The Value Creation Imperative: Shifting Market Dynamics

Shifting dynamics in the Private Equity (PE) market have led to the consensus that the past decade’s returns through existing channels, primarily driven by multiples expansion, may not be replicable in the coming years.

According to McKinsey’s 2024 Global Private Markets Review, approximately two-thirds of the total return for buyout deals executed between 2010 and 2021 (and exited before 2021) can be attributed to market multiple expansion and leverage. However, with declining multiples and interest rates remaining higher for longer , this trend is unlikely to persist.

Shifting market dynamics

Three major factors are contributing to the emergence of a new value-creation paradigm shift in PE markets.

1. Valuation Expectation Gaps: There’s a significant valuation gap in the current market between buyers and sellers. As multiples have decreased, the enterprise value of portfolio companies (Portcos) has also declined. Consequently, even if a company is performing well, its value may erode over the holding period.
   
   On the other hand, there are buyers with substantial funds who are interested in making acquisitions but are unwilling to pay a 10x multiple when the market is trading at an 8x multiple. As a result, transactions are only occurring with the highest-quality Portcos that can still command a 10x multiple. However, multiples aren’t anticipated to rebound quickly, perpetuating a cash cycle characterized by fewer transactions and less capital available for investment.
   
   
2. Higher Cash Costs: Interest rates are projected to remain higher than historical averages for an extended period. Despite ongoing speculation about potential rate cuts from the Federal Reserve, the last rate change occurred in July 2023, and the last decrease was in March 2020, over four years ago.
   
   These rates have been steadily increasing since 2022, contrasting sharply with the significantly lower rates of the previous decade, which made it easier to use leverage to acquire Portcos without requiring a high multiple. However, the current federal funds rate of 5.25-5.50% presents a significant challenge in generating the necessary returns.
   
   
3. Macroeconomic Instability: Macroeconomic trends and instabilities, such as an election year and political instability, add another layer of complexity. These factors make it even less likely for the PE market to revert back to its state from a few years ago, and we can’t expect valuation multiples to jump back to previous levels. Without the ability to use financial leverage as effectively as in the past, the path to portfolio growth becomes more limited.

So, without the ability to rely on multiple expansion or financial leverage against low interest rates, what options remain? If PE leaders expect to achieve returns similar to those seen historically, value-creation is the only path forward.

The value creation imperative

Value creation is the new foundation of successful PE strategies. As the window for leveraging market conditions narrows, the focus must shift towards making significant improvements within Portcos through revenue growth and margin expansion.

“To ensure that distributions are flowing back to limited partners (LPs), businesses need to be on track for margin expansion. Multiple expansion isn’t something we’re seeing in the market right now. The only other viable option is to ensure margin expansion that aligns with the equity story. Private equity firms must do everything possible to support their portfolio companies,” says Joshua Maxey, co-founder of Third Bridge (This Miserable Market Could Be a Catalyst for Private Equity Firms).

There are three ways to grow margins: cutting costs, selling more, or raising prices. Each method can add value to the bottom line, but not all are created equal. According to the renowned McKinsey study cited in the Harvard Business Review article Managing Price, Gaining Profit, pricing is the most significant profit lever a company can pull. A 1% price improvement yields an average 11.1% increase in operating profit.

Strategic pricing

Price increases can be challenging for a company to execute, especially in a softening economy. However, achieving a 1% price improvement doesn’t mean raising every customer’s price.

There are likely subsets of the business that are less profitable than the rest. Finding and addressing these trouble spots can improve profits by 1% or more. Actions can range from slightly higher price increases to more aggressive measures like firing unprofitable customers.

Additionally, industrials often give sales reps significant pricing autonomy to close deals. This can lead to reasonable average selling prices but significant price variations at the individual deal level, causing companies to lose potential profits.

Listed prices may not show the whole picture. Favorable terms, rebates, and other incentives can lower realized prices and profitability. Eliminating excessive concessions can easily yield a 1% improvement.

Conclusion

While holding periods traditionally provided for multiples expansion, they now serve as a limited window to execute value-creation strategies. As a result, PE firms must prioritize initiatives that will have a rapid impact.

Strategic pricing is a pivotal value-creation strategy for Portcos, directly impacting their profitability and market competitiveness.

In a market landscape where traditional expansion strategies falter, strategic pricing provides a robust alternative, emphasizing operational excellence and targeted management of pricing structures to boost overall financial performance.

If a specific Portco came to mind, or if you’re ready to learn more about strategic pricing as a proven value-creation initiative, book an intro with PE-experienced pricing expert.