I am often asked whether the private equity industry is in bubble territory. It’s a sensible question, given that the industry enjoyed two decades of strong growth and high returns which cannot forever avoid gravitational pull. Anecdotal evidence does not help either: those of us involved in any way with the investment business have observed a growing share of our friends, clients, and/or business connections self-describe as “private equity investors” over the years.
On more objective territory, several indicators—including deal multiples, leverage ratios, and the amount of dry powder (that is, uninvested capital)—are at historically high levels, and new entrants continue to flood into the market. But we believe the PE industry still has significant room to grow. A clear-eyed view of the data reveals that the proportion of PE-backed companies remains low, that PE ownership generates superior returns relative to other asset classes, and that firms have continued to deploy capital despite record funds flowing in.
That said, continued growth does not mean business as usual. As in all market cycles, corrections and disruptions are inevitable. Further, the playbook that PE firms have traditionally employed—creating value mostly through financial engineering, acquisitions, and tactical operational initiatives—is, albeit effective, no longer sufficient. Increasing competition, high deal multiples, and—the biggest disruption of all—digital technology, all require firms to change their value-creation approach. Moreover, the founders of many of the biggest and best-known firms are starting to retire, which will mean a changing of the guard. In this environment, firms must rethink organization design, double down on digital technology, and revamp their approach to talent.
To be sure, naysayers’ concerns are understandable. By many measures, the industry continues to grow extremely fast, and trees don’t grow to the sky. But average deal multiples for top-tier deals (> $250 mm) in the US, while elevated (11.3 x), are still below their 2016-2017 highs (11.5 x – 11.9 x, respectively), according to PitchBook Data. Likewise, for the same top tier, the proportions of debt to deal size (53.2%) are still below their 2013 -2014 peaks (56.2% – 55.0%, respectively), and do not seem indicative of herd behavior.
However, strong returns for the industry have drawn new entrants, which all compete for deals and, all other things being equal, push up multiples, making it that much harder to sustain high returns in the future. At last count, there are over 2,500 active private equity funds in North America, seating on a record $2 tt of dry powder, of which nearly $700 bb allocated to buyout funds, according to Bain Capital data.
As money continues to pour in from institutional investors, firms will have a tougher time finding deals that meet their performance criteria. Many of them will rely even more heavily on secondary buyouts, which has the effect of slowing down penetration growth and making value creation even more difficult.
Room to Grow
Despite the negative indicators, we have a positive outlook for growth, and investors do too. PE valuations are certainly high, yet firms in the aggregate still pay less for assets than the public markets.
The PE Model’s Uniqueness
Even factoring in the currently high levels of dry powder, the industry is still managing to deploy capital at a record rate ($713 bb in the US in 2018, according to PitchBook data) with a healthy ($365 bb) level of exits. On the other hand, capital overhang, or the amount of time it would take at current deployment rates to invest every dollar that PE firms now hold sits at about one year, roughly where it has been throughout the last decade.
New Deal Sources
Another positive metric is the portion of the economy controlled by PE firms. Looking only at the US, the number of companies owned by PE players surpassed the number of publicly owned companies back in 2007, and that split has been growing ever since. Considering the value of the companies in both categories, however, PE-owned entities are far smaller—just $862 billion in implied value as of 2016, compared with $27.4 trillion for all public companies (including huge entities such as Apple and Facebook).
Breaking down the universe of PE-owned companies by size shows a similar story. Midsize companies (those with $500 million to $1 billion in annual revenue) show the greatest rates of PE ownership, but even then, the penetration rate is only 17%. Even if the industry was to deploy all its dry powder tomorrow, that penetration rate would increase to just 27%. For companies with $1 billion or more in revenue, the penetration rate would be only 20%.
Similarly, using GDP as a baseline shows that the PE industry has a good deal of room to grow. The US is the most developed PE market, but just 1.6% of US GDP is owned by PE firms. Australia has the second-highest penetration level, at 1.1%, and no other country has more than 0.5%. Simply getting the rest of the world up to the level of the US represents a massive market opportunity.
Most PE professionals would tell you that the assertion that there is more room to grow feels at odds with the reality they are living and breathing every day. And they are right. This is the most competitive market that private equity has ever seen. Nevertheless, while we acknowledge this contradiction, the overall trend in the industry is toward growth.
An Evolving Business Paradigm
Many firms are extremely good at creating value and driving change in their portfolio companies but are far less rigorous in the playbooks they apply to their own internal operations. Moreover, a critical forcing function in the industry is the changing of the guard taking place at many of the best-known firms, as founders begin to retire. This creates an unprecedented opportunity for firms to modernize themselves. The new generation of leaders will be able to reexamine everything from the firm’s operating model to its investment approach, career paths, incentives, and critical skill sets. In contrast, firms that simply hand over the keys to a new senior team—and leave outdated thinking and processes in place—risk wasting this opportunity.
In an increasingly competitive industry, firms must change how they operate, in three key ways
1. Rethink organization design. PE firms have to rethink how they organize themselves to accommodate their steep growth over the last ten years. Many firms have made some changes, but most have not gone far enough in adapting their internal operating models. This is creating inefficiencies in their organization and tensions among their most senior ranks. Instead, firms will need to address three aspects of organization design.
- First, they need to organize themselves with the right balance of sector expertise and more thematic investing strategies. It’s a difficult needle to thread. Given the current level of competition in the market, firms with sector-specific insights can identify targets and win deals over firms that still apply a generalist model. Yet as industry boundaries continue to blur, looking at sectors in isolation can create blind spots. A similar concept applies to sourcing deals in new areas (such as minority positions, activist mandates, and truly patient capital), or looking beyond defined asset classes (such as equity or credit) to more hybrid opportunities. Firms will need to explore these opportunities, yet they must put the right organization structure in place. Otherwise, good deals that don’t fall explicitly into any one group’s mandate will fall through the cracks.
- Second, there is the question of internal processes. Growth magnifies inefficiencies, and as the firms grow across countries and into new asset classes, they need to adapt their processes—such as deal prioritization, staffing, and deal governance—accordingly. Processes that may have previously been run in an informal way now require much more formal mechanization to keep on track at scale.
- Third, PE firms should adapt decision-making rights and determine accountabilities across the firm. In 2006 and 2007, we saw funds scale up very fast without adapting their operating model, which resulted in some disastrous deals made at the top of the market. To avoid these mistakes and resist the urge to deploy capital no matter what, firms will need to stay disciplined regarding decision-making processes and accountabilities.
In short, each PE firm will need to find the scalable operating model that fits with its heritage.
2. Double down on digital technology. PE firms have generated strong returns for decades by cutting costs and improving operations at portfolio companies in order to boost margins. Today, those baseline measures still work, but they are no longer enough to differentiate PE firms. Instead, the top performers are bringing digital expertise to their investments to help companies rewire themselves, develop new products and services, better meet customer needs, and generate top-line growth.
Many of the owners at target companies understand the need for digital transformations in their businesses, but they lack the relevant expertise, time, and capital to launch a transformation. And they don’t want to learn through trial and error. If PE firms can develop a value proposition regarding digital—such as helping companies digitize their supply chain or improve their go-to-market processes, both of which enable them to better meet customer needs—they are far more attractive as buyers, and they will be far more successful in terms of unlocking new value.
3. Revamp the approach to talent. Firms must develop a holistic talent strategy that considers carefully which essential skills need to be in-house and which are best accessed through a constellation of external advisors. As value creation becomes more difficult, cutting-edge specialization becomes more important, and few firms will be able to retain in-house staff to cover the full breadth and depth of topics required to succeed. But PE firms are increasingly reluctant to outsource certain skill sets: data scientists, macroeconomists, and consumer insight specialists. As the value creation playbook shifts from financia engineering to operational improvements to digital transformation, these skills are becoming must-haves. The greater emphasis on up-front analysis is another reason to have these skills in-house, to ensure that firms have the macro and consumer trends quantitatively nailed down well before considering value creation on any particular investment.
The PE industry has not peaked. PE-owned companies are dwarfed by those that are publicly traded (a ratio of 30 to 1 in the US), and LPs continue to invest their capital in private equity, whose returns exceed those of other asset classes. All of these factors point to continued growth. Clearly, with equity multiples as high as they currently are, some sort of correction is likely. The fundamentals of private equity are strong, however, and we believe the industry will withstand any potential disruptions and emerge stronger than ever.
Yet the successful firm of the future will look nothing like it does today. Funds need to rethink how they organize themselves and strike the right balance between narrow expertise in a given sector or region and thematic approaches. They also have to apply digital to their own operating model and to the companies in their portfolios, and they must put the right talent in place. These initiatives require firms to invest in the future and remain optimistic that the industry’s best years are ahead of it, rather than behind.