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How the drivers of private equity value creation are changing

Discover the five key drivers in private equity value creation in uncertain markets.

Three questions to ask

  • What can PE firms do to keep their private equity value creation plans on track?
  • How is today’s macro backdrop driving change in firms’ approaches?
  • How are PE firms reassessing and addressing the core value creation levers and enablers of cost, cash, technology, talent and ESG?

Private equity (PE) firms thrive on their ability to acquire and build great businesses even in challenging times. They are skilled at creating rapid value and adapting their plans as circumstances change. They have always had a differentiated approach that gives them an edge, and their interventionist nature is key to getting returns in a competitive market.

Given the significant ongoing shifts in the macroeconomic environment, what can PE firms do differently now to keep their private equity value creation plans on track?

Any private equity value creation strategy put in place two years ago, as the world came out of the pandemic, may be based on assumptions that no longer apply. Since then, inflation has risen dramatically (and is now receding); supply chains have been shaken; debt has become more expensive, and the global economy has weathered tremendous volatility.

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Exit activity has slowed markedly, making targeted valuations harder to achieve amid extended hold periods. In our recent CEO Outlook Pulse (pdf), 81% of PE Executives said holding periods have been extended by up to three years longer than the historical average. Achieving desired multiples on exit has typically become more challenging, not least because affordable talent is scarce and new technologies — notably artificial intelligence (AI) — are driving waves of disruption across the business landscape.

 

Amid this backdrop, the importance of operational value-add continues to grow. In our recent PE Pulse survey, when asked about the relative contribution of return levers for deals exited two years ago vs. deals expected to exit over the next 24 months, respondents were clear in anticipating a strong pivot from multiple expansion to operational value-add as the primary driver of PE returns.

 

With multiple expansion less likely, and leverage more expensive, operational value-add to drive returns for the foreseeable future.

Deal trends

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Five drivers of private equity value creation

1. Using sophisticated cash management to increase resilience and drive growth

Maximizing the cash available to the business has always been critical to the way PE operates, as cash is much more valuable to a highly leveraged business than it is to a public company. PE portfolio companies are getting much more sophisticated about how they unlock trapped cash across all their operations and territories.

Liquidity is becoming a much higher priority, with 41% of business leaders in our CEO Outlook Pulse (pdf) saying working capital and treasury management is the top strategic priority across their portfolio companies in the next year. Many PE portfolio companies are examining their balance sheets critically, using better tools to forecast their cash needs, and establishing sophisticated cash repatriation and pooling systems so they can maximize centralized liquidity, manage working capital, and use their funds even better. saying working capital and treasury management is the top strategic priority across their portfolio companies in the next year. Many PE portfolio companies are examining their balance sheets critically, using better tools to forecast their cash needs, and establishing sophisticated cash repatriation and pooling systems so they can maximize centralized liquidity, manage working capital, and use their funds even better.

Priorities to consider include:

  • Optimizing working capital: For portfolio companies, using data analytics tools helps combine customer-specific performance metrics, leading to greater visibility and more accurate understanding of how working capital is used. This provides the business with timely and relevant information to optimize the performance of their working capital.
  • Reviewing opportunities to invest in better cash management: Leading firms focus on optimizing liquidity through flexible financing structures, releasing trapped cash and cash pooling. They fully assess the availability, cost and effective utilization of alternative funding sources, such as inventory financing.
  • Tracking cash-flow performance and escalate problems quickly: Robust monitoring of working capital metrics and cash forecast variations is a key to success. One way to do this is to implement weekly short-term cash flow forecasts from the bottom up to identify actual liquid funds across scenarios and embed a cash-focused culture by managing functions across the business to meet forecasts.

2. Putting costs under the microscope

Cost management is critical to PE-owned businesses, and their approach to it has changed. Funds are now making targeted investments to upgrade the finance functions to transform their cost-management capabilities in their portfolio companies. Our recent PE Pulse survey found that cost management ranked second (behind effective cash management) as a critical priority in today’s market environment — 70% of GPs say they’re focused on cost takeout either “somewhat” or “significantly” more than usual.

New priorities include generating the data insights needed to inform more granular decision-making about costs and embedding more robust governance controls around spending and investment decisions and reporting.

PE funds are also working hard to create operating structures that can drive operating leverage as their portfolio businesses grow. Several funds have recruited operating partners with specific finance function responsibilities to drive this effort forward.

Priorities to consider include:

  • Focusing on strengthening supply chains through nearshoring and more effective procurement: Firms have found success using nearshoring to reduce transportation costs and lead times, improve quality control and flexibility. They have renegotiated contracts and used advanced procurement analytics to optimize spend.
  • Identifying where AI automation and elimination of redundant activities can offset inflation: We have seen that implementing AI and machine learning can detect and remove redundant roles and process overlaps to optimize staffing levels and skill mix, reducing overhead costs.
  • Ensuring all new business cases stand up to increased scrutiny: Leading firms are looking at all types of spending, including indirect costs, and establishing controls and policies by applying a zero-based lens to build a more efficient and resilient organization.

3. Revolutionizing talent management to amplify value creation

The PE model has always relied on having the best management teams in place. Talent retention and recruitment have never been more important; as a result, funds are thinking differently about how they manage talent and are looking for ways to empower their workforce. They’re holding companies for longer, and their need for specialist skills and capabilities is growing, especially in data and technology.

Talent management often means equipping people – in finance or tech, for example – with the tools and support they need to perform better. Also, funds are taking a much more granular perspective on talent when they make an acquisition. They look more closely at what skills people have, how these skills can be improved, and how they might be pooled or moved to benefit other companies in the portfolio, such as by creating specialist cross-company teams to prepare for the risk of cyberattacks.

Priorities to consider include:

  • Ensuring the workforce fully meets the organization’s needs: Leading firms conduct fitness assessments to identify structural inefficiencies, opportunities to improve work through technology and AI investment, and ways to equip the workforce with the skills needed to drive business performance.
  • Finding ways to give employees what they value: The path to success often includes compelling employee value propositions featuring competitive compensation, flexibility programs, wellbeing initiatives, and professional development opportunities to attract, motivate and retain critical talent.
  • Creating human-centered, high-performing management teams: Many firms are working to develop agile, change-oriented leadership focused on continuous learning, empowering the workforce, driving sustainable transformation, and embedding a people-centric culture with related targeted incentives.

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4. Using AI to power the technology agenda
 

At a time when companies are under financial pressure, there’s less appetite for large digital transformations. Therefore, funds are focusing on ways to get more value from the technology they already have.

 

The rise of AI is causing many private equity leaders to revisit their technology priorities. AI’s potential impact has become more prominent in due diligence over the past year. Funds are asking questions such as: How AI might disrupt a business, its operating model, and its balance sheet? Where will AI create opportunities, and where might it be a threat? How AI might lower barriers to entry, either allowing competitors into a market or creating opportunities for the business to enter adjacent markets and segments?

 

Alongside this strategic thinking, funds are doing a lot of practical work to prepare their businesses for AI, such as by generating or gathering the kind of data that effective AI requires. AI is also driving greater value on sale, due to a re-rating or higher multiple. Our recent PE Pulse survey found that nearly 85% of GPs expect AI to have a significant or transformational impact on the way they do business over the next 5+ years. However, only 4% of CEOs interviewed in our October CEO Outlook Pulse said they were leading when it came to the maturity of their AI strategy.

 

Priorities to consider include:

  • Finding generative AI (GenAI) use cases you can execute now: Leading firms are identifying and prioritizing GenAI use cases that can deliver the most value, driving business growth and operational optimization. They put the right foundations in place to ensure a successful implementation, such as high-quality data, an innovative culture, and a focus on ethical and responsible use of GenAI.
  • Pushing for tangible benefits faster: Firms are achieving success by considering AI beyond a long-term initiative but pushing for the technology to deliver tangible benefits faster. They’re adopting a tactical approach to AI deployment to realize benefits quicker and establishing and initiating an AI-based roadmap at the deal due diligence stage so that it helps increase a portfolio company’s attractiveness (return) upon exit.
  • Getting your data ready: We are seeing firms implement robust data governance frameworks and data quality management processes to ensure the data is clean, complete, and reliable for AI applications. They are investing in data platforms and infrastructure to integrate disparate data sources to create unified, AI-ready data lakes.
     

5. ESG is a catalyst of value creation
 

Adoption of ESG principles has risen dramatically. In 2010, GP signatories of the landmark Principles for Responsible Investment (PRIs) amounted to just 155, according to Pitchbook. Today, they number more than 2,000. Most importantly, sustainability has moved beyond compliance exercises to an integral part of the value creation strategy. If a business can’t satisfy ESG reporting requirements, some initial public offering (IPO) routes will be closed when it is time for exit.

 

Another reason funds are more likely to stick with a progressive ESG approach is that the investment they’ve received often comes with ESG commitments attached. While ESG’s contribution to an investment shouldn’t be overestimated, PE funds are more likely to see ESG as a source of value rather than a risk issue.

 

Priorities to consider include:

  • Addressing evolving global macro trends and the growing number of sustainability-linked regulations: Leading firms are implementing comprehensive ESG reporting frameworks and controls to ensure regulatory compliance, as well as developing roadmaps to achieve net-zero targets and access green financing/incentives.
  • Embedding core ESG principles into a portfolio company’s corporate strategy: Many firms are conducting ESG maturity assessments and integrating material ESG factors into business strategy, operating models, and value chain activities to build long-term resilience.
  • Staying ahead of evolving consumer and stakeholder demands: The way forward can include sustainable strategies and approaches to capture top-line and bottom-line growth over the long term.
     

Relentless focus on value creation
 

While some funds are holding companies longer, that doesn’t mean they are slowing the pace of value creation. PE has always had an interventionist approach and a relentless focus on what matters most.

 

In these uncertain times, firms can innovate and adapt their approaches, and help portfolio companies optimize performance during extended hold periods, while still building in agility, for optionality and speed of exit when an opportunity arises.

 

This EY article is part of a sponsored content series as seen on hbr.org.

Summary

In today’s market environment, PE’s ability to drive operational value-add is more important than ever. Assumptions put into place 18 months ago may no longer be relevant. Firms need to reassess their strategies, and the ways in which the levers of cash, cost, talent, technology and ESG may need to be reassessed in order to deliver their promised optimal returns.

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