A new report published by the Copenhagen Business School looks into the consequence of private equity investment on an industry-by-industry basis.

The authors find that “industries where private equity funds invest grow more quickly [than others] in terms of total production and employment, and appear less exposed to aggregate shocks.”

That statement asserts a correlation, not a causative link. Assuming the correlation established, a least three very different hypotheses suggest themselves regarding the reason.

First, it might be that the influx of private equity funds into the firms within any one industry is good for growth there – it acts like yeast. Perhaps for example the PE investors impose corporate-governance conditions on the recipients of the money, and these conditions prove beneficial to performance.

Second, though, it might be that PE firms are good at predicting where the growth is going to be, and betting accordingly. If certain industries get this money because they are going to grow, it surely does not follow that they grew because they got this money.

Third, it might be that the investment of PE funds into particular firms within industry X is good for the other firms in industry X, the ones the PF funds don’t invest in, due to spillover effects on competitors. This would produce a correlation on an industry-by-industry level. It wouldn’t say much for the predictive ability of the investors involved, though, and it would qualify the money-like-yeast view of things.

Which of these [the yeast hypothesis, the reverse causation hypothesis, or the spillover hypothesis] seems most likely?

Each Theory Comes with a Story

It is possible to wrap each of these hypotheses within a compelling story. Let’s expound on this a bit. There has been a fair amount of discussion in recent years, from the popular to the political to the scholarly, about market structure issues, the exchanges, and IPOs. The gist of it is that small or medium sized companies are less likely than they once were to ‘go public’ and raise their necessary yeast via the exchanges, because there are considerable costs associated with that route. So perhaps the PE industry is for many the best remaining fuel for growth. That story supports the direct-causation view.