PE firms rely on organic growth for returns

Private equity firms are increasingly reliant on the organic growth of their portfolio companies.

Operational improvements and cash flow at PE-backed portfolio companies have always accounted for a portion of the asset class's returns, but now, as various alpha-generating avenues have closed, these elements are fundamental. In other words, PE is exclusively relying on the profitability of the portfolio company to generate returns, said Jeremy Deutsch, senior vice president at Neuberger Berman.

"You can't buy an average company, lever it and hope the market goes up," Deutsch said. "That worked when you had low interest rates, easy money, and when things were up and to the right, but it's not going to work anymore."

Before the Federal Reserve's interest rate hike campaign, PE firms generated returns through a lucrative combination of organic growth, leveraged portfolio companies and multiple arbitrage. For years, these avenues worked together almost seamlessly to generate record levels of deal activity: From 2010 to 2020, US PE funds churned over $6 trillion in total deal value, according to PitchBook data.

Now, the climbing cost of capital has changed the environment along with the tools at PE's disposal. Total US PE deal value hit a six-year low in Q3 2023, falling 54.7% from its peak in Q4 2021, according to PitchBook's Q3 2023 US PE Breakdown.

Instead of pulling all the levers—leverage, multiple expansion, inorganic growth—PE suddenly found itself with one lever to pull, said Stephen Brennan, head of private wealth solutions at Hamilton Lane.

"There's a flight to high-quality companies that will be able to grow organically despite a challenging environment," Brennan said.

On Monday, for example, Vista Equity Partners agreed to take private enterprise software company EngageSmart at a roughly $4 billion valuation. In 2023, EngageSmart reported a 28% year-over-year rise in its Q2 revenue and a 61% increase in adjusted EBITDA.

Over the past two years, PE has shied away from the traditional LBO. In fact, platform deals—which are characterized by their reliance on leverage—have declined 42.9% from 2022, and debt as a percentage of total deal value in the leveraged loan market fell around seven percentage points YoY, according to PitchBook data.

What's more, valuation multiples have contracted after a decade of unbridled expansion: US PE revenue multiples have plummeted 16.5% since the end of 2022, according to PitchBook data. This rules out multiple expansion as a driver of PE returns.

Inorganic growth also isn't much of an option for PE return generation as the M&A market has tightened due to wider bid-ask spreads and a constrained credit market. In the first half of 2023, North American M&A activity was down 28.5% from 2022 and 16.2% from pre-pandemic levels, according to PitchBook's Q2 2023 Global M&A Report.

That leaves one final lever to pull: organic growth driven by portfolios with cash flow-rich businesses.

Deustch said Neuberger Berman, which often acts as a PE co-investor, accounts for this dynamic in its due diligence and manager selection process by pricing in factors like an impending recession, another rate hike, and persistent inflation into the analysis of portfolio companies' capital structures.

"That's a big shift in the landscape relative to what it was before," Deutsch added.

Read more: Q3 2023 US PE Breakdown

Featured image by Yulia Reznikov/Getty Images

This article originally appeared on PitchBook News