EY: Preparing for the next wave of private equity

This article is sponsored by EY

What mega-trends will impact the private equity industry over the next 5-10 years, and how can firms prepare to address them?

Andres Saenz: We see four high-level mega-trends impacting the private equity industry: technology advancement; globalisation; demographics; and environmental issues and impact. Private equity firms have to proactively think about the implications of these trends on their business, whether that is around which companies to invest in, how to do due diligence, where to raise money or how to create value.

Pete Witte: There are a lot of dynamics shaping how private equity firms need to position themselves for the next decade and beyond. These begin with the shift in funding from public sources of capital to private, and the decline of public companies along with the concurrent rise in the number of private equity-backed businesses over the same period.

The dry powder that has been built up over time means there are strong tailwinds for private equity. Yet there is also competition coming in from different angles that were not necessarily part of the conversation 10 years ago, such as family offices and pension funds investing direct, sovereign wealth funds, and so on.

Finally, there are discussions around environmental, social and governance issues, not just from a risk management perspective but also in the way firms respond to LP demands and look at non-financial measures of value creation. All of that adds up to a much more complex and dynamic environment than firms were operating in previously. These issues are front of mind in firm leadership and need to be internalised through the organisation.

What will be some of the future drivers of value creation for private equity firms?

PW: The core competencies – finding attractive companies to buy, doing that at compelling pricing, growing them through the hold period and keeping an eye on costs – will remain at the heart of private equity. The focus on operations, capital efficiency, risk management and transforming businesses will still be there. Some of the other elements that private equity is going to have to add into the mix revolve around three additional pillars: ESG, purpose and transparency; talent; and digital.

AS: The preponderance of effort over the last few years has been focused on the core traditional levers of value, which will continue to be relevant. However, these new sources of value can allow firms to discover new opportunities at the diligence phase and execute to everyone’s benefit during the hold period. It is becoming more and more difficult to get away with not having the right ESG strategy; companies are increasingly competing in a war for talent, which raises broader questions around diversity and inclusion; and on the technology side, there are new players that are really disruptive.

What role will digital play in driving growth for the private equity firms of tomorrow?

AS: Digital is revolutionising how private equity firms go about their business. That starts with origination, in terms of where firms are looking for deals and the sectors they are prioritising. When it comes to the process itself, there are many more data sources and different ways of isolating the companies they are looking for, so we are also seeing the digitisation of the deal origination process.

On the diligence side, traditional diligence – whether that is financial, tax, legal or commercial – is now focusing much more on digital issues, such as digital readiness, value creation opportunities, cybersecurity, IP infrastructure, or research and development opportunities.

PW: From a portfolio company perspective, the digital piece is extremely important. There was a point where private equity firms would develop 100-day plans, strategy and execution models, and then look to IT to support that. Those days are gone, and now that thinking is at the forefront when buyers are asking questions about how to use digital to drive growth, integrating it into sales and marketing processes, and then making use of machine learning to drive pricing models, improve the customer experience and maximise supply chain efficiencies.

Digital has become an elevated priority and firms’ capabilities are going to be a key differentiator. We now hear companies buying manufacturing businesses, for example, that they describe as technology companies that focus on manufacturing, because there is that shift to a digital-focused mentality.

How are the talent needs of private equity firms changing, and what actions will firms need to take in order to respond?

PW: The private equity industry has long taken for granted that it has access to the best talent, but that is less certain these days. Private equity firms are not just competing with each other and with investment banks for talent. The new generation has a lot of choice, so private equity must be compelling around the reasons not only for joining a particular firm but for choosing private equity as a career.

We often still have founders in management, but generation X is out there, millennials are in the workforce and generation Z is coming in, and they all want different things from their careers. We sponsor several of the business school events and whenever there is a presentation on ESG or impact investing, it is always standing room only. To attract talent, private equity firms must be able to articulate not just how they will create financial value, but also deliver a broader purpose and fulfil a role in society.

Firms also need different skillsets and need to do a better job of building diverse teams. The questions around how you find people, keep them engaged and compensate them fairly need to be dealt with. That will become more important.

AS: Private equity has always focused on talent at the fund level. It is a people business – investors choose firms for capital and knowhow, and knowhow resides in the people helping companies grow.

The other angle is an increasing realisation of the importance of the talent pool that sits in the portfolio. If you take the 10 largest employers globally, four of those would be private equity firms. When firms add up the number of people they employ across their portfolios, they have a huge footprint of talent and are being increasingly called upon to manage that broader employee engagement, thinking about things like upskilling. Fund managers have always had direct relationships with the c-suite in the portfolio, but there is now a broader engagement across the sometimes millions of people that sit below that.

What is driving the elevated role of ESG that we are seeing in private equity? Will those themes continue to be in focus?

AS: The industry must proactively manage this part of their business, thinking about how active they are perceived to be beyond traditional value creation and how that impacts customers and employees. It has become one of the central areas for competition: competition for investment, with the priorities that LPs have set; competition for talent, because people want to work for places aligned with their values; and even competition for deals. Entrepreneurs and owners want to do business with folks that share their values, and so many companies today have their own clear sets of values that influence where they choose to take capital from.

PW: This is not a binary proposition but a continuum. At one end you have compliance-oriented activities, making sure you do not break laws, and on the other you have the full range of externalities that you are creating through your investment. That requires consideration of employees, consumers and the quality of life of everyone that might be affected by your operations. Firms are at different stages of that journey, with some in the compliance risk management paradigm while others are a lot more sophisticated, articulating goals, tracking metrics and leading the direction of travel.

EY has done some work visualising the PE industry of the future. Can you outline some scenarios that might be in store?

PW: We challenged our people to think 10-20 years ahead about the industry of the future, thinking really expansively about what could happen, so we could then work backwards. For example, we talk about the democratisation of investment, fewer public companies, more private companies and what that means for investors. What has to happen for more retail involvement in the asset class, where investors could one day pick up their phone, pull up an app and commit $20 into a private equity fund? How do you structure a fund for that type of investor? How do you think about liquidity requirements, marketing programmes and delivery channels? What kind of back office might you need to go from a hundred to a million LPs?

AS: The other scenario that really pushes the thinking is the idea of the first artificial intelligence private equity fund, raising $20 billion of capital. How far can you push AI or data analytics in terms of origination? How much can you push diligence? We have all this data on the portfolio, so what could AI do to give further financial insights to unlock value and identify risks? Ultimately, what does all that mean for talent? What is the definition of talent when a lot of insights are driven by AI? Where do we still need talent – is it in investor relations, negotiating, deal execution? By pushing our thinking about the future, we can raise some interesting questions about what needs investment today.

Andres Saenz is global head of private equity, and Pete Witte is global private equity lead analyst at EY