Private equity: Navigating the challenges of value creation in a complex and uncertain world

In this article, I talk about current challenges in value creation and provide a sneak peek at how PE managers can complement traditional methods to create value in their portfolio companies.

Depending on the maturity of a company and the type of PE fund, there are various ways for General Partners to create value in their portfolio companies. At the growth equity stage, value-creation revolves more around scaling operations and thus facilitating revenue growth, as well as measures to improve operational efficiencies (e.g., streamlining and increasing maturity of processes, organizations, and technology). Looking at typical buyout scenarios (leveraged or secondary), opportunities for value-creation are about unlocking the value of underutilized assets, restructuring complex organizational structures, process simplification & standardization to drive optimization of various operations and support functions, outsourcing, and in general cost optimization. The measures may vary depending on the organization itself and whether we are talking about small & midsize companies or large enterprises.

For small and midsize portfolio companies, it might be easier to identify and implement operational improvements – primarily due to a higher immaturity in organization, processes, and information technology systems – whereas bigger-sized enterprises offer fewer “easy” opportunities for operational improvements1 due to their complexity but provide probably more underutilized assets (or assets that can serve as collateral). In any case, there are a few emerging challenges on the way to creating value.

Last year in 2022, a lot of different industries saw an overall slowdown in M&A activities with an overall deal value decline of ~34% YoY2 (a 13.7% decline YoY in deal volume according to Pitchbook’s 2022 Global M&A Report3). The PE market declined by 38.6% YoY according to Bloomberg?. And there are various obvious reasons for that, factors that have an impact on the market conditions: Inflation and rising interest rates, supply chain disruptions, and geopolitical risks. Yet, over the years private equity has become more and more popular and will continue to do so helping to increase an investor’s portfolio’s diversification. As an asset class, private equity is also constantly outperforming public markets??? (even if both markets are not fully comparable due to their respective nature and the different metrics utilized to measure performance?). However, the alpha generated by PE decreased YoY?, and the pressure on PE firms – given the expectations of their Limited Partners and the expected return rates – is likely to increase.

Typically, when a PE firm acquires a company, those deals are highly leveraged (e.g., ~70% debt-financed and ~30% equity-financed, a leverage which is crucial for PE funds to achieve the promised returns), and historically, highly leveraged companies – with an average net debt-to-EBITDA ratio of 6.0? in buyout scenarios – also experienced a higher risk for financial distress and bankruptcy1?. Since rising interest rates will result in an even higher cost of debt, the default risk for individual portfolio companies is likely to increase. A recent survey among 111 CFOs in North America conducted by Deloitte highlights that interest rates in general and specifically access to “reasonably priced” debt capital are perceived as some of the most worrisome external risks11. Additional pressure on PE firms could arise from having too much excess capital potentially resulting in selecting less attractive investment opportunities and overpaying for their portfolio companies’ assets, as well as decreasing valuations of their respective portfolio companies, and thus decreasing exit multiples. Moreover, Limited Partners could also become more and more selective concerning PE funds to invest in and scale down their allocations to alternative investment opportunities overall12. The same also happened after the Global Financial Crisis 2007-08, and a 2023 report by McKinsey points out that in 2022, PE fundraising fell by 15% on a global scale13. One more challenge would be current geopolitical tensions impacting supply chains as well as energy and commodity costs. In some industries (e.g., manufacturing), valuing a company is becoming more and more complex due to the increased volatility of commodity prices1?.

With a typical holding period of 3 to 5 years, a portfolio company has about 2 to 4 years to show revenue growth, margin expansion, and/ or turnaround results – which is even more challenging with the abovementioned pressure and challenges. Some argue that the investment horizon for a portfolio company’s holding period might increase to 6 or 7 years or that portfolio companies will progressively exit into a continuation fund, which would give more time and space to actively manage those companies and implement appropriate measures to drive value-creation. However, it is yet to be seen if holding periods will become longer. LPs who have committed their capital already eventually expect to be incentivized after all.

PEs certainly excel in traditional value-creation initiatives as outlined above. However, given the increased economic pressure, additional methods & tools are required to navigate through the pre-deal valuation and post-deal value-creation process. In times of volatility and uncertainty, it is getting more challenging to value a company without steady EBITDA and cash flow forecasts on which to model. It is time to exploit data and descriptive, predictive, and prescriptive analytics capabilities – especially in data-rich environments – to facilitate more-informed decision-making and identify value-creation levers. Wouldn’t it be great then to highlight the relationship between expected revenue, fluctuating commodity prices, SG&A, CAPEX spending, and EBITDA faster, holistically, and more accurately to create more accurate forecasts and identify potential value-creation levers? Use cases for data-enabled valuation and value-creation can be found at any stage in the lifecycle of a portfolio company – pre-deal, during the holding period, or in preparation for an exit.

Some of the things PEs look at when valuing a company are opportunities from a market’s perspective, i.e., assessing the serviceable available and the serviceable obtainable market as well as the potential for growth in the respective sector, including technological advancements, customer demand, and regulatory changes. Furthermore, private equity companies look at a company’s past revenue and profitability and try to forecast the company’s future performance to determine its trajectory and value. Revenue streams, margins, debts, and cash flows are being analyzed as well to help assess a company’s financial health.

PE funds have already been utilizing tools to report on a fund’s overall performance and to conduct comprehensive due diligence on potential target companies by analyzing their financial statements. To a certain extent, data and analytics also play a role in analyzing market trends, identifying growth opportunities and potential buyers, as well as for valuations to facilitate investment decisions. However, LPs and GPs alike would benefit from even more detailed insights as well as real-time information on the performance of potential targets and portfolio companies by exploring other options, e.g., by utilizing data on customer behavior, customers' buying decisions and overall market trends combined with classic sector-specific experience, and the “right” pricing (i.e., pricing refinement) to drive qualitative and quantitative strategic decision-making processes alike with the overarching goal to expand a portfolio company’s revenue and profit margin. Other use cases could revolve around operational improvements (business process improvements, supply chain optimization, etc.). Furthermore, data analytics can help to improve financial modeling by building more accurate models through analyzing large datasets and identifying trends and patterns extrapolating the generated insights into the future with the help of time series analysis tools, an opportunity that might be missed through traditional methods. This can lead to more accurate revenue, expense, and cash flow projections, which are critical for valuing a company, identifying potential levers for value-creation, and preparing a suitable exit strategy. A simple example could be determining how fluctuating commodity prices impact a company’s COGS in the future. A more complex example could be how present-time CAPEX spending impacts a company’s EBITDA going forward. The general idea is to use the additionally generated insights to facilitate more informed decision-making and to consequently derive the appropriate measures to increase a company’s value. As stated above, there are value-creation opportunities at every stage of a portfolio company’s “lifecycle”, and the respective goals and use cases determine the tools and methods to create better insights.

PE managers need to explore more options for data analytics and accelerate the adoption process of new technology to make use of all the data which is available in their portfolio companies as well as their subsidiaries. The significant potential to generate value and increase returns for their Limited Partners can only be achieved in this way.

References

Cover Image: Winkler, M. (2022). Close-Up Shot of a Typewriter [Photograph]. Pexels.com. https://images.pexels.com/photos/12081244/pexels-photo-12081244.jpeg?auto=compress&cs=tinysrgb&w=1260&h=750&dpr=1

Figure 1: Stenzel, R. (2023). Valuation Bridge [Image].

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3Pitchbook. (2023). Global M&A Report. https://files.pitchbook.com/website/files/pdf/2022_Annual_Global_MA_Report.pdf

?Miller, A. (2023, January 17). ANALYSIS: How Private Equity Fared in 2022. Bloomberg Law. https://news.bloomberglaw.com/bloomberg-law-analysis/analysis-how-private-equity-fared-in-2022

?Hayes, E. (2023, March 10). Private Equity Continued To Beat Public Markets In 2022, Report Says. Financial Advisor. https://www.fa-mag.com/news/private-markets-continue-to-prosper--report-72349.html#:~:text=The%20report%20concluded%20that%20private,timeframes%20and%20through%20market%20cycles.%22

?Averstad, P. et al (2022). Private markets turn down the volume - McKinsey Global Private Markets Review 2023. McKinsey & Company. https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/mckinseys-private-markets-annual-review#/

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?Wolinsky, J. (2022, December 27). Private Equity Managers May Face Increasing Headwinds In 2023. Forbes.com. https://www.forbes.com/sites/jacobwolinsky/2022/12/27/private-equity-managers-may-face-increasing-headwinds-in-2023/?sh=23f4faee7bd5

?Rader, S. (2022, September 1). Preparing for the Rising Tide of Rates. GSAM Insights. https://www.gsam.com/content/gsam/us/en/institutions/market-insights/gsam-insights/2022/preparing-for-the-rising-tide-of-rates.html

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12Ivashina, V. (2022, February 24). The private equity industry in the new interest rate environment. Centre for Economic Policy Research. https://cepr.org/voxeu/columns/private-equity-industry-new-interest-rate-environment

13Averstad, P. et al (2022). Private markets turn down the volume - McKinsey Global Private Markets Review 2023. McKinsey & Company. https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/mckinseys-private-markets-annual-review#/

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