This Q&A was published as part of PitchBook 2023 Annual US PE Breakdown sponsored by Stout.

Recently, PitchBook-LCD noted that equity contributions had topped 50%, an all-time high. How are PE firms tactically adjusting without pressuring returns in this new reality?

In the current higher-interest-rate environment, PE firms are adjusting portfolio strategies, sector focus, investment structures, and operational enhancements to maintain return levels. There are changes to capital allocations by industry to focus on higher-growth industries with better risk-adjusted returns. This has been very apparent as numerous PE funds have sought to enter, seek exposure to, or allocate larger fund percentages to healthcare.

PE funds are developing thoughtful sector/subsector investment theses in greater partnership with operating partners and industry specialists. Due diligence has been enhanced, somewhat driven by lenders, to better understand the market dynamics, financial metrics, and growth prospects to avoid problematic investments and be aggressive on well-positioned businesses. There has been a shift to operational focus and willingness to invest, even if temporarily at the expense of margins, in product or service growth strategies. To be certain, there is a shakeout of PE coming due to the capital-raising velocity and heightened valuations seen from late 2020 to today.

What are some of the more novel methods for growth that PE firms are pursuing as they look to prioritize operational, nonmultiple growth?

Some of the best PE funds have long leveraged select operational strategies that other PE funds are now realizing, in a constrained market, drive outsized returns in any market environment. Using basic financial engineering and planning for multiple arbitrage at exit is no longer a strategy in an economy with universal access to information. Revenue growth and operational efficiencies are the focus.

Digital transformation (unlocking database value for recurring, high-margin revenue streams), executive mentoring and talent development, internal process automation, revenue stream diversification, roll-up/add-on usage, identification and management of the right key performance indicators, supply chain optimization (beyond “We have a consolidated FedEx account across our portfolio companies that saves money”), and distribution channel/sales strategy diversification are all solid strategies for growth.

The good news is that buyers are willing to “pay for growth” even when it temporarily depresses margins. As it turns out, even the largest publicly traded companies need growth to satiate their investors’ demands.

What key regulatory or industry standards are changing for valuation methods, if any? Which tactics have you seen shift for assessing valuations more accurately in this era of elevated risk?

There’s no such thing as “more accurately” in terms of M&A valuation models. A business is ultimately worth what the top buyer is willing to pay in a fair, well-orchestrated process. The best M&A bankers will advise, whether sell-side or buy-side, based on a realistic assessment of value with guidance on the path to an outlier/upside valuation. We all talk about EBITDA multiples ad nauseam, to the point my 11-year-old tells people my job is talking about “EBITDA, UBITDA, ABITDA, BEBITDA!”

The reality is that pragmatic corporate buyers still focus on discounted cash flow models, and PE funds focus on leveraged buyout models. Cost of capital is built in based on market realities. The shift is how buyers are leveraging their unique market expertise to adjust the target forecast for the specific organic and inorganic revenue growth strategies and operational efficiencies/synergies available to them. A proper sell-side banker can help prepare, support, and guide buyers toward their specific maximized financial potential of the target. We are seeing less optimism being built into forecast models and more sensitivity in moving to the high end of the internal valuation range.

Fortunately, all of us deal makers will continue to talk and negotiate in “BABITDA” multiple terms, to my son’s delight.

How else have PE tactics evolved in the past two years from what was common in the 2010s, and how does that set the stage for the PE market heading into the rest of the 2020s?

The best PE operators have focused on industry/sector specialization while adding expert resources, both operational and across industries. Industry specialization is increasingly common and will continue at an accelerated pace. There is a greater willingness to invest in growth during the holding period, whereas historically the focus was on operational expense savings.

Certain irrelevant blanket investment committee (IC) guardrails, like the maximum 20% customer concentration, have given way to industry-specific IC risk assessment. Being a healthcare banker focused on outsourced pharma and laboratory services as well as the related supply chain, I have had a front row seat to these changes. For the first 15 years of my career, it was nearly impossible to get PE to invest in outsourced pharma services; it never cleared the 20% single customer concentration IC threshold.

Turns out these companies are validated by having a Big Pharma client, and those clients create concentration by the sheer size of their spending. Today, this is one of the most sought-after subsectors in healthcare for investment, as it is recession and pandemic resistant with exponential growth potential. Pharma and government research budgets aren’t going down materially anytime soon.

We will see more thesis-driven, expert-informed, operating partner-involved investing from PE through the remainder of the decade and beyond. We will also see PE partnering with PE in new and different ways. Watch for larger, well-capitalized funds partnering with (having as a minority investor) smaller, sector-expert funds. Or larger funds continuously buying businesses from the same smaller funds that have a similar sector thesis and investment style. Smaller funds will more frequently roll-over into those exits to participate in the upside that a like-minded, deeper-pocketed PE fund can deliver. We all like to play with house money.

To some degree, LPs are well aware that emerging or newish managers can produce the highest returns, yet given the sheer degree of competition and public equities’ volatility, there is some potential consolidation in the PE industry and flight to experienced, larger fund managers. What are your thoughts on this dynamic?

There is always a flight to quality in an uncertain market. There are also the old, not-entirely-accurate adages of “Never invest beyond fund II because the GPs are not as hungry,” or, my favorite, “Don’t invest in a fund led by GPs with a private plane or vineyard.” There are high-quality large, well-diversified funds where portfolio theory and the law of large numbers ensures stable, attractive returns.

That said, LPs do understand the dynamics that midsized funds have great returns, often driven by partners that came from larger funds. It comes down to deep domain/market knowledge, specific operational expertise, and specialization. Funds with that mindset will have longevity and strong returns irrespective of tenure.

There are dedicated healthcare-only funds with around $2 billion fund sizes, still squarely in the middle market. The few dedicated healthcare funds to breach that level are going to continue to see strong inflows because of their focus, knowledge, creativity, and flexibility. Many middle market funds with diversified industry focus are also sector specialists within their industries. These “smaller,” more nimble funds can have a greater impact on portfolio companies delivering the expertise and support of a large fund with a “roll-up-our-sleeves” attitude. Plus, it never hurts to be the first institutional investor.

If you are smart in a sector, whether you are a conservative or growth-oriented fund, you will know how to enter and exit businesses and see the diamond in the rough when it is in front of you.