Private Equity Managers Urged to Adjust Value Creation Approach

Private equity managers focused on buyouts must improve their operational efficiency to ensure optimal value creation for investors, according to strategists from McKinsey & Co.

Managers have historically been able to rely on financial leverage, enhanced tax and debt structures and increasing valuations to create value for investors. However, the increasing cost of debt since 2020 has left fund performance suffering, leading managers to seek new methods of value creation.

McKinsey’s 2024 Global Private Markets Review found that these asset classes entered a slower cycle in 2023, as equity buyout entry multiples declined from 11.9 to 11.0 times EBITDA through the first nine months of 2023.

Despite signs of recovery in debt markets, McKinsey’s analysts said managers will now need to focus on operational value creation strategies for revenue growth, as well as margin expansion to offset compression of multiples and to deliver desired returns to investors.

McKinsey’s analysis of more than 100 private equity funds with vintages after 2020 found that general partners (GPs) that focus on creating value through asset operations achieve an internal rate of return up to two to three percentage points higher, on average, compared with peers.

The analysts said buyout managers should firstly invest with operational value creation at the forefront of their strategy, and secondly ensure their entire firm is involved in improving operations.

Investing in value creation

Assessing new assets should involve conducting operational diligence to identify opportunities to improve margins or accelerate organic growth, according to McKinsey’s analysts.

They noted these findings can then be used to design a value creation plan and resolve any potential issues up front, prior to deal signing. This could increase the likelihood of receiving investment committee approval for the acquisition, McKinsey found.

The review said: “It is crucial that managers have in-depth familiarity with company operations, since operational diligence is not just an analytical-sizing exercise.

“If they perform operational diligence well, they can ensure that the full value creation strategy and performance improvement opportunities are embedded in the annual operating plan and the longer-term three- to five-year plan of the portfolio company’s management team.”

Similarly, McKinsey analysts said that while assessing existing assets, managers should focus on directly monitoring them and intervening when required through routine meetings with the CEO and CFO.

If their existing assets are underperforming, managers’ prompt interventions to improve operations in the short term, and improve revenue over the medium term, can be the deciding factor in whether they should continue to own the asset or reduce their equity position.

Prioritizing internal operations

In addition to focusing on operational value creation for their assets, managers should work to implement an operating model that encourages increased engagement between their team and the portfolio companies, according to McKinsey’s analysts.

They said managers should build a team of trusted, experienced executives within the operating group and empower them to collaborate with the deal team. This collaboration is crucial in determining the value available in the asset to be underwritten, developing an appropriate value creation strategy and overseeing performance of the portfolio company’s management.

The analysts said: “It won’t be easy to adapt and evolve value creation processes and practices, but managers that succeed have an opportunity to close the gap between the current state of value creation and historical returns and outperform their peers.”

With the Federal Reserve predicting that the federal funds rate will remain around 4.5% through 2024, then potentially drop to around 3% percent by the end of 2026, private equity managers may need to rethink their value creation strategies to finance deals and meet investors’ expectations.