Private equity sponsors returning to their value creation roots

Firms are focusing more on building out operating capabilities to create value, and they are turning to private debt to finance these investments

With concerns about a global recession, accelerating inflation and rising interest rates, private equity managers are getting back to the roots of value creation and building out operating capabilities to produce returns.

And it is more likely to be private debt that finances these investments and future deals for private equity, as traditional sources of funding become more challenging, according to EY’s Private Equity Pulse report for Q2 2022.

With leverage getting more expensive and a contradictory environment for multiples, supply chain management, price optimization, digital transformation and working capital will be the primary drivers for returns, the report stated.

Underscoring the importance of operational value-add for driving returns will be some measure of multiple compression, Pete Witte, global private equity lead analyst for EY, told Private Funds CFO. But PE firms are better prepared for this value-add component than they’ve ever been.

“Firms have made heavy investments in operational capabilities over the last decade where they’re bringing in people with expertise in supply chain, digital transformation, HR, and pricing and salesforce optimization. And this is the kind of the environment where those types of resources are really going to help firms shine,” Witte noted.

EY’s report said that over the last decade, many deals that would have traditionally gone to the syndicated market instead flowed to private lenders. And this trend is expected to accelerate in the coming months as traditional sources of capital become challenging and borrowers look for lenders with the appetite, underwriting capabilities and flexibility to provide financing.

Witte also noted private debt could be more active in this economic environment because private lenders have capital to deploy.

“Also, these types of lenders tend to be able to offer a lot more flexibility than a lot of the traditional lenders. In this kind of environment that’s particularly important. So, I do think we see more private debt,” Witte added.

Although the landscape is more challenging now than it was a year ago, PE firms are looking to new strategies and investment themes for new deals. Announced deals in the first half of 2022 are down nine percent from the second half of 2021 and 18 percent from the same time a year ago, but activity is expected to remain high.

Fundraising has also declined in the first half of this year, with firms raising $275 billion through the end of June, 15 percent less than the same time last year. Witte said he is not surprised by this and there could be some additional deceleration in fundraising activity.

“The velocity of fundraising has increased over the last several years. Funds are coming back to market sooner and sooner. It used to be that you might raise a flagship fund every three to five years, then it became every two or three, and now it seems there are new funds being raised all the time. It’s a lot for the LPs to keep up with,” Witte explained.

It should also be noted that fundraising activity was dominated by large buyout funds, as investors largely feel more comfortable with established managers than smaller startup managers.

“That’s what you tend to see in periods of excess volatility where LPs tend to stick with managers that they know and have long well-established relationships, and the managers have long track records of managing through periods of volatility. Beyond that there is a large secular trend where LPs are just consolidating the number of relationships that they have and investing more with their largest relationships,” Witte concluded.