Shareholder returns from divestitures by publicly held companies are lower in the short term when the buyers are PE firms, compared to those when the buyers are other companies or companies owned by PE firms, according to a paper based on a study by Wharton management professor Paul Nary, titled “Do Corporations Benefit from Divesting to Private Equity Acquirers? An Empirical Investigation.”
Nary tracked shareholder returns from 1,055 divestitures by 308 publicly traded U.S. manufacturing firms over 14 years, between 1997 and 2010. Nearly 90% of those divestitures (932 deals) were to corporate buyers, while PE firms made up the remainder (123 deals).
The study found an average difference of 1.5% in shareholder returns for divesting companies between selling to PE acquirers and corporate acquirers. For a company valued at $10 billion, that would mean a difference in shareholder returns of $150 million, Nary explained. He defined shareholder returns from divestitures as the difference in share prices of the selling company one day before and after the announcement of the divestiture, after adjusting for overall market performance.
The study found further evidence of potentially higher value creation by strategic acquirers: Even across PE buyouts, “indirect buyouts” by PE acquirers, or acquisitions by companies they owned, fared better than “direct buyouts” by PE acquirers. For a hypothetical example, a shipping company sold directly to a PE firm would likely result in lower returns than if it were sold to another shipping company owned by a PE firm, Nary explained. “Indirect PE buyouts may be motivated by synergy-based sources of value like those pursued by corporate acquirers, even if the PE firm is the ultimate owner,” the paper stated.
Yet the publicly held corporations that are on the receiving end of low returns in the short run may reap long-term gains, Nary said. With divestitures, sellers may free up capital and other resources, better position themselves for the future, and be more focused, he added, which may result in better long-term performance.
Why Private Equity Acquisitions Underperform in the Short Run
Nary explained why the returns to firms divesting to PE acquirers differ from those divesting to corporate acquirers. First, on average, the returns to shareholders of divesting firms are lower when they sell a business to a PE firm. Second, those lower returns are more likely to occur when the PE firm may expect to create less value, or when sellers choose to divest at a suboptimal time. PE acquirers’ selection of target companies, that is differences between targets of PE firms versus targets of corporate buyers, did not impact shareholder returns.
“Private equity will buy anything, anytime, if the price is low enough.”— Paul Nary
The study highlights that PE firms distinguish themselves from corporate buyers in how they approach prospective acquisitions, according to Nary. “PE firms typically look for assets that are undervalued, assets that they can improve, or assets that are perhaps struggling because of market timing,” Nary said. “They’re looking to acquire assets where they can make a reasonably certain and quick enough return for their holding period.”
Ownership structures also dictate value creation. PE acquirers have relatively shorter investment horizons (three to six years), compared to corporate acquirers who buy businesses to achieve synergies like economies of scale, and hold them for the long run.
PE acquirers may also time their transactions more strategically than corporate acquirers do. They may buy businesses at a time when the target company is financially challenged and earns low returns. For the selling company, such timing will be suboptimal because it would get a smaller purchase price than when it is performing well.
“Firms that are suffering financially, for example, tend to get much lower shareholder returns when divesting to PE acquirers versus firms that are in great financial health and divesting for the right reasons and at the right time, rather than because they’re pressured by the market or the competitive environment,” Nary said.
At the same time, PE acquirers’ value creation strategies may interact, where higher returns from indirect buyouts could offset the negative effects of distress, the study suggested.
How Divestitures Affect Returns
Nary listed the various factors that drive the quality of shareholder returns from divestitures, citing prior studies. One, divestitures may improve the overall allocation of resources across firms and lead to better firm-level governance by matching divested businesses with comparatively more suitable owners. Two, divestitures enable companies to free up capital and other resources that they can reallocate to achieve performance improvements.
At the other end, strategic buyers may expect that the businesses they target will be complementary to their existing operations. They would also hope to create more value with the acquired business than if it were to stay with the divesting firm, which may benefit both the buyer and the seller. “The more value the acquirer expects to create, the more value there is potentially to be shared by the divesting firm,” the paper stated. For example, an acquirer may be willing to pay a higher price for a divested business that promises high synergies for the buyer, especially if other acquirers may also be interested in that business, it added.
PE firms build their business model on their ability to select undervalued targets, increase the value of those targets during their ownership period, and optimally time their transactions, the paper noted. That timing is critical — when they buy a target firm, and when they exit their investment with a sale, which is mostly to another PE firm or a public share offering.
“We’re seeing a pattern of PE firms building portfolios through strategic, synergy-focused acquisitions and creating value that way.”— Paul Nary
In 2021, PE firms participated in about 30% of all M&A deals. The most active acquirers and divesting firms in Nary’s data set were prominent firms. For example, DuPont is both a top divesting firm and a top corporate acquirer. Dow Chemical, Motorola, Johnson & Johnson, Procter & Gamble, and Honeywell are some of the other top divesting firms, while General Electric, Emerson, and Solectron are the top corporate acquirers. The top PE acquirers were Sun Capital Partners, Gores Group, Platinum Equity, Arsenal Capital Partners, and Onex Corporation. Other prominent PE firms in the sample are Bain Capital, Carlyle Group, Kohlberg Kravis Roberts, and Cerberus Capital Management.
Significance of the Study
Drawing from the study’s findings, the big question for publicly held companies is if it makes sense to divest businesses to PE firms. “At first glance, the answer seems to be no because the average short-term returns from these transactions may be comparatively worse than those from transactions with corporate acquirers,” the paper stated. “Yet, the dynamics of value creation when divesting to PE firms are nuanced.”
According to Nary, the evidence thus far has been “anecdotal” about the implications for firms divesting businesses to PE firms. The paper’s empirical study advances the discussion by highlighting the dynamics of value creation in M&A transactions. Those dynamics are nuanced, especially when considering the characteristics of the divesting firm, the divested business, and the acquirer, and “especially when that acquirer is an idiosyncratic actor such as a PE firm, as opposed to the more commonly considered corporation,” it added.
The paper called for more scholarly work that treats PE as a distinct form of governance and ownership, and PE firms as distinct actors in the market for corporate assets. In further research that is not part of the core paper, the study looked also at the bargaining dynamics of PE acquirers. PE firms have more experience than corporate acquirers in M&A transactions, and “they work harder to squeeze everything out at the negotiating table,” Nary said.
Takeaways for Buyers and Sellers
Corporations that are looking to sell a business unit must find the best owner for that business, whether that is a corporate acquirer or PE acquirer. Corporate acquirers or companies owned by PE firms are most likely to pay the best price for a business that can potentially create much value and synergies for the right owner, Nary said. But if the business being divested does not offer much by way of synergies, then PE firms may be the only ones interested in the deal, and they may extract a discount from the seller, he added. “Private equity will buy anything, anytime, if the price is low enough.”
The takeaway for PE firms is to build on the advantages with indirect buyouts, or add-on acquisitions to complement existing businesses in their portfolios. Some of that is already happening: “We’re seeing a pattern of PE firms building portfolios through strategic, synergy-focused acquisitions and creating value that way,” Nary said. “Some of the best-run and most profitable PE firms today engage in those types of strategies.”
