Does going public stifle innovation?

Stanford Professor Shai Bernstein has conducted a new study on the rate of innovation at firms who issue an initial public offering.   According to Bernstein, "Using patent-based metrics, I find that the
quality of internal innovation declines following the IPO, and firms experience both an exodus of skilled inventors and a decline in productivity of remaining inventors."    Specifically, he found a "substantial decline of approximately 40 percent in innovation novelty as measured by patent citations."  Note that he didn't find the overall number of patents decreasing for these firms, just the level of breakthrough developments.  Bernstein also finds that post-IPO firms tend to shift toward acquisitions to drive innovation.  In the five years after an initial public offering, roughly 1/3 of the patents tend to come from acquisitions.  Finally, he finds a much smaller (and not statistically significant) decline in innovation novelty at those firms whose CEO also serves as Chairman (as compared to companies who have split the Chairman/CEO positions).  What explains that finding?  Bernstein hypothesizes that the CEO who also serves as Chairman is more "entrenched" and less susceptible to short-term profit pressures from Wall Street.  Therefore, he or she may be able to invest more freely in research and development that may have a low probability of succeeding, but could lead to a breakthrough innovation. 

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Carlyle Group and Other Private Equity Firm IPOs

News reports indicate that the Carlyle Group, a large and successful private equity firm, has priced its IPO at slightly below the initially expected range.   Apparently, the firm met with some skepticism from investors about their offering, and more generally, the prospect of investing in publicly traded private equity firms. 

Dan Primack of Fortune has written an article about investing in these IPOs.  To start his article, he writes:

Shortly after the Blackstone Group went public in mid-2007, I advised friends not to buy the stock. Investors didn't seem to understand how private equity firms like Blackstone should be valued, as illustrated by a 6% share price bump in the days after Blackstone agreed to acquire Hilton Hotels. Private equity firms recognize value when they sell assets, not when they acquire assets, I argued. They aren't conglomerates that generate margin via economies of scale.

I'm quite confused by the comment.  How precisely is a private equity firm different than a conglomerate?  Both own a variety of unrelated businesses. Conglomerates don't achieve economies of scale.  In a developed market such as the United States or Western Europe, how can one achieve scale economies by acquiring unrelated businesses?    You simply cannot!


Let's get to the heart of the matter then. Private equity firms do create value in society, and they do differ from publicly traded conglomerates.  How?  In many ways, when private equity firms gained prominence, they offered a better governance model than publicly traded corporations.  Many publicly traded firms suffer from high agency costs that come with the separation of ownership and control.   Private equity ownership of a business reduces agency costs and reduces the clash of interests that often exists between CEOs and shareholders of publicly traded corporations.   If' that's a major advantage of a private equity firm, then what do we make of taking these private equity firms public?  Well, I would argue that such public offerings counteract one of the key benefits that private equity firms bring to the table.  They would seem to interest a layer of agency problems at the top, offsetting some of the very governance benefits that private equity firms bring to the companies in their portfolio.

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Groupon's IPO

Groupon announced yesterday that it would be issuing an initial public offering soon.   Many analysts expressed concern about the high valuation coupled with the significant losses that have mounted as the company grows rapidly.  Some analysts have talked of this IPO as further evidence of a bubble in new tech firm valuations.

How do we make sense of these concerns?   We have to ask ourselves:  Has Groupon built a significant sustainable competitive advantage?   Are they a successful first mover, or will they be like many early movers in technological industries who actually end up being overrun by later entrants?   To answer these questions, we have to look at several factors.  First, does the company's business model have significant scale economies?   If so, then they can amortize fixed costs as they grow, and therefore, they will become quite profitable.  Second, does the business model have substantial network effects?   Amazon's model has both scale economies and network effects.  Thus, Amazon turned early losses into sizeable profits as it grew, and it built a quite formidable competitive advantage.   At first glance, it does not appear that Groupon has the type of economies of scale and network effects enjoyed by Amazon.   The model seems to very labor intensive, with new staff required to drive new growth.  The jury, of course, is still out though.  As the company goes public and we learn much more about its finances and strategy, we will be able to discern this more accurately. 

Competitive advantage may derive from other sources as well. Groupon itself focuses on its relationships with local merchants.  Undoubtedly, they do have ties at the local level that are quite impressive. Yet, questions remain to be answered.   Have they built relationships that will be hard to duplicate or break?  Are there significant switching costs for these merchants?  The barriers to entry do not look huge at this point, as we have seen a flood of entrants into this space.  Of course, some big existing players also want a piece of this pie, and so we will have to watch the likes of Google, Amazon, and Facebook to see if Groupon can sustain its early lead.

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