Why private equity investors are (hidden) innovators

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Private equity investors aren't exactly known for being frontrunners of innovation. That buzzword is reserved for industry-disrupting startups and entrepreneurs who take Silicon Valley's move-fast-and-break-things culture as a personal creed. The term implies risk and demands revolution. It certainly doesn't describe the calculated buyouts and measured changes that private equity investors make when they invest in established businesses -- or does it?

Put popular use aside for a moment. The real definition of innovation has more to do with sparking positive change than it does with headline-grabbing disruption. At its most foundational level, innovation can be any new idea, product, or method that shifts established conventions and changes a company for the better. That brand of innovation, I would argue, is well within a private equity firm's forte. Humble and quiet as they might be about it, private equity investors spark innovation on a near-daily basis.

Most private equity firms have the same primary drive: to acquire underperforming businesses, optimize their operations and management, and sell them at a profit within a few years. This improvement-centric approach requires companies to deliver better products at lower cost and with greater efficiency than they had previously. In other words, private equity investors push for organizational innovation -- and are well-equipped to create it.

Unlike nonprofits or publicly-traded organizations, private equity owners do not have to publicly submit quarterly financial reports. This allows them to make strategic, long-view decisions without worrying about how shareholders will view the short-term economic impact. Private equity investors also have pre-established relationships with banks, which can help a company alleviate restrictive financial pressures and gather more funding for innovative ideas. Moreover, because PE firms are focused on optimizing operations and profitability over immediate performance, they can afford to be aggressive when it comes to making organizational improvements, management changes, growth decisions, and acquisitions. To rephrase another way: private equity investors are structurally equipped to take a "move fast and /build/ things" approach to organizational innovation in their investments.

The innovative edge that PE-backed firms hold over privately-owned businesses can be measured to some extent -- although it is worth noting that there is no perfect way to quantify innovation. Researchers often use patent rates as a rough proxy for measuring innovation activity. The reasoning behind this is threefold: first, patents are not self-reported and cannot be altered to reflect bias. Second, they demand resources to produce, which implies some degree of R&D spending. Lastly, they tend to coincide with other common signs of innovation, such as employment growth and industry disruption.

Significantly, research has shown that companies that enjoy private equity support tend to file more patents than privately-owned businesses. In a working paper published by the Dusseldorf Institute for Competition Economics (DICE) in 2015, researchers reported that PE-backed firms tended to file 40% more high-quality patent applications than their independent peers in the three years following a leveraged buyout (LBO). Interestingly, the positive correlation between innovation activity and LBOs was only statistically significant for private-to-private transactions, suggesting that the firms that benefit most from LBOs are private, financial-constrained firms that can thrive with new leadership and better resources. Researchers for the DICE report concluded that private equity firms facilitated a company’s investment in innovation by loosening their financial constraints. Once the company had the financial “room” to innovate, they tended to do so -- and thus set the foundation for growth and profit down the line.

It is worth mentioning, however, that while patent rates can provide a rough sense of innovation activity, it is in no way an all-encompassing measure. After all, some innovations don’t need to be formally patented if they lack commercial value outside of an organization or do not need to be protected as intellectual property. Consider operational innovations like those described above as an example. While they would have a significant impact on business performance and indicate innovative thought, they don’t necessarily need to be patented -- and thus wouldn’t be included in any patent-based survey of innovation.

I would like to offer an illustration of how valuable these intangible innovations can be for private equity investors by turning to an industry rife with them: Healthcare.

A case study: the healthcare industry
The healthcare sector has long been a lucrative hotspot for private equity investment. Statistics provided by McKinsey and Company indicate that the industry pulls ahead of all others for total returns; the consultancy estimates that in the span from 2010-2015, shareholders in healthcare earned global total returns of approximately 15%. Some healthcare subsectors draw more investment interest than others; currently, researchers believe that the sub-sectors that offer the most significant potential for growth include biotechnology, medical devices, and retail health services. The last, however, provides a particularly appealing opportunity for private equity investment and innovation.

The retail sub-sector has enjoyed quite a bit of investor attention over the last few years. According to a recent brief published by Bain and Company, the number of deals involving retail health businesses (i.e., those that offer independent health services like urgent care, dentistry, etc.) has skyrocketed, rising at a compound annual rate of roughly 34% within the North American market.

Part of the market’s appeal lies in its fragmentation and high potential for growth. By consolidating disparate care-centered businesses, private equity investors can both increase their consumer reach and earning potential as well as streamline each business into standardized efficiency. As a result, these optimized operations minimize the time and resources doctors need to spend on administrative duties and allow them more opportunities to develop innovative care delivery solutions. This leads to better experiences for patients, increased efficiency from the business, and more potential for profit for investors. These innovations might not be measured in patent rates, but they are just as -- if not more -- valuable than any registered idea or product.

As Joshua Kayle, chair of DLA Piper’s healthcare sector recently commented in an article for Modern Healthcare, “When private equity is looking to deploy capital, they're looking for opportunities not just based on value, but the drivers of value. How can they bring their sophistication into solving a problem?’”

Private equity investors answer variations on that question every day, and in every field. They might not claim headlines for their work, or take the risks that most associate with successful innovators, but one point is for sure:

Their work is equally -- if humbly -- transformative.