Playing to their strengths? Evidence that specialization in the private equity industry confers competitive advantage

The paper examines whether private equity (PE)-backed buyouts have higher post-buyout operating profitability than comparable companies as a result of the alleged superior governance mechanism of private equity (“The Jensen hypothesis”) and whether relative investment specialisation by industry or stage provides the PE firm with a competitive advantage over its peers (“The advantages-to-specialization hypotheses”). A sample of 122 UK buyouts over the period 1995–2002 and a matched sample of non-PE-backed UK companies are constructed to test the three hypotheses. We find that over the first 3 post-buyout years (i) operating profitability of PE-backed companies is greater than those of comparable companies by 4.5%, consistently with the Jensen hypothesis; (ii) industry specialization of PE firms adds 8.5% to this premium, consistently with the industry-specialization hypothesis; (iii) stage (buyout) specialization does not impact profitability but may provide a spur to growth, inconsistently with the stage-specialization hypothesis. Finally, initial profitability of the PE-backed company plays a major role in post-buyout profitability, suggesting that skill in investment selection and financial engineering techniques may be more important than managerial incentives in generating higher PE company performance.