There’s trouble on the horizon for private equity. As the 50-year-old industry matures, investment returns are falling. In fact, for the past three decades, average buyout performance — the return a buyout firm generates from buying, improving, and then selling a company — has been on a downward trend. A study by Harvard professor Josh Lerner, State Street, and Bain, for example, found a meaningful drop of six percentage points between the 10-year annualized return in 1999 and the comparable return in 2019.
Private Equity’s Mid-Life Crisis
As the 50-year-old private equity industry matures, investment returns are falling. Traditional tools of value creation such as financial engineering are outdated. The next frontier of value creation is to design and manage PE portfolios as a business ecosystem. With portfolio companies linked together, synergies can be realized. Value is primarily created through revenue enhancements, procurement advantages, other cost efficiencies, higher valuation ratings, and some downside protection. What’s more, value-creating relationships that cut across the portfolio can often be maintained after portfolio businesses have been sold, so they can increase the sale price. To take advantage of an ecosystem approach private equity firms will need to embrace new organizational structures, a harmonization of systems, new skills, changes to remuneration arrangements, and a culture of cross-business coordination.