2.1 Entrepreneurial and administrative management
Entrepreneurial management is a set of opportunity-based management practices covering a continuum of firm behavior that can help organizations remain vital and contribute to firm and societal level value creation and competitiveness (Stevenson and Gumpert
1985). At one end of the continuum, entrepreneurial management is an outward opportunity-seeking approach to management without regard to resources currently controlled. At the other end, administrative management is a more inward-oriented management approach toward resources and competcompetenciesare currently controlled (Table
1). The six dimensions of this model are: strategic orientation, resource orientation, management structure, reward philosophy, growth orientation, and entrepreneurial culture (Brown et al.
2001). Changes in entrepreneurial management are a result of changes in one or more dimensions of this model.
Table 1
Stevenson’s conceptualization of entrepreneurial management (Brown et al.
2001)
Driven by perception of opportunity | ← Strategic orientation → | Driven by controlled resources |
Many stages with minimum exposure at each stage | | A single stage with complete commitment out of decision |
Episodic use or rent of required resources | ← Resource orientation → | Ownership or employment of required resources |
Flat, with multiple informal networks | ← Management structure → | Hierarchy |
Based on value creation | ← Reward philosophy → | Based on responsibility and seniority |
Rapid growth is top priority; risk accepted to achieve growth | ← Growth orientation → | Safe, slow, steady |
Promoting broad search for opportunities | ← Entrepreneurial culture → | Opportunity search restricted by resources controlled; failure punished |
An organization can lean toward either administrative or entrepreneurial management. We choose the entrepreneurial management model because we believe that the six dimensions of the model are appropriate to cover conceptually the expected changes following a buyout.
The renewed ownership structure and the increased leverage of the buy-out firm can lead to changes in the way the company is led by management (Robbie and Wright
1996), or to changes in its strategic and growth orientation (Phan and Hill
1995), its organizational culture (Green
1992), and the allocation of resources and choice of incentives (Reid
1996). Especially in divisional buyouts, the strategic orientations of managers are initially motivated by the market opportunities they see in the business setting that they were unable to pursue as former directors of a subsidiary (Wright et al.
2001a). After the buyout, the directors are spurred to allocate resources to operations with the strongest cash flow and to eliminate unprofitable operations (Jensen
1993; Wright et al.
1994). Management structures after buyout tend to become more decentralized, with fewer management layers, thus enhancing the speed of decision-making and leaving room for managers and workers to adapt freely to changing circumstances (Phan and Hill
1995). Monitoring and rewarding by the PE firm will stimulate a post-MBO philosophy based on creating value for the firm in terms of improving efficiency (Harris et al.
2005) and/or innovative growth (Bruining and Wright
2002; Meuleman et al.
2009). Pre-MBO, divisional buyout managers may find growth-oriented strategies are limited by headquarters; after the buyout, these barriers may be removed. Managers may be freed from bureaucratic limitations set by the former parent company, which opens up opportunities to carry out their own policy and plans (Green
1992; Wright et al.
2001a; Zahra
1995).
We use the entrepreneurial and administrative management model to formulate hypotheses relating to how the increase in financial leverage and the majority equity of PE firms post-buyout may affect behavior toward administrative or the entrepreneurial management.
2.2 Hypotheses development
The level of debt increases substantially after MBO, enabling PE investors and management to control most of the stock. Concentrated ownership provides PE firms with the ability to monitor and control the strategy of the buyout target firm through their active presence on the board (Nikoskelainen and Wright
2007). According to Cotter and Peck (
2001), LBO transactions are more likely to be financed with less short-term and/or senior debt and are subsequently less likely to default when buyout specialists control most of the post-LBO equity. Furthermore, they also find evidence of active monitoring of management by buyout specialists through greater board representation on smaller boards.
Following Cotter and Peck (
2001) we define a majority PE position as owning 50% or more of the voting common stock. Majority and minority PE investors use their effort to encourage the buy-out management team to focus on cash flow and activate its strategic thinking. However the governance of a minority PE investor is more defensive in nature compared with the majority PE investor. Concentrated ownership in PE firms means an incentive to take action (Cotter and Peck
2001). For example, a majority PE investor can install a supervisory board when this is seen as necessary to add value to the firm, or to counterbalance possible gaps in knowledge in the management board of the company in which they have invested. They can be more “hands-on” by taking decisions to replace the incumbent management and appoint new managers. This may bring the buyout firm back on track faster with innovative products/services than under the former management (Bruining and Wright
2002). Such intervention may be especially necessary when unexpected situations occur and the majority PE investor seeks value creation during the holding period by active ownership. We argue that this offensive stance of a majority PE investor is usually difficult for a minority PE investor. The minority PE investors can use their voting block for some decisions documented in the shareholders’ agreement, for example to hold up the PE’s approval of expansion/growth plans. This is a more defensive way of acting. Hence, as contracts are incomplete, minority PE investors may face serious limitations in the adaptation of policies in cases of unexpected changes (Williamson
1991). Majority PE investors hold such ex-post contracting rights because strategic decisions of the portfolio company generally need to be approved by the investor, which is the owner of the majority of authorised shareholder votes. Both types of PE firm behavior affect the buy-out firm and may have positive effects on post-MBO performance. However, the minority PE investor generally trusts the disciplining effect of debt and monetary incentives to motivate managers to maximize the value of the firm, whereas the majority PE investor uses, in addition to these mechanisms, their active presence in the supervisory board as a financial and strategic control of the buyout firm and thus as a substitute for debt as a disciplining device (Cotter and Peck
2001). At the same time, both types of investor want to retain their reputation as a good borrower to ensure access to debt capital. In contrast, investors such as management and banks have different incentives to improve post-MBO firm value. For example, through decisions about allocation of firm’s resources, managers can transfer wealth from debt holders to themselves, which results in more conflicts between shareholders and debt holders than in cases of private equity ownership. Commercial banks do not have stock ownership in MBO firms and thus have less incentive to monitor MBO management to increase the equity value of the firm, rather they prefer tighter debt terms.
Nikoskelainen and Wright (
2007) found that returns are driven by the size of the buy-out firm and by acquisitions after the buyout. This supports the importance of incentives for entrepreneurial management to realize growth opportunities. Divisional buyouts are initiated if managers recognize growth opportunities that were constrained by the former parent company (Wright et al.
2001a). PE firms are keen to select divisions which are peripheral to the parent’s strategy and which have to catch up with investment. Divisional buyouts are associated with refocusing of the strategic activities of the firm, especially for deals involving listed corporations and firms in distress (Robbie et al.
1993; Wiersema and Liebeskind
1995). Evidence from the Netherlands, USA and UK in the 1980s shows that other types of buyout, for example going private and buyouts from private firms, are also followed by significant increases in new product development and other aspects of corporate entrepreneurship (Bull
1989; Green
1992; Wright et al.
1992; Zahra
1995). Scholes et al. (
2010) report strategy changes after family firm buyouts that offer large potential for growth and efficiency gains if the founder is still involved in the business on buyout. Divisional buyouts reduce trading dependence on the former parent by introducing new products they had previously been prevented from developing and by finding new customers (Wright et al.
1990; Meuleman et al.
2009).
The firm can be viewed as an organizational device to establish and implement a particular cognitive focus (Nooteboom
2009). However, firms often need a complementary and distant cognitive focus in order to refocus their cognitive model. After the buy-out, the firm may need to go through a transition of cognitive refocusing and may utilize the different and complementary cognition of the majority PE investor to achieve this. Majority PE investors contribute to the development of a new cognitive focus by assisting in new ventures to broaden market focus and, by having industrial experience, to assess investment in product development (Bruining and Wright
2002). They also contribute positively to the development of management control systems that facilitate strategic change (Jones
1992; Bruining et al.
2004). Lerner et al. (
2008) report that buy-outs increase patent citations after PE firm investment with the quantity of patenting remaining unchanged.
Thus, we expect that PE firms with majority equity stakes in MBOs combine the advantages of changing the capital structure and board governance with strong involvement in strategic decision making and operations (Jensen
2006). PE firms need majority stakes to achieve the specialization and control required for an active governance role that helps buy-out firms to develop and implement a new cognitive focus that prepares the firm for entrepreneurial growth. Without a majority stake, the PE firm is more likely to focus on financial engineering and selective changes in governance, and take a more passive governance role similar to that of banks. Hence we formulate:
Debt levels normally increase after buy-out, leading to a reduction of agency costs and an increase in firm value through improved operating efficiency. Jensen (
1986,
1989) predicts positive effects on business performance from higher debt levels post-MBO because incumbent managers take better decisions than before. Before the divisional buyout, the large and complex parent firm frequently lacks appropriate control and incentive mechanisms. Concentrated ownership and active involvement by the PE investor on the board combined with realignment of incentives makes close monitoring of the business and controlling of the strategy possible, with consequently improved performance (Hite and Vetsuypens
1989). Berger and Bonaccorsi di Patti (
2006) support this view, and found that high leverage or a low equity/asset ratio reduces agency costs of outside equity and increases firm value by constraining or encouraging managers to act more in the interests of shareholders. From a corporate governance perspective, debt is a disciplining device. Investors are keen on information that signals the ability of the firm to meet its interest payments.
Some studies support this agency perspective (Kaplan
1989; Cotter and Peck
2001) and report a positive relationship between increased financial leverage, realignment and operating performance of buyout companies. Other studies provide evidence of cost cutting, improved margins, and efficiency post-MBO (Lichtenberg and Siegel
1990; Desbrières and Schatt
2002; Harris et al.
2005) or show reductions in capital requirements after a buy-out (Easterwood et al.
1989; Singh
1990; Smith
1990; Long and Ravenscraft
1993). Robbie and Wright (
1995) argue that in smaller buyouts debt commitment and covenants are important triggers for corrective action. However, the agency argument does not appear to receive strong support for public to private buyouts (Halpern et al.
1999; Opler and Titman
1993; Weir et al.
2005; Renneboog et al.
2007).
Evidence regarding the effect of high leverage on R&D expenses is at best mixed. Long and Ravenscraft (
1993), for example, show that R&D intensity falls by 40 percent compared with pre-buyout levels as a result of increased leverage, whereas Lichtenberg and Siegel (
1990) did not find evidence that the R&D/sales ratio declined post-MBO. Long and Ravenscraft (
1993) also find that R&D intensive LBO firms outperform their non-LBO peers and LBOs that do not have any R&D expenditure.
Being strongly committed to servicing debt obligations can imply that a significant portion of the firm’s future cash flow is not invested in new business opportunities nor distributed to the owners, but will only be used to reduce debt. Rappaport (
1990) emphasizes that high debt levels form new resource constraints post-MBO and may be harmful for the survival of the company and thus for entrepreneurial management. Andrade and Kaplan (
1998) find that the primary cause of financial distress is high leverage, with poor firm and industry performance as less important causes. Post-MBO debt levels generally increase significantly (Wright et al.
1991; Acharya et al.
2007). Therefore we formulate:
Entrepreneurial management, driven by a broad search for opportunities, involves development of new markets, new designs, and new channels of distribution. These variables measure business performance in terms of growth by utilizing the upside potential in new products and markets of the company in which they have invested. In contrast, administrative management is driven by opportunity search restricted by the resources controlled and involves expanding existing markets, established designs, and increased efficiency of existing distribution channels. These variables measure business performance by improving efficiency through controlling the downside risks of existing operations. Both entrepreneurial growth and administrative efficiency are needed on a sustainable level because performance is a joint function of explorative search and development and efficient exploitation of organizational capabilities (March
1991).
The occasion of a buyout is an appropriate moment to rethink the existing product portfolio and the long-term adaptations needed. These fundamental considerations emphasize the role of targets or aspiration levels in regulating allocation of effort to search (March
1988) and take place in buyouts stemming from different sources. In the context of divisional buyouts, lifting of the constraints imposed by the former parent’s control enables renewal of aspirations of the new owners, which is a significant factor that drives the strategy and organization and their respective changes post-MBO. In the context of buyouts of family owned firms, changes in the marketplace require new leadership and adaptation of strategies to facilitate transition to the new growth phase (Wright et al.
2001b; Scholes et al.
2010). In general the new owner-managers view the buy-out as an opportunity to free them from control by the parent firm or by the overly conservative founder and implement the course of action they think is best for the company. The focus of our paper is on the private equity investor that exercises ownership by monitoring and controlling the strategy of the buyout company through active presence on the board (Nikoskelainen and Wright
2007). As a minority private equity investor it is more difficult to be more hands-on and take an active stance toward growth opportunities. Therefore we expect that a private equity investor before deciding to take a majority equity stake seriously reflects on his contribution, on the supervisory board, to value creation. He must be convinced he is able to fill a gap in management knowledge or provide additional influence through networks which are essential if the company in which the investment has been made is to exploit entrepreneurial opportunities.
Because MBOs typically involve increased levels of external funding, the PE firms need stable business relationships with the banks as they supply the necessary financial resources. Debt holders prefer cash flow rights associated with earnings and debt repaid ahead of common shareholders in case of bankruptcy, and are reluctant to engage in risky projects. Therefore, buyouts with very high debt levels may face initial pressure to improve administrative management practices post-MBO to improve the efficiency of existing operations, and thus reduce the debt level, before engaging in entrepreneurial management to realize growth opportunities. The literature (Wright et al.
2000) indicates that the debt side of buyout firm financing will trigger managerial cognition, whereas the ownership or incentive side will activate entrepreneurial cognition. Therefore we argue that majority PE investors will strengthen this managerial cognition by improving administrative management practices such as accounting information management, cash flow management (Mitchell, Reid and Terry 1997), and capital allocation processes, including elimination of unprofitable operations (Jensen
1993; Wright et al
.
1994). Hence, with very high debt levels the focus of the majority PE investor will be first on administrative management to enhance efficiency in order to reduce the risks of debt. The more efficient monitoring and strategic control by the majority PE investors increase administrative management and thus reduce entrepreneurial management. Therefore we formulate: