What private equity investors need to consider in this higher interest rate environment

Sign up for the Globe Advisor weekly newsletter for professional financial advisors on our sign-up page. Get exclusive investment industry news and insights, the week’s top headlines, and what you and your clients need to know. For more from Globe Advisor, visit our homepage.
The cost of debt has increased dramatically over the past 18 months, with many predicting a more challenging period for private equity. This change will likely create a bifurcation between private equity general partners that have the expertise to grow a company’s enterprise value – even on an unleveraged basis – versus those that need access to constantly cheap capital to meet their equity return targets.
A successful private equity investment should make a business more valuable, and investors should profit from that added value. The ultimate goals are to create value in a business during ownership and then to exit the business, either by selling it or through an initial public offering.
The goal at exit is not only to recoup the initial investment but to realize additional returns because the changes implemented by the general partner made the business more valuable over time.
It’s important to note that the role of leverage in private equity buyouts has diminished over time with equity contributions now accounting for an increasingly large share. While it was not uncommon for leveraged buyouts in the late 1980s to be financed with just 10 per cent equity, this percentage has risen to around 40 to 45 per cent in recent years.
There has been a shift from a cash-flow-focused investment approach to a growth-oriented investment approach that’s centred around driving faster earnings growth through strategic and operational improvements. Put another way, private equity is now less about financial engineering and more about operational engineering.
Henry Kravis, the legendary co-founder of private equity giant KKR & Co. Inc., once said, “Any fool can buy a company. What matters is what you do once you own a business.” He stressed that the role of private equity is to make companies better, and the only way to do that is to improve the bottom line.
In an environment in which multiple expansions can no longer be relied upon to lift all boats (as has been the case in past years), growing a company’s earnings before interest, taxes, depreciation, and amortization is a value creation must.
Access to the resources of a leading private equity manager can be a true differentiator in private market investing.
The world’s leading general partners have developed in-house operational expertise and resources that their investment teams leverage to create value in their investments through active management.
According to research from AlpInvest Partners, a leading private markets investment firm, general partners that had internal operating partners generated an average gross multiple on invested capital on their investments that was 25 per cent higher than those that relied on deal teams.
There are many other ways a general partner can seek to create value in a portfolio company. Beyond operational expertise, their resources might extend to environmental, social and governance/sustainability matters or in providing the technology expertise necessary to assist companies with digital transformations.
Investors considering a private equity investment should consider which managers they believe are most capable of creating value in their investments.
Sean O’Hara is co-founder and chief investment officer at Obsiido Alternative Investments Inc. in Toronto.
For more from Globe Advisor, visit our homepage.