Going private: Is it really a path to better performance?

A long line of academic research argues that privately owned companies should be better managed than their publicly owned counterparts. But recent research by Finance Professor Sreedhar Bharath calls this conventional wisdom into question.

A long line of academic research argues that privately owned companies should be better managed than their publicly owned counterparts. The reasoning goes like this: A small group of private shareholders, with more of their wealth tied up in the company, will better monitor managers, ensuring that they make smart investments and don’t squander resources on vanity projects. This, in turn, should lead to greater firm efficiency and productivity.

Business people often echo these sentiments — especially when their company is being taken private. Thus, when Warren Buffett’s Berkshire Hathaway bought BNSF Railway in 2009, the railroad’s CEO, Matthew Rose, said he welcomed the chance to escape from the hassles of public ownership. Being owned by Buffett and Berkshire, he said, would let him focus on the long term, as a manager should. But recent research by Finance Professor Sreedhar Bharath calls this conventional wisdom into question.

Bharath, along with coauthors Amy Dittmar and Jagadeesh Sivadasan, both of the University of Michigan, examined dozens of deals in which publicly owned plants were taken private and found no improvement in productivity. “The newly private firms do well, but so do comparable public firms,” Bharath explained. “They do equally well.” And that suggests that there’s no great advantage in private ownership, at least among the manufacturers that the researchers examined. “There’s a belief that the market penalizes companies if they don’t show great numbers now,” Prof. Bharath said.

To achieve these results, the argument goes, managers may feel forced to cut employment and investment, hurting their firms’ long-term health and productivity. “If this is really true, when companies go private, they should be freed from all of these short-term pressures and rack up great future numbers. But whichever way we tried to cut the data, we couldn’t find that.”

Disappearing advantage

The three researchers dug into going private deals that happened from 1981 to 2005. They were able to go deeper than some prior studies because they analyzed plant-level data collected by the U.S. Bureau of the Census. Among the going private transactions in their data set were three kinds of deals: those led by (1) private-equity firms, (2) company managers and (3) private operating companies.

The researchers studied more than 400 companies across a variety of industries, comparing them with industry peers of similar size and age. Before their buyouts, the going private plants were, by some measures, more productive than peers, Prof. Bharath said. But when the researchers compared their post-buyout performance with that of their still public peers, the apparent advantage disappeared. “We find no evidence that going private causes plants to improve their productivity relative to their matched peers,” the three scholars write in a paper that was the lead article of The Review of Financial Studies.

Even six years after their deals, the firms that went private showed no edge in operational efficiency. What could explain the comparable performance? Better technology might be one answer, Prof. Bharath said. Technological improvements often pulse through an industry, affecting many firms. In the textile industry, for example, many makers of blue jeans switched their process at roughly the same time. “They used to weave the fabric and then dye it in indigo,” he said. “The newer type of technology is you dye the individual strands and then weave the cloth and make the jeans. This change would’ve been common to public and private firms — all of them would’ve needed to keep pace, so you’d see a common effect in the industry.”

The myopia hypothesis

Deals to take companies private can spark debate. When they involve prominent public companies, they can be among the biggest and most controversial events in the hurly-burly world of mergers and acquisitions. Sometimes, they’re triggered by a buyout firm making a bid. Perhaps the most famous example was KKR & Co. L.P.’s purchase of RJR Nabisco Inc. in the late ’80s.

That inspired the bestselling book “Barbarians at the Gate: The Fall of RJR Nabisco” and a movie, too. Other times, company managers take their firms private. That was the case in 2013, when Michael Dell led a group of private investors who purchased the PC maker that bore his name. In a letter published last year in The Wall Street Journal, Mr. Dell said the move let his company escape the “myopia” of the public market. “Shareholders increasingly demanded short-term results to drive returns; innovation and investment too often suffered as a result,” he wrote. “Shareholder and customer interests decoupled.” Dell wasn’t the first person to accuse public investors of shortsightedness. Scholars have done the same, calling the behavior “short-termism.” “In the academic literature, the vast majority of the papers have taken the position that short-termism is a problem,” Prof. Bharath said.

But again, Prof. Bharath and his colleagues beg to differ. They point out that a shortsighted manager would value current earnings over her firm’s long-term health, and thus would likely slash payroll and underinvest in property and equipment. Jobs and investments cost money now but may not yield immediate benefits. If going private liberated managers from having to sweat short-term results, then one would expect to see increases in employment and investments after going-private deals.

“The myopia hypothesis would also predict that there would be productivity gains relative to public firms once the constraint is removed by going private,” the scholars write. “We find no evidence that this is the case; thus, our evidence is largely inconsistent with public firms being more subject to myopia.” Simply put, the private firms in their study didn’t appear anymore oriented to the long term than public ones did.

The renovation hypothesis

Just because newly private firms aren’t more productive than their public peers doesn’t mean they’re similar in every way. Prof. Bharath and his colleagues did find differences. The most notable was that going private firms were more likely to sell their least productive plants. In other words, the private buyers didn’t improve the performance of the plants they kept, but they did get rid of the duds.

This finding, too, contradicts conventional business wisdom, especially as pertains to buyouts led by private equity firms (that is, companies like KKR that specialize in doing these kinds of deals). “There’s a view that private equity guys fix things,” Prof. Bharath said. “They can take these public firms private, fix their problems and then exit through a public stock offering.” While that may be true in some cases, it wasn’t true on average among the plants that Prof. Bharath and his colleagues studied. “In the kinds of deals we examined, there doesn’t seem to be a high value-addition,” he said. “They’re not adding productive capacity to the plants. It’s more that they’re removing unprofitable stuff.”

Breaking up the empire

This finding does suggest that at least one criticism of public ownership may be true: public company CEOs may be more prone to “empire building” than their private company peers. That is, they may be more likely to try to expand the size of their enterprise, even if doing so doesn’t represent to best use of scarce company resources. Warren Buffett has chided public company CEOs for this tendency in his letters to Berkshire’s shareholders. But when firms go private, the new owners often restructure, scaling back the “empires” they acquired, the three scholars found. “The differences in the restructuring activities provide evidence consistent with the reversal of empire building,” they write. “However, these reversals do not lead to improvements in productivity within retained establishments.”

Implications for investors

Business people might take a mixed message from Prof. Bharath’s research. Someone faced with lending money to finance a buyout might be encouraged, as the results show that “the private guys do as well as the public guys, and they weed out bad stuff,” he said. But someone faced with investing, as a limited partner, in a buyout fund might be less enthusiastic. Among manufacturing firms, at least, “these aren’t the deals that are going to give great value,” he said. One criticism of Prof. Bharath’s study might be that it focused on manufacturers, which, while important, represent a relatively small part of the total U.S. economy. According to the Economic Policy Institute, a Washington, D.C., think tank, manufacturing directly employed about nine percent of US workers and accounted for about 12.5 percent of U.S. GDP in 2013.

What’s more, the number of manufacturing jobs has been dropping over the last two decades, as plants have moved to lower-wage countries like China and Mexico and the U.S. economy has become more service-oriented. “The U.S. has moved away from manufacturing to services — we can’t refute that,” Prof. Bharath said. But the beauty of manufacturing as a study subject is that offers a wealth of data and that financial economists agree on how to measure its productivity. So while Prof. Bharath and his colleagues may be creating a picture of only a part of the economy, they’re confident that it’s a finely detailed and accurate one.

First published in the autumn 2015 issue of W. P. Carey magazine.