Private equity firms are increasingly relying on the organic growth of their portfolio companies to generate returns. This shift is driven by various factors, including the changing economic environment, rising interest rates, and a more constrained market for traditional avenues of generating alpha.

In the past, PE firms were able to generate returns through a combination of operational improvements, leverage, and multiple arbitrages. However, with the changing landscape, they are now focusing more on the profitability of their portfolio companies. This means that they can no longer rely on financial engineering alone to drive returns.

The rising cost of capital has led to a decline in traditional leveraged buyout (LBO) and platform deals, as well as a decrease in the use of debt in the leveraged loan market. Additionally, valuation multiple shave contracted, ruling out multiple expansion as a driver of PE returns. The M&A market has also tightened, making inorganic growth less viable for generating returns.

As a result, PE firms are now placing greater emphasis on investing in high-quality companies with the potential for organic growth, driven by cash flow-rich businesses. This shift has implications for due diligence and manager selection processes, with a focus on factors such as impending recession, interest rate hikes, and persistent inflation when analyzing portfolio companies' capital structures.

Overall, the increasing reliance on organic growth reflects the evolving dynamics of the private equity industry and the need for firms to adapt their investment strategies to the changing market conditions.

March 8, 2024