Private Equity and Family Business - Can Private Equity Investors Add to the Success of Formerly Owned Family Firms?

No. 87

Private Equity and Family Business –
Can Private Equity Investors Add to
the Success of Formerly Owned
Family Firms?
Torsten Wulf, Stephan Stubner, Robert Gietl, Christian Landau

June 2010

An analysis conducted by the Chair of Strategic Management and Organization
at HHL – Leipzig Graduate School of Management

HHL-Arbeitspapier
                                                 HHL Working Paper
                                                                No. 87

Private Equity and Family Business –
Can Private Equity Investors Add to
the Success of Formerly Owned
Family Firms?
Torsten Wulf, Stephan Stubner, Robert Gietl, Christian Landau

 ISSN 1864-4562 (Online version)
  HHL – Leipzig Graduate School of Management

Private Equity and Family Business – Can Private Equity Investors Add to the Success
of Formerly Owned Family Firms?

Abstract
We extend family firm research by showing which resource deficiencies exist in family firms
and what impact private equity investors have with regard to these deficiencies. We use
value-adding activities of private equity investors as our main proxy, as they are only applied
where shortcomings are expected. Building on the resource based view we develop a set of
categories where private equity investors try to support family firms. Our analysis of 118
family firms that were acquired by private equity investors show that especially cooperation
and networking seem to be neglected factors in family firms. Furthermore, low performers
are shown to have deficiencies in structures and systems.
Our main contribution to family firm research lies in the development of distinct categories
alongside which resource deficiencies of family firms can be analyzed. As a large part of
family firms eventually get sold to private equity investors, we also add to research by
providing a first linkage between family firm research to private equity research.

Keywords: family firm research, resource deficiencies, private equity, empirical study

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INTRODUCTION

Family Owned Businesses (FOBs) are privately held firms, in which a family is typically not

only the major shareholder but also actively engaged in strategic and operational

management (Davis, 1983; Stern, 1986; Handler, 1989). Usually, FOBs strive to keep

ownership within the family across several generations (Chua, Chrisman & Sharma, 1999).

However, handing over the reign to a family member may sometimes not be feasible. This

can refer to succession problems, e.g. due to a lack of qualified or willing heirs (Birley &

Westhead, 1990) an insufficient and late planning for succession (Le Breton-Miller, Miller &

Steier, 2004) or a lack of funds to finance the transfer or stand-alone survival (Mishra &

McConaughy, 1999). Additionally, FOBs might consider alternatives to a family succession

due to a lack of funds to ensure further growth and success of the company (Mishra &

McConaughy, 1999; Sirmon & Hitt, 2003; Carney, 2005).

One of the options which FOBs can consider in such situations, is the sale of the firm or parts

of it to outside investors (buyout), e.g. to Private Equity Firms (PEFs) (Birley & Westhead,

1990). In Europe alone, for example, around 21% of FOBs are eventually sold to external

investors (Linnemann, 2007). PEFs are firms which professionally invest in other companies

with the aim to sell their shares with a profit after a limited time period of usually 3-5 years

(Jensen, 1989b; Coyle, 2000; Sudarsanam, 2003; Bance, 2004; Berg, 2005). As the profits

of PEFs stem mainly from the differential of the buy-price and the sell-price for the FOBs’

shares, they are interested in investment possibilities which have the potential to increase in

value over the respective holding period. One potential lever for PEFs to actively add value is

the active support of their portfolio companies (Sapienza, Manigart & Vermeir, 1996). The

rationale for these value-adding activities lies mainly in the perception of PEFs that FOBs

often lack some critical resources. This perception is supported by existing research in the

family business literature, which highlights that FOBs, whilst showcasing a set of specific

resources often referred to as distinct familiness (Habbershon & Williams, 1999), regularly

                                                                                              2

lack certain other resources that are vital for successfully competing in the market (Kets de

Vries, 1993), thus creating an opportunity for PEFs.

Both, the value adding activities of PEFs (e.g. Berg & Gottschalg, 2004) and the resource

lack of FOBs (e.g. Kets de Vries, 1993) have been highlighted in the literature. However,

many of the existing studies have limitations insofar that they include only case-studies,

focus on the viewpoint of the PEFs and not the FOBS, or assess just part of the activities that

PEFs apply (Meier, 2005). In addition, so far only few studies exist which try to combine the

two perspectives of PEFs and FOBs (e.g. Howorth, Westhead & Wright, 2004; Gröne, 2005;

Scholes, Westhead & Burrows, 2008). Indeed, no research exists so far, which assesses the

value-adding activities of PEFs in the light of resource deficiencies of FOBs. A better

understanding of this relationship and the performance implications for PEF investments in

FOBs would thus be beneficial for the owning family faced with a decision for the future of

their firm and the private equity investors which are looking for promising investment

opportunities.

With this empirical study we aim to add to the body of knowledge about the relationship

between FOBs and PEFs. Specifically, we aim to assess the performance impact of activities

PEFs use to create value in their former FBO-portfolio companies. Drawing on existing

literature and 52 expert interviews we identified eight distinct value creation levers of PEFs

and developed a set of hypotheses to describe the fit between the two perspectives of

resource-deficiency of FOBs and value levers of PEFs and that enables us to test their

performance impact. We tested the hypotheses on a dataset for 118 European PEF-buyouts

of FOBs. The results show that PEFs indeed can add value to the former FOBs in their

portfolio, but that the impact depends on prior performance of the invested firms and that not

all identified value levers have the same impact.

                                                                                             3

We begin our investigation by introducing the concepts of PEF propensity of FOBs and the

value adding activities of PEFs. We then develop the logic specifying which resource

deficiencies of FOBs can be addressed by the singular value levers and we argue for the

relation that can be expected. After that we present the results of our analysis and discuss

their implications on our hypotheses.

                                 THEORY DEVELOPMENT

Resource deficiencies of FOBs as driver for PEF propensity

Family Owned Businesses are characterized by the high influence that one family has

through both ownership rights and managerial involvement. The majority of shares usually lie

with one family which is represented in the management team or through board activities

(Davis, 1983; Dyer, 1986; Stern, 1986). In Europe, FOBs account for over 70% of jobs

(GEEF, 2003) and for between 55-65% of the GNP (IFERA, 2003) and also internationally,

FOBs are seen to be a dominant economic factor in most countries (Astrachan & Shanker,

2003; Morck & Yeung, 2003), thus presenting a relevant research object.

According to the Resource Based View (Wernerfelt, 1984; Barney, 1991), success of any

company can be traced to the set of resources it has and how it is using them. It is based on

the assumptions that markets are imperfect and that resources are heterogeneously

distributed among companies. The Resource Based View regards the ideosyncratic

resources of a company as the main source of its competitive advantage (Wernerfelt, 1984).

According to Barney, such ‘resources include all assets, capabilities, organizational

processes, firm attributes, information, knowledge etc. controlled by a firm that enable the

firm to conceive of and implement strategies that improve its efficiency and effectiveness’

(Barney, 1991).

In the case of FOBs this set of resources is especially linked to the resources they have due

to their strong relations to a family and the accompanying impact on the organization. This

driver for competitive advantage in FOBs is generally referred to as distinctive familiness

(Habbershon & Williams, 1999; Habbershon, Williams & MacMillan, 2003). For example, due
                                                                                           4

to the strong relation between company performance and family wealth FOBs are often said

to be very cost efficient (Anderson & Reeb, 2003, Carney, 2005). Furthermore, with a long-

term orientation to ensure company survival over several family generations, FOBs often

develop a reputation for high quality (Davis, 1983; Ward, 1988; Kets de Vries, 1993).

However, FOBs are also often characterized by certain resource deficiencies (Kets de Vries,

1993; Sirmon & Hitt, 2003) called constrinctive familiness (Habbershon & Williams, 1999).

We argue that these resource deficiencies can be a reason for PEFs to believe that the

engagement into value adding activities will indeed create value in their portfolio companies

as they address the resource gaps and try to fill them with PEF resources. So far, only few

studies exist that address the constrinctive familiness of FOBs and thus a comprehensive

overview of resource deficiencies is still missing. Generally, discussed aspects of resource

deficiencies are limited access to financial capital (Sirmon & Hitt, 2003) due to the FOBs’

avoidance of ownership dilution, too small size for bond issuances and reluctance to raise

debt Mishra & McConaughy, 1999; Sirmon & Hitt, 2003). Additionally a low level of

professionalization in operational and strategic issues and a lack of talented management is

seen in FOBs. Finally, they are said to be inwardly focused, avoiding too much collaboration

with other companies and largely neglecting outside advice. Accordingly, PEFs can be

attracted to invest in FOBs as they perceive these resource deficiencies and see potential to

create value through active involvement.

Also for FOBs several reasons exist to engage into discussions with PEFs (Birley &

Westhead, 1990). In Germany, for example, around 21% of FOBs are eventually sold to

external investors (Linnemann, 2007), on a European scale more than 25% of PEF

transactions are including FOBs (EVCA, 2005). One major influencing factor for FOBs is a

failed succession process. Although they usually strive to keep ownership within one family

across several generations (Chua et al. ,1999), this sometimes is not possible, e.g. due to a

lack of qualified or willing heirs, an insufficient and late planning for succession (Birley &

Westhead, 1990), Le Breton-Miller et al., 2004), or a lack of funds to finance the transfer

(Mishra & McConaughy, 1999). Another major reason for FOBs to sell to PEFs can be a

                                                                                            5

limited ability to grow and ensure stand-alone success induced by a lack of investment funds

(Mishra & McConaughy, 1999; Sirmon & Hitt, 2003; Carney, 2005). Here, the PEFs can be

seen as an alternative to growing the firm independently. Ultimately, the buyout to a PEF

serves to ensure the survival of the firm and creates an exit opportunity for the family if they

realize they are not able to continue the business themselves.

Value adding activities in PEF investments

PEFs are firms that professionally invest in other companies, normally via a buyout of old

shareholders. The acquisitions are usually financed through a combination of funds provided

by secondary investors and a debt leverage that increases the acquisition power of a PEF

(Schaaf, 2005). From the outset every PEF transaction has a limited timeframe of three to

five years with the aim to profitably sell the acquired shares again (Jensen, 1989a; Wright,

Robbie, Thompson & Starkey, 1994; Berg & Gottschalg, 2004). There are two main drivers

for value generation in Private Equity buyouts. The first is the identification and acquisition of

undervalued companies, thus the realization of arbitrage effects through selling the portfolio

company at the “real” value. Secondly, PEFs can increase the value of acquired companies

by actively engaging into value levers, i.e. value adding activities that PEFs apply on their

portfolio companies with the aim to increase the value of their investment (Sapienza et al.,

1996; Berg & Gottschalg, 2004). This involvement of PEFs in their portfolio companies has

been the subject of research in a number of studies in the Private Equity field. Mostly, these

studies confirm a positive impact of involvement on value generation (MacMillan, Kulow &

Khoylian, 1989; Howorth et al., 2004; Scholes et al., 2008), although performance influence

differs depending on e.g. the life-cycle of the company that is acquired (Schefczyk, 2004).

Furthermore, existing studies do not draw onto a generally accepted structure for the value

adding activities (Berg & Gottschalg, 2004; Scholes et al., 2008). Thus, we developed an

own categorization of value levers for this study that PEFs use to increase the value of their

portfolio companies. We did this by applying a combination of deductively combining the

value levers that are discussed in the literature (see e.g. Berg & Gottschalg, 2004 for an

                                                                                                 6

extensive overview), and inductively identifying additional levers through expert interviews.

These interviews with 52 experts, which lasted on average 66 minutes, were conducted with

managers from PEFs, facilitators, associations and academia and served also to validate

the set of identified value adding activities.

                                                 Value adding
                                               activities of PEFs

                                    Direct                               Indirect
                                influence of                           influence of
                                     PEF                                   PEF

                 Direct value                    Indirect value        Indirect value
                   creation                         creation              creation

                 Involvement in                   Change of             Involvement of
                 financial                        structures &          external
                 management                       systems               consultants

                 Involvement in                   Change of top         Encouragement of
                 operations                       management team       cooperation
                                                  setup
                 Involvement in                   Governance &
                 strategy & business              interaction of top
                 development                      management
                                                                              Research Colloquium August 26th, 2008   1

Figure 1: Overview over value adding activities in PEF investments

This resulted in a set of 8 value levers that PEFs typically engage into. We differentiated

these levers into three groups depending on the degree of influence that the activities have

on value creation within the FOB (figure 1). The first group comprises activities where the

PEF directly influences value creation in the portfolio company. This can include advice with

the sourcing and allocation of financial funds, the direct interference in operational issues or

the support in the development of strategy and business development. Activities within the

second group have a potential for indirectly creating value as these include the change of

organizational structures, the influence on the setup of the top management team and the

optimization of the firm´s governance and interaction within the top management. Finally, a

third group comprises value adding activities not through the PEF but through external

influences induced by the PEF. Examples in this group are the engagement of external
                                                                                                                          7

consultants to work with the FOB and the integration in cooperation activities with other

portfolio companies of the PEF.

Hypotheses on the impact of PEF value levers on FOB performance

Involvement in financial and asset management. As FOBs strive to keep ownership and

control of the business in the family, they usually have only limited access to typical financing

sources of corporations as external equity and debt. They try to avoid dilution of their shares,

external influence on management decisions (Roman, Tanewski & Smyrnios, 2001;

Achleitner & Poech, 2004; Achleitner, Poech & Groth, 2005), and furthermore lack the

experience to negotiate with equity investors (Achleitner, Poech & Burger-Calderon, 2005).

In addition, FOBs are reluctant to share financial information with outsiders (Achleitner &

Poech, 2004; Achleitner et al., 2005) and try to avoid debt financing if possible (Blank, 2004),

Gallo & Vilaseca, 1996; Mishra & McConaughy, 1999; Wiechers, 2006). Finally, they show

high commitment to past investment decisions and potentially lock funds in unattractive

investments even if other more promising alternatives emerge (Ward & Aronoff, 1991;

Sirmon & Hitt, 2003).

PEFs are professional investment companies and thus are not concerned with the

highlighted issues. Thus, they can more easily add value by engaging into financial and

asset management, especially an optimization of capital structure, reduction of corporate tax

and optimization of working capital. The PEF can use its financial engineering skills to

improve a company’s mix between debt and equity (Anders, 1992), which often concurrently

implies an increase in debt and a tax-shield induced reduction of tax (Kaplan, 1989a). PEFs

can also be helpful to reach terms for debts and bond issuing that the FOB would not have

been offered on a stand-alone basis (Kaufman & Englander, 1993). Additionally, inventory

and accounts receivables management can often be professionalized after a buyout (Singh,

1990; Magowan, 1989; Long & Ravenscraft, 1993), leading to a lower working capital level

(Holthausen & Larcker, 1996). Accordingly, it seems that the PEF can indeed can add value

by providing access to new sources of funding and by transferring their expertise in financial
                                                                                               8

management into the former FOB. Thus hypothesis 1 states:

       Hypothesis 1. The involvement in financial and asset management has a positive

       impact on performance in buyouts of FOBs.

Involvement in operational issues. FOBs are usually oriented towards family ownership

over several generations, and often build up a reputation for high product quality which can

be seen as a driver for long-term survival (Davis, 1983; Ward, 1988; Kets de Vries, 1993;

Daily & Dollinger, 1993; Upton, Teal & Felan, 2001). In addition, the corporate culture in

FOBs also can lead to a high identification of the employees with the company. This again

has an impact on internal motivation and effort for improving the product and optimizing the

offerings. As the profitability of FOBs is directly connected to the wealth of the owning family

(Anderson & Reeb, 2003), FOBs also have a tendency for high cost awareness, not only in

situations where they strategically pursue a low-cost leadership approach (Carney, 2005).

They avoid unnecessary spending and thrive to continuously streamline their operations.

PEFs might consider active involvement in operational issues as a value adding activity, as

e.g. focus on high product quality is often perceived to lead to a neglect of process and

material costs. Furthermore, as FOBs are mostly small- to medium-sized businesses, PEFs

might assume a lack of competency for process optimization and cost cutting. Although

saving initiatives are common in PEF buyouts (Kaplan, 1989b; Muscarella & Vetsuypens,

1990), we argue that the outsider influence of PEFs in operational issues will rather have a

negative impact, as saving costs in operational issues might deteriorate quality as a major

factor of competitive advantage, or even be totally fruitless as the cost-aware FOB should

                                                                                              9

already have reaped potential savings to maximize profitability of the owner. Thus hypothesis

2 states:

       Hypothesis 2. The involvement in operational issues has a negative impact on

       performance in buyouts of FOBs.

Involvement in strategy and business development activities. FOBs strive to keep

ownership within the family for several generations. With this long-term approach strategic

decisions often are rather conservative to limit risky investments that endanger survival of the

firm (Zahra, Hayton & Salvato, 2004). As the management in FOBs usually does not have to

report to an outside board, decision processes are furthermore not necessarily based on

objective criteria and standards. This can for example lead to situations where FOBs

continue in businesses that have become unprofitable (Carlock & Ward, 2001; Sharma &

Manikutty, 2005), because the management avoids reassessing past decisions and is not

forced to do so as no sounding board is available. Also, FOBs often even lack a formalized

strategy process or decision-oriented business planning (Upton et al., 2001).

Through active involvement in strategy and business development, PEFs can address these

aspects. They can ensure a coherent strategy process and require decisions to be prepared

and conducted based on objective analyses rather than subjective preferences. This can

lead to more growth-oriented strategies, e.g. a focusing of the corporate portfolio (Seth &

Easterwood, 1993; Phan & Hill, 1995), the abandoning of unprofitable or unrelated business

lines (Hoskisson & Turk, 1990; Liebeskind, Wiersema & Hansen, 1992) or the acquisition of

other companies to leverage on core competencies. All these effects should have a positive

impact on performance, thus hypothesis 3 states:

       Hypothesis 3. The involvement in strategy and business development activities has a

       positive impact on performance in buyouts of FOBs.

Changing organizational structure and management systems. FOBs often have a long

history and, as shown, lack decision making process based on objective criteria. This can

                                                                                             10

lead to organizational structures that have grown with the company but where adaptation to

e.g. larger size, changes in market structure and competitive dynamics have been neglected.

Furthermore, with usually low attrition rates of employees, informal structures and

communication lines increase in importance (Geeraerts, 1984; Goffee & Scase, 1985; Daily

& Dollinger, 1993), making the organization dependent on individuals. Typically, FOBs are

said to have structures that are less formalized and show a lower degree of specialization. In

such situations, PEFs might be able to add value by optimizing the organizational structure to

meet current requirements from strategic or market viewpoints (Muscarella &Vetsuypens,

1990). They also tend to update management control systems in their portfolio companies,

introduce more performance related compensation systems (Jensen, 1989a; Anders, 1992;

Fox & Marcus, 1992; Schulze, Lubatkin, Dino & Buchholtz, 2001; Berg & Gottschalg, 2004;

Lubatkin, Schulze, Ling & Dino, 2005) and formalize workflows in the organization. Although

these measures might lead to a loss of the FOB-typical positive identification of employees

with the firm (Kets de Vries, 1993), we believe that as long-established structures and

systems are changed, the positive impacts of a more flexible and professional organization

on average will dominate. Thus, hypothesis 4 states:

       Hypothesis 4. Changing organizational structure and management systems has a

       positive impact on performance in buyouts of FOBs.

Changing the top management team. Top management teams in FOBs on average have a

long tenure of 15 to 25 years (Miller & Le Breton-Miller, 2006). This can lead to a very

thorough understanding of the market dynamics and competencies of the organization

(Sirmon & Hitt, 2003; Le Breton-Miller & Miller, 2006), as indicated by the sustainable

survival of many of these firms. However, several studies show that top managers in FOBs

regularly seem to be underqualified (Lubatkin et al., 2005; Schulze et al., 2001; Sirmon &

Hitt, 2003; Dyer, 2006). Reasons for this could be a tendency for nepotism in the FOB

(Lubatkin et al., 2005), where decisions for manager positions are based on family

                                                                                           11

membership or personal preferences and not on qualification or performance (Kets de Vries,

1993). A side effect of this might also be that highly competent managers become unsatisfied

with promotion practices in the firm or are tired of covering the underperformance of

unqualified colleagues and finally leave the firm (Donnelley, 1964). Gomez-Mejia, Nuñez-

Nickel & Gutierrez (2001) found e.g. that FOBs led by family members were more reluctant

to discharge family CEOs, but when they did, performance improved significantly.

PEFs could then add value by implementing performance based assignment processes for

the top management team and accordingly exchange underqualified managers (Jensen &

Ruback, 1983; Anders, 1992). This should then lead to higher motivation and

professionalization of the firm as H5 states:

       Hypothesis 5. Changing the top management team has a positive impact on

       performance in buyouts of FOBs.

Different interaction with top management. Besides the assignment process for the top

managers, also control and incentive systems in FOBs may show potential for improvement.

As discussed, top managers in FOBs often are insufficiently qualified. Besides, the

processes and incentive systems are hardly performance oriented and non-family managers

seldom participate in company success through own equity in the firm. The activities PEFs

take to approach these governance issues combine coaching and control aspects (Kets de

Vries, 1993; Palepu, 1990; Anders, 1992; Cotter & Peck, 2001). Often, they engage into

actively supporting the development of top managers to fill in competency gaps, and serve

as sparring partners for strategic and operational decisions (Baker & Wruck, 1989; Bruining

& Wright, 2002; DeAngelo & DeAngelo, 1987; Houlden, 1990; Kester & Luehrman, 1995;

Sapienza & Timmons, 1989). In addition, PEFs regularly realign the governance by ensuring

a clear goal setting and higher standards for quality and reporting also for top managers

(Baker & Wruck, 1989; Magowan, 1989) and implement more performance oriented incentive

systems as profit sharing or equity shares (Muscarella & Vetsuypens, 1990; Baker &

Montgomery, 1994; Phan & Hill, 1995). With these measures the drawbacks of FOB

                                                                                         12

governance should be positively influenced leading to our hypothesis 6:

       Hypothesis 6. Changing governance approach and interaction with top management

       has a positive impact on performance in buyouts of FOBs.

Engagement of external consultants. The use of consultants is rather limited at FOBs. A

reason for this might be a tendency of an inward-focus (Kets de Vries, 1993) or hubris of

family top managers that have endured for a long time already or even were instrumental in

founding and/or growing the company. In such situations the need for outside advice might

not be so apparent. Furthermore, FOBs are more secretive and do not share information

easily with outsiders (Dyer, 2006). Also, as consultants normally pose a high cost position,

efficiency- and profit oriented FOBs might avoid considering their help out of financial

considerations.

As the expert interviews showed, hiring consultants is an activity which PEFs often

encourage their portfolio companies to do (Baker & Smith, 1998). The reason for this might

be that consultants can add value by assessing the competitiveness of organizations and by

helping to optimize outdated or insufficient structures and processes, i.e. also by

implementing many of the value adding activities that PEFs want to pursue. However, we

argue that also PEFS are more prone to avoid unnecessary cost positions and thus would

only involve external consultant if the FOB is underperforming and a need for outside advice

arises. As firms in which consultant are involved into are likely to perform worse than other

firms from the outset, we rather see a negative relation between the involvement of external

consultants and company performance, as expressed in hypothesis 7:

       Hypothesis 7. The involvement of external consultants has a negative relation to

       performance in buyouts of FOBs.

Encouragement of cooperation with other portfolio companies. Due to the inward-

looking focus of FOBs and their overall secrecy, cooperation with other companies outside

typical supplier-buyer relations does seldom take place. However, this phenomenon is not

                                                                                          13

limited to FOBs but can also be observed at non-family businesses. As the expert interviews

showed, the attempt to establish active networking between the portfolio companies is a

common approach of PEFs. This is not too much focused on synergy creation between the

singular companies (Baker & Montgomery, 1994), but especially highlights exchange of best

management- or industry practices (Kets de Vries, 1993) and experience exchange. Hence,

encouragement of cooperation with other portfolio companies is likely to improve the

performance of the former family business as stated in the eighth hypothesis:

       Hypothesis 8. The value-adding activity encouragement of cooperation with other

       portfolio companies has a positive impact on performance in buyouts of FOBs.

Difference between performing and non-performing FOBs. The resource based view of

the firm states, that success of companies is based on the application of ideosyncratic

resources (Wernerfelt, 1984; Barney, 1991). This already implies that there might be

companies within the group of FOBs that have different intensities of resource advantages

and –deficiencies (Nordquist, 2005; Miller & Le Breton-Miller, 2006; Chrisman, Steier &

Chua, 2006).

Accordingly, PEFs might not be consistently engaged into all of the supporting activities for

their portfolio companies. Rather, we argue that a PEF might consider to apply its resources

mainly in cases where they perceive a need for support. Thus, the intensity of support should

vary in the number and types of value levers that are used, especially between groups of

outperforming and non-outperforming FOBs. The latter might pose a higher need for the

support through the PEF thus there will be differences in the influence the activities have on

the performance outcome. As non-outperforming FOBs seem to lack critical resources and

PEF might add higher value here, we also believe that the strength of the impact will be

higher for this sub-groups of FOBs in a buyout. Thus hypothesis 9 states:

       Hypothesis 9: There is a difference between the relation of supporting activities and

       performance    between     the   two   sub-groups     of   outperforming   and    non-

                                                                                           14

outperformingFOBs. The impact of the supporting activities will be higher for the

       group of non-outperforming FOBs.

                                           METHODS

Sample

We tested the hypotheses on a sample of 118 European buyouts of FOBs. To derive this

sample we sent out a questionnaire to 4,475 managers in portfolio companies of PEFs.

Managers of portfolio companies were chosen as they are assumed to have the best

overview of a company’s resources and are likely to have a good judgment about the

intensity of value-adding activities that investors exercise and the resulting development of

performance. The questionnaire resulted in 128 answers from former FOBs, of which we

used 118 in the final analysis as ten of the answers were incomplete. The responses came

from 15 European countries. With 28 and 26 responding firms, respectively, the UK and

Germany together make up almost half of the participants. France and Sweden follow with

12 participants each. The remaining respondents are from companies based in Switzerland

(6), Italy (5), Norway (5), the Netherlands (5), Belgium (4), Spain (4), Austria (3), Finland (3),

Denmark (2), Portugal (2) and Poland (1). Of the 118 participating companies, 52 were spin-

offs of FOBs and 66 former autonomous FOBs. Over 90% of respondents were on the board

member level and 97.5% had direct experience with the activities of the PEF.

Measures and Model

The independent variables measure the intensity of the value-adding activities of PEFs. As

these activities are directly observable, the variables are manifest and we measured them

directly. For the inquiry of all eight variables, we presented statements to the participants

about the respective activity of the investor, for example “… got involved in financial and

asset management” for the first value-adding activity. We asked participants to rate the

extent to which their PEF engaged in the respective activity on five-point Lickert scales

                                                                                               15

ranging from “not at all” (1) to “extensively” (5). A five-point scale was used as pre-tests with

seven-point scales showed that participants found it hard to distinguish between seven

different levels of intensity of the activities and thus the return rate was lower than for five-

point scales. We then coded the variables from 1 to 5 to include them into the analyses. In

the first group of activities, we labeled involvement in financial management as FINASS, the

involvement in operational issues as OPERATIONS and support in strategy and business

development as STRATEGY. We chose ORGSTRUC for the involvement in changing

organizational structure and systems in the second group, as well as CHANGEMGMT for the

influence on the setup of the top management team and INTERACTION for all activities

concerning the optimization of governance and interaction in the top management team. In

the third group of activities we named the involvement of external consultants as EXTCONS

and the encouragement to engage into cooperation with other portfolio companies as

COOPERATION. As dependent variable we used the performance relative to competitors

with a seven-point Lickert scale ranging from “significantly worse” (-3) over “same” (0) to

“significantly better” (+3) at the time of the survey. Thus, the absolute development of

performance in an industry will not distort the findings of this study. As Chandler and Hanks

(1993) stated, using subjective perception of performance relative to competitors is relevant

and “a strong independent construct with a high level of internal consistency” (Chandler &

Hanks, 1993: 404). Brush and Vanderwerf (1992) furthermore showed that managers

regularly are knowledgeable about sales and profits of competitors. To include responses

given by companies where the PEF had already conducted an exit, we asked these

companies for the relative performance at the time of the PEF exit, and labeled both answers

into PERFEXIT. To avoid handling negative numbers, the answers were recoded by adding 3

to each value, so that the range of the data values is from 0 to 7. To control for prior

performance and to allow for an analysis of performance change, we included PERFBO as

the performance relative to competitors at the time of the buyout. Additionally, we included

the growth situation of the FOB at time of buyout, checking for “shrinking”, “stagnating”,

“growing moderately” or “growing significantly” as GROWTH. We also controlled for size

                                                                                              16

(SIZE) through asking for sales per year (Chrisman, Chua & Litz, 2004; Cooper, Upton &

Seaman, 2005; Miller, Le Breton-Miller & Scholnick, 2008). Also, we included the investors’

industry-specific knowledge, or feeling for an industry as FEELIND as we assume an

influence on performance impact of value adding activities (Sapienza et al., 1996). The

resulting model of performance influence of PEF value adding activities on former FOBs in

presented in figure 2 below:

      FINASS
                                PERFBO          SIZE        GROWTH
    OPERATIONS

     STRATEGY

    ORGSTRUC
                                                                     Independent variables
                                              PERFEXIT               Dependent variable
   CHANGEMGMT
                                                                     Controll variables

                                                                     Variance explained of interest
   INTERACTION
                                                                     Variance explained not of interest
                                              FEELIND
     EXTCONS

   COOPERATION

Figure 2: Statistical model

We performed multivariate analysis with the standard statistical software SPSS and entered

the control variables via forced entry in a first block, the independent variables via forced

entry in a second block. Therefore, only the predictive power of the independent variables on

the variance of the dependent variable not yet explained by the control variables was

explored.

We first applied the statistical Models 1 and 2 to the full sample of buyouts of FOBs. Then we

reapplied these models to (1) a subsample of all buyouts of family firms that outperformed

their competitors at buyout (PERFBO > 4), these models are referred to as Model 3 and

Model 4; and (2) a subsample of all buyouts of family firms that did not outperform their

competitors at buyout (PERFBO ≤ 4), these models are referred to as Model 5 and Model 6.
                                                                                                          17

For evaluation of hypotheses 1 to 8 we assessed Models 2, 4 and 6. Hypothesis 9 is

evaluated comparing Model 4 and 6. Model 1, 3 and 5 that only contain the control variables

allow for a better understanding of the part of variance explained by the other influencing

factors.

                                        RESULTS

Descriptive statistics

The means, standard deviations and correlations for the full sample are reported in Table 1.

The PERFBO mean of 4.53 is lower than the PERFEXIT mean of 5.60 and PERFBO is

highly positively correlated with PERFEXIT, which shows that the relative performance of the

portfolio companies improves on average in a buyout and also that performance at buyout is

related to performance at exit. SIZE is positively with FINASS, INTERACTION, EXTCONS

(all at p < 0.001), STRATEGY and CHANGEMGMT (both at p < 0.01), which indicates that

PEFs are more active in larger buyouts. Surprisingly, GROWTH is not correlated with any of

the indicated variables. PEFs seem not to differentiate the intensity of their influence

between growing, stagnating or shrinking companies. FEELIND is positively related to all

value-adding activities: with OPERATIONS, STRATEGY, INTERACTION, COOPERATION

at p < 0.001, with CHANGEMGMT at p < 0.01, FINASS and ORGSTRUC at p < 0.05 and

with EXTCONS at p < 0.1. This indicates that PEFs who have a profound knowledge of a

portfolio company’s industry appear to be more involved. Also, FEELIND is positively related

to PERFEXIT (p < 0.05), which could indicate that PEFs should try to aim on gaining industry

knowledge.

                                                                                         18

Variable                      Mean            SD     Pearson's correlation coefficient

                                                         1         2        3        4         5          6          7          8          9         10       11       12
 1. PERFBO                       4.53        1.61
 2. SIZE                         2.08        0.90     -0.93
 3. GROWTH                       3.00        0.82     -0.37***   -0.06
 4. FEELIND                      2.85        1.09     -0.02      -0.08     -0.10
 5. FINASS                       2.90        1.21     -0.00      -0.28**   -0.14   -0.21*
 6. OPERATIONS                   1.86        1.04     -0.17†     -0.11     -0.13   -0.42***   -0.36***
 7. STRATEGY                     2.96        1.14     -0.05      -0.19*    -0.01   -0.47***   -0.45***   -0.36***
 8. ORGSTRUC                     2.08        1.10     -0.13      -0.14     -0.13   -0.22*     -0.37***   -0.42***   -0.35***
 9. CHANGEMGMT                   2.29        1.50     -0.16†     -0.22*    -0.12   -0.25**    -0.24**    -0.30***   -0.35***   -0.58***
 10. INTERACTION                 3.14        1.32     -0.84      -0.28**   -0.11   -0.34***   -0.50***   -0.37***   -0.47***   -0.38***   -0.36***
 11. EXTCONS                     2.29        1.19     -0.10      -0.29**   -0.10   -0.15†     -0.33***   -0.41***   -0.37***   -0.53***   -0.48*** -0.31***
 12. COOPERATION                 1.85        1.04     -0.43      -0.06     -0.01   -0.37***   -0.25**    -0.29**    -0.36***   -0.08      -0.14    -0.27** -0.24**
 13. PERFEXIT                    5.60        1.30     -0.44***   -0.04     -0.08   -0.21*     -0.05      -0.12      -0.06      -0.10      -0.12    -0.03    -0.27**   -0.20*

 Notes:
 Significance (2-tailed): † p < .10; * p < .05; ** p < .01; *** p < .001
 N = 118, SD: Standard deviation

Table 1: Correlation matrix and descriptive statistics of all buyouts of FOBs

Multiple regression

Table 2 presents the results of multiple regression analysis for the dependent variable

PERFEXIT. In total, six models were estimated. Model 1 only includes the control variables.

In model 2 the eight value levers that PEF apply to actively add value to the acquired FOB

are also included. For models 3-6 the sample was divided into two sub-groups. One group

contains all FOBs that were outperforming at the time of the buyout, the other all FOBs that

were not outperforming. Model 3 only includes the control variables for the sub-group of

outperforming FOBs and model 4 additionally the eight value levers. Model 5 and 6 use the

same approach, only for the sub-sample of non-outperforming FOBs.

Model 1 and 2 are significant (p < 0.001) and explain between 25 and 38 percent of the

variance in performance at exit of the PEF. For the analysis of the two sub-groups only the

models 4 and 6 are significant (p < 0.01 and p < 0.001) and explain 32 and 46 percent of the

variance in PERFEXIT respectively. For all six models additional tests showed that

requirements of homoscedasticity and normal distribution were met and that collinearity is of

no major concern.

Model 2 shows that two of the eight hypotheses about the relation of value levers on

performance are supported for the full sample. Hypothesis 7 proposes a negative

performance relation between the involvement of external consultants and the performance

                                                                                                                                                                               19

of the former FOB, because PEFS are likely to call for consultants only in cases where the

performance of portfolio companies is suffering. This hypothesis is supported by a negative

and significant coefficient for the variable EXTCONS. In support of hypothesis 8 we found a

positive and significant relationship between the encouragement to cooperate with other

portfolio companies of the PEF and performance. A significant relationship between the other

six value levers and performance, however, could not be reported for the full sample.

For the sub-group of outperforming FOBs hypothesis 7 could be supported as well, all other

results are not significant. The sub-group of non-outperforming FOBs delivers more insight.

Here, significant relations could be found for four of the eight support activities. The

involvement in OPERATIONS has, as suggested in hypothesis 6, a negative relation to

performance. Activities concerning organizational structure and systems (ORGSTRUC) have

a positive relation as proposed in hypothesis 4, and the encouragement of cooperation

between portfolio companies (COOPERATION) also shows a positive relation, as proposed

in hypothesis 8. Furthermore, for hypothesis 6 significant results could be found for the sub-

group of non-outperforming FOBs. The direction of the relation, however, is the opposite

direction than assumed. In addition to the main effects, the influence of two control variables

has to be emphasized. Performance at buyout and feeling for the industry have a positive

and significant effect on company performance at exit of the PEF for the large sample. This

could also be shown for the sub-group of non-outperforming FOBs for the variable FEELIND.

As the results for both sub-groups are different with regards to hypothesis 1 to 8, this also

delivers partial support for hypothesis 9. The divergence between models 4 and 6 indicates

that the relation between support activities and performance is different between FOBs that

outperform and those that do not. While in model 4 only one significant relationship could be

found for the outperforming FOBs (between involvement of external consultants and

performance), model 6 reports four significant relations for the group of non-outperforming

FOBs (negative relation between OPERATIONS and INTERACTION with performance and

positive relation with ORGSTRUC and COOPERATION). However, as model 5 shows only

                                                                                            20

one significant result, it cannot be shown that the influence is higher in one of the sub-

groups.

   Variable                      Mean            SD     Pearson's correlation coefficient

                                                           1         2        3        4          5          6          7          8          9         10      11       12
   1. PERFBO                       5.77        0.75
   2. SIZE                         2.19        0.81     -0.15
   3. GROWTH                       3.28        0.63     -0.18      -0.14
   4. FEELIND                      2.88        1.09     -0.04      -0.13     -0.31*
   5. FINASS                       2.97        1.19     -0.22†     -0.15     -0.11    -0.29*
   6. OPERATIONS                   1.69        0.89     -0.03      -0.08     -0.19    -0.34**    -0.57***
   7. STRATEGY                     3.02        1.11     -0.23†     -0.07     -0.07    -0.45***   -0.54***   -0.44***
   8. ORGSTRUC                     1.97        1.05     -0.07      -0.12     -0.03    -0.20      -0.54***   -0.43***   -0.50***
   9. CHANGEMGMT                   2.14        1.40     -0.12      -0.25*    -0.10    -0.27*     -0.43***   -0.25*     -0.49***   -0.55***
   10. INTERACTION                 3.16        1.30     -0.17      -0.15     -0.13    -0.26*     -0.60***   -0.39**    -0.51***   -0.37**    -0.35**
   11. EXTCONS                     2.13        1.18     -0.04      -0.31*    -0.18    -0.07      -0.47***   -0.43***   -0.49***   -0.70***   -0.50*** -0.30*
   12. COOPERATION                 1.97        1.07     -0.23†     -0.30*    -0.06    -0.38**    -0.36**    -0.35**    -0.35**    -0.22†     -0.14    -0.31*   -0.21
   13. PERFEXIT                    6.14        1.01     -0.13      -0.01     -0.09    -0.19      -0.14      -0.11      -0.16      -0.30*     -0.26*   -0.02    -0.44*** -0.05

   Notes:
   Significance (2-tailed): † p < .10; * p < .05; ** p < .01; *** p < .001
   N = 64, SD: Standard deviation

Table 2: Correlation matrix and descriptive statistics of buyouts of outperforming FOBs

                                                   DISCUSSION AND INTERPRETATION

Private equity buyouts have become a relevant route for family businesses to ensure the

survival of their firms (Birley & Westhead, 1990; Linnemann, 2007) while exiting from the

entrepreneurial role. In the 3-5 years that PEFs typically own the FOB before an exit

(Sudarsanam, 2003), they regularly engage into activities with which they claim to support

the development of the former FOBs after the buyout. The underlying reasoning highlights

the resource deficiencies that FOBs have (Kets de Vries, 1993; Habbershon & Williams,

1999) and that PEFs are able to create value as their support activities address these

deficiencies (Berg & Gottschalg 2004). However, so far no study exists that combines these

two perspectives.

Building on existing research on advantages and deficiencies of FOBs and an inductive

process based on literature review and 52 interviews with practitioners and scholars we

developed a model that aims to analyze the impact that the support activities of PEFs have

on the performance of FOBs after a buyout. Our results suggest that in general there is

indeed a relation between two of the eight activities we identified with the performance of the

former FOBs. In addition, we also found at least partial support for three additional

                                                                                                                                                                                21

hypothesis from the analysis of the sub-groups.

For the full sample, there is a negative relation with the involvement of external consultants,

which we argue to originate in the circumstance that PEFs are more likely to engage

consultants when the performance of the FOB is suboptimal, and that typically this

performance has not recovered in the short timeframe the PEF is invested. Furthermore, we

found a positive relation between the encouragement of the former FOB to cooperate with

other portfolio companies of the PEFs and performance. As FOBs tend to be rather inwardly

focused, we argue that the positive impact results from the increased networking with other

companies and the exchange of best practices. Thus we found support for hypothesis 7 and

8.

For the full sample, we were not able to find support for six of our eight hypotheses regarding

the support activities. Hypothesis 1, that an involvement of the investors in financial and

asset management in buyouts of FOBs during the holding period has a positive impact on

performance, could not be supported by the results of the regression analysis. We supposed

that means of financial management are used in the holding period of the PEF investment

and that this increases the performance of the portfolio company. One possible explanation

for not finding a significant support for this hypothesis could be that most aspects of financial

management (e.g. debt level) are already determined in the acquisition phase and thus only

limited observations are available from the holding period (Baker & Montgomery, 1994).

The lack of support for hypothesis 2 in the full sample could be a result of the already good

cost management that FOBs are said to have, where the PEFs see no need to further

engage into operational issues. However, for the group of non-outperforming FOBs we did

find a significant negative relation as proposed. This follows our argumentation that PEFs will

seek involvement into operational issues when they perceive the performance of the FOB to

be suboptimal, but that still the FOB is likely to be better in managing the operational

business than an outsider could be.

Surprisingly, we found no positive impact of PEF involvement in strategy and business

                                                                                              22

development activities in any of the sample groups. Therefore, Hypothesis 3 could not be

supported by the results of the regression. Several explanations for this are possible. It could

be, for example, that the involvement in strategy in business development, namely a focusing

of the strategic approach and the encouragement to grow quicker through acquisitions etc.

has a counterproductive effect, as it confronts with the often rather conservative corporate

culture in FOBs. Thus the positive impact of strategic support could be lowered by internal

barriers. Further, if PEFs push for a divestment of traditional business lines, this could

additionally lead to a decrease in motivation. Another explanation could also stem from an

investment bias, that PEFs only invest in FOBs where the strategic outlook is positive,

originating from professional processes and good strategy execution. In such FOBs the

investors would not need to heavily engage into optimizing strategy and business

development.

Hypothesis 4 proposed an impact of the PEFs’ influence on organizational structures and

management systems and performance, as both are said to be underdeveloped in FOBs.

The data, however, did not support the notion that PEFs in general can improve the

performance by urging the former FOBs to define responsibilities and work tasks more

precisely, improving the incentives of middle management, increasing the pay-to-

performance sensitivity for all employees and fostering a formalization of internal control

systems. Still, as for hypothesis 2 we did find the assumed relation in the sub-group of non-

outperforming FOBs, supporting the argumentation that performance at buyout influences

whether PEFs will engage into an activity.

For hypothesis 5 we could not find any support. The data implies that changing the top

management team is no effective means for PEFs to improve the performance during the

holding period. This could be interpreted in two ways. First, it could be that in the case of

FOBs’ having incapable and unqualified managers the PEFs negotiate a change in the

management team even before the holding period, so that the incompetent managers are not

any longer in charge when the acquisition is closed. It is likely that e.g. board members know

in advance that they will not be able to persist under the new owners so that they leave the

                                                                                             23

company voluntarily when it becomes clear that the deal will take place. A second reason

might be, that underqualified managers having profound company-specific knowledge

perform more or less the same as competent managers who lack company-specific know

how. Newly engaged managers need some time to accumulate company-specific know how.

Maybe this constrains the measuring of this effect, because in some cases where managers

are exchanged the tenure of the new managers is merely too short for them having a positive

effect on performance.

As for hypothesis 2 and 4 we did only find significant relations for hypothesis 7 in the sub-

group of non-outperforming FOBs. Contrary to our assumption, the direction of the relation

between the support through optimization of governance and implying different interaction

with top management performance is negative. This implicates that the monitoring and

mentoring of PEFs could be inferior to the situation which prevails in FOBs, where top

management and owner often come from the same family or even are the same people.

Hypothesis 7 is supported by our data. The involvement of external consultants is negatively

correlated with performance in both the sample of all buyouts and the subsample of buyouts

of outperforming FOBs. However, the argumentation needs to be expanded. As the negative

relation of involving external consultants is especially high for outperforming FOBs, the

reasoning that PEFs call for external help if the FOB has performance problems is not

unambiguous. Firstly, it could still be that this argumentation still holds true, as the

development of the FOB could decrease after the buyout when the original owners leave the

firm. This could have a negative impact on motivation of the employees and lead to a loss of

important know-how and networks as the key people of the organization are not active

anymore. On the other hand, it could be that the trigger leading PEFs to involve consultants

is differently and they are also using this activities for FOBs that are performing well. Then

the influence of the outside advisor could have the impact that established and successful

processes and approaches are changed, leading to a decline of performance of the firm.

A positive relationship of investors encouraging cooperation between portfolio companies

and performance could be proofed for both the total sample and the subsample of buyouts of

                                                                                           24

non-outperforming FOBs. Hence, Hypothesis 8 is considered as supported. This is

interesting, as usually PEFs do not intend to benefit as much from synergies as strategic

investors do (Baker & Montgomery, 1994). However, this value-adding activity is one out of

only two that we found to generally have a positive impact on performance.

With hypothesis 9 we proposed that the impact of support activities on performance is

different between two sub-groups of former FOBs. We assumed that the impact would be

higher for companies that are in the group of non-outperforming companies, as these should

be more receptive for support activities that address potential resource deficiencies.

Outperforming companies, in contrast, already are successful and thus are in less need of

outside support from the PEF. Our results show that there is a difference between the

relation of support activities and performance between the two sub groups. But as the

findings for the outperforming FOBs are not significant for seven of the eight value levers we

were not able to show that the impact is indeed higher for non-outperforming FOBs. Thus

hypothesis 9 is only partly supported.

Conclusion

With this study we add to the growing literature in two research fields: family firm research

and private equity research. For family firm research we add more insight into the

understanding of resource problems of FOBs and analyze the potential benefits of PEF

investments for the long-term survival of the firms. The private equity literature benefits from

our study as we add to the scant empirical evidence about family business buyouts and

highlight the value levers that are most promising.

FOBs seem to have a resource deficiency induced by a lack of cooperation and networking

with other firms. Furthermore, especially non-outperforming FOBs seem to have deficiencies

in organizational structures and management systems. Thus, they can expect the most value

from PEF investors for the business when they support to improve the specification of work

tasks and responsibilities, incentive systems for middle management and non-management

employees as well as the formalization of internal control systems, and if they encourage

                                                                                             25

their portfolio companies to actively cooperate. The impact of external consultants that are

involved after the buyout is ambiguous, because it cannot be clearly stated whether their

impact decreases the performance of the former FOB or the performance decrease is the

reason for the involvement of the consultants.

FOBs often have a long tradition and even when the family is considering the buyout with a

PEF for some reason, as highlighted in the introduction, they might want to ensure that firm

survival and thus employee workplaces are secured long-term. For these families our results

have the implication that in negotiations with PEFs they should be aware that the main

positive influence the PEF will have on the firm are likely to originate from the integration in

the network of portfolio companies, in addition to the financial resources the PEF might

provide. Any negotiations based on performance impacts of other support activities, e.g. the

argumentation that the buyout price needs to be decreased as the PEF will have to involve

own resources to develop the FOB, could then be neglected. However, if it seems clear that

the FOB is part of the group of non-outperforming firms, then additional benefit from support

in the optimization of organizational structures and systems can be expected.

For PEFs, our results indicate that in family firm buyouts they should focus on helping former

FOBs to address their value adding activities on these highlighted issues and avoid

interfering with the operations of the firm or governance structures, if possible. PEFs could in

their deal-making phase even focus on finding FOBs that are especially weak in

organizational structure and management systems. It also seems to be beneficial for the

PEFs to invest in FOBs in industries of which they already have a profound understanding.

However, more work as to be done in this field of research. One major concern is the size of

a homogeneous sample which could be reached in two ways. First, it could be tried to vastly

increase the sample to allow for enough cases from different control areas as industry

affiliation. Secondly, concentrating the analysis on FOB buyouts within one industry or

country only could ensure that certain control variables can be neglected in the analysis.

Also, there still remains the need for an in-depth structured analysis of the resource

deficiencies of FOBs. A better understanding of the categories for resource deficiencies and

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