Every private equity fund insists that they’re working on value creation. But most are barely moving the needle, and traditional strategies no longer make a material difference. It is clear that new thinking is needed. We believe that to differentiate, attract capital, and achieve superior returns, funds need to focus on alpha creation above all.
After some great years, private equity returns have flattened
Private equity had a great run in the years between the global financial crisis and the COVID 19 pandemic, delivering strong returns on the basis of four powerful sources of value creation. Leverage and multiple expansion drove over half the value creation in global buyouts during this period, while revenue growth and margin expansion accounted for approximately 40–50%.1 Measuring the impact of revenue growth is difficult, especially when determining the split between real organic growth and inorganic growth (i.e., M&A); from our experience working with private equity clients, we believe that during this time period, organic revenue growth (and by extension, organic Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) growth) represented just a fraction of what drove PE returns.
Additionally, buyout valuation multiples rose steadily during this period, from roughly 6.5x (2009) to around 12.0x (2021–22), undoubtedly aided by an influx of limited partner capital and the very low interest rates in effect at the time,2 which meant that funds had more money available to invest.
But that was then. Since 2022, multiples, while still elevated, have plateaued, and there’s a shift in the factors driving value creation in the private equity space. Funds must devote a higher share of income to debt service, and as a result be more purposeful with their capital allocation.
The playbook is changing. Unfortunately, many funds are not.
Traditional value creation methods no longer deliver
It’s not that funds aren’t creating any value. It’s just that recent vintage results are, as of this moment, mediocre. Assets show minimal growth. They’re held too long, often because entry valuations are far higher than current market valuations, or forced into continuation vehicles. Why? Because many funds are still focused on the strategies that worked so well in the years between the financial crisis and COVID 19: margin optimization, back-end integrations, roll-ups, inorganic growth, and buying down the multiple.These strategies can have impact but they no longer pack the same punch, in part because of today’s higher interest rates, debt loads, and multiples. And now that every fund uses them, these strategies are no longer differentiators, they’re table stakes. While some funds are taking important steps—building out teams, bringing in expert advisors, developing high-level plans—it’s simply not enough to deliver differentiated returns.
Alpha generation is today’s play
In today’s market, successful private equity funds focus on alpha generation, taking big, bold swings that drive benchmark-beating returns. Here’s how they do it:
Plan for the exit from Day One. When leading private equity funds close a deal, they already have their eye on the exit. They’re crystal-clear on their time horizon and know exactly who they intend to sell the asset to. This requires the deal team to have a firm understanding of the industry dynamics and value chain composition. It involves refreshing the portfolio company strategy and mapping it to exit intent. And it requires detailed value creation planning with a clear and realistic execution plan.
Revenue growth should be regarded as a mission-critical value driver. Leading funds underwrite their deals with a clear, executable plan to grow revenue and improve EBITDA—by making changes to improve organic revenue growth rates, reduce risks, and increase the asset’s terminal value. These funds go into a new deal already knowing where every dollar in new revenue will come from, and aim to overshoot their target by 30%.
Embrace an execution-first mindset. Leading funds don’t simply issue direction and leave the acquired business’s executive team to take it from there. They monitor their assets’ performance continuously, hold themselves accountable for results, and proactively intervene to keep things on track. They’re also not afraid to invest early to capture revenue later, realizing margins as the business scales.