Private equity as a driver for productivity growth

In the Dutch context of labour scarcity and aging, it is crucial to reverse the trend of declining productivity growth. There is no single solution for this. Private equity (PE) can be an important catalyst for increasing productivity. By increasing available capital, implementing better management practices, and stimulating innovation, PE can enhance the efficiency and competitiveness of companies, according to PwC's chief economist Barbara Baarsma and private equity expert Cornelis Smaal.

Private equity (PE) is often critically examined by public opinion. The perception of PE as merely a financial instrument that prioritises short-term profit has overshadowed its potential benefits. However, in the right context, private equity can be a significant catalyst for productivity. Private equity investors anticipate improving the performance of the companies they invest in¹ and they can deliver on that promise.

Private equity focuses on untapped potential 

The right context for private equity to thrive is exactly the scenario where it is most often applied: companies that are facing financial constraints and have untapped potential for improved financial performance². PE firms are adept at identifying these opportunities where they can add value. They look for businesses that, despite having solid fundamentals, are underperforming due to a lack of resources, good management practices or strategic direction.

Once a target company is acquired, private equity investors work to unlock its potential. They may restructure debt, optimize the balance sheet, and bring in new management teams. These steps are often pivotal in turning around a company's fortunes, leading to improved productivity and profitability. The objective is to create a leaner, more focused, and more competitive entity that can thrive in its market.

Capital infusions for investment in technology, research, improved operations and internationalisation

One of the primary ways through which private equity can boost productivity is by providing an infusion of capital. This influx is particularly beneficial for companies that face financial constraints, limiting their ability to invest in new technologies, research and development, or even day-to-day operations³. With the additional capital from a PE investment, these companies can modernise equipment, streamline processes, and adopt new technologies, all of which can lead to substantial gains in productivity.

Moreover, PE firms often bring more than just money to the table; they also introduce better management practices that are related to higher productivity⁴. Private equity investors typically have a wealth of experience and a network of professional contacts that can be leveraged to optimise a company's operations. They may implement strategic planning, performance measurement systems, and operational improvements that drive efficiency. This hands-on approach to management can help companies to identify areas where productivity is lagging and address those issues effectively.

Internationalisation to increase competitiveness and productivity  

Private equity investments also encourage internationalisation of target companies by bringing in capital and strategic resources needed for global expansion. PE investors provide access to international contacts and expertise in cross-border transactions. Internationalisation is often an important strategic move for them to diversify market presence and revenue streams, which can increase the value, competitiveness and productivity of the target company, in line with the PE's goal of achieving a high return on their investments⁵.

Private equity often stimulates an innovative culture 

Innovation is another key area where private equity can make a significant impact. There is evidence that the number of patents increases after a leverage buyout takes place. This applies to private-to-private deals (i.e., deals involving only non-listed companies) and especially for companies that had financial constraints before private equity entered. And not only does the patent stock increase, but they also register more impactful patents⁶. By providing the necessary capital and strategic oversight, PE firms can enable companies to pursue new product development or improve existing offerings. This drive for innovation can lead to the creation of more efficient or higher-quality products and services, which can, in turn, enhance productivity.

Furthermore, private equity investors often encourage a culture of innovation within their portfolio companies. They may incentivise management teams to pursue innovative solutions and invest in employee training and development. This cultural shift can lead to a more dynamic and agile company that is better equipped to respond to market changes and customer demands⁷.

Productivity spillover effects

The influence of private equity on productivity extends beyond the walls of the companies they invest in. There is evidence to suggest that there are productivity spillover effects to other firms within the same industry⁸. When a PE firm invests in a company and implements changes that lead to increased productivity, it often raises the bar for the entire industry. Competitors may be compelled to adopt similar improvements to keep pace, leading to industry-wide enhancements in productivity.

This spillover effect can be particularly pronounced in sectors where competition is fierce. As one company becomes more efficient, others must follow suit or risk losing market share. This dynamic can lead to a virtuous cycle of continuous improvement and innovation within the industry, ultimately benefiting consumers through better products and services.

The benefits of private equity often outweigh the costs

Companies targeted by private equity often exhibit greater resilience during disruptive events like the Global Financial Crisis and the COVID-19 pandemic⁹. Their focus on strategic long-term planning, inherent in private equity investments, and a more proactive management approach combined with close collaboration with management teams, ensures that these companies are often better prepared for unexpected market shifts, enabling them to adapt and thrive even in difficult circumstances.

At the same time, private equity has faced its fair share of criticism. While there is no support to the claim that PE always leads to excessive debt, more insolvency risk or have an excessive short-term focus, other criticisms find stronger support^{10 11 12}. In certain circumstances, PE can lead to cost-cutting through layoffs¹³. And the employees facing more risks are those who perform routine tasks or tasks that can be offshored, leading to job polarization¹⁴. However, this is also a consequence of a passive attitude from the existing management of a company, which sometimes hesitates to lay off people and make the operations more efficient. When PE takes over the management of the company, decisive action is often taken.

The relationship between private equity and productivity is complex and multifaceted.  

When PE investment is made in the right context, it can lead to significant productivity improvement. By understanding and harnessing this relationship, private equity can contribute to the growth and success of businesses, industries, and the broader economy.

In addition, when we examine the reasons that lead private equity to positively impact productivity, there are lessons to be learned. Good management practices, access to capital and investing in innovation do not need to be exclusive to PE funds. Those are well-known drivers of productivity that can be prioritised by all companies and incentivised by public policy.

_{¹ Gompers et al. (2014) - What Do Private Equity Firms Say They Do?
² Kaul et al. (2017) - Who does Private Equity buy?
³ Davis et al. (2019) - The (Heterogeneous) Economic Effects of Private Equity Buyouts
⁴ Bloom et al. (2015) - Do Private Equity owned firms have better management practices?
⁵ Bosio et al. (2021) - The Strategic Role of Private Equity in the Internationalisation of Italian SMEs
⁶ Amess et al. (2015) - The Impact of Private Equity on Firms Patenting Activity
⁷ WEF (2024) – Private equity holds the key to creating quality jobs for millions
⁸ Altamaz and Brown (2020) - Private equity in the global economy: Evidence on industry spillovers
⁹ Lavery et al. (2014) – Private equity financing & firm productivity
¹⁰ Harford and Kolasinski (2012) - Do Private Equity returns result from wealth transfers and short-termism?
¹¹ Huang et al. (2014) - Private Equity Firms Reputational Concerns and the Costs of Debt
¹² Wilson and Wright (2013) - Private Equity, Buy-outs and Insolvency Risk
¹³ Davis et al. (2019) - The (Heterogeneous) Economic Effects of Private Equity Buyouts
¹⁴ Olsson and Tag (2016) - Private Equity, Layoffs, and Job Polarisation}