- Multiple expansion fuelled by low interest rates can no longer be counted on to deliver private equity performance.
- GPs need to sharpen their value creation models.
- Data analytics, AI and ESG are key growth levers.
The private capital playbook is changing. Value creation is now the big talking point, with general partners’ ability to generate superior returns increasingly dependent on their success in adding operational value to portfolio companies.
“Gone are the days when private equity players could acquire companies, put in cheap debt and then sell in a rising market,” cautioned PwC’s private capital 2024 Mid-Year Outlook. “Buyers are now looking for special opportunities for future growth and transformation plans.”
Tougher investment environment for private equity
Private equity has long outperformed other asset classes. The American Investment Council’s 2024 Public Pension Study found private equity investments delivered a 15.2% median annualised return over a 10-year period. Public stocks returned 10.2%, real estate 9.6% and fixed income 2.1%. The AIC study added that private equity has been the best-returning asset class in public pension portfolios since 2012. Diversification and access to growth companies offer further benefits.
Performance has been tempered in the last couple of years though by higher interest rates and a squeeze in dealmaking.
Improving US inflation data has fuelled hopes the Federal Reserve could at last start cutting interest rates in September from the current 23-year high range of 5.25%-5.50%, following a tentative first move by the European Central Bank in June. However, the pace of cuts in the US and elsewhere will likely be gradual, with rates settling substantially above the historic lows of recent years.
The dealmaking picture is similarly mixed. Private equity firms announced a subdued US$92 billion in deals during Q1 2024, according to EY’s Private Equity Pulse, with a hike in deal values in the US offset by declines in Asia-Pacific and Europe. While still substantially below the 2020-22 period, Q2 saw its strongest quarter in two years, hitting $196 billion across 122 deals, helped by a narrowing valuation gap. April and May were particularly active, with June softer by comparison.
Growth equity and late-stage VC are where PE firms see most opportunity. Take-privates remain a powerful theme amid the increasingly concentrated nature of public markets, observed EY, noting “PE firms continue to see opportunities in companies with compelling growth prospects that may have been left behind by recent market rallies.”
Exit activity also ticked higher in Q2, but remains well below 2021-2022 levels. EY put the exit bottleneck down to GPs being focused on ensuring their portfolio companies are performing optimally to present a compelling equity story; waiting for valuations to improve to maximize value; and, to a lesser degree, waiting for the IPO window to crack wider.
GPs sharpen focus on value creation
Faced with a sluggish exit market – and a resultant lag before fundraising picks up as limited partners wait for distributions – GPs need to look to sharpen their value creation models, Bain argued in its 2024 Private Equity Midyear Report.
Cost-cutting and multiple expansion driven by rock-bottom interest rates have been key drivers of portfolio company performance for years. But in a higher-rate environment, Bain noted, the onus must shift to producing margin and revenue growth.
“What is the firm’s secret sauce, and will it still work in a repeatable way? How effective are operating teams at working with management to drive performance? Do teams have the right resources and capabilities to succeed, and, if not, where will you get them? Effective portfolio monitoring and governance are also critical here to track performance holistically and make decisions that balance the best interests of the firm overall.”
A recent survey by consultants A&M found private equity firms are increasingly pursuing more specialised value creation strategies to generate top- and bottom-line organic, profitable growth at their portfolio companies. “Some of the levers being pulled to achieve that are market diversification, more focus on high profitable service business growth, better pricing, improved customer experience and optimised processes – many with the help of cutting-edge data analytics and tested-and-proved digital tools including AI,” it said.
Almost all respondents (97%) see digital infrastructure as key to implementing their value creation plan. Artificial intelligence is a central component, with 87% using it for market insights and competitor analysis, 79% for strategic decision making, 70% in financial management, 45% for operational efficiency initiatives such as process automation and supply chain optimisation, and 42% to enhance the customer experience. ESG considerations are also gaining ground, with 62% of respondents agreeing that “improved ESG credentials have a positive impact on the long-term performance of portfolio companies.”
Who can deliver?
Value creation can be challenging to deliver at the best of times. A sharp rise in the number of active portfolio companies buyout firms manage as exits have slowed and funds hold assets for longer though is leaving sponsors with more claims on their attention and resources, observed the Bain report.
“General partners who can’t shepherd portfolio companies to attractive outcomes may face a shakeout,” it warned.
At times such as these, GP due diligence to see who has a track record of success and the capabilities to deliver it going forward will be ever more important.
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This content is for information purposes only. Treble Peak does not provide investment or tax advice, and information on this website should not be construed as such. Potential investors should seek specialist independent tax and financial advice before investing in any alternative investment. Past performance is not a reliable guide to future returns. Your capital is at risk.
