An LP’s guide to a reckoning in private equity

After decades of declining interest rates, capital markets are experiencing a transformation unfamiliar to most private equity (PE) investment professionals working today. Dizzying developments in artificial intelligence (AI) are prompting revolutionary changes in the real economy, too. What are prospective limited partners (LPs) contemplating capital commitments to expect now? As co-investors with a broad view of the PE market and its sectors, sponsors, and portfolio companies, we see two interrelated trends worth watching as the industry approaches an inflection point. Each may soon reveal something about which PE firms will likely thrive, and which ones won’t.

1 Specialization and operating skills are now needed more than ever

PE opportunities are becoming harder to exploit. While diversification benefits of the asset class remain intact, the magnitude of future returns probably won’t match historical results. Without the benefit of low borrowing costs and strong economic growth, the composition of return drivers is also likely to shift. Revenue growth will remain a crucial value creation lever, but the days of a rising market valuation tide lifting all multiples are past. Instead, prospects now reside in the ability of sponsors to grow—and fundamentally improve—their portfolio companies’ operations, thereby driving up margins and enterprise value. We think the trend of top PE firms becoming more specialized by sector and more operationally savvy will therefore accelerate.

Specialization can lead to more proprietary deal sourcing, better risk assessment, and deeper insight that fosters targeted value creation strategies for each investment. Evidence suggests specialization also helps drive returns. Mantra Investment Partners tracks specialized PE funds investing in niche strategies, which averaged a net multiple on invested capital, or MOIC, of 2.2x from 2010 to 2020, well above the 1.7x average for PE overall.

We believe PE firms will need to upskill their teams and hire domain experts in specific industries and functional areas to execute a sector-focused operational strategy effectively. The old model of PE firms populated by finance generalists bearing M.B.A.s may no longer work; instead, talent with data science, engineering, human capital, and other operationally relevant proficiencies are now more likely to drive profitability at portfolio companies.

Many PE firms have taken steps to develop this sector-focused operational capability. One that stands out as masterful in reshaping industrial businesses is American Industrial Partners (AIP). AIP customizes an operating agenda for each portfolio company, drawing on lean implementation, procurement optimization, commercial excellence, IT enablement, and tightened strategic focus. Over half of the firm’s partners have operating or engineering backgrounds. In monitoring investments made alongside AIP, we’ve observed the firm in the boardroom; however, it’s on the factory floor where its transformative expertise is readily apparent. Touring an assembly line before and after an AIP-led lean implementation reveals an operations-based value creation approach that sponsors relying on financial levers alone can’t match

2 Generative AI is reshaping investment priorities and value creation strategies

Best practices in operations management don’t stand still. Generative AI, with its ability to create content, simulate scenarios, and generate data, is changing how companies maneuver in the marketplace. The disruption may lead to the emergence of new business models, while challenging the viability of traditional ones. PE firms will need to stay at the forefront of these developments to identify investment opportunities in industries that stand to benefit most from AI-driven innovation. PE firms will also need to know how to help portfolio companies exploit such opportunities.

Generative AI’s potential is massive and might increase global GDP by as much as 7%, or nearly $7 trillion, in the next decade. Business leaders around the world are taking notice. In fact, three out of four senior management executives across industries rank generative AI as the technology that will have the most significant effect on their businesses over the next three to five years.

Across our PE relationships, we’ve seen a wide range of sophistication around this technology. When used wisely, generative AI will help inform the enterprising sponsor’s investment decisions. Hg, for example, is using ChatGPT to mine—in a matter of seconds—its database of 25 million business descriptions to identify the best merger-and-acquisition targets for its portfolio companies. With its 15-member data science team, Hg is also fine-tuning its AI tools by training them on internal portfolio company datasets, leveraging the synthetic reasoning skills of AI, in addition to its knowledge base. Doing so responsibly requires diligence and cybersecurity expertise to ensure accuracy and data security. Hg aims to enhance core products at each of its portfolio companies while optimizing operations—through research and development augmentation, customer support triage, lead generation, and sales automation. Implementing such AI-powered solutions can lead to improved performance and competitiveness, increasing a portfolio company’s attractiveness to potential buyers when it’s time to exit.

The reckoning represents a healthy process of renewal in the PE industry

One of the unheralded benefits of co-investing is the insight it brings in deciphering which PE firms really are bringing value to management teams. We’re skeptical of PE firms that have historically practiced a generalist approach and have only recently narrowed their focus. Choosing to concentrate in industries where they’ve had the most success (while dropping those where they haven’t) doesn’t necessarily correlate with repeatable value creation. Instead, building true expertise comes down to assembling a durable, diverse, and operationally talented team with deep sector experience and a willingness to adopt technology that accelerates operating excellence. Aiming for growth at all costs has come and gone. It’s a sharp focus on portfolio company profitability that will distinguish top-performing PE firms from their peers prospectively. We think valuation discipline, creative sourcing, and—especially—operational improvements will be key to strong private PE returns.

Editor's note: Much of this material first appeared on October 1, 2023, in Buyouts.