For private markets, the period from 2020 to 2022 witnessed unprecedented deal activity. However, the current environment presents a stark contrast marked by subdued deal flow, record levels of dry powder, extended deal close duration, and macroeconomic uncertainty.
Catch up quick: Interest rates that have remained higher for longer than anticipated, continued inflation, and the ‘valuation expectations’ wedge between buyers and sellers, have created a challenging landscape for dealmakers resulting in deal volume down 25% year over year. [i]
Between the lines: According to a 2023 year-end report, investment performance across private market asset classes fell short of historical averages with private equity experiencing its lowest annual performance in the past 15 years, excluding 2022. [ii]
- With enterprise valuation multiples and deal volume down, the market has seen a flight to quality, with buyers that transacted over the past 18 months focused on quality and willing to pay for it.
- Those that are closing are generally considered “A+” portfolio companies which represent situations where buyer and seller expectations on value can align more quickly.
- With a dearth of appealing deals coming to market—where there is a strong strategic fit for a sponsor—buyers have been willing to pay a premium that results in valuations closer to 2021 levels.
Why it matters: As investors look for ways to deploy their near-record high cash stockpile, there will be a sustained emphasis on creating real value.
- Over the next 18-24 months, both buyers and sellers will need to come back to the deal table, making the ability to deliver and defend valuations crucial for successful deals.
- To deliver future returns aligned with historical returns and the expectations of LPs, GPs will have to reassess their value creation strategy to ensure they can build long-term growth and sustainable value.
Flashback: Historically, private equity’s success has been underpinned by their ability to acquire and build great businesses through active ownership and strategic restructuring of acquired companies, often yielding robust internal rates of return across cycles and in competitive markets.
- Yet, the value creation strategies of the past—reliant on leverage, financial structuring, and multiple expansion—will not produce the same results going forward.
Fast forward: Future value creation will come from sharper focus on operational value add, particularly for those companies that are relentlessly focused on developing best-in-class capabilities, across technology, AI, people, and revenue-generating competencies to drive growth.
- With multiple expansion less likely and leverage more expensive, operational value-add will drive returns with the emphasis set to pivot decisively towards levers such as revenue growth and margin expansion.
- Additionally, technology enablement and digital transformation will play a critical role along with talent optimization and culture management.
The shift from traditional value drivers like leverage and multiple expansion to a renewed emphasis on revenue growth, margin expansion, and operational efficiency underscores a pivotal transition.
Punch line: A value creation strategy put in place a year or more ago may be based on assumptions that are no longer valid, and success hinges on a company’s ability to adapt quickly and create sustainable value.
What’s old is new again. While revenue growth and margin expansion may not be as sexy as M&A and add-on activity, these are poised to become key value drivers in the current environment and for the foreseeable future—and for many a clear way to evidence true value.
- Seizing market share, revitalizing underperforming businesses, expanding into new markets, investing in product development, and creating stellar customer experiences while building powerful brands are solid, time-tested strategies to drive revenue growth.
Technology enablement and digital transformation will be a centerpiece of value creation plans going forward as well.
- Much of a company’s ability to create long-term sustainable value is rooted in superior capabilities related to digital engagement, data and analytics, and AI.
- Generative AI has promises of being a game-changing technology—understanding how AI can create opportunities, enhance existing capabilities, completely overhaul a business model, or impact human capital is key to securing future value, and defending against being left behind.
Last, but certainly not least, companies that have a clear people advantage and can attract, develop, and retain capable and specialized talent will lead in value creation in this new era.
- The focus on workforce capabilities that are aligned with organizational needs has intensified, prompting a shift in how firms recruit and retain talent and empower their workforce.
- Securing top-tier, performance-driven leadership continues to be a priority while there’s a growing emphasis on fostering a culture that prioritizes people and that offers competitive compensation, flexible work arrangements, wellness initiatives, and professional growth opportunities.
Bottom Line: The ability to navigate complex economic environments, coupled with a keen focus on sustainable value creation will define success in the future. Value creation assumptions put into place 18 months ago may no longer be relevant.
Go deeper: Stay tuned for the next article in Auxo’s series that will further explore value creation strategies to capitalize on operational efficiencies, technological advancements, and effective talent management to drive revenue growth and margin expansion.
[i] PWC. PWC Global M&A Industry Trends, Q2 2024
[ii] McKinsey. McKinsey Global Private Markets Review 2024: Private Markets in a Slower Era