For those of us who have been in this industry for 20+ years, we grew up hearing that the Private Equity industry offered the most efficient path to professional success. Why? There was a formula that almost guaranteed beating the traditional stock market returns, and it could be applied again and again and again. In the US, Western Europe, and Asia-Pacific, the S&P 500, MSCI Europe PME, and the MSCI Asia Pacific PME all had better returns than the PE if the time horizon was limited to one year. However, if the time horizon was adjusted to five, ten, or even twenty years, the LBO returns were higher in every region. To sweeten the deal, long-term capital gains – where the hold period is greater than one year – are taxed at a much lower rate than short-term capital gains (held for less than a year). So, in theory, simply rinse and repeat.
Historically, to hit these top decile returns, executives and their PE partners increased the revenue of their portfolio assets (organically or through M&A) and then multiplied this increased revenue number by a purchase price multiple that increased as the asset grew. However, the purchase price multiple growth rate has reversed in the past few years, as has the ability to use debt to fuel growth. With multiples down, investors are hyper-focused on figuring out how to boost the profitability of their businesses. An article by Goldman Sachs entitled How private equity strategies are changing amid higher-for-longer rates highlights that investors are working against the clock with pressure from LPs who need to see returns. Investors must then prioritize the value-creation levers that generate growth most efficiently. This often starts with a change in the C-Suite (Lancor completes ~120 PE-backed searches each year). In concert with this, private equity firms have identified several tools their teams can use to solve this problem. These primary avenues are typically evaluated in the following order:
- Can we increase EBITDA? If so, what is the asset-specific plan?
- Do we need to re-underwrite the plan in our Investment Committee?
- Do we need to look at our Balance Sheet to give us more time?
- If these three options are not available and a sale is not feasible, what are our Secondary options?
Unfortunately, most PE investors now spend the majority of their time on troubled assets and not on making good assets great. While this is necessary to adhere to the financial obligations required by the LPs, a better question is how to avoid them in the first place. We have seen that working with executives before you acquire an asset to sharpen the investment thesis drastically reduces the number of surprises on the downside. We surveyed our C-Suite placements, and the #1 thing they wish they could have told themselves before taking their first C-Suite job – based on their own eventual experiences in the role – was to move quicker on changing talent as the clock is always ticking in a PE investment and IRR is agnostic.