Understanding private equity's impact on the economy
20 August 2018
Guernsey’s stability and depth of expertise continues to see the Island placed at the forefront of the private equity funds industry. There are however few industries that evoke the sort of strong feelings that characterise perceptions about private equity.
Fortunately, there exists a significant body of academic research that can help unwrap the mystery and provide an objective voice in the debate.
As with anything, there exist both pros and cons, but it is clear that there are net economic gains that are associated with PE's model of corporate ownership. Indeed, taken in aggregate, the evidence is compelling that:
PE has measurable benefits on the productivity of the companies in which it invests
- PE is not the job destroyer it’s often portrayed to be
- PE does not pose a systemic risk — on the contrary, PE's access to capital during tough times is a stabilizing factor
- PE-owned companies raise competitive standards in their industries, causing entire industries to become more productive
The growing importance of PE in the global economy
Currently, there are at least 15,000 companies owned by institutional-quality PE funds, spanning all industries and stages of development. The industry is continuing to grow, driven by a number of important dynamics. New companies are staying private longer, enabled by a wide variety of investors willing to provide capital at attractive terms.
Closed Ended schemes are a popular option in Guernsey and the current Net Asset Value is over £105 billion, which makes up 59% of all Closed Ended schemes registered on the Island 7.
An essential role in investors’ portfolios
PE is playing an increasingly important role in portfolios. Preqin recently reported that there are now more than 6,800 institutional investors in PE, up 8% in just the last year.
Numerous academic studies have documented the outperformance of private equity relative to public equity benchmarks, estimates are consistently positive at around 3% per year on a net basis, after fees and expenses are factored in 1.
However, from a broader economic perspective, the gains for investors do not necessarily mean gains for the broader economy.
Understanding the economic impacts of PE - what does the research tell us?
PE leads to measurable gains in productivity
Several research studies have examined the ways in which PE investment changes operations and identified positive impacts on operational efficiency.
A 2017 study, “Private Equity and Industry Performance" 2 examined 20 industries across 26 different countries with known PE investments between 1991 and 2009. The results showed that in industries with greater PE investment, future growth in production, value added and employment is faster. Importantly, the improved performance does not appear to be associated with greater cyclical risk (such as from higher leverage); in fact, industries with increased PE activity are even more resilient to industry-level shocks.
What about financial risk?
Academic researchers have examined what happened to PE-backed companies during the financial crisis. A recent 2017 paper, “Private Equity and Financial Fragility During the Crisis" 3 examined 434 PE-owned companies from the UK. The authors found that PE-backed companies increased investment relative to their peers, a result tied to fewer financial constraints and better access to new capital. Combined with a lower overall cost of capital compared to public markets, the PE model appears to provide additional flexibility and access to capital even during times of broad economic and financial market distress.
Effects on employment
One of the most controversial aspects of PE arises from perceptions around the effect it has on the employment levels at the companies firms acquire.
The 2014 study, “Private Equity, Jobs, and Productivity" 4 found job losses at existing establishments of about 3% over the two years following a PE acquisition. Perhaps the most important finding in this large study of employment patterns is that both job losses and job gains at PE-backed firms occur at a much greater rate than at other similar firms.
The study also examines what happened to earnings at these companies, and found an approximately 2.4% decline in earnings per worker relative to similar businesses. However, earnings at newly created units were higher than wages at units in the control sample.
While evidence suggests some modest downward pressure on earnings, it also showed growth in higher earning positions at new facilities established under PE ownership.
Other studies have examined whether the quality of employment changes. A 2016 study, “Private Equity and Workers' Career Paths: The Role of Technological Change" 5 found that at PE-owned firms, large IT investments are positively associated with the long-run employability of workers, shorter unemployment spells and a tendency to transition to companies that have demand for lT-complementary human capital. Together, these results suggest that (at least some) employees at PE-backed companies get differentially more valuable skills versus their counterparts at non-PE-backed companies.
Overall, the evidence suggests that PE isn't the job-eating machine that many critics assert. While there are small, but measurable, net declines in employment at PE-backed companies, there are also potential gains from higher quality new employment.
PE-owned companies raise competitive standards
Research detailed in “Private Equity in the Global Economy: Evidence on Industry Spillovers” 6 suggests that positive spillovers are created by companies responding to competitive pressure from PE-backed companies. Essentially, PE-owned companies raise competitive standards and cause the entire industry to become more productive. On average, a one standard deviation increase in the amount of PE investment in an industry leads to a 0.9% increase in employment growth, a 1.2% increase in labour productivity growth and a 2.6% increase in profit growth.
Regulations in Guernsey
Simplicity is key to Guernsey’s regulations, a risk based approach is taken to ensure that the protection of investors is maintained, whilst at the same time ensuring a flexible, proportionate and competitive regime is followed.
The Island’s financial services regulator works extremely closely with the PE industry to ensure that the regulations continue to develop to be able to provide structures required by modern investors.
The bottom line
Rigorous analyses of the data make a compelling case that PE activity creates positive overall benefits to society that are the result of both direct operational efficiency improvements as well as positive externalities that are created by these gains.
Guernsey as an established specialist finance centre, enhanced by the evolution of the Island’s regulations and implementation of new technology, continues to contribute significantly to these societal benefits, and is exceptionally well-placed to leverage from its stability and depth of professional skills in the face of the economic and political challenges to be faced in the coming years.
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