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The Impact of Private Equity in the Swedish Independent School Sector

Stockholm School of Economics Master Thesis in Finance The Impact of Private Equity in the Swedish Independent School Sector A Study on Private Equity s Impact on Corporate Governance, Operating Performance
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Stockholm School of Economics Master Thesis in Finance The Impact of Private Equity in the Swedish Independent School Sector A Study on Private Equity s Impact on Corporate Governance, Operating Performance and Students Academic Achievement Ludvig Lundsten a Martin Löfqvist b This thesis evaluates private equity s impact on the Swedish independent school sector by benchmarking the corporate governance, operating performance and students academic achievement of private equity owned school groups against other independent schools, as well as public schools. We find evidence that private equity create economic value through improved growth, profitability and capital efficiency. The value creation do not seem to stem from a reduction in quality as we find that private equity owned school groups employs a higher number of teachers per student and have better qualified teaching staff than other independent schools, as well as public schools. This might be a consequence of differences in corporate governance, as we find that private equity employ professional boards and implement thorough reporting systems that contribute to a professionalization of its school groups. Furthermore, private equity has had a significantly positive impact on the academic achievement of students in primary school, whereas we find a negative impact on upper secondary students enrolled in vocational programs. However, as vocational programs focuses on preparing students for particular trades and not for academic studies, we believe that metrics related to academic achievement are suboptimal in measuring the quality of such programs. Our results indicate that private equity is a suitable owner of the independent school groups in our study, as corporate governance, operating performance and students academic achievement has improved post-buyout. Keywords: Private Equity, Independent Schools, Corporate Governance, Operating Performance, Academic Achievement Tutor: Professor Per Strömberg Date: June 7, 2011, 12:00 13:15 Location: Stockholm School of Economics, room 538 Discussants: Erik Källmin and Carl Jakobsson Acknowledgements: We thank Professor Per Strömberg for valuable input and support during the process of writing this thesis, Assistant Professor Thomas Hjelström for helpful comments and advice, The Swedish Private Equity and Venture Capital Association (SVCA) for funding our dataset, and all participating representatives without whom this study would not have been possible. a b Table of Contents 1. Introduction Literature Review Privatization Private Equity Private Equity and Leveraged Buyouts Value Creation and Corporate Governance Empirical Evidence on Value Creation and Corporate Governance Private Equity and Corporate Social Responsibility Empirical Research on Public versus Private Education Data and Methodology Interviews Operating Performance Academic Achievement Results Interviews Primary Sources of Value Creation Corporate Governance Reporting Systems and Follow-ups Concluding Comments Operating Performance Academic Achievement Primary School Upper Secondary School Summary and Discussion Interviews Operating Performance Academic Achievement Concluding Comments and Implications for Future Research References... Appendix... 1. Introduction In 1992, the Swedish government implemented a school voucher reform a state-funded, private alternative to the public education system, where entrepreneurs can set up independent schools and receive government funding based on the number of students enrolled. The voucher reform was introduced as a way to introduce diversity and competition in the education sector. Primarily it attracted individual entrepreneurs aiming to offer alternative teaching practices and programs, but as the sector has matured, it has attracted investors with a more explicit profit interest. Over the last two decades the sector has grown into a SEK 24 billion industry 1, with one out of every seven students attending an independent primary or upper secondary school. Today 2, five of the largest independent school groups Academedia, Baggium, John Bauer Organization, Pysslingen and Theducation are owned by private equity (PE) firms, which specialize in acquiring majority stakes of companies in leveraged buyouts. As these investment firms have a limited holding period and an explicit objective to generate high returns for its investors, their involvement in the independent school sector has resulted in extensive public scrutiny. Critics question the suitability of PE ownership in this sector and claim that the PE governance model compromises educational quality when employing actions designed to improve the value of their school groups. However, research on this topic is to date nonexistent and it has not yet been established whether the entrance of PE ownership has had any effect on their independent school groups operating performance or on the enrolled students academic achievement. This thesis attempts to fill this gap and it evaluates what type of impact, if any, the PE corporate governance model has had on operating performance and students academic achievement proxies we deem crucial in determining the suitability of PE ownership in the sector. We do this through (i) conducting interviews with three PE groups with holdings in the sector and with owners of three independent school groups with different ownership structures in order to gain insight into the PE value creation process in the sector and potential differences in corporate governance; (ii) benchmarking operating performance, preand post-buyout, for PE owned school groups against a group of comparable independent school groups owned by other types of investors to illustrate PE s impact on operating 1 Based on an estimate for the year 2010, by Edman and Hjukström (2011). 2 As of the writing of this thesis in June, performance; (iii) examining whether the academic achievement of students enrolled in PE owned school groups has been affected by private equity ownership by benchmarking academic achievement against students in public and other independent schools pre- and post-buyout, using a proprietary dataset of academic results. In terms of corporate governance, we find that there are significant differences between the corporate governance models employed by PE owned school groups and other independent school groups. The outcome of our interviews indicates that the governance difference stems from the professionalization that comes with institutional capital rather than as something unique for PE per se. More specifically, such investors contribute with increased monitoring, well-aligned incentive schemes and through employing an experienced board of directors with extensive knowledge from a broad range of relevant sectors. In terms of operating performance we find that PE owned school groups have outperformed other independent schools in terms of (i) growth, (ii) profitability and (iii) capital efficiency, post-buyout. Our results also indicate that the PE owned independent schools improved operating performance does not occur at the expense of the number of employees in relation to their size (in terms of revenue). Furthermore, we find that the personnel cost per employee decreases more in the PE owned school groups than in other independent schools postbuyout, indicating that the PE owned schools on average employ more low-cost or junior personnel. In terms of academic achievement, we find that PE has had a significantly positive impact on students in primary school. We also find that the impact has been negative for upper secondary students enrolled in vocational programs. However, results for the vocational programs are hard to interpret because (i) not being directed towards continuing education, and (ii) being more susceptible to selection effects. Interestingly, PE owned groups employ a higher number of teachers per student and also have better qualified teaching staff for both primary and upper secondary school post-buyout. Privatization programs, broadly defined as the sale by a government of state-owned enterprises or assets, have significantly reduced the role of state-owned enterprises in most countries over the last decades (Megginson and Netter, 2000). The 1992 Swedish voucher reform enabled individuals to establish schools in direct competition with public schools. Privately-owned school groups had been present prior to the reform. However, as they did not receive government funding, they were tuition based and hence not available to the broader 2 public 3. The school reform introduced a school voucher, entitling independent schools to compensation per each student enrolled, equaling the average cost of schooling in the student s home municipality 4. The reform aimed to increase competition and to broaden the range of educational programs and teaching practices. Since the reform the sector has experienced high growth, corresponding to 78% over the last five years and is expected to continue to grow at a high pace. In 2010, the sector had a turnover of SEK 24 billion and encompassed one out of every ten primary school students and one out of every five upper secondary school students 5. The independent school sector has a number of characteristics that have attracted institutional capital, such as recent deregulation, government funding, predictable market size, high level of fragmentation and high growth. These features are especially attractive for PE as such characteristics imply relatively stable cash flows that allow for a considerable amount of debt in buyouts typically 60-90% (Kaplan and Strömberg, 2009). Furthermore, recently deregulated sectors are less mature and provide opportunities to enhance value by professionalizing operations. Today, the five independent school groups owned by either PE or other institutional investors enroll 37% of all independent school students and approximately 5% of all students enrolled in the Swedish educational system, including pre-, primary- and upper secondary school 5. Due to a reliance on government funding and a significant increase in their market share in recent years, independent schools have been subject to public and media scrutiny, which primarily highlights potential conflicts of interest in for-profit education. The current debate portrays owners of independent school groups as compromising the level of educational quality for the benefit of short term profit. As PE groups have funds with a contractual lifespan, the short-term holding period is even more explicit for these investors, who typically invest over periods of five to eight years. Proponents of independent school groups, both PE firms and other investors, argue that there are no conflicts of interest and that supplying educational quality is their main value creation strategy, i.e. the value of their investment is contingent on supplying outstanding educational quality as students otherwise would choose to study elsewhere. 3 Such as the boarding schools Grennaskolan, founded in 1963, Lundsbergs skola, founded in 1896 and Sigtunaskolan Humanistiska Läroverket founded in Sveriges Rikes Lag, Skollagen, 9 Ch., 6 and 8. 5 Based on data supplied by Edman and Hjukström (2011). 3 Previous research shows that school competition in Sweden has increased the overall level of education achievement (Sahlgren, 2010). More specifically, students enrolled in independent schools enjoy higher grade point averages (GPA) and higher scores on national proficiency tests (NPTs). Furthermore, a larger proportion of these students are eligible to enroll in higher studies (Svenskt Näringsliv, 2010a, Skolverket, 2010). In addition, there is evidence that parents of students in independent schools are more satisfied with their children s education and believe that the schools are more efficient in allocating available resources. (Svenskt Näringsliv, 2010b, Novus Opinion, 2009a). Additionally, research shows that a higher proportion of teachers in independent schools are more satisfied with their schools than teachers in public schools. Specifically they believe that their school is good at providing the support that students require, that the schools resources are primarily allocated to teaching and finally, that they benefit from having less formal decision procedures (Novus Opinion, 2009b, Svenskt Kvalitetsindex, 2009). Existing research in this area focuses on the differences in educational quality between independent and public schools. Our study also evaluates if there are any differences within the independent school sector separating PE owned school groups from school groups owned by other investors. More specifically, we evaluate the impact that PE has had on the operating performance and academic achievement of the PE owned school groups, as a proxy for determining the suitability of PE ownership in the sector. We do this by researching (i) if and how PE firms create value through operating improvements and changes in corporate governance (through interviews with both PE professionals and other investors), (ii) if there are any significant improvements in operating performance post-buyout, and (iii) if students academic achievement, as a proxy for educational quality, has been affected by the leveraged buyout. To our knowledge, no study has to date evaluated this topic. We believe that academic research should contribute to the ongoing media coverage and public debate on this topic. Our methods and findings are structured as follows. Section 2 contains a literature review. Section 3 reviews the methodology used in this thesis and describes the construction of our dataset. Section 4 presents our results. Section 5 contains a summary and discussion of our results. Finally, section 6 includes concluding comments and implication for future research. 4 2. Literature Review As this study researches PE s impact on the Swedish independent school sector, we have reviewed literature on (i) privatization researching its effects on efficiency and possible externalities, (ii) private equity corporate governance and the value creation process, and (iii) academic achievement differences in academic results between public and private schools and the effects of for-profits motives in the education sector. In this section, we discuss our main findings and how they relate to our study. 2.1 Privatization Since their introduction over three decades ago, privatization programs, where a government sells state-owned enterprises or assets, have significantly reduced the role of state-owned enterprises in most countries. Today, privatization is accepted as legitimate policy to slim down government services and is considered by many an important aspect in using markets to effectively allocate resources (Megginson and Netter, 2000). As the use of privatization programs alone says little about the economic and political benefits, numerous studies on the efficiency of state versus private ownership have been conducted. Research shows that privately-owned firms are more efficient, more profitable and financially healthier than otherwise-comparable state-owned entities. Interestingly, research indicates that these privately-owned firms significantly increase profitability, output per employee, and real sales post privatization. Research also indicates this is done without reducing average total employment levels (D Souza, 2001). Furthermore, evidence suggests that adopting a large-scale share issue privatization program is often a major catalyst in modernizing a nation's corporate governance system (Megginson and Netter, 2000). However, research shows that governments tend to underprice share offerings, particularly initial public offerings (Jones et al, 1999). Additionally, a market without government intervention is not always optimal on an efficiency basis if markets have failed in some way. For example, this is the case if there are externalities in production or consumption, if the product is a public good (such as education), or if the market is monopolistic in nature. In such occasions there are clear merits of governmental intervention to resolve such failures. A special type of privatization is the voucher system 6, which allows for competition but maintains a certain level of government 6 A voucher is a government-funded certificate redeemable for tuition fees at a school other than the public school that a student can attend for free. 5 control. This is generally seen as the least economically productive divestment technique, inferior to asset sales and share issue privatizations. However, this option is generally used when governments have few other viable options as it guarantees competition and freechoice, but also guarantees the existence of a particular service or product. (Megginson and Netter, 2000) 2.2 Private Equity Private Equity and Leveraged Buyouts Since the emergence of leveraged buyouts in the mid-1980s, PE has grown to a USD 850 billion industry 7. PE is an asset class that comprises investment firms that specialize in acquiring majority stakes of companies in leveraged buyouts, using relatively large portions of debt financing (Kaplan and Strömberg, 2009). PE firms are typically organized as partnerships or companies with limited liability and usually have a lean, decentralized structure with relatively few investment professionals (Jensen, 1989). To finance its investments, PE firms raise capital through PE funds typically closed-end vehicles in which investors commit to provide a specified amount of capital which is then used for investments in companies or other assets. PE funds normally have a fixed contractual lifetime, typically ten years, with the possibility of extension for an additional three years. In general, PE funds invest in companies during the first five years, and then divest of these holdings during the following five to eight years to return the capital to investors. The explicit exit horizon of PE investments is an important aspect of the investment process. Common exit alternatives are sales to either a strategic or to a financial buyer (i.e. another PE firm), or floating the company on an exchange through an initial public offering (IPO). PE firms are often compensated by both a fixed management fee and a variable fee, referred to as carried interest, dependent on the returns generated in their investments (Kaplan and Strömberg, 2009) Value Creation and Corporate Governance In general, PE firms apply three sets of actions to enhance the value of their investments, commonly referred to as financial, governance, and operational engineering. (Kaplan and Strömberg, 2009) 7 Estimates as of 2006, as in Kaplan and Strömberg (2009). 6 Financial engineering involves the use of leverage in order to put pressure on managers to increase capital efficiency and thus reduce the problem of investing excess cash in projects with low or negative net present value, often referred to as the free cash flow problem. In addition, there are tax benefits of debt as the additional debt in leverage buyout transactions gives rise to valuable tax reductions. Governance engineering includes owners being more actively involved than in most other corporate forms, and the creation of more efficient incentives such as providing management with equity stakes through common stock and/or options. In addition, a consequence of active governance is a reduction of agency costs through improved monitoring. Operational engineering includes improvements in operational effectiveness and strategic focus by employing a board and senior management that can contribute with valuable experience and industry expertise. Common operating improvements include reducing overhead costs and utilizing economies of scale and/or scope to achieve a lean and efficient organization. (Acharya and Kehoe, 2008) Empirical Evidence on Value Creation and Corporate Governance Proponents
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