As changes in everything from technology and interest rates to sustainability concerns ripple through the corporate world, private equity will have advantages compared to public market investing when it comes to large-scale company transformation for the modern economy. However private equity’s playbook will likely be quite different than the past, according to Goldman Sachs Asset Management.
The era to come is expected to be defined by slower economic growth, shrinking labor forces, and higher inflation, write James Gelfer and Juliana Hadas, in Portfolio Solutions for Alternatives Capital Markets and Strategy, in a report. As a result of higher interest rates, investors and operators will likely have to contend with headwinds to revenue growth, margin compression, and a structurally higher cost of capital. “We believe that private equity can continue to create attractive value for investors in this environment, but that the future path to value creation will be different than in the past,” Gelfer and Hadas write.
Private equity is predicated on active, control-oriented ownership, which allows general partners (GPs) to reshape acquired companies, their balance sheets, and strategic plans. This approach has enabled the private equity industry to generate 15% internal rates of return (IRR) over the past 10 and 20 years — although performance has varied, both across managers and over time.
While approaches to buyout investment vary widely, the drivers of return can be broadly classified into four categories: revenue growth, margin expansion, changes in valuations (for example, multiple of EBITDA paid to acquire the company versus received upon sale), and the use of financial structuring and leverage. Data shows that as the market environment evolved over the past four decades, private equity GPs adapted their playbook to emphasize different return drivers. Leverage and financial structuring have become less important in recent decades, for example, while multiple expansion and operational factors have gained prominence.
Even as higher interest rates cause shifts through the economy, private equity managers are expected to continue to be able to generate attractive returns, according to Goldman Sachs Asset Management. But leverage and multiple expansion are unlikely to add as much to value creation as they have previously. Operational initiatives — revenue growth and margin expansion — are poised to become the main determinants of success in the new regime. In addition, entry multiples and leverage levels are likely to decrease from recent levels.
Revenue growth and margin expansion could become more important
At today’s cost of capital, using a lower entry multiple, and without the benefit of multiple expansion, a company would need to generate low double-digit EBITDA growth to achieve the same return as with high single-digit EBITDA growth in the pre-Covid period, according to Goldman Sachs Asset Management’s analysis. This can be achieved by various combinations of revenue growth and margin expansion.
As a means to boosting revenue, private equity merger and acquisition strategies (often referred to as “buy-and-build") could be more difficult in a world of higher-for-longer interest rates and challenging and costly integration execution. “As such, we believe organic growth will become even more important for value creation in the years ahead,” Gelfer and Hadas write. “This growth could potentially be achieved by fixing broken business models or by super-charging growth in healthy, but slower-growing, businesses and industries.”
Margin expansion could be challenging. With elevated (though moderating) inflation and labor costs near the forefront of macroeconomic risks, margin expansion — and, indeed, the threat of margin contraction — is receiving increased attention. For some GPs, a focus on margins may represent a shift in mindset from prioritizing growth to now focusing on efficiency, as the cost of capital has risen. Margin enhancement is likely to rely on optimizing processes, enhancing supply chains, and rationalizing the workforce to be prepared for technological challenges and opportunities.
It may be that companies need to flip the value creation playbook between growth and profitability, if the less-used lever is more likely to generate future marginal benefits, Gelfer and Hadas write. For instance, companies in high-growth areas may need to focus on margins as economic tailwinds abate. Investments in traditional sectors may need to generate topline growth as structurally higher inflation may impede margin expansion. These types of initiatives require different skillsets, so operating teams may need to expand their execution capabilities beyond those they’ve relied on in the past. The value of an experienced and knowledgeable investment partner, with both extensive operational networks to support management teams and the financial resources for the upfront costs of driving impactful transformation, should become increasingly apparent.
Technology isn’t a “stand-alone thesis” for higher returns
In the meantime, technology — including data science, AI, robotics, and automation — is providing tools for transformation that weren’t available in the last decade. These tools offer opportunities to effect large-scale business transformation while forcing a re-imagining of the characteristics of successful businesses. This may be especially valuable for businesses and industries that are performing well but below potential.
But technology as a stand-alone thesis won’t be enough to drive returns. “Cautionary tales abound of companies that spent heavily on technology without reaping the full benefits due to organizational frictions,” Gelfer and Hadas write. “Over time, what are now novel technologies (including AI) will become a requirement rather than a competitive advantage.” GPs need to not only create first-mover advantage and build a defensible moat, but also form a realistic view on the ability of technology to expand or create new markets.
Tech initiatives, meanwhile, often mean capital spending at a time when the cost of capital has increased. But the cost of transformation tends to be front-loaded while the benefits accrue over time.
As a result, either GPs will need to extend holding periods to benefit from these upfront costs or find ways to reap the benefits of transformation faster. Execution timelines may need to speed up — with more of the work done in the diligence and underwriting phase than the post-acquisition phase, requiring closer collaboration between the GPs' investment and operating teams. While the use of leverage and financial structuring is unlikely to drive returns going forward, expertise in optimizing capital structures and managing certain macro risks (for example interest rates and foreign exchange) will be increasingly important to optimize cash flow and overall value of assets.
While all companies are likely to face headwinds from the rise in interest rates, private equity still has advantages compared to public market investing for large-scale transformation, Gelfer and Hadas write: “A long-term time horizon that allows for mid-journey pivots and adjustments as necessary, a more streamlined governance model in which a single owner makes resource allocation decisions, and additional resources that the GP can potentially deploy over time may all prove a decisive advantage in weathering a challenging environment.”
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