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    All Insights Perspectives

    The New Math of Private Equity Value Creation

    THE NEW MATH OF PRIVATE EQUITY VALUE CREATION

    October 31, 2023  |  14 Minute Read

    Daniel Murphy

    Head of Alternatives Portfolio Solutions

    Daniel Murphy

    James Gelfer

    Portfolio Solutions for Alternatives Capital Markets and Strategy

    James Gelfer

    Juliana Hadas

    Portfolio Solutions for Alternatives Capital Markets and Strategy

    Juliana Hadas

    Key Takeaways


    • As the market environment evolved over the past four decades, private equity GPs adapted their value creation playbook to emphasize different return drivers. In recent decades, leverage and financial structuring have become less important, while multiple expansion and operational factors have gained prominence.
     
    • We believe the next ten years are unlikely to look like the last ten. The upcoming era may be defined by slower economic growth, shrinking labor forces, and higher inflation than the past decade—leaving investors and operators to contend with impacts from headwinds to topline real growth, margin compression, and a structurally higher cost of capital resulting from higher interest rates.
     
    • We believe that private equity maintains certain structural advantages in effecting large-scale company transformation, compared to public markets. However, the value creation playbook will need to evolve once again, as operational value creation levers—revenue growth and margin expansion—are poised to become the main determinants of success in the new regime.

    Surveys have shown that investors continue to view private equity as a critical component of their portfolios.1 The asset class may offer an important route for accessing long-term economic growth opportunities via a large universe of companies that are outside the publicly traded markets. Private equity may also help to drive innovation and evolution in the way companies operate. At today’s inflection points across technology, sustainability, and geopolitics, we believe many companies and industries must undergo dramatic transformation to thrive in the next decade and beyond. 

     

    However, we acknowledge that in an era that may be defined by slower economic growth, shrinking labor forces, and higher inflation than the past decade, investors and operators will likely have to contend with impacts from headwinds to revenue growth, margin compression, and a structurally higher cost of capital resulting from higher interest rates. We believe that private equity can continue to create attractive value for investors in this environment, but that the future path to value creation will be different than in the past.

     

     

    A History of Private Equity Value Creation

    Private equity is predicated on active, control-oriented ownership, which allows General Partners (GPs) to reshape acquired companies, their balance sheets, and strategic plans. This approach has enabled the private equity industry to generate 15% internal rates of return (IRR) over the past 10 and 20 years2—although performance has varied, both across managers and over time, such as around significant transitions in the macroeconomic cycle.

     

    While approaches to executing a buyout investment vary widely, the drivers of return can be broadly classified into four categories: revenue growth, margin expansion, changes in valuations (e.g., multiple of EBITDA paid to acquire the company vs. received upon sale), and the use of financial structuring and leverage. Data shows that as the market environment evolved over the past four decades, private equity GPs adapted their value creation playbook to emphasize different return drivers. Leverage and financial structuring have become less important in recent decades, for example, while multiple expansion and operational factors have gained prominence.3

     

     

    The Beginning: Leaning on Leverage

    The buyout industry as we know it today began to coalesce in the 1980s,4 when tailwinds from tax and regulatory changes, combined with the development of leveraged loans, led to the advent of the “leveraged buyout” (LBO). The term itself suggests that leverage (debt) is a key component of the strategy—and in fact, leverage was the primary driver of returns in those early days. Academic studies have shown LBOs done prior to 1992 were structured with Debt/Value ratios in the range of 0.65-0.85x.5

     

    With high leverage acting as the primary value creation driver, buyouts in this era generally focused on aggressively slashing costs in their portfolio companies, to maximize cash flows for debt repayment. In many cases, the underlying companies had been operating inefficiently, making cost savings a straightforward endeavor. However, such an aggressive leverage structure left little room for operational stumbles. Relatively small declines in revenue growth or margins could wipe out the entire equity investment. A number of prominent LBO-owned businesses went bankrupt in 1990-1992. A 1993 study showed that among the 83 large LBOs completed between 1985 and 1989, 26 defaulted and 18 entered Chapter 11 bankruptcy proceedings.6

     

     

    Second Era: Fundamentals in Focus

    In the next era, between the dot-com bust and the global financial crisis, private equity began its evolution to the industry of today. GPs pursued a more prudent capital structure, moving towards a more even split between debt and equity. In recent years, equity has made up as much as half of the overall financing in LBO transactions.  

     

    Against this market backdrop, GPs’ value creation strategy shifted towards generating greater value at the enterprise level, taking a longer-term view. Focus turned to driving revenue growth and margin expansion—unlocking untapped potential in underperforming businesses, fine-tuning operations of healthier companies, and building scale through add-on acquisitions. Some private equity firms began hiring dedicated operating professionals to work alongside their portfolio companies’ management teams to unlock value. As a result of these efforts, private equity managers have been able to generate superior operating performance in their portfolio companies, in aggregate, than was experienced in public markets.7 According to a 2021 academic study, revenue growth has been the most persistent source of value creation since 2000—contributing more than one-third to overall value-add, both before and since the Global Financial Crisis (GFC).8

     

     

    Post-Crisis: Riding the Beta Wave

    Multiple expansion has also served as an important contributor to overall buyout value creation over the past 20 years.  This factor has been particularly important since the GFC, with buyout deals seeing as much as 2-4x turns of EBITDA expansion from entry to exit.9 This multiple expansion has come through a combination of market-based (beta) effects and GP-specific (alpha) effects, such as improved company quality and growth prospects (see chart for more detail). Another effect has been evidenced in the frequently-employed buy-and-build (platform) strategies, wherein the manager combines a portfolio company with multiple smaller companies in the same business line. Because smaller companies tend to transact at lower valuations, this strategy averages down the cost basis for the consolidated enterprise. 

     

     

    “The radically altered investment backdrop means that the path to value creation will need to look different than may have been the case in the past.”

     

     

    Academic analyses attribute the multiple expansion in the period between the dot-com crash and the GFC primarily to the effects of GPs’ efforts. Conversely, the analyses suggest that multiple expansion since the GFC has been attributable primarily to market-based effects (given the significant run-up in public company multiples during this period), accounting for a quarter of overall value created for buyout deals executed since 2008.10 Nevertheless, GP-based multiple expansion added value in this period as well; the fact that buyout exit multiples have been consistently above acquisition multiples in a given year serves as evidence of alpha effects.11

     

    While multiple expansion played a meaningful role in value enhancement at the industry level over the past decade, our analysis suggests that it alone was insufficient to generate above-median private equity returns historically. According to our analysis, in order to achieve top-half performance, revenues would have had to grow by at least 7% annually (assuming nominal impact from margin expansion)—above the level experienced by publicly traded US companies in the 2010s.12

     

     

    Leverage Has Been Less Important In The Post-GFC Era

     

    Source: Matteo Binfare, Gregory Brown, Andra Ghent, Wendy Hu, Christian Lundblad, Richard Maxwell, Shawn Munday, and Lu Yi, “Performance Analysis and Attribution with Alternative Investments”, as of January 24, 2022.

     

     

    Uncharted Territory: New Math for the Road Ahead

    We believe the next ten years are unlikely to look like the last ten. The upcoming era may be defined by slower economic growth, shrinking labor forces, and higher inflation than the past decade—leaving investors and operators to contend with impacts from headwinds to topline real growth, margin compression, and a structurally higher cost of capital resulting from higher interest rates. Against this backdrop, we believe that private equity managers will continue to be able to generate attractive returns. However, the radically altered investment backdrop means that the path to value creation will need to look different than may have been the case in the past. Leverage and multiple expansion are unlikely to add as much to value creation as they have previously. Operational value creation levers—revenue growth and margin expansion—are poised to become the main determinants of success in the new regime.

     

    Based on our analysis, at today’s cost of capital, a lower entry multiple, and without the benefit of multiple expansion, a company could generate  low double-digit EBITDA growth to achieve the same return as with high single-digit EBITDA growth in the pre-COVID period. Our analysis also suggests that value creation is more sensitive to margin expansion than revenue growth. But while margin expansion may be powerful, it has been the more difficult lever to achieve, which may explain its relatively small contribution to value creation in the past 20 years.

     

    It may be that companies need to flip the value creation playbook, if the less-used historical lever is more likely to generate future marginal benefits. For instance, companies in high-growth areas may now need to focus on margins as economic tailwinds abate, while investments in traditional sectors may need to generate topline growth as an environment of structurally higher inflation may impede margin expansion. These types of initiatives require different skillsets, so operating teams may need to expand their execution capabilities beyond those they’ve relied on in the past.  The value of an experienced and knowledgeable investment partner, with both extensive operational networks to support management teams and the financial resources for the upfront costs of driving impactful transformation, should become increasingly apparent. 

     

     

    Revenue Growth: Going Organic

    Platform strategies, M&A and add-on activity have historically driven a significant portion of historical revenue growth in private equity—and this trend has only intensified in the post-GFC era. Add-ons accounted for over three-quarters of US buyout transactions in 2022, up from 50% in 2008.13 However, going forward, higher interest rates may impact financing availability for such transactions, and growing anti-trust regulatory scrutiny may limit rollup opportunities in some sectors. Therefore, while we anticipate that add-ons will continue to be an important strategy for value creation even once financing markets normalize, we also believe that relying solely on inorganic growth will no longer be sufficient. 

     

    As such, we believe organic growth will become even more important for value creation in the years ahead. This growth could potentially be achieved by fixing broken business models or by super-charging growth in healthy, but slower-growing, businesses and industries. Organic growth may be accomplished by gaining market share in existing areas through better products, services or customer experiences; expanding into new markets by launching new products, entering new geographies, and targeting new client segments; and/or having a more analytical, data-driven pricing strategy to optimize revenues from each transaction. This will require more finely-honed capabilities and talent around brand building and communication, sales channel optimization, and market research. It will likely mean more technology capex and R&D spend to create new products and optimize existing ones. 

     

     

    Expanding at the Margin: A Renewed Focus on Operational Efficiency

    Over the past several years, many private equity-owned companies have been able to pass through higher costs to customers, but the limits of price increases are beginning to be felt, with revenue growth outstripping increases in EBITDA in 2022.14  With elevated (though moderating) inflation and labor cost increases continuing to be in the forefront of macroeconomic statistics, margin expansion—and, indeed, the threat of margin contraction—is receiving increased attention.

     

    Margin expansion can be an impactful value creation lever, and with the correct approach, can become a more meaningful contributor to value creation than was the case in the past. For some GPs, a focus on margins may represent a shift in mindset from prioritizing growth to now focusing on efficiency as the cost of capital has risen.

     

    Margin enhancement is likely to rely on optimizing processes, enhancing supply chains, and rationalizing the workforce to be prepared for technological challenges and opportunities. GPs will need to question everything—from marketing budgets and the structure of sales organizations to raw material procurement and logistics—in order to understand the most efficient ways to drive growth, customer acquisition costs and unit economics. This effort will likely need more systems, processes, and technology to accurately understand costs, quantify their impact, and identify prudent ways of reducing expenses without hurting topline growth.

     

     

    Technology: Time to Upgrade

    Fortunately, today’s environment also offers tools for transformation that were not available in the last decade. Data science, AI, robotics, and automation continue to mature and accelerate. They are increasingly in a position to drive revenue growth and enhance efficiency in ways not possible before. As such, they are providing opportunities to effect large-scale business transformation while forcing a re-imagining of the characteristics of successful businesses.  This may be especially valuable for businesses and industries that are performing well but below potential.

     

    However, we believe technology as a standalone thesis is not sufficient to drive returns. Success is predicated on strategy and execution—implementing the correct processes, structures, and frameworks to harness technology.  Cautionary tales abound of companies that spent heavily on technology without reaping the full benefits due to organizational frictions. As more companies lean into similar technological theses, the use of technology will cease to become a key differentiator. Over time, what are now novel technologies (including AI) will become a requirement rather than a competitive advantage. GPs need to not only work to create first-mover advantage and build a defensible moat, but also form a realistic view on the ability of technology to expand or create new markets—which may vary by technology and product/service type. This all adds complexity and cost to executing on a value creation plan.

     

    These initiatives often require capex at a time when the cost of capital has increased, and the costs of transformation tend to be front-loaded while the benefits accrue over time. As a result, either GPs will need to extend holding periods to benefit from these upfront costs or find ways to reap the benefits of transformation faster. Execution timelines may need to speed up—with more of the work done in the diligence and underwriting phase than the post-acquisition phase, requiring closer collaboration between the GP’s investment and operating teams.  In addition, GPs can seek out capital solutions to expedite some distributions to investors.  While the use of leverage and financial structuring is unlikely to drive returns going forward, expertise in optimizing capital structures and managing certain macro risks (e.g., interest rates, FX) will be increasingly important to optimize cash flow and overall value of assets. We believe demand can continue to grow for innovative capital structures spanning the spectrum from senior credit to preferred and traditional equity, with the mix potentially evolving over the life of the deal. This dynamic may facilitate the growth of the all-weather strategic solutions strategy.  

     

     

    Why Take the Hard Road?

    All companies, regardless of ownership structure, will likely face higher capital costs, headwinds for multiple expansion and a more challenging operating environment. It is likely, however, that private equity is advantaged relative to public markets in effecting large-scale company transformation. A long-term time horizon that allows for mid-journey pivots and adjustments as necessary, a more streamlined governance model in which a single owner makes resource allocation decisions, and additional resources that the GP can potentially deploy over time may all prove a decisive advantage in weathering a challenging environment. To the extent that new value-creation skills and competencies need to be developed, private equity GPs can amortize them over a broader capital base—a portfolio of companies, rather than an individual company. 

     

    As such, we continue to believe that private equity, with the right partner, should present attractive investment opportunities for investor portfolios. However, dynamics of the new environment will have implications for GPs around how to think about their competitive advantages and for LPs in terms of how to select managers.

     

    In a period of acute uncertainty, we believe great investors will differentiate themselves by their confidence in what they can transform, a humility to accurately assess their abilities to create value and the discipline to price deals accordingly, and the ability to admit when they are wrong and change course.  

     

     

     

     

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    1 See, for example, Goldman Sachs Asset Management 2023 Private Markets Diagnostic Survey.  As of September 24, 2023.

    2 Cambridge Associates.  Pooled buyout IRRs over 10-year and 20-year periods through Q4 2022. Metrics are shown as of December 31, 2022 for the past 10 year and 20 year period. Like all trackers of fund data, such results do not represent the complete universe of private markets funds. As such, the databases referenced may face bias risks such as survivorship bias and non-reporting bias risks which may lead to higher overall returns than if such biases did not exist. IRR does not reflect the performance of any financial product offered by Goldman Sachs Asset Management. Past performance does not predict future returns and does not guarantee future results, which may vary.

    3 Matteo Binfare, Gregory Brown, Andra Ghent, Wendy Hu, Christian Lundblad, Richard Maxwell, Shawn Munday, and Lu Yi, “Performance Analysis and Attribution with Alternative Investments.” As of January 24, 2022.

    4 “Private equity, history and further development.” Harvard University. As of December 27, 2008.

    5 Matteo Binfare, Gregory Brown, Andra Ghent, Wendy Hu, Christian Lundblad, Richard Maxwell, Shawn Munday, and Lu Yi, “Performance Analysis and Attribution with Alternative Investments.” As of January 24, 2022.

    6 Journal of Applied Corporate Finance, Vol 19 No 4. “Private Equity: Boom and Bust?” As of Fall 2007.

    7 Cambridge Associates LLC Private Investments Database, FactSet Research Systems, and Frank Russell Company. Data from January 1, 2000 – March 31, 2022.

    8 Matteo Binfare, Gregory Brown, Andra Ghent, Wendy Hu, Christian Lundblad, Richard Maxwell, Shawn Munday, and Lu Yi, “Performance Analysis and Attribution with Alternative Investments.” As of January 24, 2022.

    9 Prof. Gregory Brown, IPC. “Debt and Leverage in Private Equity: A Survey of Existing Results and New Findings.” As of January 4, 2021. A 2x turn of EBITDA expansion means that, for instance, a company that may have been purchased at a price equal to 10x the EBITDA it was generating at the time of acquisition would have been sold at 12x the EBITDA it was generating at the time of sale.

    10 Matteo Binfare, Gregory Brown, Andra Ghent, Wendy Hu, Christian Lundblad, Richard Maxwell, Shawn Munday, and Lu Yi, “Performance Analysis and Attribution with Alternative Investments.” As of January 24, 2022.

    11 Burgiss Company Fundamentals Review. As of 4Q 2022.

    12 Based on S&P 500 aggregate revenue annual growth rates as reported by Dr. Edward Yardeni: “Corporate Finance Briefing: S&P 500 Revenues & Earnings Growth Rate.” As of May 29, 2023.

    13 PitchBook 2Q 2023 Private Equity Breakdown. As of June 30, 2023.

    14 Burgiss. As of 1Q 2023.

    Glossary

    IRR is a frequently referenced performance metric in the private markets industry using a money-weighted return calculation.

    Multiple expansion refers to acquiring a company at a lower valuation multiple and selling a it at a higher valuation multiple.

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    New Zealand: This material is distributed in New Zealand by Goldman Sachs Asset Management Australia Pty Ltd ABN 41 006 099 681, AFSL 228948 (’GSAMA’) and is intended for viewing only by wholesale clients in Australia for the purposes of section 761G of the Corporations Act 2001 (Cth) and to clients who either fall within any or all of the categories of investors set out in section 3(2) or sub-section 5(2CC) of the Securities Act 1978, fall within the definition of a wholesale client for the purposes of the Financial Service Providers (Registration and Dispute Resolution) Act 2008 (FSPA) and the Financial Advisers Act 2008 (FAA),and fall within the definition of a wholesale investor under one of clause 37, clause 38, clause 39 or clause 40 of Schedule 1 of the Financial Markets Conduct Act 2013 (FMCA) of New Zealand (collectively, a “NZ Wholesale Investor”). GSAMA is not a registered financial service provider under the FSPA. GSAMA does not have a place of business in New Zealand. In New Zealand, this document, and any access to it, is intended only for a person who has first satisfied GSAMA that the person is a NZ Wholesale Investor. This document is intended for viewing only by the intended recipient. This document may not be reproduced or distributed to any person in whole or in part without the prior written consent of GSAMA.

    Canada: This presentation has been communicated in Canada by GSAM LP, which is registered as a portfolio manager under securities legislation in all provinces of Canada and as a commodity trading manager under the commodity futures legislation of Ontario and as a derivatives adviser under the derivatives legislation of Quebec. GSAM LP is not registered to provide investment advisory or portfolio management services in respect of exchange-traded futures or options contracts in Manitoba and is not offering to provide such investment advisory or portfolio management services in Manitoba by delivery of this material.

    Japan: This material has been issued or approved in Japan for the use of professional investors defined in Article 2 paragraph (31) of the Financial Instruments and Exchange Law by Goldman Sachs Asset Management Co., Ltd.

    South Africa: Goldman Sachs Asset Management International is authorised by the Financial Services Board of South Africa as a financial services provider.

    Colombia: Esta presentación no tiene el propósito o el efecto de iniciar, directa o indirectamente, la adquisición de un producto a prestación de un servicio por parte de Goldman Sachs Asset Management a residentes colombianos. Los productos y/o servicios de Goldman Sachs Asset Management no podrán ser ofrecidos ni promocionados en Colombia o a residentes Colombianos a menos que dicha oferta y promoción se lleve a cabo en cumplimiento del Decreto 2555 de 2010 y las otras reglas y regulaciones aplicables en materia de promoción de productos y/o servicios financieros y /o del mercado de valores en Colombia o a residentes colombianos. Al recibir esta presentación, y en caso que se decida contactar a Goldman Sachs Asset Management, cada destinatario residente en Colombia reconoce y acepta que ha contactado a Goldman Sachs Asset Management por su propia iniciativa y no como resultado de cualquier promoción o publicidad por parte de Goldman Sachs Asset Management o cualquiera de sus agentes o representantes. Los residentes colombianos reconocen que (1) la recepción de esta presentación no constituye una solicitud de los productos y/o servicios de Goldman Sachs Asset Management, y (2) que no están recibiendo ninguna oferta o promoción directa o indirecta de productos y/o servicios financieros y/o del mercado de valores por parte de Goldman Sachs Asset Management.
    Esta presentación es estrictamente privada y confidencial, y no podrá ser reproducida o utilizada para cualquier propósito diferente a la evaluación de una inversión potencial en los productos de Goldman Sachs Asset Management o la contratación de sus servicios por parte del destinatario de esta presentación, no podrá ser proporcionada a una persona diferente del destinatario de esta presentación.

    Israel: This document has not been, and will not be, registered with or reviewed or approved by the Israel Securities Authority (ISA”). It is not for general circulation in Israel and may not be reproduced or used for any other purpose. Goldman Sachs Asset Management International is not licensed to provide investment advisory or management services in Israel.

    Jordan: The document has not been presented to, or approved by, the Jordanian Securities Commission or the Board for Regulating Transactions in Foreign Exchanges.

    Bahrain: This material has not been reviewed by the Central Bank of Bahrain (CBB) and the CBB takes no responsibility for the accuracy of the statements or the information contained herein, or for the performance of the securities or related investment, nor shall the CBB have any liability to any person for damage or loss resulting from reliance on any statement or information contained herein. This material will not be issued, passed to, or made available to the public generally.

    Kuwait: This material has not been approved for distribution in the State of Kuwait by the Ministry of Commerce and Industry or the Central Bank of Kuwait or any other relevant Kuwaiti government agency. The distribution of this material is, therefore, restricted in accordance with law no. 31 of 1990 and law no. 7 of 2010, as amended. No private or public offering of securities is being made in the State of Kuwait, and no agreement relating to the sale of any securities will be concluded in the State of Kuwait. No marketing, solicitation or inducement activities are being used to offer or market securities in the State of Kuwait.

    Oman: The Capital Market Authority of the Sultanate of Oman (the "CMA") is not liable for the correctness or adequacy of information provided in this document or for identifying whether or not the services contemplated within this document are appropriate investment for a potential investor. The CMA shall also not be liable for any damage or loss resulting from reliance placed on the document.

    Qatar: This document has not been, and will not be, registered with or reviewed or approved by the Qatar Financial Markets Authority, the Qatar Financial Centre Regulatory Authority or Qatar Central Bank and may not be publicly distributed. It is not for general circulation in the State of Qatar and may not be reproduced or used for any other purpose.

    Saudi Arabia: The Capital Market Authority does not make any representation as to the accuracy or completeness of this document, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of this document. If you do not understand the contents of this document you should consult an authorised financial adviser. The CMA does not make any representation as to the accuracy or completeness of these materials, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of these materials. If you do not understand the contents of these materials, you should consult an authorised financial adviser.

    United Arab Emirates: This document has not been approved by, or filed with the Central Bank of the United Arab Emirates or the Securities and Commodities Authority. If you do not understand the contents of this document, you should consult with a financial advisor.

    East Timor: Please Note: The attached information has been provided at your request for informational purposes only and is not intended as a solicitation in respect of the purchase or sale of instruments or securities (including funds), or the provision of services. Neither Goldman Sachs Asset Management (Singapore) Pte. Ltd. nor any of its affiliates is licensed under any laws or regulations of Timor-Leste. The information has been provided to you solely for your own purposes and must not be copied or redistributed to any person or institution without the prior consent of Goldman Sachs Asset Management.

    Vietnam: Please Note: The attached information has been provided at your request for informational purposes only. The attached materials are not, and any authors who contribute to these materials are not, providing advice to any person. The attached materials are not and should not be construed as an offering of any securities or any services to any person. Neither Goldman Sachs Asset Management (Singapore) Pte. Ltd. nor any of its affiliates is licensed as a dealer under the laws of Vietnam. The information has been provided to you solely for your own purposes and must not be copied or redistributed to any person without the prior consent of Goldman Sachs Asset Management.

    Cambodia: Please Note: The attached information has been provided at your request for informational purposes only and is not intended as a solicitation in respect of the purchase or sale of instruments or securities (including funds) or the provision of services. Neither Goldman Sachs Asset Management (Singapore) Pte. Ltd. nor any of its affiliates is licensed as a dealer or investment advisor under The Securities and Exchange Commission of Cambodia. The information has been provided to you solely for your own purposes and must not be copied or redistributed to any person without the prior consent of Goldman Sachs Asset Management.

    337355-OTU-1895364 Date of First Use: October 31, 2023

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