Private equity: Humble hero in an evolving market?

Global disruptions and volatility have become commonplace between pandemic, war and climate shocks. As a result, business leaders are faced with concentrated surges in public spending, massive labor supply swings, as well as supply and product scarcity.

For the better part of 2021, the public market continued its ascent. In the first half of 2022 however, public market valuations suffered their worst half-year performance in decades. With inflation persisting, central banks acted. For example, U.S. federal interest rates jumped tenfold in the same period, from 0.25% to 2.5%, and may increase further to 4% by the end of next year.

The shift from pandemic recovery momentum to moderating growth and structural instability clouds the public market. Of course, no business is immune to global market challenges. But private investment―notably private equity (PE)―may be best suited to weather the storm. PE is uniquely unencumbered by detailed public reporting, while benefiting from longer hold periods for capital and less frequent mark-to-market. In addition, the global PE industry holds dry powder in the order of US$1.8 trillion.

Four primary forces will challenge PE over the next year:

• Stability of multiples: The MSCI software and service index showed an EV/EBITDA multiple decline of 22.5 to 19.6 last quarter. While this is still above historical averages, due to reporting delays following fund rounds, adjusted downward valuation may persist the next 9-12 months.
• Cost of capital: Rising interest rates have seized near-term primary lending levels, diminishing access to debt and spending power.
• Margin threat: Direct material and labor costs drove eurozone inflation to record levels and U.S. inflation to a 40-year high. While signs point to stability, margin erosion remains a headwind.
• Disrupted supply and service: Companies are facing a mixed bag of short supply, labor shortage and service delays, with subsequent inventory surpluses bringing a higher compound risk of carrying costs and operating expenses.

The net result is that much of private equity has access to capital and shows more stability than public markets, but without assurance of multiple expansion and with an intense focus on profitability.

To maintain the steady earnings and cash flows that private equity is known for, we recommend several actions for PE leaders.

1. Acquire selectively

Dry powder offers buying opportunities, including take-privates in undervalued public companies and investment in stable sectors that haven’t experienced an upswing since the pandemic.

With higher cost of capital, leaders will need to be smart with their dollars. Smaller bolt-ons and strategic adjacency plays to platform companies can make great targets to drive innovation and new business growth. Technology enhancement and rapid synergy capture will be essential in such deals. In most cases, the combination of a higher enterprise value for digital-at-scale businesses along with operational gearing from such investments have preserved and compounded multiples for portfolio companies, increasing exit potential.

2. Reinvest in the portfolio

With hold times growing for PE firms, there is a renewed case to invest in innovation within the existing portfolio. Leaders can improve ROIs by focusing on areas such as digital transformation and flexible outsourcing models. There has been a massive uptake in business process improvement alongside automation, increasing near-term capital expenses (capex) to remove structural operating expenses (opex). The rise in labor costs has reset traditional ROI measures, as PE leaders look beyond a 1-3 year return model.

This type of thinking requires innovative strategies. However, 81% of companies say that their employees lack the behaviors and mindsets needed to build a strong innovation culture. Innovation pacesetters on the other hand create a virtuous cycle of structures, mindsets and behaviors that hardwire the organization for innovation. They fuel a culture that helps accelerate innovation ROI.

3. Challenge spending and pricing conventions

At the portfolio level, leaders have some tough choices to make―quickly―to protect margins. Through data capture and analysis, portfolio company leaders can gain valuable insights to optimize their speed and response to the difficult trade-offs that market volatility demands:

Cost scenarios
Optimize operational costs. Use control tower analytics to identify bottlenecks and understand the impact of price fluctuations. Explore alternative suppliers, transportation routes and distribution channels.

Cost and growth duality
Seek to improve liquidity and cash flow while freeing up resources for growth. Use zero-based approaches to achieve full visibility into costs and prices. Reset the baseline, make cost structures more variable and build operational efficiency.

Customer demand and retention
Use technology to gain an understanding of where your customers are in their struggle with inflation. Track customer sentiment, spending and churn in real time. Adjust supply and pricing. Monitor how competitors adjust their products and prices.

Retention, wage and process
Rethink work processes and focus on removing low-value tasks for workers through automation, reset responsibility on high-return activity and reward approaches that drive engagement and boost productivity.

Be forthcoming with stakeholders about the changes you’re making to address inflation, especially with customers, employees and partners. There is greater acceptance of change now than ever before.

The world is in flux. This creates challenges for PE firms, absolutely. But a track record of outperformance and strong cash positions may shepherd an era where middle-market and bulge-bracket funds can grow respectably, with greater investment focus on the existing portfolio. A combination of compressed cost, growth and digital transformations can make this happen. It all comes down to an ability to drive innovation at speed and at scale in a tumultuous environment.

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