Private equity firms earned a reputation in the 1980s as corporate raiders. But a recent University of Georgia study found modern buyouts generate profit because they supply what small and mid-sized businesses need to thrive: capital.

Terry College accounting professor Erin Towery studied 240 private equity buyouts of privately owned businesses to find the sources of value creation after the acquisitions.

“I think many people believe value is being created by private equity firms, but the lack of publicly available data for private businesses makes it difficult to know what’s happening inside these companies, post-acquisition, that generates value,” Towery said. “We know very little about private equity buyouts of private firms in the U.S., and this market has exploded. Access to US tax return data enabled us to examine these important transactions.”

Towery published her paper on private equity buyouts, “Sources of Value Creation in Private Equity Buyouts of Private Firms,” with coauthors Jonathan Cohn, of the University of Texas -Austin, and Edith Hotchkiss, of Boston College, in a 2022 edition of Review of Finance.

Understanding the mechanics of these deals and the risk involved is important because the last five years saw a drastic uptick in institutional and retirement account investment into private equity firms. Unlike publicly traded companies that issue stock to shareholders, private equity companies aren’t required to make public disclosures about their financial health. 

“Substantial amounts of money flow into private equity funds via consumer and institutional funds, so it is important to understand what’s happening with that capital,” added Towery, who studies financial reporting, taxation, and corporate finance.

Towery’s study revealed that most companies targeted for buyouts fell into two categories. The companies were either struggling with their operating performance, or they were doing quite well but not growing as quickly as they could.

“We found that the private equity buyout transactions were concentrated in the extremes,” she said. “The private equity firms targeted companies with the weakest profitability, which represented potential turnaround opportunities. Or they targeted companies with the highest profitability that had a lot of growth potential they had not been able to realize. We observed improvements in operating performance and substantial sales growth for both kinds of buyout companies.”

The world of private equity firms that buy up small companies is generally a bigger pool of more specialized firms than the private equity firms buying publicly traded companies. Many private equity firms specialize in one or two industries and use their expertise to grow or turn around a company that fits its portfolio. For instance, a private equity firm may only target small technology companies or machine part manufacturers, Towery said. The private equity firm knows how its target businesses work and can bring an economy of scale to the buyout companies.

However, one of the biggest advantages a private equity firm brings to the buyout company is money. Struggling companies often do not have the cash needed to invest and improve their businesses, and healthy businesses might not have access to the capital they need to grow.

What Towery’s team didn’t find was evidence of the financial engineering that characterized private equity buyouts of publicly traded companies. Those deals usually entail levering up the newly purchased company with debt that shields income from taxation. That didn’t happen in these deals, Towery said.

“In public company buyouts, many buyout companies take on so much debt that their tax liability was generally zero,” she said. “We don’t see that with this set of firms, which suggests financial engineering is not a major motive for these transactions.”

One additional takeaway from the study, Towery said, is that there are likely a lot of investment opportunities that are essentially untapped. News organizations generally cover big publicly traded companies, but the heart of the U.S. economy is smaller businesses, and they need capital to realize their investment opportunities.