Higher rates have changed the game for private equity

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Private capital is under pressure. Higher interest rates and still sluggish new listing markets have made it difficult to sell holdings and return cash to investors. That, in turn, has made it more difficult to raise new funds because pension funds, endowments and family offices have less money to allocate and a growing range of other options.

One way to know that the pressure is starting to bite is the recent announcement by Blackstone, the largest and best-known private equity firm, that it has launched a “shared ownership initiative” to give workers at its companies portfolio a shareholding. The program will begin in Copeland, which Blackstone bought for $14 billion last year. When the climate control group is eventually sold, its 18,000 employees will receive payments tied to the PE firm’s profits from the deal.

Blackstone has plenty of company: Rival KKR began offering ownership stakes in 2012, and a charity founded by company executive Pete Stavros has hired nearly 30 private equity firms (but not Blackstone) to do the same. . Ownership Works has helped organize employee share schemes worth almost $400 million across 88 companies and aims to reach $20 billion within a decade.

For private equity firms struggling to attract new investors, these plans have multiple attractions. Firstly, they allow EP sponsors to argue that they are helping to address social inequality, unlike private credit and hedge funds with whom they compete for allocations to “alternative investments”.

Such claims are likely to resonate with investors who are concerned about the PE’s role in directing most of the gains from productivity gains to investors rather than workers over the past two decades. The outgoing chief investment officer of Calstrs, the second-largest pension fund in the United States, has explicitly called for greater profit sharing by private equity firms, and the head of the New York state pension fund has advocate for employee ownership more broadly.

However, the growing enthusiasm for shared ownership plans should go beyond marketing. Higher interest rates have fundamentally changed the game for private equity firms, forcing them to rethink how they do business. Between 2010 and 2021, debt represented half of the PE’s total performance, according to consulting firm StepStone.

But that strategy fails when interest rates are higher. Loading a portfolio company with debt affects its bottom line immediately and harms the PE sponsor’s ability to sell or take it public later. The impact is already starting to show: The 2023 acquisitions were made with significantly less debt relative to company earnings than in previous years, according to McKinsey statistics.

With less leverage, private equity firms must find other ways to generate strong returns, even as investors demand better results because the comparable risk-free rate is much higher. “Going forward we have to do things differently,” says Amit Garg, senior partner at McKinsey. “The question is how.”

The obvious path to lasting profits is through operational changes that increase revenue, reduce costs, or both. Private equity firms have always claimed to do this, but leverage has made some of them less diligent than they could be.

Tried and true methods mean better management. Some private equity firms focus on new appointments to the board of directors and management team of a newly acquired portfolio company. Others maintain a staff of full-time in-house consultants who provide services to multiple companies. A third way is to hire a roster of veteran executives to advise company leaders.

At Goldman Sachs’ private equity arm, its “value accelerator” experts offer advice on everything from choosing the right headhunters and consultants to upgrading IT platforms and redesigning management processes.

In the past, PE ownership’s primary interest in rank-and-file workers has too often been to eliminate them to cut costs. The new focus on employee profit sharing suggests that’s about to change.

Surveys show American employee engagement has plateaued after falling from early 2020 highs, while union organizing is on the rise. Profit sharing could help change that and harness the positive energy. Who knows better than current workers where money is wasted, where sales opportunities are wasted, or where processes need to be improved.

Employee ownership cannot guarantee success, as demonstrated by the recent problems of British retail chain John Lewis. But if investors truly believe that top executives are motivated by awards and stock options, they should reward private equity firms that expand that principle beyond a select minority.

brooke.masters@ft.com

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