How fund size defines the challenges and opportunities facing PE firms and portfolio companies

The BDO 2023 Private Capital Survey, produced by BDO USA, contains input from 405 U.S. private equity fund managers and operating partners, 200 U.S. portfolio company CFOs, and 50 U.S. board members.

The survey presents a holistic look at current and future trends defining the business reality for private equity firms and portfolio companies. Overarching themes include addressing economic uncertainty, increasing resilience and re-aligning business priorities.

Evolving challenges and opportunities

An uncertain economic outlook, including interest rate hikes and inflation, are among the factors that define and determine PEs’ value creation strategies, new deal efforts, portfolio company interactions and task prioritisation.

PE professionals cite risk exposure (34% of surveyed mentioned this risk), lack of bandwidth among vendors (29%), market consolidation (27%), a gap between buyer and seller expectations (26%), and increased competition (26%) among the most significant challenges. A lack of quality deals, supply chain disruption, and economic uncertainty all polled at 25%. Finally, a need for more internal resources was identified by 23%.

As is often the case in tumultuous economic times, traditional value creation strategies, including pursuing topline growth and solving staffing and talent challenges, have become top priorities.

“Some quite stalwart institutions in the middle market are struggling to close new funds, in part due to the economic circumstances. Across all fund sizes, there may be a need to re-align the investment thesis to take greater economic uncertainty into account.“ – Jamie Austin, Corporate Finance Partner, National Head of Private Equity and Co-head of Life Sciences Corporate Finance, BDO UK.

However, PEs’ approaches, strategies, and challenges – and those of their portfolio companies – vary depending on fund size.

Capital deployment for deals and support

PE deal volume observed a decline in 2023. The first quarter saw the lowest PE M&A activity since 2020. As detailed in the Private Capital Survey, this downturn coincides with a shift in focus from new deals to deploying more capital toward current portfolio companies. However, the situation is slightly different for smaller funds, which remain more interested in new deals than their larger peers.

^{Source: BDO 2023 Private Capital Survey}

The divergence in capital priorities suggests that smaller funds are more susceptible to certain forms of pressure, needing to put capital to work via new deals and addressing Limited Partners’ (LPs) liquidity.

New deals are also influenced by shifting priorities and preferences among LPs and the market. For example, ESG criteria are increasingly vital to deals, underscored by the survey’s finding that 80% of fund managers had walked away from a deal due to ESG concerns.

This fact serves as a reminder that value creation starts long before a deal is signed, during deal preparation and due diligence processes. 

Creating value in uncertain times

The strategies for value creation fluctuate based on fund size. Most larger funds, with Assets Under Management (AUM) surpassing $15 billion, are focused on revenue growth. In contrast, smaller funds exhibit more diverse strategic priorities, including greater focus on talent management, cash flow optimisation, and operational improvements.

^{Source: BDO 2023 Private Capital Survey}

The changing economic circumstances also influence portfolio companies.

More than half (54%) of CFOs and board members expect meeting the objectives of their private equity owners' investment thesis will be challenging. At companies owned by smaller private equity funds (with under $1 billion of AUM), this number climbs to 64%.

Economic lever options

PEs and portfolio companies can prioritise different options to address economic uncertainty. Focus areas may include revenue growth, cross-customer opportunities, capital increase or expenditures and operational expenditures. Other levers include talent management, including through interim financial staffing solutions, and the preferred option will be influenced by portfolio company industry, size and maturity. 

^{Source: BDO 2023 Private Capital Survey}
 

That said, the survey shows how PE operating partners at funds greater than $15+ billion and their PE-backed CFOs are aligned, focusing on revenue growth.

^{Source: BDO 2023 Private Capital Survey}

PE operating partners and PE-backed CFOs at smaller funds have slightly different value creation strategies. This is particularly true for operational expenditures and increased capital, which are the CFOs' preferred levers, compared to the PEs prioritising capital expenditures and revenue growth. Similar differences, but much smaller, exist for companies owned by bigger funds.
"Access to capital remains a challenge for smaller funds, as do talent and staffing. Large funds have fewer issues with access to capital but are not exempt from staffing challenges, necessitating innovative financial management solutions. We have supported large and small funds with temporary financial management solutions to navigate a difficult market." – Sunil Sharma, National Leader, Transaction Services and Private Equity, BDO Canada.

Finding common ground for growth

While the pressures felt by CFOs and portfolio companies vary based on fund size, they share common needs to align on operational issues and drive business growth, including through add-on integrations and cost-synergy realisation.

Portfolio companies and fund managers also need to align on the strategy to ensure that a value creation roadmap can be put in place and followed by both parties.

“Across fund size, caution is a key theme. PEs are keen to see portfolio companies and potential targets demonstrate a proactive engagement with the changing market dynamics.” – Sebastian Stevens, National Leader, Private Equity, Partner, Corporate Finance, BDO Australia.

One added challenge in this context is that many of today's CFOs have little experience navigating uncertain economic times.

With this in mind, addressing the difference between funds and portfolio companies and future-proofing operations may require a thorough re-evaluation of value creation strategies and engaging objective third parties to help find optimal solutions for both PEs and portfolio companies.