Private equity firms need to make fundamental changes to their business model to catch up with technology transformation, investors’ focus on social issues and environmental damage from companies, and the potential for more scrutiny from regulators, according to a new report from Ernst & Young.
“This report has been a big work in progress for some time,” said Pete Witte, global private equity lead analyst at EY, in an interview. “The question we posed to people across disciplines was what does the PE firm of the future look like?’”
Private equity firms will no longer be able to solely rely on restructuring companies’ finances or cutting costs with mass layoffs, outsourcing or cutting pensions. While those strategies aren’t going away, they will need to expand their digital capabilities and seriously implement impact and environmental, social, and governance initiatives. This will be a new requirement for private equity firms, whose money-making turnaround strategies still look a lot like those made infamous by the 1980s novel “Barbarians at the Gate.” The book featured KKR & Co.’s brutal restructuring of RJR Nabisco.
“Four megatrends — advances in technology, globalization, shifting demographics, and environmental issues — are combining to upset the existing order and create new working patterns and relationships,” according to the EY report, called “How can private equity firms transform to find new routes to value creation.”
Witte said successful PE firms will need to continue to do what they’ve long done but also layer in these new capabilities.
“How do you to integrate digital technology to better enable some of these value drivers?” said Witte. “How do you better leverage data from existing portfolio companies and how do you use that as part of the origination process? We see firms now experimenting with different tools to look for new ideas, for example, that they might not have uncovered otherwise,” he said.
The EY executive stressed that private equity firms are still rife with many inefficient and expensive manual processes and need to do a better job with technology, including using techniques like artificial intelligence, within their own shops as well as within the companies they own for investors. PE firms also need to better understand the technologies and geopolitical trends that will disrupt their portfolio companies’ strategies.
While many private equity firms have launched impact and ESG funds, EY said firms will need more than just a few products.
“Companies across sectors are moving toward this view that we need to create shared values with society. Whether or not a private equity firm is a true believer in that or not, that’s the direction of travel for the global economy. There’s a need for a better understanding of the impact your business has on a wider range of stakeholders,” Witte said.
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Private equity will have to adopt impact and ESG goals so they can be attractive buyers of the businesses they want to own and if they want to hire the best people. Founders and family business owners, which make up a big target of private equity firms, increasingly want to sell to buyers that will treat their employees and vendors well and not sell off assets. As for talent, Witte said, “When we go to business school events, the panels on impact investing are standing room only. The best talent wants to work for businesses that share their values. So private equity will have to change.”
There’s plenty of evidence to support ESG. EY found that 95 percent of investors are either already looking at ESG risk factors or plan to in the coming year. Public companies that rank well by ESG standards have outperformed the market over the past five years.
Private equity firms will also face more regulatory scrutiny. As a greater share of economies work for private equity-backed companies, regulators are likely to enact more rules on disclosure, employee protections, and environmental impacts.
“There is also social pressure and the question of PE’s license to operate. The PE industry is under greater scrutiny than ever before, and PE firms must do a better job of capturing and tracking the value they are creating and the impact of their activities,” according to the report.