table 10-1: Relative Status of Venture-Backed and Non-Venture Firms at the End of 2009

	Number of Firms	Market Capitalization	Employees	Sales	Operating Income before Depreciation	Net Income	Average Profit Margin
Venture-Backed	794	1,946,561	3,334	974,631	182,153	75,042	7.7%
Non-Venture	4,842	10,980,893	34,715	11,296,722	1,611,619	510,288	4.4%

Even within the limitations of our measurement, venture-backed firms have had an unmistakable effect on the U.S. economy. One way to assess the overall impact of the VC industry is to look at the economic weight of venture-backed companies in the context of the larger economy.⁹ As Table 10-1 reports, in late 2009, some 794 firms were publicly traded on U.S. markets after receiving their private financing from venture capitalists. (This does not include the firms that went public, but were subsequently acquired or delisted.) Venture-backed firms that had gone public made up over 14 percent of the total number of public firms in existence in the United States at that time. And of the total market value of public firms ($14 trillion), venture-backed companies represented $1.9 trillion13.7 percent. (Page 307)

Venture-funded firms also made up over 4 percent (nearly $975 billion) of total sales ($22 trillion) of all U.S. public firms at the time. Contrary to the general perception that venture-supported companies are not profitable, operating income margins for these companies hit an average of 7.7 percentclose to the average public companys profit margin of 4.4 percent. Finally, those public firms supported by venture funding employed 8.8 percent of the total public company workforceand most of these jobs were high-salaried, skilled positions in the technology sector. Clearly, venture investing fuels a substantial portion of the U.S. economy.

This impact is, of course, not spread equally across all sectors of the economy. It is quite modest in industries dominated by mature companies, such as those in manufacturing. In highly innovative industries, though, the picture is completely different. For example, companies in the computer software and hardware industry that received venture backing during their gestation as private firms represent more than 75 percent of the industrys value. Venture-financed firms also play a central role in the biotechnology, computer services, and semiconductor industries. In recent years, the scope of venture groups activity has been expanding rapidly in the critical energy and environmental field, though the impact of these investments remains to be seen. Given that the economic effects of these emerging industries in the future is likely to be particularly important, the calculations just provided actually understate the economic impact of VC.

The preceding discussion helps paint a broad picture of the wider impact of VC, but it still omits much detail. Manju Puri and Rebecca Zarutskie introduce a more precise way to look at the performance of venture-backed firms.10 They employ the detailed information in the U.S. Bureau of the Census Longitudinal Business Database (LBD), which tracks virtually all for-profit entities in the United States, whether publicly traded or privately held. This rich source of information allows a careful comparison between venture-backed companies and similar companies that did not get venture financing.

In their paper, the authors track the average employment and sales by firm age for all venture-backed and non-venture firms in the LBD that were founded between 1981 and 2005. The firms are followed until the year of their first exit eventa failure, acquisition, or initial public offering (IPO). Two key patterns emerge. Venture-backed firms are larger than non-venture firms, measured by both employment and sales, at each age of the life cycle before the exit event. In addition, the size difference between venture and non-venture firms becomes larger with time; that is, the average growth rate of venture-backed firms is higher.

One might wonder whether the larger scale of venture-backed firms was simply driven by a higher failure rate for these companies. If venture capitalists were simply more ruthless in shutting down small companies, we might see a similar patternthat is, the venture-backed companies would grow faster because the laggards were truncated from the samplewithout the venture capitalists doing anything particularly positive for their companies.

The analysis in the paper does not support this. Venture capitalists, the Census data show, are less likely to shut down firms in the first four years after the company receives funding. After more than four years, though, the pattern reverses and the venture-backed firms are more likely to be closed. The authors suggest that the venture capitalists give their companies a certain period to grow; but should the companies cross this threshold without reaching some sort of milestone, the venture capitalists patience could be exhausted and underperforming companies are shut down relatively quickly. All in all, this analysis is consistent with the notion that venture capitalists, as active investors, do seem to have some sort of secret sauce that facilitates portfolio company growth and that they will cease providing it if their efforts appear to be wasted. (Page 308)

Indeed, Yael Hochberg provides some specific evidence as to what that secret sauce may be: better governance.11 She considers governance in three areas: the use of discretionary accounting accruals to smooth earnings fluctuations; the adoption of a shareholder rights agreement (poison pill) to protect the managers in hostile takeover situations; and board independence. She focuses on firms that went public and looks at 2,827 IPOs between 1983 and 1994, roughly 40 percent of which were venture-backed.

She finds that venture-backed firms were more likely to pursue policies that ensured transparency and maximization of company value than were non-venture-backed companies. The earnings results of venture-backed firms were less likely to be muddled by discretionary accruals, which can be used to artificially smooth quarterly fluctuations. As a result, shareholders had a more accurate picture of these companies performance. Likewise, the adoption of shareholder protection rules like poison pills, which can either protect incumbent management by making it harder to take a firm private or ensure that all shareholders are treated equally regardless of the size of their holding, are more likely to trigger a stock price increase in venture-backed firms. The positive reaction to the enactment of such provisions suggests that they are in the best interests of all shareholders.

Hochberg also examines board independence. An outsider-dominated board is seen as another way to protect shareholders since outsiders are thought more likely to act as a check on management, more willing to replace the CEO for underperformance, and more amenable to major restructuring events such as mergers and acquisitions. She shows that the boards of venture-backed companies had substantially more outsiders than insiders. In addition, the influential audit and compensation committees of VC-backed companies were much more likely to consist solely of outside members, further freeing them from management influence. Separation of the CEO and chairman, also a way of providing checks and balances in a company, was more common in venture-backed companies. Thus, even after the firms went public, venture-backed firms seemed to be examples of good governance.

Thus far, the research has suggested that venture-backed companies grow faster and have better governance than do non-venture-backed operations. But we might ask if this growth and governance is to any avail. If venture-backed companies are no different from their peers, should we be celebrating the existence of these financiers? A question that is attracting increasing research is the impact of VC on innovation. If VC creates high-growth, well-run companies that can bring innovative solutions to the pressing problems that the world is likely to face over the next decadesglobal warming, environmental degradation, proliferating pandemics, terrorism, and the likewe can make a stronger case for its contributions to society overall.

But even if VC-funded firms cannot solve these problems, innovations have a particular social importance. Since the pioneering work of Morris Abramowitz and Robert Solow in the 1950s,12 we have understood that technological innovation is critical to economic growth. Technological change has not just made our lives more comfortable and longer than those of our great-grandparents, it has made our nations richer as well. Innumerable studies have documented the strong connection between new discoveries and economic prosperity both across nations and over time. This relationship is particularly strong in advanced nationsthat is, countries that cannot rely on copying others or a growing population for economic growth.

Some readers may think we should be able to assess the impact of VC on innovation in a more rigorous manner. For instance, we could seek to explain across industries and time whether, controlling for R&D spending, VC funding has an impact on various measures of innovation. But even a simple model of the relationship between VC, R&D, and innovation suggests that this approach is likely to give misleading estimates, because both venture funding and innovation could be positively related to a third unobserved factorthe arrival of technological opportunities. Thus, there might be more innovation at times of high VC activity not because VC caused the innovation, but rather because the venture capitalists reacted to some fundamental technological shock that led to more innovation. (Page 309)

The relationship between VC and innovation is indeed complex. For instance, the first silicon semiconductor was invented in 1958 at Fairchild Semiconductor, a division of Fairchild Camera and Instrument that had adopted the project only because it caught the interest of the founder, Sherman Fairchild. Silicon-based semiconductors completely changed the playing field, which had been dominated by vastly more expensive germanium-based production. Shortly thereafter, venture capitalists did get involved. The best-known venture investment in semiconductors, however, happened an entire decade later when Arthur Rock backed Intel, which was founded by Robert Noyce and Gordon Moore from Fairchild Semiconductor. So to what extent were venture capitalists responsible for innovations in the semiconductor industry?

Indeed, some venture capitalists argue that they dont make money on inventing things but on commercializing them. The Internet, for instance, was invented by U.S. government scientists at the Defense Advanced Research Projects Agency (DARPA) but only commercializedwith the help of a lot of venture investmentin the early 1990s.

The first of the papers that have attempted to address these challenging issues, by Thomas Hellmann and Manju Puri,13 examines a sample of 170 recently formed firms in Silicon Valley. The authors examine both venture-backed and non-venture firms. Using questionnaire responses, they find evidence that VC financing is related to product market strategies and the outcomes of start-ups. They find that firms that are pursuing what they term an innovator strategy (a classification based on the content analysis of survey responses) are 69 percent more likely to obtain VC than are those pursuing an imitator strategy, and the innovators raise financing faster. The presence of a venture capitalist is also associated with a significant reduction in the time taken to bring a product to market, especially for innovators (probably because these firms can focus more on innovating and less on raising money). Furthermore, these companies are more likely to list obtaining venture capital as a significant milestone in their life cycle as compared to other financing events, such as obtaining a bank loan. This may well reflect the fact that receiving VC is not just a funding event for the company but also a credentialing moment in its life. The product idea and team have been assessed and found to deserve not only funding but also the advice and interaction that accompany a venture investment.

The results suggest significant interrelations between VC and innovation-heavy firms, in addition to a role for VC in encouraging innovative companies. But this does not definitively answer the question of whether venture capitalists cause innovation. For instance, we might observe personal injury lawyers at accident sites, handing out business cards in the hopes of drumming up clients. But just because the lawyer is at the scene of the car crash does not mean that he caused it. In a similar vein, the possibility remains that more innovative firms choose to finance themselves with VC, rather than VC causing firms to be more innovative.

Sam Kortum and Josh Lerner visit the same question.14 Here, the study looks at the aggregate level: did the participation of venture capitalists in any given industry over the past few decades lead to more or less innovation? It might be thought that such an analysis would have the same problem as the personal injury lawyer example just described. Put another way, even if we see an increase in venture funding and a boost in innovation, how can we be sure that one caused the other?

The authors address these concerns about causality by looking back over the industrys history. In particular, as we discussed earlier, a major discontinuity in the VC industrys recent history was the U.S. Department of Labors clarification of the Employee Retirement Income Security Act in the late 1970s, a policy shift that freed pensions to invest in various higher-risk investment strategies, including VC. This shift led to a sharp increase in the funds committed to the asset class. This type of external change should indicate the impact of VC on innovation because the policy shift (whose impact on venture financing was little anticipated) is unlikely to be related to how many or how few entrepreneurial opportunities there were to be funded. (Page 310)

The results in Kortum and Lerner suggest that venture funding does have a strong positive impact on innovation. In particular, they find that the policy shift seems to have triggered a substantial amount of innovationmeasured by number of patents received. The estimated coefficients of their regressions vary according to the techniques employed, but on average a dollar of VC appears to be three to four times more potent in stimulating patenting than a dollar of traditional corporate R&D. The estimates therefore suggest that VC, even though it averaged less than 3 percent of corporate R&D in the United States from 1983 to 1992, is responsible for a much greater shareperhaps 10 percentof U.S. industrial innovations in this decade.

A natural worry with the preceding analysis is that it looks at the relationship between VC and patenting, not VC and innovation. One possible explanation is that such funding leads to entrepreneurs to protect their intellectual property with patents rather than other mechanisms such as trade secrets. For instance, the entrepreneurs may be able to fool their venture investors by applying for a large number of patents, even though many of the patents are not particularly important ones. If this is true, it might be inferred that the patents of venture-backed firms would be of lower quality than non-venture-backed patent filings.

This question certainly bears consideration. To address it, we can check the number of patents that cite a particular patent.15 Higher-quality patents, it has been shown, are cited by other innovators more often than lower-quality patents because they moved the state of the industry forward. Similarly, if venture-backed patents are lower in quality, then companies receiving venture funding would be less likely to initiate patent-infringement litigation. (It makes no sense to pay money to engage in the costly process of patent litigation to defend low-quality patents.)

So, what happens when patent quality is measured with these criteria? As it happens, the patents of venture-backed firms are more frequently cited by other patents and are more aggressively litigated; thus, it can be concluded that they are of high quality. Furthermore, the venture-backed firms more frequently litigate trade secrets, suggesting that they are not simply patenting frantically in lieu of relying on trade-secret protection. These findings reinforce the notion that venture-supported firms are simply more innovative than their non-venture-supported counterparts.

Marcos Mollica and Luigi Zingales,16 by way of contrast, focus on regional patterns instead of looking across industries. As a regional unit, they use the 179 Bureau of Economic Analysis economic areas, which are composed of counties surrounding metropolitan areas. They exploit the regional, cross-industry, and time-series variability of venture investments in the United States to study the impact of VC activity on innovation and the creation of new businesses. Again, they grapple with causality issues by using an instrumental variable: as a standard for the size of venture investments, they use the size of a state pension funds assets. The idea is that state pension funds are subject to political pressure to invest some of their funds in new businesses in the state. Hence, the size of the state pension fund triggers a shift in the local supply of VC investment, which should help identify the effect of venture activity on innovation.

Even with these controls, they find that VC investments have a significant positive effect both on the production of patents and the creation of new businesses. An increase of one standard deviation in the VC investment per capita generates an increase in the number of patents between 4 and 15 percent. An increase of 10 percent in the volume of venture investment increases the total number of new business by 2.5 percent.

Thomas Chemmanur, Karthik Krishnan, and Debarshi Nandy look at yet another measure of innovation.17 They focus on the growth in what economists call the firms total factor productivity (TFP), which can be defined as the change in output after accounting for the growth in various inputs (e.g., labor, materials, and energy). In other words, this measure focuses on the amount of the firms growth that is due to doing things in a more innovative way, as opposed to simply doing more of the same (an improvement in manufacturing processes versus adding a second shift). (Page 311)

These authors, like Puri and Zarutskie, employ the U.S. Census dataset because it allows them to compare public and private firms. But productivity is hard to measure in many sectorshow do we realistically capture the efficiency of a consulting firm, for instance?so they focus on manufacturing firms. Here they find several interesting patterns that are largely consistent with the results noted earlier, despite the very different measures. The TFP of venture-backed firms before receiving financing is higher than that of non-venture-backed entities, and this disparity only widens in the years after the transaction. These results suggest not only that venture capitalists are able to find and fund companies that are more innovative but also that their monitoring and mentoring after the financinggovernancemake a difference.

Interestingly, Chemmanur and coauthors find that the effect of venture capitalists is not the same across firms. They divide the venture firms into those that have raised a relatively larger and smaller share of funds in the previous years (they argue that by and large, the more successful funds should have raised more capital). The authors find little difference in the TFP of the companies funded by the large and small groups at the time of the deal. After the transactions, however, the growth in TFP is significantly higher for firms backed by more established venture investors compared to smaller funds. Here again we find support for the claim that not all private equity groups are equalbetter firms create better outcomes in their companies, thus further enhancing their reputations.

THE IMPACT OF BUYOUTS

The growth of the buyout industry over the past decade has triggered anxiety about its impact in nations as diverse as China, Germany, South Korea, the United Kingdom, and the United States. This anxiety is reasonable given the magnitude of recent activity and the industrys somewhat checkered reputation since the Barbarians at the Gate era of the 1980s.

These anxieties have led to a recent surge of work on the consequences of buyout investments. Some may wonder why this work is needed: after all, the leveraged buyout transactions of the 1980s were scrutinized in a number of important academic analyses. To understand the strengths and limitations of the earlier works, we can consider the two classic studies of the period, both by Steve Kaplan.19

Assessing the Buyouts of the 1980s

Kaplan examined a sample of 76 large management buyouts of public companies completed between 1980 and 1986, in an effort to determine the operating changes that take place in the firms after the transactions. He investigates the validity of the view that these transactions really added value to the firmsfor instance, by improving operations or providing new incentives to managersor, instead, generated value by expropriating wealth from the companys existing employees or public shareholders. To do this, he seeks to relate the value increases that the firms experienced post-buyout with the changes in company performance.

The analysis finds that the firms have noticeably better post-buyout operating performance than other firms in their industry, particularly when measured by returns on assets and sales. Most significantly, buyout companies experience a reduction in capital expenditures in the three years after the buyout, at least when compared to other firms in the same industry. These results could be interpreted in two ways: they might reflect either a curbing of wasteful expenditures by the newly motivated management team or the crippling effects of heavy debt burdens. These firms also display large increases in cash flows from operations after the buyout.

In a closely related paper, Kaplan explores the possibility that the increase in buyout performance is just driven by the tax advantages provided by the interest payments on the debt, as we discussed earlier. Is it possible that much of the bought-out companies ostensible improvement simply reflects tax savings? 20 Again looking at these large public buyouts, he showed that while the typical company did pay little federal tax in its first two years after the transaction, it generally paid taxes in the third year and thereafter. To do this, he compares the tax benefits of the transaction with the value that the market believed the transaction created, which he argues is measured by the premium over the market price before the buyout that was paid to the shareholders (i.e., the difference between the transaction and the pre-buyout valuation). This premium, on average, was 40 percent of the companys pre-buyout market price. 21 The tax benefits ranged from 21 to 143 percent of the premium paid by the buyout group. While tax advantages are an important source of value, Kaplan concludes that this is unlikely to be the sole source of the wealth created in the buyouts. In short, Kaplan concludes that the evidence supports the contention that buyouts created value in terms of operating efficiencies and/or better incentives. (Page 312)

But these studies, and many of their contemporaneous work, had some important limitations. First, the bulk of the older research focused on a relatively small number of transactions involving previously publicly traded firms based in the United States. But public-to-private transactions represent only a very modest fraction of all buyouts. The second limitation of the older research relates to the fact that the industry has grown and evolved tremendously since the 1980s, as we saw in Chapter 1.

Assessing Recent Buyouts

Recent research has sought to assess the consequences of buyout investments over more comprehensive and more global samples. Each study has looked at a particular consequence of the investment process.

First, Per Strmberg examined the nature and outcome of the 21,397 private equity transactions worldwide between 1970 and 2007.22 In the most straightforward possible outcome, the author simply sought to understand the consequences of these transactions. The key findings were as follows:

Holding periods for private equity investments have increased, rather than decreased, over the years. More than half58 percentof the buyout funds investments are exited more than five years after the initial transaction. So-called quick flips (i.e., exits within two years of investment by the buyout fund) account for 12 percent of deals and have also decreased in the last few years.

IPOs account for only 13 percent of private equity investment exits, and this exit route seems to have decreased in relative importance over time. The most common exit route is trade sales to another corporation, accounting for 38 percent of all exits. The second most common exit route is secondary buyouts (24 percent), which have increased in importance over the last decade, consistent with anecdotal evidence.

Table 10-2: Exits of LBO Transactions, 19702007

With a Financial Sponsor Number of Exits Percentage of Total

Bankruptcy 552 6

IPO 1,110 13

Financial buyer 3,366 39

LBO-backed corporate buyer 2,106 24

Sold to management 446 5

Strategic buyer 130 2

Other/unknown 948 11

No exit 12,739 60

Total exited 8,658 40

Source: Adapted from: Per Strmberg. The New Demography of Private Equity, in ed. A. Gurung and J. Lerner Globalization of Alternative Investments Working Papers Volume 1: Global Economic Impact of Private Equity 2008, (New York: World Economic Forum USA, 2008), 326, available at www.weforum.org/pdf/cgi/pe/Full_Report.pdf.

As Table 10-2 shows, of exited buyout transactions, only 6 percent end in bankruptcy or financial restructuring. This translates into an annual rate of bankruptcy or major financial distress of 1.2 percent per year. This rate is lower than the default rate for U.S. corporate bond issuers, which has averaged 1.6 percent per year. (Page 314)

This study, of course, examines only a small fraction of the possible consequences of these transactions. It cannot answer the question of whether the bulk of the firms would be worse or better off because of these transactions. Also note that these counts are computed using the number of transactions rather than their dollar sizes. Because the largest deals tend to be concentrated at market peaks, and a disproportionate number of these transactions tend to get into trouble (more about this later), the results may differ for the broader sample.

Nick Bloom, Raffaella Sadun, and John Van Reenen 23 examine management practices across four thousand private-equity-owned and other firms in a sample of medium-sized manufacturing firms in Asia, Europe, and the United States by using a unique double-blind management survey to score firms across eighteen dimensions. The main goal of the study is to determine whether private equity ownership, relative to other ownership forms, improves management practices within firms through the introduction of new managers and better practices.

As shown in Figure 10.1, the authors find that private-equity-owned firms are on average the best-managed group. They are significantly better managed across a wide range of management practices than are government-, family-, and privately owned firms. This is true even when controlling for a range of other company characteristics such as country, industry, size, and employee skills. Private-equity-funded firms are particularly strong at operations management practices, such as the adoption of modern lean manufacturing practices and the use of continuous improvements and a comprehensive performance documentation process. But because the survey is only cross-sectional, the authors cannot determine whether the private equity groups turned these companies into better-managed ones or simply purchased firms that were better managed in the first place. Even if the companies had better practices in the first place, it is noteworthy that the private equity owners did not degrade them.

FIGURE 10.1: Average score on eighteen management practice questions

Source: Nick Bloom, Raffaella Sadun, and John Van Reenen, Do Private Equity-Owned Firms Have Better Managements Practices? in A. Gurung and J. Lerner (eds.), Globalization of Alternative Investments Working Papers Volume 2: Global Economic Impact of Private Equity 2009 (New York: World Economic Forum USA, 2009).

Another question raised about private equity ownership involves the period over which buyout-owned companies enact changes. Being privately held, some argue, enables managers to implement challenging restructurings without the pressure of catering to the markets demands for steadily growing quarterly profits, which can make companies focus on short-run investments. Others, who point to practices such as special dividends to equity investors, have questioned whether private-equity-backed firms do indeed take a longer-run perspective than their public peers. To address this question, Josh Lerner, Morten Sorensen, and Per Strmberg examined long-run investments by private-equity-owned companies. (Page 315)

This study examined one form of long-run investment: investments in innovation. Due to various factors, innovation provides an attractive testing ground for the issues described earlier. These factors include the long-run nature of R&D expenditures and their importance to the ultimate health of firms. Moreover, an extensive body of work in the economics literature has documented that the characteristics of patents can be used to assess the nature of both publicly and privately held firms technological innovations.

The key finding was that patenting levels before and after buyouts are largely unchanged. Firms that undergo a buyout, however, pursue more economically important innovations, as measured by patent citations, in the years after private equity investments. The increase in the number of citations given to private-equity-backed firms patents is quite substantial, about 25 percent. This means that the companies intensify their focus on the technologies that they have targeted historically, but improve the quality of the research that they perform. It is noteworthy to observe that Orangina, under the ownership of Lion Capital and Blackstone, embarked upon a number of R&D projects, including the development of a diet version of its namesake beverage. Its former corporate parent, Cadbury, had focused far more on the mainstay chocolates and biscuits business, starving the soft drink operation of R&D funding.

Of course, many people initially respond to news of a buyout with concern about job losses. The 1980s movies Other Peoples Money and Wall Street imparted to the popular consciousness the idea that buyouts were synonymous with massive cuts and company shutdowns. Even more recently, a German politician decried buyout firms as locusts. Critics have claimed huge job losses from buyouts, while private equity associations and other groups have released several recent studies that claim positive employment effects from private equity activity. Even many academic studies have had significant limitations, such as the reliance on surveys with incomplete responses, an inability to control for employment changes in comparable firms, the failure to distinguish cleanly between employment changes at firms backed by various types of private equity, and an inability to determine nations in which jobs are being created and destroyed.

In a pair of recent studies, Steve Davis and coauthors examined the impact of buyout investment on employment and productivity. 25 The authors constructed and analyzed a dataset in order to overcome the limitations noted earlier and, at the same time, to encompass a much larger set of employers and private equity transactions. The study is based on the LBD, which was used in two of the venture studies already described. With the LBD the authors could analyze employment at both the firm level and establishment level. Establishments in this context mean the specific factories, offices, retail outlets, and other distinct physical locations where business takes place. The LBD covers the entire nonfarm private sector and includes annual data on employment and payroll for about five million firms and six million establishments. Within that group, 5,000 U.S. firms were acquired in private equity transactions from 1980 to 2005 (target firms), and about 300,000 U.S. establishments were operated by these firms at the time of the private equity transaction (target establishments).

The key results paint an interesting picture: (Page 316)

Over the five years before the buyout, employment grows 2 percent faster in total at target companies than at the control group, In the year of the transaction, it jumps by a further 2.25 percent, perhaps as management tries to bolster production and avoid a buyout or compensates for insufficient capital expenditure by hiring more workers. Put another way, relative to their peers, companies that underwent buyouts were bulking up before the deal.

As shown in Figure 10.2, employment declines more rapidly in bought-out establishments than in control establishments after the private equity transaction and it stays depressed. In the five years after the buyout, employment at the private equity-owned establishments falls a total of 6 percent relative to the controls, more than 1 percent per year on average, an effect that is particularly dramatic in public-to-private transactions.

But in unreported calculations, companies backed by private firms have 5 percent more greenfield job creation in the years after the dealthat is, jobs created at new facilities in the United Statesthan their peer group. Thus, it appears that the job losses at already existing establishments of firms after a buyout are largely offset by substantially larger job gains in the form of greenfield job creation by these same companies.

FIGURE 10.2: Net growth ratesdifference between targets and controls

Source: Steve Davis, John Haltiwanger, Ron Jarmin, Josh Lerner, and Javier Miranda, Private Equity and Employment, in Globalization of Alternative Investments Working Papers Volume 1: Global Economic Impact of Private Equity 2008 ed. A. Gurung and J. Lerner (New York: World Economic Forum USA, 2008), 57, available http://www.weforum.org/pdf/cgi/pe/Full_Report.pdf. (Page 317)

In their follow-on study, the authors focus on whether and how labor productivity changed at U.S. manufacturing firms that were targets of private equity transactions from 1980 to 2005. The authors find that while firms acquired by private equity groups had higher productivity than their peers at the time of the original acquisition (by roughly 4 percent), productivity growth in the two-year period after the transaction averages two percentage points more. About 72 percent of this differential in productivity growth after the deal reflects more effective management of existing facilities, rather than the shutting down and opening of operations. (Note that private equity investors are much more likely to close underperforming establishments at the firms they back, as measured by labor productivity.) Nor does the differential narrow thereafter; it continues to grow at roughly 1 percent per year, perhaps indicating that the good habits are retained.

As private equity has spread across the world, its impact has been scrutinized elsewhere as well. Some of the most important work has been done in the United Kingdom:

In a pair of studies, Kevin Amess compared the productivity growth of 78 buyouts with 156 similar control firms matched along a variety of dimensions.²⁶ All of the firms were manufacturers of small and medium equipment and machinery. Using a variety of productivity measures, he showed that the firms that underwent buyouts seemed to use inputs more efficiently after the transaction.

Richard Harris, Donald Siegel, and Mike Wright assessed the total factor productivity of a much larger sample of entitiesover 35,000 manufacturing establishments before and aftermanagement buyouts. They found that these plants are less productive than comparable plants before the buyouts, but they experience a substantial increase in productivity after the transactions. The authors argued that these productivity improvements seemed to be due to measures undertaken by the new owners to reduce the labor intensity of production, in particular their much greater reliance on outsourcing various inputs to the production process.

Kevin Amess and Mike Wright then looked at the employment consequences of leveraged buyouts.²⁸ They examined a sample of 1,350 LBOs, which they argued were representative of the entire population of U.K. buyouts. Buyouts, they found, had a very modest impact on employment growth; but these firms had significantly lower wage growth than did matching firms. (Page 318)

There are far fewer studies of the consequences of private equity outside the United Kingdom and the United States. One exception is the study of how buyout transactions affect corporate growth in France that focused on deals between 1994 and 2004. (Note that large, highly leveraged transactions did not become common in France until the mid-2000s.) During these periods, French private equity funds seemed to act as an engine of growth for small- and medium-sized enterprises. Post-LBO growth in jobs, productivity, and the sales and assets of the acquired companies was higher than in comparable firms. These effects seem higher in industries that have insufficient internal capital as well as at times when the capital markets are weak.

Some Important Caveats

So far, the consequences of the private equity and VC industry appear to be relatively positive. Both VC and buyouts do seem, in general, to create overall economic value by inculcating good governance, funding innovation, and, to varying extents, increasing job growth and productivity. We must acknowledge that net job growth is a very gross measure; a job lost is a crisis for that person, even if productivity increases as a result. We do not want to appear to minimize that experience, but simply to state the findings on a broader level.

Note also that all of these studies have important limitations. First, they consider the impact of these financing sources in the aggregate. As alluded to repeatedly in this volume, and as we explore in depth in Chapter 13, both the venture and buyout industries are very cyclical, characterized by highly lumpy fund-raising wherein a few years account for the peak of the fund-raising. These years are also characterized by poorer private returns and higher rates of bankruptcy among portfolio companies, which might suggest that the social returns from these periods are modest as well.

The data limitations are particularly acute in the case of the private equity studies. None of them can grapple with the consequences of the 20052007 market peak, which accounted for 34 percent of the private equity raised (in inflation-adjusted dollars) between 1980 and 2007.²⁹ We will simply have to wait until the results of that frenetic period work through the system.

Those few studies on buyout activity during the 20052007 peak raise questions about what goes on during these boom periods. As we discuss in Chapter 13, these periods are associated with more leverage in transactionseven if it does not seem to be justifiedas well as higher failure rates and fewer operational improvements among companies. But the extent to which these periods have long-run detrimental effects on society remains hotly debated.

THE CONSEQUENCES OF PUBLIC INTERVENTIONS

In the aftermath of the economic crisis, governments have intensified their involvement in the VC and private equity industries. These efforts have taken two forms. On the one hand, public efforts to stimulate VC and growth equity for entrepreneurial firms have become widespread. On the other, the question of whether and how to regulate alternative investors, including private equity funds, has been increasingly debated. In this final section, we will take a quick look at both of these efforts. (Page 319)

Stimulus Efforts

When we look at the regions of the world that are emerging as the great hubs of entrepreneurial activityplaces such as Silicon Valley, Singapore, Tel Aviv, Bangalore, and Guangdong and Zhejiang provincesthe stamp of the public sector is unmistakable. Enlightened government intervention played a key role in creating each of these regions. Even a review of the history of Silicon Valley shows that public funding helped build many of the critical foundations of the entrepreneurial cluster there.

But for every effective government intervention, there have been dozens, even hundreds, of failures, where substantial public expenditures bore no fruit. Examples abound from Europe, Japan, and many of the U.S. states, where literally billions have been spent in the hope of promoting VC and entrepreneurial finance more generally with no lasting benefits.

This account of the results of public investment might lead the reader to conclude that the public sectors pursuit of entrepreneurial growth is a massive casino. Some may think that the public sector is simply making bets, with no guarantees of success. Perhaps there are no lessons to be garnered from the experiences of the successful and the failed efforts to create entrepreneurial hubs.

The truth, however, is very different. In many cases, the failure of government efforts to promote venture and entrepreneurial activity was completely predictable. These efforts shared a set of design flaws that doomed them virtually from the start. In many corners of the world, from Europe and the United States to the newest emerging economies, the same classes of problems have reappeared.

Certainly, from an abstract intellectual perspective, one can offer rationales for government investment to promote VC. These arguments rest on two indisputable pillars:

1. The role of technological innovation as a spur for economic growth is now widely recognized. Indeed, government statements of policy worldwide highlight the importance of innovation in promoting and sustaining economic growth and prosperity.

2. As we discussed earlier in the chapter, academic research has highlighted the role of entrepreneurship and VC in stimulating innovation. Venture capital and the entrepreneurs it funds will never supplant other wellsprings of innovation, such as vibrant universities and corporate research laboratories (in an ideal world, these components of growth all feed each other). But in an innovative system, a healthy entrepreneurial sector and VC industry will be important contributors. (Page 319)

If that were the whole story, the case for public involvement would be pretty compelling. But the case for public intervention rests as well on a third leg: the argument that governments can effectively promote entrepreneurship and VC. And this, alas, is a much shakier assumption.

To be sure, entrepreneurial markets have features that allow us to identify a natural role for governments in encouraging their evolution. Entrepreneurship is a business in which there are increasing returns. Put another way, it is far easier to found a start-up if ten other entrepreneurs are nearby. In many respects, founders and venture capitalists benefit from their peers. For instance, if entrepreneurs are already active in the market, investors, employees, intermediaries such as lawyers and data providers, and the wider capital markets are likely to be knowledgeable about the venturing process and the strategies, financing, support, and exit mechanisms it requires. In the activities associated with entrepreneurship and VC, the actions of any one group are likely to have positive spillovers, or externalities, for their peers. In these types of settings, the government can often play a very positive role as a catalyst.

This observation is supported by numerous examples of government intervention that successfully triggered the growth of a VC sector. For instance, the Small Business Investment Company (SBIC) program in the United States led to the formation of the infrastructure for much of the modern VC industry. Many early VC funds and leading intermediaries in the industrysuch as law firms and data providersbegan as organizations oriented to the SBIC funds and then gradually shifted their focus to independent venture capitalists. Similarly, public programs played an important role in triggering the explosive growth of virtually every other major venture market around the globe.

But there are also many reasons to be cautious about the efficacy of government intervention. In particular, two well-documented problems can derail government programs. First, they can simply get it wrong by allocating funds and support in an inept or, even worse, a counterproductive manner. An extensive literature has examined the factors that affect the quality of governmental efforts in general and suggests that more competent programs are likelier in nations that are wealthier, have more heterogeneous populations, and are based on an English legal tradition.

Economists have also focused on a second problem, delineated in the theory of regulatory capture. These writings suggest that private and public sector entities will organize to capture direct and indirect subsidies that the public sector provides. For instance, programs geared toward boosting nascent entrepreneurs may instead end up boosting cronies of the nations rulers or legislators. The annals of government venturing programs abound with examples of efforts that have been hijacked in such a manner.

The SBIR program, the largest public venture program in the United States, provides an illustration of this problem in an analysis by Josh Lerner. The effect of a fairness policy can be seen by comparing the performance of program recipients with that of matching firms. (See Figure 10.3, which compares the growth of SBIR awardees and matching firms. The figure shows that the awardees grew considerably faster than companies in the same locations and industries that did not receive awards.)

Unfortunately, beneath these positive results lie some intense political pressures and conflicting interests. For one thing, congressmen and their staffers have pressured program managers to award funding to companies in their states. As a result, in almost every recent fiscal year, firms in all fifty states (and indeed every one of the 435 congressional districts) have received at least one SBIR award.

Figure 10.3 also highlights the consequences of such political pressures. In particular, it contrasts what happened to the workforce size of SBIR awardees located in regions characterized by considerable high-tech activity (i.e., the company received at least one independent VC financing round in the three years before the SBIR award) and those elsewhere. The figure reveals that in the ten years after receipt of SBIR funding, the workforce of the average award recipient in a high-tech region grew by forty-seven employees, doubling in size. The work forcesof other awardeesthose located in regions not characterized by high-tech activitygrew by only thirteen employees. Though the recipients of SBIR awards grew considerably faster than a sample of matched firms, the superior performance, as measured by growth in employment (as well as sales and other measures) was confined to awardees in areas that already had private venture activity. In the name of geographic diversity, the program funded firms with inferior prospects. (Page 320)

FIGURE 10.3: Change in employment in SBIR and Non-SBIR awardees

Source: Josh Lerner, The Government as Venture Capitalist: The Long-Run Effects of the SBIR Program, Journal of Business 72 (1999): 285318. Journal of Business, University of Chicago Press, 1999.

In addition to the geographic pressures, particular companies have managed to capture a disproportionate number of awards. These SBIR mills often have staffs in Washington that focus only on identifying opportunities for subsidy applications. This problem has proven difficult to eliminate since mill staffers tend to be active, wily lobbyists. While mildly distressing in theory, the problem would be acceptable if mills were more efficient at innovation. Sadly, they are not; mills commercialize far fewer projects than do those firms that receive just one SBIR grant. Though a single SBIR grant does seem to encourage performance in awardee firms, the program clearly still has some work to do in eradicating waste and distortions.

A more systematic look at these issues is provided in a paper by Jim Brander, Qianqian Du, and Thomas Hellmann.³¹ This paper assesses the record of government support for VC through three different channels:

1. Direct provision of VC through government-owned VC funds

2. Investment in independently managed VC funds that also rely on private investors

3. Provision of subsidies or tax concessions to venture capitalists (Page 321)

The researchers analyzed over 28,800 enterprises (based in 126 different countries) that received VC funding between 2000 and 2008. The enterprises cover a wide range of industries but are dominated by high-technology firms. The performance of enterprises financed by some form of government VC was compared with those supported by private venture capitalists to determine the impact of public involvement on performance.

The key findings illustrate that:

Enterprises with moderate government VC support outperform enterprises with only private VC support and those with extensive government support, both in terms of value creation and patent creation.

Government VC performance appears to differ markedly; public funds associated with national governments and international organizations perform better than those associated with subnational (e.g., state and provincial) governments. This may occur because broader government mandates allow the firm to choose from a larger pool of investment opportunities that may be more likely to succeed.

Venture funds with a combination of public and private backing and those with indirect government subsidies exhibit stronger performance