In recent decades, private equity has consistently generated strong returns, outperforming public equity. However, this was in a world characterized by macroeconomic and geopolitical stability, declining interest rates, and equity market tailwinds. As we navigate through a period of greater uncertainty, the question arises: Can private equity continue to generate strong absolute and relative returns?

Private equity managers employ a range of strategies to create value and generate returns. Some of these strategies remain effective today, while others have lost much of their power, carrying important implications for investors.

There are seven key strategies that private equity managers use to generate returns:

1. Investment Selection: This involves selecting companies that stand to benefit from secular tailwinds, resilient business models, high barriers to entry, recurring or re-occurring revenue, and the potential to create sustainable earnings growth.

2. Management Incentivization: This refers to recruiting, retaining, and motivating experienced managers to oversee the business operations of a company.

3. Resources and Capital to Support Growth: This strategy entails allocating the operating resources and/or capital to a company to expand products and services, augment distribution and sales efforts, and/or increase geographic footprint.

4. Operational Improvement: This involves providing resources for optimizing revenue and pricing, cutting costs, enhancing procurement, and consolidating vendors.

5. Strategic M&A: This strategy involves sourcing, executing, and integrating corporate acquisitions to bolster supply chains, expand products and services, and access new customers.

6. Free Cash Flow Generation/Debt Paydown: This strategy involves using a company’s free cash flow to pay down debt.

7. Multiple Expansion: This involves participating in an increase in the multiple of earnings at which a company is valued.

The effectiveness of each strategy depends on the idiosyncrasies of each transaction and the prevailing market and operating conditions during the ownership period.

The first five strategies—Investment Selection, Management Incentivization, Resources and Capital to Support Growth, Operational Improvement, and Strategic M&A—require significant skills and resources, and their effectiveness is less reliant on market conditions.

On the other hand, Free Cash Flow Generation/Debt Paydown and Multiple Expansion are largely market-driven and do not depend significantly on manager skill or company quality. Today, high interest rates and full valuation multiples make it less likely for managers to generate value through these strategies. As such, it is crucial when selecting private equity manager to work with, that one selects a manager that focuses on the first five strategies.

We believe private equity can continue to generate attractive returns in today’s market environment, but the reliance on skills-based value-creation strategies is likely to result in higher dispersion of performance. This means strong due diligence skills and a highly selective investment approach are essential in the current environment. Furthermore, diversification is important to mitigate risk, but not so much that portfolios become private equity indexes.

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