The Private Equity industry: time to reinvent itself or to disappear…

Private Equity Insight/ Out | Issue 1, 2018

by José Aubourg (Director, Private Equity) and Olivier Coekelbergs (Private Equity Leader), EY Luxembourg.

Since its beginnings in the 1960’s, the Private Equity industry (“PE”) has grown enormously to become a sector worth more than USD 4 trillion in assets under management. In the same period, the PE world has changed, and past growth alone does not guarantee the industry’s future success. Today, the PE industry stands clearly at a crossroads and needs to engage in an in-depth transformation process to continue bringing real added value to its customers.

Alongside the industry’s strong growth, the competition among players in the race for the best deals has intensified and become fiercer. In addition to the exponential increase of new PE funds and major industrial groups comes the entry of new players such as sovereign wealth funds or some large pension funds, more and more often in direct competition for acquisitions with traditional PE houses. Furthermore, borders between PE houses, investment banks and asset managers have become more and more blurred and open. Nowadays, PE houses represent only 30% of total alternative assets under management.

Competition for deals remains fierce

In a low interest rate environment and with a growing appetite for high returns on investment, the hunt for assets is constantly disputed, with the result being a significant and sustainable growth of valuations and the increasing difficulty of fulfilling a promise of investment profitability. PE houses have no other choice but to either overpay for assets to be able to deploy considerable amounts of “dry powder” that they have accumulated over recent years (USD541 billion in April 2017 against USD473 billion in 2015 and USD470 billion on average for the period 2006 to 2007)* or target lower quality assets.

Nowadays, competition for capital and for investors is also intensifying. In 2017, a record number of 1,865 funds have been attempting to raise approximately USD624 billion*[1]. At the same time, we observe a trend of large traditional investors now being much more selective in their choice of management companies or eager to restrict their relationships to a few carefully selected houses.

“The days where the leverage effect and “cost-cutting” allowed for the generation of enough value on their portfolio companies are definitely over.”

Value creation at stake

The Private Equity industry is clearly at a crossroads, and should rethink its model as well as engage in an in-depth transformation process to reinvent itself and continue bringing real added value to its customers. The days where the leverage effect and “cost-cutting” allowed for the generation of enough value on their portfolio companies are definitely over. PE houses will need to be more innovative to continue creating value for their investors.

Search for the best talents 

The first challenge to take on is to attract talent and to gain a competitive advantage on transactions in developing real expertise, while simultaneously developing in sectoral, geographical and technological areas which can really make a difference in identifying the best targets. This is particularly true for funds with a focus on technology or for Venture Capital funds.

Digital transformation

The second challenge, which is probably the most important, is to be able to create value in portfolio companies. Indeed, using conventional financial engineering techniques, as in the past, is no longer sufficient; one must now be able to support companies in their strategy, as well as in their “business model” and “process” transformation processes in order to improve income and net income. This inevitably implies being able to develop new digital and technological solutions, as well as the ability to attract new entrepreneur profiles capable of achieving the digital transformation of portfolio companies.

The risk of digital gap is to be found first in the PE houses themselves which will have to go through a revolution in their own processes. Curiously enough, PE companies with a strong focus on transactions and the management of portfolio companies have often not really assessed the risk of digital gap within their own organisations and have not yet truly integrated this dimension in their strategies. Most PE houses have not yet appointed someone in charge of their digital development, which would not only allow them to implement a digital transformation strategy in the portfolio companies but would also enable them to transform their own organisations, reduce their costs and optimise their data usage.

The next generation of PE leaders

Finally, the third biggest challenge to take up is the implementation of a real transition plan to allow for the handover to a new generation of partners. The largest PE houses are indeed closely organised around their founders and many of them will be prompted to cease their activities in the coming years. Achieving a smooth transition between old and new leaders is a mutual interest, and there must be the implementation of an attractive scheme for new partners which will likely bring about changes without betraying the root values which will prove to be absolutely critical in the years to come.

The Private Equity industry, though flourishing, should recognise the nature of all the challenges threatening its business model and not push its arrogance to the point of thinking that it could do without an in-depth transformation to embrace the emerging technological revolution. Only the players who will make this shift early enough will be able to survive and continue to thrive.

[1] Preqin