Bridging private equity’s value creation gap

McKinsey & Company argues that private equity (PE) buyout managers, who for roughly 40 years benefited from declining interest rates, financial leverage, favorable tax and debt structures, and rising asset valuations, now face a materially different environment. Since 2020, the cost of debt has risen and debt liquidity has become harder to access. Fund performance has suffered accordingly, with PE buyout entry multiples falling from 11.9 to 11.0 times EBITDA through the first nine months of 2023.

To offset multiple compression and meet investor return targets, McKinsey contends that managers must prioritize operational value creation in revenue growth and margin expansion. Drawing on its research and work with private-capital firms, the firm identifies two principles. First, managers should place operational value creation at the forefront by conducting operational diligence alongside strategic diligence, setting value creation objectives before signing, emphasizing operational and top-line improvements after closing, and monitoring existing assets with oversight aligned to each asset's health. Second, operating groups and deal teams within PE firms should jointly hold portfolio companies accountable for executing the value creation plan, with a focus on "linking talent to value." McKinsey's initial analysis of more than 100 PE funds with vintages after 2020 indicates that GPs focused on asset operations achieve internal rates of return up to two to three percentage points higher, on average, than peers.

McKinsey cites two headwinds. First, the US Federal Reserve projects the federal funds rate will remain around 4.5% through 2024 before potentially falling to about 3.0% by end-2026. Even with a 200-basis-point decline, rates would remain above levels during the period when many recent buyouts were underwritten. Average leveraged loans are underwritten at roughly 3x interest coverage, which could fall below 2x and approach covenant triggers near 1x; McKinsey notes that in 2023 the average leveraged loan in healthcare and software was already below 2x. Second, valuation mismatches may force longer holds or exit-value shortfalls, as private valuations lag public-market equivalents. McKinsey cites Harvard University endowment CEO commentary in Harvard's 2023 annual report that private valuations will take longer to reflect market conditions given the continued slowdown in exits and financing rounds.

McKinsey characterizes operational efficiency as a competitive necessity rather than a source of advantage. It recommends operational diligence to identify margin and growth opportunities, estimate cash flow improvements and costs, and embed initiatives in portfolio companies' annual and three- to five-year plans. For existing assets, it advises more direct monitoring, touchpoints with portfolio company CEOs, CFOs and chief transformation officers, KPI tracking tied to investment theses, and in some cases transformation management offices. Underperforming assets may require prompt operational intervention, illustrated by one manager's cash management program that helped a portfolio retail asset avoid liquidity covenant breaches. McKinsey also recommends that managers empower trusted operating executives as equal collaborators with deal teams.