Private equity: Four paths to accelerating value

In the past year, we’ve seen an unparalleled level of disruption. M&A deal volume declined by the most in 21 years.¹ Leverage buyout (LBO) volume sunk the most since the Great Recession.² And as the federal funds effective rate increased by 53x,³ debt financing for these deals experienced the largest volume contraction in 33 years.⁴

Today, ever tightening supply and demand balance and cyclical issues with global money supply, supply chain dislocations, and geopolitics are converging. Together, they’re creating persistent levels of inflation, tighter credit markets, and unbalanced labor markets. The pandemic quelled these issues as central banks and governments worked to reduce marketplace chaos. Now these issues are back with a vengeance.

Like many industries, private equity (PE) investing has felt the impact in several ways.

• Deals: Global LBOs pulled back from a high of 4,387 in Q4-2021 to 2,498 in Q1-2023. Qualitatively, sellers have been more likely to transact higher-quality assets that meet stricter underwriting, sometimes executed as 100% equity financed deals. These assets include many non-core lines of business from retrenching corporate owners.

• Secondaries: Despite predictions that the secondary exit market would increase and partly fill the gap, we see the opposite in three straight quarters of declining secondary exits. Many factors are dampening secondary activity: cost of capital, revenue contraction, unclear macro, and refinancing capacity.

• Alternative exit avenues: From Q4-2021 to Q1-2023, capital invested in newly public companies fell from US$137 billion to US$19 billion and deal count fell by 63%. Fewer exit options brought longer hold times for assets, forcing PE firms to look for different ways to create value.

What can PE firms do? In this environment, we see four potential paths to accelerating value.

1. Consider public-to-private in a lower multiples landscape. From Q4-2021 to Q1-2023, the next twelve months P/E ratio declined from 22.3 to 18.8 for the S&P 500 and from 16.7 to 14.6 for the S&P 1000.⁵ With this repricing, PE firms may reach for previously untouchable targets, especially mature operating businesses underperforming their peers.

2. Engage with corporates who are restructuring their portfolios. In a world of increased volatility and higher weighted cost of capital, corporations are realigning their portfolios and carving out non-core units. The average capital invested for divestitures increased from US$450 million in 2019-2021 to US$655 million since.⁶ PE firms are finding newer and larger acquisition targets.

3. Dig deeper on true, sustainable cost and productivity improvement. For multi-traded assets, the easier projects like procurement and quick cost takeouts have often been done and the value wrung by prior PE owners. The burden of deeper value interventions will ultimately fall to current sponsors. Structural changes in the mid-/back-office can take longer to reach the bottom line, but front-loading these investments in people and technology can result in higher quality exits.

4. Open the aperture of considered deal types. Firms could explore potentially higher risk deals like legacy family-owned businesses, rollups of more challenging or fragmented industries, or adjacent markets or capabilities. This strategy favors larger PE firms that have the ability, experience and required funds to drive complex change.

Aligning investments and accelerating value

In this high return volatility world, the importance of capable leaders and talent in driving this value will deliver the returns PE is seeking. Consequently, PE leaders and their management teams should consider:

Focusing on short-term financial health and cash management. A recent Accenture survey of 104 PE executives shows that PE firms are embarking more on organizational rightsizing, working capital improvements, pricing strategy improvements to pass through costs, and asset efficiency increases including sales of non-performing assets.⁶ These changes coupled with better visibility and analytics around cash management give operators a better embarkation point for other changes.

Simplifying the operating platform. Many PE targets operate globally but run on disparate platforms. This hinders a unified view of operations, increases cost to serve, stunts productivity, and sinks customer experience. PE companies must roll up their sleeves and address the end-to-end operating platform. It’s not easy, but “passing the buck” only pushes the problem forward.

Standardizing through proven solutions. Poorly integrated businesses, large-scale carve outs, and traditional roll-ups can bring broken operating models, lackluster customer experiences, and other issues leading to high overhead and variable costs. By using turnkey solutions and strong partners with more than point solutions, investors can focus scare resources on differentiated, high-value opportunities rather than routinized functional areas.

Creating scale by tuning customer acquisition, experience and high-quality service models. In the short term, we see many firms focused on customer retention and loyalty. Companies are creating long-term stickiness and clarity through a more sophisticated and agile cost-per-customer acquisition approach and greater value retention powered by predictive insights and better customer experience.

The game is changing: successful outcomes in PE require different calculus, new approaches and distinctive executional paths. Integrated capabilities and pre-curated solutions can take firms beyond traditional, more manual interventions and enable PE-backed companies to reduce costs and deliver value at greater speed with less risk.

The author wishes to thank Ben Liwnicz and Ben Socher for their contributions to this article.