The Private Equity Business Model Is Changing. Here’s Who Will Win.

But what do you do when that formula stops working? If both the debt and the company you’re buying are too expensive to turn around at a profit, how do you invest your client’s money? And if you can’t invest their money, how do you give them the return they promised, with your tidy 20% of profits taken off the top?

The combination of high interest rates and high asset prices has been putting a brake on the private equity gold rush for several years. Industry transaction volumes fell by more than a third in 2023.AND Apollo CEO Marc Rowan highlighted the plight of the industry earlier this month.

“Over the last decade, let’s say the last 15 years, a lot of what was being produced wasn’t the result of big investments, but the result of $8 trillion of money being printed,” Rowan said on an earnings call in August. Now that the Fed “has stopped printing as much money,” many private-equity firms are seeing their strong performance as the result of a rising tide lifting all boats, Rowan said (though he was clear in distinguishing Apollo from the rest).

So how do private equity firms make money in this new climate? That’s where the chief portfolio officer comes in. Every private equity firm has a team of people responsible for working with the management of its portfolio companies to run their day-to-day operations. Unlike their jet-setting, deal-making counterparts, they tend to stay behind the scenes, doing the dirty work of making sure these companies run smoothly, from technology to payroll.

Kevin Desai, a partner at PricewaterhouseCoopers and PwC’s U.S. operations sector leader, told BI that portfolio operations professionals are becoming increasingly important as private equity firms hunt for the next wave of big gains: transforming companies with technology to cut costs and increase revenue.

“The culture of private equity is that investors who find and sign a deal are the favorites, and their portfolio operations are in the background,” Desai said.

But in the current climate, portfolio professionals are gaining respect. Firms are inviting them into the trading room to assess the technology transformation potential of acquisition targets before signing deals. — although this can lead to conflict when operations teams point out flaws in the deal team’s plan.

It’s part of a larger shift Desai describes as private equity 3.0, in which firms are relying more on company management—even complete transformation of firms—to generate returns for investors. In this model, portfolio operations roles are more important than ever before, said Desai, who spoke with BI about private equity 3.0, how it got there, and what it all means for the traditional private equity hierarchy.

Making money used to be easier

Private equity began as a “cottage industry” in the 1980s before evolving into a “much more sophisticated part of our economy,” Desai said. In the early days, buyout funds took private corporate conglomerates and then sold parts of the companies for a profit.

This era, which Desai calls private equity 1.0, focused on using debt to increase the returns an investor could earn on equity, using theorems of the University of Chicago School of Economics and a maniacal focus on efficiency.

But early success led to more competition and fewer acquisition targets. Suddenly, it became much harder to generate huge profits through financial wizardry alone. Instead, companies had to focus on cutting costs and beating industry rivals.

This led to the rise of private equity 2.0. In this era, efficiency was king as companies turned to cost-cutting strategies such as layoffs, corporate consolidations, and corporate relocations. The goal was to generate revenue at the lowest possible cost.

“Can we extract more value or get more ROI on our capital expenditures to really increase the return on cash on cash,” Desai said, explaining the mindset of companies in this era.

But competition only grew, leading to what Desai calls private equity 2.5, using the money generated by a company to buy more growth. One example is the classic roll-up strategy, in which an operator of a chain of small businesses, such as a car wash, uses the cash flow to buy more of those businesses, increasing the size of the company and the return on the investor’s original capital.

Private Capital 3.0

Rising interest rates nearly two and a half years ago ushered in a new economic reality that hit private equity firms squarely in the pocketbook. Cash flows that previously could have been reinvested in the company or distributed to investors now had to be used to cover the debt that originally financed the deal.

Persistently high corporate valuations exacerbate this problem, making finding a lucrative target more difficult than ever.

“If I’m a private equity investor, I have a problem because I have a junior seller looking at his stock portfolio, and the S&P 500 price-to-earnings multiple hasn’t gone down much,” Desai said. “Why would I sell my business for a lower multiple of EBITDA? Because “The stock market tells me the economy is doing great.”

The industry has two options, Desai said: reduce debt or “do something different to generate above-average cash returns.” Because private equity relies on debt to boost returns, the first option is out of the question.

What remains is a new model, which Desai calls private equity 3.0, forcing buyout firms to build new revenue streams to generate returns for investors.

He added that this model typically starts with technology that reduces costs and then uses the savings to find ways to increase the company’s ability to make money.

Desai cited the example of a car wash chain that had previously used its profits to buy more locations. As the extra cash flow is eaten up by high debt costs, the owner now has to introduce labor-saving back-office technologies, including generative AI and even chatbots.

These savings will then be used to implement new money-making opportunities, such as creating an app that could attract more loyal customers or selling other related services at your car washes.

That’s one reason private equity firms are increasingly focusing on physical businesses, such as pest control or cleaning.

“A lot of clients are saying to me, ‘We need to start thinking about how to transform old-economy companies into new-economy companies,’” Desai said.

Step into the Portfolio Operations Professional

The rising star of this new investment paradigm is the portfolio professional. Instead of just handling companies between purchase and final sale, they now help turn them into income-generating machines.

“We now surround our financiers, who have been the historical engine of private capital, with really smart operators, some of whom have led digital transformation in large corporations,” Desai said.

Portfolio operations partners have historically been former CEOs and CFOs with a proven track record of successfully leading companies. They have expanded to include professionals from all major business functions, from HR and marketing to procurement, and especially CTOs and those who have driven major digital transformations.

Desai said there’s a growing need for operational talent, including people who may have run an e-commerce platform for Walmart or managed digital for Nike, for example. These people are taking their talents to private equity firms to run smaller companies using a proven playbook for technology transformation.

They add value at the acquisition stage, assessing how long a transformation might take and how much it might cost. If a deal goes through, they actually help manage the day-to-day changes in those companies, along with the management team at the companies themselves.

“With unlimited capital, a lot of things sound like a great idea,” Desai said. “In a capital-constrained world, we have to see what’s possible.”

Clash of cultures

The importance of portfolio operations specialists is already growing.

A study cited by Harvard Business Review found that operations (revenue growth and cost reduction) contributed 47% of all private capital value creation since 2010, compared to 25% of value delivered by financial engineering. This is a reversal from the 1980s, when operations accounted for just 18% of private capital value creation and financial engineering accounted for more than half, at 51%.

Of course, Desai warned, the growing status of the operations expert could lead to more potential conflicts in the negotiation process.

“When portfolio management teams get under the hood of portfolio companies, they discover challenges to the value creation program or perhaps obstacles that were not known at the time of due diligence,” Desai said. “This can create conflict within the fund; the deal teams and the operations teams may disagree on how to actually execute the PE firm’s investment thesis.”