What Private Equity's Shift Means for Investors, Business Owners

Green balls move through the center of a sphere and turn into purple squares.

Private equity is in flux as the threat of consolidation looms and more expensive debt reduces firms' ability to rely on deal structure and leverage to deliver outsized returns.

Economic conditions have changed, and private equity needs to change along with them, focusing less on financial engineering and more on traditional business-building principles.

Private equity's boom years

Since interest rates peaked in the 1980s, U.S. financial markets benefited from a secular decline in interest rates from 19.0% to 0.0%. Declining interest rates create accommodating conditions for high-risk assets, creating the foundation of several decades of success for the private equity industry.

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Low interest rates also enabled high leverage, allowing companies to use additional debt capacity to create the lowest cost of capital in the financial markets.

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That strategy served the industry well for years, generating returns in excess of those available in public markets. A PE-owned company's ability to carry and service debt became almost as important as its underlying customer value proposition.

The cost of capital advantage allowed private equity firms to outcompete even public market investors for assets, leading to a significant decline in the number of public companies per capita, down by nearly 70% from the late 1990s to today.

This private equity structure proved the most attractive form of business ownership over the past 20 years.

The cost of cheap debt

Despite the gains for limited partners, however, the ecosystem around these companies suffered; customers, suppliers and employees were left worse off thanks to private equity's financial engineering.

A company could be bought, merged with smaller businesses using significant debt facilities and then sold in less than three years without improving its underlying human capital, technology or operations.

The focus of business ownership shifted from expanding productive capacity at attractive profit margins toward debt-funded market share expansion at a high cost to ecosystem participants.

The pursuit of businesses with low-cost debt facilities also brought private equity firms into unfamiliar industries, ranging from accounting firms to car dealerships and sandwich shops.

Any company of sufficient earnings could act as a platform for private equity firms to perform debt-financed M&A on a huge scale.

But increased interest rates limited the debt capacity of companies, diminishing PE return prospects along with them. The ability to create value purely through debt-financed M&A has diminished, challenging the "roll-up" model that dominated industry returns for the past decade.

What must private equity do now?

Private equity must now return to business-building — basics that many industry participants ignored during the era of cheap debt.

By nimbly pursuing highly strategic, complementary acquisitions and by actively managing businesses, PE firms can revitalize and streamline businesses by bringing scale, technology and improved supply chain management to sleepier economic sectors.

PE firms need to build standalone public companies or private companies that could operate as standalone divisions of public companies.

The current market offers PE firms the opportunity to become champions of their companies, improving the experience of customers, suppliers and employees in the process.

To succeed, PE firms must become more industry-specialized and more selective in both their "platform" companies and their add-on acquisitions. PE firms must also develop a clear sense of the particular ways they can add value to each company.

Rather than buying mom-and-pop companies across the country, successful firms should bring industry knowledge, relationships and resources to deploy into opportunities that can scale into industry leaders.

For PE's clients, time frames for investments may elongate. The industry benefited from debt-driven M&A growth, which allowed exits within two years for successful consolidators. Building companies organically and through strategic acquisitions requires true market share expansion and revenue growth, which takes time.

Building better businesses

Despite interest rates declining, the cost to acquire a company has not declined. Today's investors face an environment where good companies remain expensive and cheap leverage is no longer the engine of returns.

As a result, value creation must come from fundamentally improving the businesses themselves, requiring a deep and strategic understanding of industries where PE firms choose to invest.

Passive value creation through financially engineered company expansion will not deliver attractive returns to limited partners anymore.

Instead, private equity firms need to be active in shaping the levers that drive sustainable performance: Human capital, digital transformation, go-to-market excellence and strategic M&A.

It's not crafting financial engineering — these are the areas where operational expertise makes the difference between good and great investments.

The future of private equity belongs to those who can drive returns by building successful businesses, working alongside founders and entrepreneurs to build scalable foundations for growth.

Private equity firms' success in this new landscape won't come from leverage or as a result of low interest rates. It will come from building better businesses — systematically, intelligently and in partnership with people who know them best.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Alexander G. Stacy joined Hudson Hill Capital in 2018. At Hudson Hill Capital, Alex focuses on the firm’s investments in industrial technology, software and financial services. Prior to joining Hudson Hill Capital, Alex worked at Hillhouse Investment Management, Genstar Capital and Barclays Capital.