PE and value creation to jump on the next cycle of sustainable returns

The world has seen dramatic changes in the last 12 months with significant geopolitical shifts and a consequently marked impact on all the macro, microeconomic and financial conditions facing private equity operators. In fact, over the past year, geopolitics have made a come-back as a key driver of the global economy. The confrontation between “the West” and Russia over Ukraine has triggered an energy crisis as well as soaring food prices. Far from normalizing, international trade has reorganized in line with political alliances, marking the dawn of a more multipolar world. This has created a new economic reality with higher levels of inflation and an approach to monetary policy that is prioritizing inflation stability overgrowth. And, as a result, interest rates are at their highest in years and economic growth is slowing down.?

Up until the first semester of 2022, PE enjoyed a long period of relative stability all over the world and came to rely on certain trends, such as quantitative easing, ease of financing and very low cost of capital, high and growing multiples on transactions and low rates of inflation. However, during 2022 many of those trends reversed with decade-long norms shifting fast.

The turbulence of 2022 weighs heavily on the investment outlook for 2023 and beyond with one priority to be addressed by all PE operators: after years of significant over-performance, how to interpret what is happening in the market and, if necessary, what changes to make to the modus operandi to continue to be successful in driving sustainable returns?

All of this in a particular historical moment for PE which, in 2021 achieved the best results in its history. Just think of the record levels achieved with regard to dry powder, the evolutionary trend of fund raising, the total value of assets under management, the volumes and values of PE-backed M&A transactions, the number of IPOs and the amount of money raised by SPACs, the further growth of multiples on transactions and finally the statistics about returns on investments.??See the following figures.

A context that absolutely gave no possibility to foresee the sudden changes that have since taken place. In fact, following the events of 2022, there has been a clear slowdown in pretty much all the above indicators with a downward trend in new raisings and some prestigious international funds struggling to achieve their raising targets in 2022, a decrease in the number of M&A transactions (both in terms of volume and value), an almost zeroing of the IPO market and the approaching expiry of a significant portion of the dry-powder of the SPACs, and an initial average downward revision of the trend in multiples. Multiples which, however, remain very high, both implicitly in the current valuations of portfolio companies, and ‘relatively’ with regard to the market for listed companies which immediately reflected in current valuations the changes in geopolitical, macro-micro economic and financial conditions.The following figures give some explanation.

In the scenario from 2021 up to the beginning of 2022, the goal of PE funds was mainly focused on closing more and more big deals with the consequent deployment of ever greater amounts of money, exiting as many assets as possible exploiting the growing trend in multiples and providing Limited Partners with returns and liquidity, in order to speed up the possibility of raising new multi-billion funds, further increasing the size of the sector.

For that purpose, over time, Private Equity cleverly built a model strongly focused on: relational skills and the ability to originate and improve deal flows, an ability to design alternative financial structures to maximize leverage and returns, a capacity to select the right chief executives for portfolio companies, as well as negotiating skills and intuition in anticipating the trends and cycles of underlying valuation multiples. All elements which, as can be seen from figure 9 on the right, facilitated significant performance, far ahead of all other asset classes, except venture capital

A deep dive into how returns have historically been achieved by PE is needed to understand their chances of being replicated in the future. From the analysis in figure 10 on the right, it is pretty clear how relevant on the past performance have been the arbitrage of multiples and the growth in revenues of portfolio companies. Value creation on portfolio companies (margin expansion) has remained still very marginal. Meanwhile, the impact on returns deriving from the funds’ ability to guide a qualitative and ESG transformation of portfolio companies, due to the lack of accurate and verifiable reported ESG drivers, remains difficult to assess.?

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The question that all market players are now trying to answer is: is it possible to hypothesize another cycle of generation of returns quantitively and qualitatively consistent with the past? Some concerns obviously emerge, given that: i) it is difficult to imagine further important and such significant multiples arbitrage in the foreseeable short-term future, also given the peaks reached in 2021, high interest rates and the slowdown in the IPO market; ii) the growth of companies in the portfolio is now more complicated given the current situation for consumers whose purchasing power has been severely penalized by generalized inflationary pressures and the increase in interest rates; iii) it has become even more complex and articulated to guide transformative processes of value creation given the geo political impacts on business models and related supply-chains, a generalized increase in energy, raw material and labor costs. All at a time of objective difficulty for LPs which, after having bankrolled the growth of PE for years, now find themselves having to reconsider some of their asset allocation choices, despite the obvious overperformance of the PE sector, due to medium-long term constraints linked to commitments. Value creation then comes into the spotlight, even more than in the past, as the real and only available instrument to continue fuelling significant and sustainable returns in the future. Being able to count less than in the past on the growth trends in multiples and the businesses, PE is for the first time obliged to really ‘work’ the portfolio. But what are the main issues that must be addressed to be able to fully?deploy a much more value creation-oriented business model?

1.?????Avoid the ‘Talent Trap’

The talent skills that made deals successful in the past may not necessarily be the skills that will make deals successful in the future. In particular, the issue of talent skills concerns both the key managers of the companies in the portfolio and the investment professionals in the PE funds.?

The selection of the right managers is less obvious today given the lack of experience of most sector managers of the geo-political, macro and micro economic environments such as those we are currently experiencing and where the focus on earnings growth is likely to be the principal driver of PE returns going forward.?

With regard to PE operators/professionals, a greater crossover, technological and sustainable understanding of the typical transformative issues facing companies today with a particular ability to interpret investment theses as transformative moments in the medium-long term, albeit in the continuous and necessary short-term pressure on returns, is much more demanded. Almost all international funds have for some time been developing value creation skills internally with the inclusion of former sector managers and former consultants with industry, transformative and execution skills. If we?look at regional and/or local funds, such resources are still limited.?

2.?????Normal dealflow vs thematic investing

While maintaining and even pushing harder on the classic approach that aims to select the champions in the industrial sectors of focus, the issue of thematic investing is becoming increasingly important. It is a facet of human psychology that we tend to assume that what is true today will be more or less true tomorrow. This puts many investors at risk of failing to adequately discount the potential for radical structural change—and possibly forgoing the opportunity to take advantage of generational shifts in market dynamics. Thematic investing, or investing in long-term shifts that promise to alter current market trends and assumptions, has expanded rapidly serving both investors who want to navigate through short-term volatility by extending their horizons beyond the holding period and those who aim to diversify their portfolios not only by asset classes, regions, and market capitalizations, but by ideas. What are the most relevant, evident and necessary thematic trends? By way of example and without intending to be comprehensive: i) Technology as a sector of focus and digital transformation implications on other sector’s investment theses; ii) The SDGs and the ESG transformation implications on every sector’s investment thesis; iii) An aging population and the consequences for healthcare and life sciences; iv) The talent gap, the training of human resources and the alignment of supply and demand of the workforce; v) The generational evolution of consumers and stakeholders and their future purchasing habits/ needs; vi) The issue of energy transition as an investment area and as the transformation of companies in other sectors. Investing in any company that has an impact on the aforementioned thematic trends certainly has a greater chance of generating significant returns in the medium-long term (well beyond the first or second holding periods) and prospects for significant multiples arbitrage when implementing and delivering qualitative and broad value creation plans. The scouting of target companies perhaps becomes more complicated in the short term, necessarily passing from a more in- depth and vertical knowledge of the selected thematic trends, but certainly more sustainable and recurring going forward.?

3.?????Value creation as an investment approach

The process of value creation is now essential and evidently begins well before closing a deal and is preceded by a broad preventive understanding of the general issues on which the target company is focused and the consequent evolutionary and transformative needs of the target company in the medium-long term. The need to build, already in the evaluation phase, a wide-ranging and all-inclusive value creation plan with a high level of functional details is clearer than ever. It is no longer sufficient to worry about the expectations for a sector and the strategic positioning of a company in that sector; elements typically included in investment theses. Additional much more vertical issues must be addressed such as; geopolitical impacts on the business models, the implications of digital transformation on the operations and functions of each and every business, the ESG effects on the strategy and how to guide ESG improvements in the value chain of reference, how to enhance and retain human capital and build a better and sustainable working environment, how to improve the approach to governance, risk and control, and more. These vertical issues should form part of the initial investment thesis and be broken down into a value creation plan that goes into execution from the first post- closing day. Clearly a very hands-on and industrial approach which foresees for the close involvement of PE operators in providing real support and sometimes in constructive discussions with the future executives of the companies in the portfolio.?

4.?????SDGs focused and ESG driven investment theses?

The days when sustainability was a moral issue are long gone. Carbon emissions are well on their way to becoming a standard metric of fundamental research, with a steady and growing number of companies and governments making commitments to neutralize their carbon emissions, and investors and regulatory agencies alike demanding more detailed disclosures. So far, however, the data available to investors on sustainability metrics is a work- in-progress and data are not always really representative. Moreover, it is still very difficult to link ESG actions and activities to exit multiples and returns on investments.

The industry has long interpreted its fiduciary duty to clients as a requirement to ‘maximise’ financial returns for ‘beneficiaries’. For many years, the industry has rigorously debated the impact of integrating environmental, social and governance (ESG) criteria into this duty. What we can now say with some certainty is that ESG integration, more often than not, leads to better financial outcomes. The fiduciary duty debate has largely been put to bed when the majority of Limited Partners have agreed at the highest levels to this. As professional investors, PE has a duty to act in the best long-term interests of its beneficiaries, recognizing that ESG issues can affect the performance and the valuation of portfolio companies (to varying degrees across companies, sectors, regions, asset classes and over time) and consequently the returns.

While the industry agrees in principle, much remains to be done to implement ESG integration with appropriate strength and accuracy across portfolios. The gap between ambition and implementation underlies much of the recent criticism of ESG (e.g. greenwashing) revolving around misleading claims by some investors and the messiness of ESG data. PE needs to make a step further and come full cycle, moving away from a purely financial focus on integrating ESG factors towards recognizing that investors can have a real impact on the world – and that their ability to generate sustainable returns also depends on a healthy planet and population. With an increasingly clear understanding that the ESG quality of an asset also has a significant impact on the exit multiples.?

In this context of a clear structural change in the cycle and after decades of incredible over-performance, PE today faces the enormous challenge of building the next cycle of returns, with a greater focus on sustainability. The basic intrinsic elements for achieving this objective are all in place: dry powder at a peak, possible decreasing trends in entry multiples, growing assets under management, undervalued listed businesses, and more besides. On the other hand, the external factors and conditions under which PE operates changed entirely during 2022 and are certainly making it more difficult to achieve the objective. This means that PE needs to amend and improve its day-to-day operations and business model, prioritizing some medium-long term strategic choices over the exclusive pursuit of short-term financial returns.?

An innovative approach to talent issues, especially regarding PE professionals and the C-suites of portfolio companies, an orientation towards thematic and ESG driven deal flows and investments, a real and proactive front-end capacity for value creation and a meaningful and substantial approach to ESG issues are therefore crucial to navigate the rough waters of external factors and jump on to the next wave of sustainable returns.?

Alongside all this, there are great opportunities for PE that go far beyond the next cycle of financial returns. By making continuing amendment and improvements to the business model – i.e. taking full account of the issues outlined above – it will be much more likely that the important weight of PE, in areas currently considered key, strategic and systemic (i.e. ESG, labour, energy transition, digital spread and transformation), becomes substantially more visible and provide the PE sector as a whole with a clearer and higher purpose.?