PE firms are coming into 2023 with a number of challenges. Both funding and deal volume have dropped since 2021. However, companies have a significant amount of dry powder (cash reserves) heading into the New Year, which could lead to investment pressures — and those aren’t the only potential pressures on the horizon.

Focus on Value Creation

The Federal Reserve instituted a series of interest rate hikes over the course of 2022. The increased cost of capital is prompting many PE firms to take greater equity shares than they have in the recent past. At the same time, after surging in 2021, exits dropped off this year as valuations fell and initial public offerings (IPOs) virtually dried up.

As the industry largely resigns itself to waiting for a friendlier exit environment, PE firms are focusing on creating value in their portfolio companies. With an eye toward generating returns and mitigating debt issues, some firms are establishing operating groups within the firm. This approach is especially wise when holding portfolio companies with shrinking valuation multiples.

Value creation can come from a variety of strategies, including supply chain optimization, investments in technology and automation, and the expansion of products, geographic markets and sales teams. Another popular choice — which also offers an opportunity to deploy dry powder — is the acquisition of add-ons to scale platform investments or create synergies to cut costs or boost revenue. Add-on deals as a percentage of buyouts has skyrocketed.

The downside of focusing on value creation is that it requires a long-term perspective. Operational and similar changes can’t be implemented overnight and take some time to bear fruit. This mindset can be frustrating to PE firms that are accustomed to fast turnarounds of their investments.

Diversity Matters

In the face of the tight labor market, PE firms have closely scrutinized the effects on portfolio companies, existing and potential. But they may need to assess their own teams. A new report from global consulting firm McKinsey & Company indicates that institutional investors prize diversity in deal teams. Many PE firms have a long way to go on that front, though.

The report found that chief investment officers would allocate twice as much to a more gender-diverse PE firm if choosing between otherwise comparable firms. Similarly, more ethnically and racially diverse deal teams would receive 2.6 times as much capital.

According to McKinsey, though, even women and minorities who make it to senior investment ranks may not hold the same amount of power as their white male counterparts. Women account for only 9% of PE investment committees globally. In Canada and United States, ethnic and racial minorities represent only 9% of investment committees. These figures are three to eight percentage points lower than their shares of investing managing director roles.

How should PE firms react to this information? For starters, they need to appropriately incorporate it into their recruiting and retention planning. With institutional investors beginning to routinely request diversity data, firms also must develop streamlined methods to collect and communicate relevant quantitative and qualitative information on their staffing.

“Greenwashing” in the Crosshairs

The increased consideration of environmental, social and governance (ESG) factors has drawn the attention of the Securities and Exchange Commission (SEC). In particular, the SEC has noted the varying ways that different funds define ESG, as well as the significant differences in the data, criteria and strategies employed.

As a result, the SEC has proposed changes that could affect PE firms that purport to incorporate or consider ESG factors as part of their strategy. The amendments aim to help investors determine whether a fund’s ESG marketing statements translate into concrete measures to address ESG goals and portfolio allocation.

The proposed rules would mandate specific disclosures in registration statements, the management discussion of fund performance in annual reports and advisor brochures. The level of detail required will depend on the extent to which a fund considers ESG factors in its decision making.

While the rules wouldn’t apply to PE funds that aren’t registered with the SEC, they could drive future investor expectations regarding ESG-related disclosures. It makes sense for ESG funds to begin to prepare now.

We Can Help

The experiences of the PE industry this year suggest that 2022 was an anomaly, rather than a “new normal.” As you position yourself to re-align yet again, you’ll need a strong partner to help you deal with today’s challenges. Contact our Venture Capital & Private Equity group for assistance in these areas and others.