Private Equity’s New Business Services Challenge (2022)

Since 2010, the business services sector has been among private equity’s most active hunting grounds. Over that period, it has accounted for 12% of investment value and 23% of deal count globally. PE funds have averaged more than 750 business services deals worth $48 billion each year.

The appeal is clear: The sector has enjoyed a strong set of technology-enabled growth trends made stronger by the long economic expansion. Chronic talent shortages and increased outsourcing of noncore business activities have spurred demand for everything from IT, legal and market analytics expertise to logistics, business process outsourcing (BPO) and janitorial services. PE investors have benefited from steady organic growth and the opportunity to execute lucrative buy-and-build strategies to create scale players. That, plus a healthy dose of multiple expansion, has led to strong, consistent returns.

But whether the momentum can continue, especially in the wake of the Covid-19 pandemic, will hinge on PE funds’ willingness to alter their investment approach to the sector.

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A new ball game

It’s not that the future for business services isn’t still bright. While the sharp slowdown in global economic activity due to the pandemic will inevitably hurt short-term demand for outsourced services, the longer-term outlook in most subsectors remains relatively strong (see Figure 1). The challenge is that asset price multiples remain at record levels (as is the case for nearly all industries), suggesting that investors will need additional sources of upside in the future. It’s also true that many key sectors are already well along the outsourcing penetration curve, meaning the pace of growth may soften over time. Taken together, these issues suggest that creating the kind of value PE investors have become accustomed to will require deploying a new set of strategies.

Private Equity’s New Business Services Challenge (1)

Private Equity’s New Business Services Challenge (2)

Breaking down which factors have contributed most to the sector’s impressive returns over the current cycle outlines the challenge (see Figure 2). Business services deals have relied almost exclusively on revenue growth (often via mergers and acquisitions) and multiple expansion; margin improvement hasn’t been a factor. The implication is clear: As top-line growth and multiple expansion become harder to generate—especially in a slowing economy—deal sponsors will have to work harder on businesses’ fundamentals to improve cash flow and generate returns.

Private Equity’s New Business Services Challenge (3)

Private Equity’s New Business Services Challenge (4)

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The good news is there’s ample opportunity to build value at most business services companies. The Covid slowdown, in fact, provides a chance to both rework cost structures and improve how services are delivered. Very often, BPO and professional services firms have been built through acquisition, and the race to increase scale and market share has been all consuming. Focusing on revenue growth has left less energy for things like integrating acquisitions, rationalizing G&A expenses, optimizing salesforce behaviors and integrating IT systems. Targets also have had little time to innovate with automation and digital technology to improve efficiencies and enhance services. Focusing on these internal functions can tee up a lot of quick wins, and over time, it can change the company’s earnings trajectory.

Creating value from the inside out

In our experience, four areas of focus can deliver the biggest impact: optimizing service delivery, improving the operating model, creating a more focused and efficient commercial organization, and applying digital technology to everything you do.

Service delivery. Depending on the business services subsector, full-time salaries can make up as much as 70% of the overall cost structure. So there is usually plenty of room for improvement when it comes to managing people and optimizing the processes they use to deliver services. Retraining call-center employees to handle varied tasks, for instance, can increase staffing flexibility and improve service at the same time. Offshoring certain processes and automating others can produce significant efficiencies. The wild card post-Covid will be how demand for services changes as companies adjust to the new order of things. But this can be a chance to get a jump on the competition for leadership teams that proactively anticipate change and innovate new ways to satisfy evolving customer needs.

Operating model. Business services companies, especially those stitched together through acquisition, haven’t had to worry much about the bread-and-butter business of optimizing the operating model to match the services they’re delivering. But rapid growth in complexity and a lack of organizational integration eventually create confusion and inefficiency, almost imperceptibly at first. Starting with a clean sheet of paper is key. The slowdown is a good time to zero-base offerings and processes—thinking through how services should be delivered vs. how they have been delivered in the past. It’s also a good time to define clear mission-critical roles and reporting lines, filling those roles with the right people, rationalizing incentives and instilling new behaviors. This kind of work in the trenches can create a more agile, fit-for-purpose organization.

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Commercial excellence. Business services companies have traditionally focused on initiatives like salesforce optimization to improve top-line performance—and that should remain a priority. But there is also a cost angle to creating a smarter, more focused sales organization that has gotten less attention. It involves giving teams the tools, processes and training to help them be most efficient and productive. One example: data scraping tools that provide salespeople with core information about a prospect. Traditionally, teams relied on sales support to do this grunt work. But scraping is a more efficient way to capture the data.

Digital. As with any sector these days, technology is transforming business services, both on the product side and in the back office. The right investments can improve service delivery, enhance quality and cut costs at the same time. Not surprisingly, digital upstarts are also disrupting the status quo.

A good example is Modria, a unit of Tyler Technologies that, before Covid-19, had built a strong business in online dispute resolution. Specializing in e-commerce, insurance and other small claims–type disputes, Modria uses digital interfaces and artificial intelligence to reduce the cost of what is otherwise a very expensive, time-consuming process. The average case takes six days to resolve (vs. many weeks in court) and eliminates the need for expensive legal advice. Modria is currently focused on the US but is expanding in Canada and eying the EU and China. It is also opportunistic: As the Covid crisis hit, its parent introduced an offering called Tyler Virtual Court, which allowed shuttered courthouses to conduct sessions entirely online.

Faced with the threat of disruption, incumbent business services companies need to get faster and smarter. Ultimately, that may require a back-office transformation—integrating IT systems and migrating to the cloud—especially for buy-and-build companies that are getting by with a thicket of different legacy technologies. But a digital focus can also produce important wins on the front end, particularly through robotic process automation.

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A large BPO company based in the UK faced a typical challenge. Having grown rapidly through acquisition with little attention to integration, the company eventually began to trip over its own cost structure and complexity. Setting it right required intervention on various fronts: a complete zero-basing of the G&A cost structure and a transformation of the operating model to deploy workforce tools and rationalize spans and layers. The company also optimized its IT systems by increasing offshore development and eliminating legacy systems.

What changed the game for this company and its clients, however, was building an internal capability dedicated to automating repetitive, mistake-prone processes that were both labor intensive and costly. The new capability was not an attempt to bring everything in house, but a center of automation excellence that could create partnerships, assemble resources and help scale automation across the company.

This has led to impressive savings. In a typical case, the company began managing the customer refund process for a client that got flooded with such requests each year. Previously, vetting the refunds was a complex manual exercise in sorting through claims and comparing them to documented facts, a mind-numbing process that required a dedicated group of customer service representatives. By building a robot to do the sorting automatically, the process became cheaper, faster and more accurate.

In another case, the service provider helped a healthcare client automate processes to calculate benefits, validate registrations and make sure cancer screening letters are sent on time to the right patients. Under the old system, the institution would produce a list of people who should get screening letters, and a team would send them manually. Not only was the process inefficient but the error rate for this crucial communication was unacceptably high. Automating the process with robotics had the triple benefit of eliminating human error, reducing clinical risk and cutting costs.

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The post-Covid agenda

As with every sector across the global economy, the economic impact of the Covid-19 pandemic presents major challenges for business services companies. Yet it also offers a unique opening to reset your business for the next chapter of growth. The companies that accelerate out of the downturn will focus on several key questions as they chart their course over the next 12 to 24 months:

  • What is the demand outlook for the specific services, customer segments and geographies in which this business competes?
  • What do we have to do to win amid the change—i.e., what new channels are required, or how do service offerings need to evolve?
  • Given these changes, how should we deliver services differently? What changes to the operating model are required? What are the cost takeout opportunities? How much investment do we need?
  • What is the digital roadmap to get us there? Can we use technology to engage more effectively with customers, enhance delivery, drive out cost or improve the value proposition?

Business services still offers private equity investors the opportunity to generate strong returns. But as the historical sources of value ebb in a weakening economy, the formula for success is changing, too. To win in a more difficult environment, funds will have to think harder about how to use digital and operational excellence to create stronger, more efficient competitors.

FAQs

What are the challenges of private equity? ›

  • The risk of a weak legal system in private equity funds. The important issue facing the development of private equity funds is its legality. ...
  • Private equity funds have market manipulation risks. ...
  • External environmental risks of private equity funds. ...
  • Private equity funds have certain regulatory risks.

What services do private equity firms provide? ›

A private-equity firm is an investment management company that provides financial backing and makes investments in the private equity of startup or operating companies through a variety of loosely affiliated investment strategies including leveraged buyout, venture capital, and growth capital.

What typically happens when a private equity firm acquires a company? ›

When a private-equity firm (PE) acquires a company, they work together with management to significantly increase EBITDA during its investment horizon. A good portfolio company can typically increase its EBITDA both organically and by acquisitions.

How do private equity firms evaluate companies? ›

Private equity acquirers determine a company's true value through rigorous and dispassionate due diligence. A top-to-bottom examination of the company allows them to test their "going in" assumptions against the facts.

What is the future of private equity? ›

The private markets are expected to grow to about $12.5 trillion in 2025 from $7.2 trillion in 2020, according to Morgan Stanley. Buyouts, growth equity and venture capital account for about 69% of the industry, the investment bank said.

Who funds private equity? ›

Who can invest? A private equity fund is typically open only to accredited investors and qualified clients. Accredited investors and qualified clients include institutional investors, such as insurance companies, university endowments and pension funds, and high income and net worth individuals.

What is the goal of private equity firms? ›

The purpose of private equity firms is to provide the investors with profit, usually within 4-7 years. It comprises companies or investment managers that acquire capital from wealthy investors to invest in existing or new companies.

Why do companies sell to private equity firms? ›

Private equity firms invest money in mature businesses in traditional industries in exchange for an ownership stake – also called equity – in that company. Private equity firms invest in businesses with the goal of increasing the value of the business over time and eventually selling that business.

What is first close in private equity? ›

Initial closing – the first time that investors commit to making their investment in the fund. Final closing – the last investors commit to making their investments. Commitment period – the period over which investors are required to make their commitments, i.e. pay the money over!

How do private equity firms ruin companies? ›

Their tactics include paying themselves fees for nonexistent services and quickly converting the assets of the companies they have bought into dividends for the private equity firm. This leaves the companies without resources to invest in sustaining and growing their businesses, or paying workers fairly.

What happens when a PE firm buys a public company? ›

The buyout is considered “leveraged” because much of the financing is with borrowed funds. A PE firm may buy a private or a public company. But when it buys a public company, the firm will often take that company private. PE firms often target companies for buyouts that need an influx of cash or a management change.

How long do PE firms hold companies? ›

Private equity investments are traditionally long-term investments with typical holding periods ranging between three and five years. Within this defined time period, the fund manager focuses on increasing the value of the portfolio company in order to sell it at a profit and distribute the proceeds to investors.

How do PE firms do due diligence? ›

PE due diligence is typically guided by the confidential information memorandum (CIM)—a massive document the company provides that includes financial data, an overview of the management team, and commercial details including insights around the customer base, products, and competitors.

What returns do private equity firms target? ›

Instead, PE investors typically target a 22% internal rate of return on their investments on average (with the vast majority of target rates of return between 20 and 25%), a return that appears to be above a CAPM-based rate.

What metrics do private equity firms use? ›

The three measures of private equity performance you need to know are internal rate of return (IRR), multiple of invested capital (MOIC), and public market equivalent (PME). It's important to learn and use all three metrics in tandem because they account for the others' blind spots.

Does private equity beat the market? ›

From 1990 to 2010, private equity firms outperformed the S&P by 6.3%, net of fees. However, according to the American Investment Council, in the decade preceding September 2020, private equity funds generated a 14.2% median annualized return compared to annualized return of 13.7% for the S&P 500.

Is private equity better than public? ›

Generally, public equity investments are safer than private equity. They are also more readily available for all types of investors. Another advantage for public equity is its liquidity, as most publicly traded stocks are available and easily traded daily through public market exchanges.

How fast is private equity growing? ›

Private market assets under management (AUM) grew by 10 percent in 2019, and $4 trillion in the past decade, an increase of 170 percent (Exhibit 1), while the number of active private equity (PE) firms has more than doubled and the number of US sponsor-backed companies has increased by 60 percent.

How much money do you need to start a private equity fund? ›

Another important factor to consider is a firm's minimum investment requirement. Historically, the standard minimum investment amount for private equity has been $25 million.

What is the difference between equity and private equity? ›

To go back to first principles, equity is a stake of a company's value. Public equity is a share in a company that is publicly traded on a stock exchange. Private equity is a stake in any company that is not publicly traded.

How does private equity make money? ›

Key Takeaways. Private equity firms buy companies and overhaul them to earn a profit when the business is sold again. Capital for the acquisitions comes from outside investors in the private equity funds the firms establish and manage, usually supplemented by debt.

What is private equity in simple terms? ›

Private equity refers to the debts and shares of companies that are not publicly traded on a stock exchange. The term may also refer to venture capital that is invested in newly started businesses, known as startups.

What are the functions of private equity? ›

Private Equity Funds function on the following investment ideas: Venture Capital - Private Equity capital can be used to fund the companies which are still in the initial stages of formation and do not have access to traditional financing means or to financial markets.

Do private equity firms invest in startups? ›

Private equity firms buy these companies and streamline operations to increase revenues. Venture capital firms, on the other hand, mostly invest in startups with high growth potential. Private equity firms mostly buy 100% ownership of the companies in which they invest.

How do private equity firms find deals? ›

Private equity firms find their deals through these sources:
  • Investment banks / M&A intermediaries.
  • Referral sources (attorneys, accountants, etc.)
  • Other private equity firms.
  • Management team sponsors.
25 Apr 2019

Do private equity firms borrow money? ›

A private equity sponsor often uses borrowed funds from a bank or from a group of banks called a syndicate. The bank structures the debt using a revolving credit line or revolving loan, which can be paid back and drawn on again when funds are needed.

What is the difference between hedge funds and private equity? ›

Key Differences Between Private Equity and Hedge Funds

Private equity funds invest in companies that can provide higher profits over a more extended period. In contrast, hedge funds are used to invest in assets that yield good ROI or return on investment over a shorter period.

What does 2 and 20 mean in private equity? ›

"Two" means 2% of assets under management (AUM), and refers to the annual management fee charged by the hedge fund for managing assets. "Twenty" refers to the standard performance or incentive fee of 20% of profits made by the fund above a certain predefined benchmark.

What is clawback in private equity? ›

A clawback in private equity gives limited partners' the right to reclaim the interest that general partners carry if they receive extra compensation for the losses borne.

What is dry powder in private equity? ›

At venture capital and private equity firms, “dry powder” is cash that's been committed by investors but has yet to be allocated to a specific investment. This term dates back to the 1600s, when it referred to stashes of reserved (and still-dry) gunpowder that could be accessed during combat.

What percentage of private equity investments fail? ›

Looking at bottom-quartile funds, he found that 75 percent had failure rates of 35 percent or higher. The average is around 27 percent for buyout firms.

Will private equity wreck HVAC? ›

HVAC private equity is doomed to crash and burn. There are too many players chasing too few contractors. Nearly 20 private equity funds are targeting contractors. Not all of them are major players, but 20 is too many.

How much do you make in private equity? ›

For the vast majority of private equity associates, the base salary is around $135k-$155k. Then, based on fund performance, bonuses tend to range from 100% to 150% of the base salary.

Why is it difficult to find a potential buyer for the participation the PE owns? ›

1. Why is it difficult to find a potential buyer for the participation the PE owns? wrong: The buyer may not be intereseted in the financing of the company. wrong: The price is defined by the market and a seller could buy the shares forspeculative purposes.

Is private equity good for employees? ›

Researchers analyzed almost 10,000 debt-fueled buyouts between 1980 and 2013 and found that employment fell by 13 percent when a private-equity firm took over a public company. Employment declined by even more — 16 percent — when private equity acquired a unit or division of a company.

What happens to employees when a public company goes private? ›

Unfortunately, there are many possible outcomes for employees with stock options when a public company goes private: Vested stock options may be cancelled in exchange for a cash payment, generally equal to the excess (if any) of the new share price over the exercise price.

What is the life cycle of private equity? ›

According to Blackstone's Private Wealth Solutions group, the life cycle of PE funds is typically 7 to 10 years, and is generally broken down into three stages: the fundraising period, the investment period, and the harvest period.

Why is private equity successful? ›

Their ability to achieve high returns is typically attributed to a number of factors: high-powered incentives both for private equity portfolio managers and for the operating managers of businesses in the portfolio; the aggressive use of debt, which provides financing and tax advantages; a determined focus on cash flow ...

Why do private equity firms go public? ›

A private equity firm can either list publicly as a quoted public company, or launch an investment trust. "Going public is sometimes a way for a founder to exit the company," explains Sanjay Mistry, head of European private equity research at Mercer. "It providers owners with a release of capital."

What is it like to work for a PE owned company? ›

The dynamic, fast-paced operating environment of a PE-backed company can provide executives with a unique career opportunity and very attractive rewards. But it's not for the faint hearted. Managing a private equity-backed firm brings a unique set of opportunities and challenges for senior executives.

How long do private equity firms keep companies? ›

Private equity firms' average portfolio company holding periods have historically averaged from four to five years (Strömberg 2008), and a majority of private equity firms use a five-year forecasting period in evaluating investments (Gompers et al. 2016).

What is private equity dry powder? ›

Dry Powder is a term referring to capital committed to private investment firms that still remains unallocated. Under the specific context of the private equity industry, dry powder is a PE firm's capital commitments from its limited partners (LPs) not yet deployed into active investments.

What is a private equity buyout? ›

Buyouts occur when a mature, typically public company is taken private and purchased by either a private equity firm or its existing management team. This type of investment makes up the largest portion of funds in the private equity space.

Is it good to work for a private equity company? ›

A career in private equity can be highly rewarding, both financially and personally. Private equity managers often take a great deal of satisfaction from successfully guiding their portfolio companies to new high levels of profitability.

What is a VC backed company? ›

The term venture capital-backed IPO refers to the initial public offering of a company that was previously financed by private investors. These offerings are considered a strategic plan by venture capitalists to recover their investments in the company.

What is it like to work in venture capital? ›

Working at a venture capital firm, you get to be the one to decide which businesses will get the backing they need to become huge. But VCs do more than just sign checks—in this field, you'll get to work with inspiring entrepreneurs to create business models that work. (And yes, you'll profit nicely when they do.)

What is the life cycle of private equity? ›

According to Blackstone's Private Wealth Solutions group, the life cycle of PE funds is typically 7 to 10 years, and is generally broken down into three stages: the fundraising period, the investment period, and the harvest period.

How much do you make in private equity? ›

For the vast majority of private equity associates, the base salary is around $135k-$155k. Then, based on fund performance, bonuses tend to range from 100% to 150% of the base salary.

How do private equity firms make money? ›

Private equity firms buy companies and overhaul them to earn a profit when the business is sold again. Capital for the acquisitions comes from outside investors in the private equity funds the firms establish and manage, usually supplemented by debt.

What is private equity overhang? ›

This refers to the amount of capital committed by investors to equity firms for investing purposes. When private equity funds are created, most have limited lifetimes. That means that fund managers typically have 5-7 years to invest the private equity overhang, or they have to send the capital back to their investors.

How much dry powder is in a VC? ›

The amount of dry powder at VC funds is now nearly double the $147 billion annual average between 2016 and 2020, before the pandemic-fueled surge in fundraising, according to Sakoda's analysis.

How much dry powder do private equity firms have? ›

As of June 30, 2020, private debt funds had about $273 billion of dry powder available, according to PitchBook. Around $66 billion of that capital was held by managers focused on distressed debt, a class of riskier investments in troubled companies with the potential to offer bigger returns.

How do private equity firms ruin companies? ›

Their tactics include paying themselves fees for nonexistent services and quickly converting the assets of the companies they have bought into dividends for the private equity firm. This leaves the companies without resources to invest in sustaining and growing their businesses, or paying workers fairly.

What is the difference between acquisition and buyout? ›

Key Takeaways

A buyout is the acquisition of a controlling interest in a company and is used synonymously with the term acquisition. If the stake is bought by the firm's management, it is known as a management buyout, while if high levels of debt are used to fund the buyout, it is called a leveraged buyout.

Why do people go into private equity? ›

You prefer PE because it's a blend of both operations and finance and because you can help Founders with well-established businesses make them even better via solid analysis and research rather than just guesswork.

Videos

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2. Bridgepoint Private Equity Challenge 2017
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4. Big bank CEOs testify before House Financial Services Committee
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