Private equity’s strategy to improve and expand their companies without relying on acquisitions appears to be working. More than half of the growth in equity at portfolio companies is organic and does not come from deals, according to the latest research from Preqin.
According to Preqin’s definition, organic expansion is fueled by increasing revenues and profit margins at portfolio companies, while inorganic growth is driven by rising debt and the expansion of valuation multiples.
On average, private equity firms were able to sell their portfolio companies at 2.4x the acquiring price between 2015 and 2019, according to the research. Revenue growth contributed half — or 1.2x — to the multiple, while increasing profit margin contributed 0.3x.
On the inorganic side, about 1.1x of the 2.4x equity growth is from the expansion of valuation multiples. Leverage drags down growth by negative 0.1x, according to the research.
“Debt can help fuel investment and scalability for a company, but it can also be a burden to profitability if too much is added,” the paper explained, adding that debt reduces the exit equity multiples in the U.S. twice as much as it does elsewhere in the world.
In recent years, amid rising competition in the mergers and acquisition market, private equity firms have been shifting their focus from constant dealmaking to value creation for their portfolio companies. They have been working with operating partners and leveraging economies of scale to drive up profit organically at target firms.
According to Paul Lavery, a scholar from the Adam Smith Business School at the University of Glasgow, the holding period has also lengthened over the last decade, which has allowed PE firms to spend more time growing companies organically. A natural outcome of this, he added, is that PE firms have pushed into growth capital, where they have more room to improve revenues and other financial performance metrics for smaller and younger companies.
The Preqin research added that it’s important for PE investors to understand what’s behind the performance of their PE portfolios. “The details behind private equity returns can be overshadowed by headline performance,” the paper said. PE investors should dig deeper into the details, because market forces are sometimes out of a manager’s control.
For example, according to Preqin, if a PE firm relies too much on leverage to grow exit multiples, the rising cost of debt could become a major concern. On the other hand, if it relies too heavily on the expansion of valuation multiples, it could be caught flatfooted in a deteriorating exit environment.