The Global Economic Impact of Private Equity Report 2008 - World ...

Private equity and long-run investment: the case of innovation*Josh LernerHarvard Business School and NBERPer StrömbergStockholm Institute for Financial Research and NBERmorten sØrensenUniversity of Chicago Graduate School of Business,NBER and SIFR1. IntroductionIn his influential 1989 paper, “The Eclipse of the PublicCorporation”, Michael Jensen predicted that the leveragedbuyout (LBO) would emerge as the dominant corporateorganization form. With its emphasis on corporategovernance, concentrated ownership by active owners,strong managerial incentives and efficient capital structure,he argued, the buyout was superior to the public corporationwith its dispersed shareholders and weak governance.The paper argued that these features enabled managersto proceed without the pressure of catering to the market’sdemands for steadily growing quarterly profits, which Stein(1988) and others argue can lead to firms myopicallysacrificing long‐run investments.These claims excited much debate in the subsequent years.Critics have questioned the extent to which private equitycreates value, suggesting that funds’ profits are insteaddriven by favourable tax treatment of corporate debt,inducing senior executives of publicly traded firms intoaccepting deals that go against the interests of shareholdersor abrogating explicit and implicit contracts with workers(e.g. Shleifer and Summers 1988). Moreover, these criticsquestion whether private equity‐backed firms take alonger‐run perspective than their public peers. They point topractices such as special dividends to equity investors and“quick flips” – that is, initial public offerings (IPOs) of firmssoon after a private equity investment – which enable privateequity groups to generate fees and raise new funds morequickly. Sceptics argue that given their incentives toundertake and exit deals, private equity investors arealso likely to take steps that boost short‐run performanceat the expense of sustained corporate growth.In this paper, we examine one form of long‐run investment:investments in innovative activities. This arena is an attractivetesting ground of the issues delineated above for four reasons:1. These expenditures have the classic features of a long‐runinvestment: the costs associated with generatinginnovations must be expensed immediately by firms,yet the benefits are unlikely to be observed for severalyears thereafter. As a result, a number of studies ofmanagerial “myopia” have examined R&D expenditures(e.g. Meulbroek et al 1990).2. An extensive body of work in the economics oftechnological change has documented that thecharacteristics of patents can be used to assess thenature of firms’ technological innovation. While thisliterature acknowledges that these are not a perfectmeasurement of innovation – many inventions areinstead protected as trade secrets – the value of patentsas a measure of innovative activities is widely accepted(e.g. Griliches 1990, Jaffe and Trajtenberg 2002).3. Unlike many other measures, patents are observable forboth public and privately‐held firms, which is importantwhen studying private equity transactions.4. Finally, innovation is important. Economists haveunderstood that technological innovation is criticalto economic growth since the pioneering work ofAbramowitz (1956) and Solow (1957). At the same time,not all research expenditures are well spent: critics ofmajor corporations (e.g. Jensen 1993) have suggestedthat many corporate research expenditures have beenwasteful and yielded a low return.We examine the impact of private equity investmenton the patenting behaviour of 495 firms with at least onesuccessful patent application filed from three years beforeto five years after a later‐stage private equity investment. 1We find that:• Firms pursue more economically important innovations,as measured by patent citations, in the years after privateequity investments. This pattern is robust to a variety ofspecifications and controls* Harvard Business School and National Bureau of Economic Research; University of Chicago Graduate School of Business, NBER, and SIFR; andStockholm Institute for Financial Research and NBER. We thank Geraldine Kim, Jodi Krakower, Sanjey Sivanesan, and especially Sarah Woolvertonfor assistance with this project. The World Economic Forum and Harvard Business School’s Division of Research provided financial support for thisresearch. We thank for helpful comments from participants in the World Economic Forum’s “Global Economic Impact of Private Equity” project andin a seminar at the London School of Economics, especially Mark Schankerman and John van Reenen. All errors and omissions are our own.1Throughout this paper, when we refer to private equity transactions, we are referring to equity investments by professionally managed partnershipsthat involve leveraged buyouts or other equity investments with a substantial amount of associated indebtedness.The Global Economic Impact of Private Equity Report 2008 Large-sample studies: Long-run investment 27