How an evolving PE ecosystem impacts portfolio companies

The BDO 2023 Private Capital Survey, produced by BDO USA, polled 405 U.S. private equity fund managers and operating partners, 200 U.S. portfolio company CFOs, and 50 U.S. board members. It provides a detailed snapshot of the situation for private equity (PE) and their portfolio companies.

Its results show a reshaping of the expectations and operations of PE firms and portfolio companies.

Navigating these shifts while creating value and keeping an eye on future funding or exit paths poses significant challenges but also offers opportunities.

As a portfolio company, you have a good idea of the pathway and timeline to exit. However, the increased uncertainty in the market may fundamentally change certain aspects of that, making it an opportune time to revisit strategies, plans and projections.” Sunil Sharma,  National Leader, Transaction Services and Private Equity, BDO Canada.

Private Equity shifts its focus to traditional value creation strategies

As detailed in the survey, PE firms are reprioritising, moving from focusing on new deals and growth towards fortifying existing portfolio companies and value creation.

Four out of five fund managers and operating partners predict that assets will trade higher in the next six months. The emphasis is on inflation-adjusted growth and "applying equity relief to portfolio companies" in the near term.

However, the situation does not mean new deals or add-on integration deals are a bygone phenomenon. Portfolio companies can look to increase resilience and market potential, including toward an exit or future funding activities, through bolt-on acquisitions that add value through increased sales or adding talent.

"There has been a general trend of larger PE firms setting up fund structures, like impact and growth funds, which increase convergence on M&A targets. For mid-market businesses and even growth stage ventures, this can increase the available funding or exit options." – Sebastian Stevens, National Leader, Private Equity, Partner, Corporate Finance, BDO Australia.

Differing opinions on value plan trajectories

It is intriguing to note a divergence of perspective between portfolio companies and their private equity owners regarding staffing. More than half (56%) of portfolio company CFOs under PE funds with assets under management (AUM) exceeding $15 billion perceive their organisations as understaffed. In contrast, 38% of fund managers and operating partners view their organisational staffing levels as overstaffed.

Then, consider that talent management is a significant value creation lever in private equity (about 20% of fund managers identify it as their most frequently deployed strategy).

The takeaway is that fund managers and portfolio companies may have differing views and priorities regarding core issues and how to drive growth.

For example, BDO’s survey reveals a discrepancy in growth strategies between smaller fund managers and their portfolio companies. While fund managers with less than $1 billion in AUM expect capital and revenue growth prioritisation, portfolio companies' CFOs are primarily concerned with increasing capital and operational expenditures.

Aligning and finding common ground

The situation around talent and which financial levers to prioritise underscores the need to find common ground – and perhaps explore alternative solutions. For example, outsourcing functions and tasks may alleviate talent shortages.

Alignment between fund managers and portfolio company executives is crucial for top-line growth achievement, irrespective of company or fund size.

It is crucial for PEs and their portfolio companies to consistently re-evaluate their value creation plans and adapt them to the changing market conditions.

"Financial clarity and transparency is key to success whatever the preferred exit or funding path. Making sure that your CFO and financial team is capable of handling and producing detailed data that serves as a foundation for your growth story and future projections is key.“

PEs hate surprises, so be sure to keep them informed throughout the investment processes and let them know what is coming down the track. This including visibility in challenges and any developments in metrics such as quality of earnings." – Jamie Austin, Corporate Finance Partner, National Head of Private Equity and Co-head of Life Sciences Corporate Finance, BDO UK.

Company CFOs play a crucial part in aligning expectations and decisions on which economic levers to pull to create top-line growth and meet the PE investment thesis. These tasks are added to a role that the ongoing economic uncertainty has redefined. Many find themselves navigating the uncharted waters of high interest rates and inflation for the first time.

Portfolio company CFOs and board members, working under the shorter time horizons of PE ownership, must face this uncertainty head-on. Given the shorter time horizons of PE ownership, CFOs and board members also need to remain focused on the next step in their evolution.

The current situation for holding periods and M&A

The first thing to consider from a funding and M&A standpoint is the current economic climate, which is marked by a significant slowdown in the IPO market and fewer Special Purpose Acquisition Companies (SPACs). This will, for some companies, lead to extended PE holding periods.

PEs are placing higher emphasis on sales to strategic buyers and financial sponsors as preferred exit routes. Carveouts, which facilitate the distribution of returns to Limited Partners (LPs) while allowing private equity firms to hold onto their assets, have gained popularity, jumping from last place in 2022 to second place in 2023.

Flexibility and various optionshave become even more critical for portfolio companies and PEs in navigating the funding and exit landscape. With financial sponsors still being the favoured path for exits, there is a notable decrease in fund managers viewing their fellow funds as potential homes for their portfolio companies.

Consequences for portfolio companies

Given the current economic challenges, portfolio companies are compelled to reassess their financial strategies, including their exit and funding plans. They – and PEs - can leverage the recent slowdown to ensure their readiness to seize the opportunity when the markets become favourable.

Private equity dealmakers are initiating sales processes earlier to mitigate potential risk exposure in their portfolio companies effectively. This strategic shift indicates the critical need for a proactive and flexible approach to navigating the current market landscape.

Any plans must include addressing the current changes in the market.

"An important area to address during economic downswings is investments in the future vs. luxury items in your cost base. Private equity will invest in resilience and value drivers but needs a clear business case. This includes when considering bolt-on acquisition that offers scale and synergies, including through new market entry and cross-selling opportunities." – Jamie Austin,

For example, Environmental, Social, and Governance (ESG) factors have moved to the forefront of private equity considerations. Over 80% of fund managers and operating partners have reported rejecting at least one deal due to ESG-related concerns, with larger funds being more likely to do so. Similar dynamics impact other funding and exit avenues.