For Private Equity Firms, Buying New Companies and Laying Off Employees Isn’t Cutting It Anymore

As the mergers and acquisitions market slows down, private equity firms can no longer generate sustained growth by constant dealmaking. Instead, they’ve become more reliant on the value creation process to drive up profit.

Value creation accounted for 68 percent of PE activity in the second quarter, up from 59 percent during the same period last year, according to the latest data from BluWave, a consulting and solutions provider to private equity firms. Meanwhile, due diligence activity went down from 41 percent to 32 percent, signaling a sluggish M&A environment in which valuations in both public and private markets are plummeting. 

BluWave measures PE activity by analyzing project requests from over 500 PE firms, including some of the big names like Blackstone and KKR. The goal of each project is to help the PE firm find the most suitable third party for a due diligence or value creation task, such as conducting a market study or coming up with a digital transformation plan. 

Sean Mooney, the founder of BluWave, has noticed that value creation activities have been trending upward for the past few years. One reason is that the M&A market is getting more competitive, with more capital chasing a shrinking pool of quality companies. “Prices are going up, and that’s putting pressure on returns,” Mooney said. For this reason, PE firms have begun to contemplate generating cash flows by transforming businesses, instead of acquiring new ones.

Human capital plays the most important role in the transformation process, according to Mooney. “The notion that all private equity firms do is cut costs and fire people… They can’t do that anymore,” he said. Instead, he added, private equity executives are now thinking about how to retain interim leaders and hire new talent. In the first six months of 2022, 50 percent of value creation activity focused on human capital, followed by operations, sales and marketing, and technology, according to data from BluWave.

But PE firms aren’t creating jobs out of altruism. “They’re doing it because they have to, because that’s how to generate above-market returns [in the current environment],” Mooney said. 

Compared to value creation activities, due diligence has received less attention from PE firms. But that doesn’t mean that managers have been slacking off during the due diligence process, Mooney said. As deal flows shrink, PE firms are examining companies more carefully so they can pick the ones that offer the best quality. According to Mooney, BluWave has seen the greatest amount of due diligence activities in technology and healthcare, and the least amount in manufacturing. 

Going forward, Mooney expects that value creation will continue to dominate PE activities, with M&A deal flows unlikely to return to their 2021 peaks. “Recession is coming, if it’s not already here,” he said.