‘There is no new normal’ – Bain report shows change in private equity necessitates innovation

The Global Private Equity Report 2021 by Bain & Company is a cautionary tale for the PE community. While headlines focus on the growing value of deals, the number of exits, and dry powder available – which all suggest good times – PE firms are in fact doing fewer but larger deals. This has foundational implications for the entire industry, according to Bain. 

The consulting firm believes the market has changed significantly, particularly over the past year, and continues to evolve. As such, the old playbooks for dealmaking and value creation are growing obsolete. As Hugh MacArthur, Head of Global Private Equity Practice for the consulting firm, wrote in the introduction, “There is no new normal”.  

The report makes a strong case supporting this perspective. It shows how historically successful investment strategies have been turned upside down over the last few years:

“Traditionally recession-resistant sectors like retail health clinics suddenly turned toxic as stay-at-home orders halted movement overnight. Meanwhile, many of the cyclical sectors that tend to tank in a downturn – home improvement, recreational vehicles, gardening retail – took off like a shot.”

It also illustrates how a great deal of uncertainty remains because we do not yet fully understand the impact of these market changes:

“Many industries have changed fundamentally in the wake of Covid-19 in ways that can alter profit pools. Customer expectations may have evolved; disruptive innovations may have been pulled forward.”

PE trends for the near-term

Despite the variables, the authors of the Bain report articulate several trends that they believe have staying power over the near term:

• LPs favour larger funds. LPs “are becoming increasingly picky about the funds in which they invest” which has “benefited large, well-established funds most”. While “fewer funds closed in 2020” they also “skewed” larger and “raised more than” planned.
   

• Financing favours the established. “Banks also made more financing available for large deals than for smaller ones. In a jittery market, they were most comfortable lending to well-established GPs acquiring large, stable targets.”
   
• Deal sizes will continue to grow. As funds get larger, investment managers will naturally need to make bigger bets to yield the desired returns for investors.
   
• Record valuations reduce the margin of error. “Sky-high asset prices are by far the biggest challenge facing PE investors”, Those price levels “leave little room for error” – particularly “in a highly volatile and uncertain business environment”. It’s worth noting our industry research found that PE firms are increasingly scrutinizing costs more closely – and slimmer margins of error will only add to the pressure.
   
• Talent matters more than ever. “Getting talent decisions right – especially at speed, across dozens of portfolio companies – is one of the stiffest challenges”. This is crucial to success given “the quality of portfolio company management is the most-cited reason for deal success and second-most-cited reason for deal failure”.
   
• The reality of ESG sinks in. As “survey after survey shows that consumers…are flocking to companies that they believe act responsibly” ESG is becoming “a core part” of differentiation. “ESG isn’t about doing good for good’s sake; it’s about recognizing what customers and other stakeholders really want and turning that into a strategy that creates tangible value”.

Change as the impetus for innovation

While Bain doesn’t lay out a prescriptive list of recommendations, there are some common threads throughout the report: 

• Develop deep industry insights in designated investment areas
• Foster creative thinking about value creation
• Build the capacity to act quickly. 
   

Technology is an essential prerequisite to building or refining these capabilities. Indeed, the report is explicit about the need for PE firms to accelerate their digitization, data and analytics initiatives:

“PE firms need to accelerate their plodding transition from analog to digital. Private equity remains a highly labor-intensive, paper-driven industry. The pandemic held up in high relief how inefficient this is.”

Yet the digital transformation itself is becoming table stakes – it’s foundational not cutting edge. The secret sauce is in how the organization uses these tools. To remain competitive, PE firms need to develop expertise and infuse the insights they glean with data across the PE value chain (Also see our new report written with Morae Global: Why financial services are embracing legal tech.)

As the report puts it:

“A major element of going digital will be excellence in using tools and analytics throughout the private equity value chain. Before Covid-19 hit, the most effective firms were already deploying artificial intelligence, big data, web-based analytics and other technologies to make smarter, faster decisions about companies and their prospects. Over the past year, they’ve learned that these tools can lead to significantly deeper insights into how industry patterns are shifting, where disruption is coming from and whether their portfolios are prepared for whatever is coming next.” 

The full report is an insightful read that’s free to download.

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Be sure to check out our free ebook: Guide to Managing Legal Expenses in Private Equity 

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