Preparing for the Storm
The report, entitled Lessons for private equity from the last downturn,[1] showed that during the 2008 financial crisis, one of the ways that PE firms were able to mitigate the downturn was by focusing on value creation.
‘Value creation’ in this context means looking for opportunities to increase the value of a portfolio firm - for example, by improving the efficiency of a company’s operations.
Logically, companies that improve their operations during lean times are more likely to survive. They also gain a competitive advantage over less efficient competitors, thus increasing their relative value.
This ability to innovate swiftly in the face of rapidly changing circumstances is one of the advantages that private equity - and private markets in general - have as an asset class.
Whereas investors in public stocks typically have little or no influence over the strategy of the firm, private equity investors have the opportunity, as well as the ability, to make beneficial changes to secure a company’s long-term future.
Source: Data as of April 30, 2024. U.S. and NAM Buyout EBITDA margin based on median data from Pitchbook. Russell 2000 and S&P 600 EBITDA margins are as per Bloomberg. (Original source: https://www.kkr.com/insights/private-equity-vs-public-market-returns)
What Has Happened Since
In the end, the COVID-19 pandemic recession lasted only two months - the shortest on record.[2] Despite many dire predictions over the past few years, we have still not seen another recession (as of the time of writing in November 2024). The world, however, has continued to change.
In addition to digitalization, deglobalization, and decarbonization[3], the most impactful trend for the world of investments has been the relatively swift return of high interest rates. These higher rates place a greater burden on companies that are in debt, as well as increasing the required rate of return they are expected to deliver to shareholders.
This has affected private equity firms as it has everyone else. Much as was the case during the Great Financial Crisis, it has become more expensive for PE funds to make acquisitions, and passive ‘buy and hold’ strategies are not an option.
What This Means for Value Creation
Private Equity’s response has been to double down on value creation.
Rather than being a way to mitigate crises, firms with the expertise to do so now incorporate value creation into the deal-screening process itself. For example, by critically examining the opportunities for improvement in a target company, and laying plans to implement such strategies post-acquisition.[4]
In a follow-up report this year, McKinsey revealed the results of an analysis of PE firms who have taken this approach, confirming the efficacy of this approach, and the findings of the original report in 2020.[5]
Furthermore, the scope of value creation is also widening beyond efficiency alone, with revenue growth and talent management increasingly core to the remit. A study by KPMG showed that firms who incorporated both cost-saving and revenue growth measures saw higher EBITDA growth (15%) compared to those focusing simply on cost savings (5%).[6]
Conclusion
We know from 20 years of experience in the private investments market that some forces are outside the control of a deal team, such as inflation, regulation, and economic growth. However, the ability to add value through focus, experience, and a network of expertise is always both feasible and effective.
We would add that value creation is not just for the "bad times." It is equally essential during times of market euphoria, when the ability to discern which assets are overvalued and undervalued is key to surviving the next downturn—whenever it arrives.
[2] National Bureau of Economic Research (NBER)