How can PE firms find new routes to value creation?

It is risky for businesses to make long-term assumptions based on today's PE industry structure, market participants and profit pools. In an era in which the COVID-19 pandemic has closed entire economies and fundamentally reordered the ways we interact and work with one another, we are reminded of the speed and magnitude in which disruption can occur. As entirely new markets and ecosystems emerge, any assumptions extrapolated from historical trends are rendered questionable, if not utterly meaningless.

Those who lead companies must confront this reality. The demand for private capital itself has not diminished; in fact, it is more relevant than ever. The shifting balance from public to private markets has seen small and medium-sized enterprises keen to access capital with fewer associated costs and a lesser regulatory burden while retaining greater control over their business. But for PE companies operating in this climate, demand is only a part of the equation.

Optimizing the deal lifecycle will see increasing pressure over the next decade: pressure to source proprietary deals, to accelerate diligence and operational processes via digital, and to demonstrate value creation, to name just a few examples. As the industry redefines itself, firms that have not moved in step could become irrelevant.

To remain competitive in an environment that is changing faster than ever, firms must continue to maximize value through traditional levers — operational value creation and financial optimization — as well as adopt new levers of value creation; in particular, the three pillars of digital, purpose and transparency, and talent.

In a world of historic high pricing multiples and record dry powder, digital had already emerged as a value creation lever for PE firms to gain an edge in a highly competitive market.

Today, the need to prepare for and adapt to crises has never been more pertinent. Embracing digital is now a necessity, as the pandemic has forced companies to digitize in areas that were previously considered too high-risk. But digital technology also allows PE firms and their portfolio companies to anticipate and navigate externalities that come from uncertain economic climates, changing consumer tastes and needs, and a dynamic regulatory landscape.

Furthermore, a strong digital agenda is leaner and not bound by physical real estate, thus placing less reliance on manpower, while empowering workers with flexibility and connectedness.

As the focus on digital technologies rapidly accelerates for PE firms, activating a digital strategy throughout the deal life cycle is becoming a core component of the value creation agenda and leading to higher multiples on exit. For example, according to Harvard research, shares of listed non-technology companies that implement digital technologies are valued significantly higher than shares of firms that don’t, by between 7% and 23%, and such companies have greater returns per dollar of incremental earnings than those that do not.

In the current PE environment, there is an increasing emphasis on purpose and transparency. This is being driven by a combination of things: demand from LPs, the dynamics of origination, regulatory developments, and the ability to attract the best talent.

There is also social pressure and the question of PE’s license to operate. The PE industry is under greater scrutiny than ever before, and PE firms must do a better job of capturing and tracking the value they are creating and communicating the impact of their activities.

It is not difficult to grasp that value these days is increasingly being driven by nonfinancial factors. For PE, incorporating these new value elements can open doors — offering new types of investment opportunities, and partnerships with entrepreneurs and family owners who care about their business’ legacy.

The combined effects of globalization, demographic shifts, technological advances, the COVID-19 pandemic and increasing regulation mean PE firms and their portfolio companies are looking to create more agile and adaptable workforces. In light of these factors, it is getting harder to recruit, manage, motivate and retain talent.

For the first time ever, there are four generations co-existing in the workforce: traditionalists, baby boomers, Generation X and millennials. It is clear that new entrants to the workforce have differing expectations to previous generations: millennials want to join firms whose values align with their own, and while Gen Z are not yet working in full force, early indicators suggest they will seek out organizations that make a positive impact on society and have a highly diverse workforce. Purpose-driven, socially responsible organizations have become magnets for young talent.

But it is not just the new entrants who are forcing PE firms to rethink. The make-up of the workforce itself is changing, with the definition of “employee” now encompassing full-time, contingent, remote and even robotic. Digital applications will continue to expand their presence, in some instances replacing and in others enhancing current roles.

A future talent agenda will also need to incorporate a proactive approach to diversity, equity and inclusion (DEI), ensuring a strong tone is set from the top. Incorporating a comprehensive DEI strategy will address a firm’s commitment to elevating society while expanding its talent pool and creating new perspectives in investing.

A time for transformation

The success of the PE industry is rooted in its ability to help companies transform and adapt to changing conditions. If firms are to succeed in the NextWave of private equity, they must apply those same abilities to transform their own business models and use digital, purpose and transparency, and talent as new levers of value creation.