RESEARCH REPORT
Conquering the next value frontier in private equity
5-MINUTE READ
May 2, 2023
In brief
- As committed capital and dry powder grow—with a finite supply of investibles—private equity (PE) is forced to invest in more complex deal archetypes.
- These more complex deals require a higher degree of intervention and longer hold periods to deliver the same level of returns to investors.
- Investors are rethinking playbooks and exploring new capabilities and intervention models that accelerate time to value and shareholder outcomes.
An ever-shifting landscape
The PE space is more crowded, with more limited partner (LP) capital and buy-side competition than ever before. At nearly US$1.3 trillion, dry powder for buyouts is near its all-time high, but the number of available assets may not be keeping pace.
There’s more competition to buy great targets and it’s harder to make returns on those targets.
US-based PE firm / Operating partner
To top things off, the high cost of capital is forcing firms to rethink their capital structure and underwriting for new deals. We know PE firms can succeed regardless of tough conditions. Yet, we have never had this many firms and this much dry powder trying to deploy capital under such stringent circumstances.
Leaders acknowledge these difficulties. Half of those surveyed think PE investments have become more complex in the past five years. In this environment, new mechanisms to drive value will be required to continue to deliver outpaced returns to limited partners and meet fiduciary responsibilities.
50%
Half of surveyed leaders say PE investments have become more complex.
Diving deeper to find value
To thrive in these circumstances, we see PE firms gravitating toward two main paths to investment value: driving scale and tackling complexity. Doing either successfully means adopting new strategies.
Compared to a decade ago, PE firms are holding their assets 9 months longer, at an average of 6.6 years. This requires a longer runway to create more significant operating value and more fundamental operating model interventions. Such comprehensive transformations are new territory for many investment and operating professionals, but are critical for continuing to generate outsized returns.
6.6 years
PE firms are holding their assets longer, at an average of 6.6 years in 2022.
The obstacles ahead
When we surveyed PE leaders about the most difficult issues to overcome, clear themes emerged. The biggest challenges: a lack of value creation planning in their portfolio companies, broken operating models, an inability to scale operations and the high cost of capital.
These challenges are significant and PE firms are unlikely to achieve the desired returns if they remain unsolved. That's the downside. The upside? These problems are solvable with the right approaches.
75%
Financial engineering isn't enough. Leaders believe 75% of efforts should focus on operational value creation.
We tested 31 unique operational value creation levers and found that more traditional cost, cash and revenue levers are still king, making up three-quarters of the most often used levers. Meanwhile, the reported data suggests that more difficult and deeper transformational levers are underutilized.
Overwhelmingly, PE firms stick to what they know, but a shift is underway. To push for a multiple on invested capital (MOIC) beyond 3x, firms will need to start earlier and go deeper with: existing playbooks, additional operational interventions and new capabilities.
Value creation is a team sport
We looked within the industry to uncover commonalities leading to outsized returns in PE-backed companies. Among companies that grew more profitably than their peers, we saw four themes emerge:
01. Moving out of the comfort zone
As deals become more complex, leaders are expanding their toolkits by leveraging more transformational levers and employing new value creation approaches. It’s about expanding at speed by being willing to work in less insular ways.
02. Investing for future growth
Leading firms consistently invested more as a percentage of revenue in building new capabilities and capacity to scale growth and create new revenue streams.
Every deal I’ve been part of used to be all about synergies. Now, I’m increasingly focused on add-ons to drive top-line growth.
mid-market PE firm / Partner.
03. Putting technology at the core
Technology-driven operating models support transformations that are broader and faster than ever before and enable continuous, dynamic reinvention. We see leading portfolio companies grow their technology investments much faster than other PE-backed companies.
04. Doubling down on talent
Transforming the operating model, change management and driving future growth demand cultural readiness coupled with strong leadership and talent at both the PE firm and portfolio company level.
More profound transformation
Our research shows how PE firms, grappling with unprecedented turmoil, are evolving their approaches to reshape their portfolio companies more profoundly than ever before. As they apply proven interventions, they must also embrace new value creation approaches and execute an expanded set of transformational value drivers to generate outsized returns.
The dynamics driving change in private equity
