Private Equity’s Mid-Life Crisis

There’s trouble on the horizon for private equity. As the 50-year-old industry matures, investment returns are falling. In fact, for the past three decades, average buyout performance — the return a buyout firm generates from buying, improving, and then selling a company — has been on a downward trend. A study by Harvard professor Josh Lerner, State Street, and Bain, for example, found a meaningful drop of six percentage points between the 10-year annualized return in 1999 and the comparable return in 2019.

What’s ailing the industry? Simply put, the traditional tools of private equity for generating performance have become less effective, which is a natural evolution for a maturing industry. First, financial tools — leverage and price arbitrage — are less potent than in the past and hard to control. As the number of active PE firms reaches record levels, returns from the former are largely competed away. And with PE firms paying more for businesses than ever before (on average, relative to the businesses’ underlying earnings), the return potential is meaningfully reduced.

Second, operational tools — margins and growth — have become harder to capitalize on. Global competition and commoditization make it harder for products to command a premium price, which squeezes margins, and often a business’s easy-to-accomplish cost savings have already been collected by previous owners. A classic PE strategy — integrating small acquisitions into an existing business — still offers revenue growth and other benefits, but its popularity raises the prices of these acquisitions, so returns naturally fall.

Faced with a maturing, more efficient market that is chipping away at their returns, PE firms have innovated — operationally and financially — to create value. For example, they have upgraded their operational capabilities and created new forms of financial engineering, such as introducing debt at different levels of their groups (i.e., at the portfolio company, fund, and manager levels). But these incremental moves are not sufficient to halt the structural erosion of industry returns.

What is called for is a novel way for PE firms to think about — and create — value.

PE’s Next Frontier of Value Creation

The current PE approach is to treat the businesses in a firm’s portfolio as a bunch of isolated, individual investments, and to focus on how the stand-alone performance of each one can be improved over time. Of course, this approach is about diversifying risk, and it is how PE investors create value vertically. At the top are PE owners, which drive the improved performance of their portfolio businesses (in the middle) via strategic, operational, or management changes. At the bottom, bolt-on acquisitions are absorbed into those portfolio businesses to extract more value.

Conversely, we believe the next frontier of value creation is to design and manage PE portfolios as a business ecosystem. In this approach, which is largely unexploited, a PE firm orchestrates a network of relationships between some of its portfolio companies, linking previously unrelated goods and services across industries, and helping the companies unlock new value in each other. As a basic example, two businesses could coordinate the procurement of common services (such as employee health insurance) to reduce costs. The incremental value derived from leveraging the portfolio this way complements vertical value very well — the horizontal links between companies give PE firms more, and novel, options for increasing their portfolio’s worth.

This value is primarily created through revenue enhancements, cost efficiencies, higher valuation ratings, and some downside protection. In one basic area, procurement, a large PE fund has generated $550 million in cumulative savings over five years through coordination across its portfolio. Another player generated a 2.3x return on investment in three and a half years in a significantly declining sector, driven in large part by revenue relationships between interacting businesses. In sophisticated cross-portfolio arrangements, we find that operating profit can be increased by 15% or more.

The proposed value creation system is specifically adapted to PE’s unique buy-to-sell strategy — the firms’ practice of buying businesses and then, after driving meaningful operational and other improvements over a certain number of years, selling them. That means that while some portfolio businesses will form collaborative relationships with each other, they must remain operationally autonomous. This is to diversify portfolio risk and give PE owners the flexibility to sell them at any time. So building such business ecosystems is a balancing act between value on one side, and risk and flexibility on the other.

Basic elements of this approach may be deployed opportunistically after PE funds have acquired their portfolio businesses, without having planned in advance how to link the parts together. However, the greatest opportunity for value creation is when those links are considered before acquisition, as funds can carefully select and arrange the ecosystem’s parts into a high-performing whole. In this approach, PE investors would, at the outset, design a roadmap of potential links between their businesses, and then use it to evaluate potential investments. So the new screening process would consider not just a target’s individual potential but also its capacity to form new connections. The ambitious vision is for a fund to build, with each acquisition, a virtuous business ecosystem, continuously enhancing value without compromising risk or flexibility.

How an Ecosystem Approach Creates a Competitive Edge

Shaping their portfolios as business ecosystems can secure different kinds of competitive edge for PE investors, beyond just the direct improvement in financial performance.

For one, a sourcing and price advantage can be gained. For example, a family-owned business could collaborate and connect with a PE portfolio company that complements its activities, allowing it to innovate better, grow faster, or defend a market position. The PE firm looking to invest in the family business can therefore secure a meaningful price discount by arguing that the proposed partnership would create far more value for the family owner than any other prospect would.

Another competitive edge is in auctions, where PE firms can have a bidding advantage over rivals. Because they have a unique plan to make more from an investment — through an ecosystem with existing portfolio businesses — they are justified in paying more for it. Combining this ecosystem approach with higher financial leverage can also enhance a PE firm’s ability to compete with corporate buyers, which are natural builders of synergistic ecosystems.

Moreover, this value creation system is a major source of alpha (the industry term for outperformance). Based on a data set of 30 buyouts, we find that, on average, an increase in revenue growth of only 5% — created through the portfolio ecosystem — increases the alpha by 50%, which in this context means outperformance over average industry revenue growth. Therefore, this system has an outsize impact on the value PE creates in excess of key benchmarks such as public equity returns.

Overall, PE’s risk/return profile can be meaningfully enhanced. We find that, crucially, value-creating relationships that cut across the portfolio can often be maintained after portfolio businesses have been sold, so they can increase the sale price. Yet portfolio risk is unchanged, as portfolio firms still operate autonomously and are not intertwined in a way that would thwart their owners’ ability to spin them off at any time.

As the PE industry matures, adopting an ecosystem perspective, as opposed to a firm-focused one, greatly expands the possibilities for PE value creation. Despite the perceived challenges, significant and sustainable value can be unlocked by connecting businesses that are complementary or that share certain characteristics. Implementing this horizontal thinking will require PE firms to become ecosystem orchestrators. They will need to embrace new organizational structures, a harmonization of systems, new skills, changes to remuneration arrangements, and a culture of cross-business coordination. As industry returns continue to dwindle over time, PE innovators that build ecosystems to maximize their portfolios’ performance can secure a leading competitive edge.