But what do you do when this formula no longer works? If both the debt and the company you're buying are too expensive to flip for a gain, how do you put your client's money to work? And if you can't invest their money, how will you give them the return you've promised, with your tidy 20% of profits taken off the top?

The combination of high interest rates and high asset prices has been crimping the private-equity gold rush for several years. Industry transaction volumes plunged by more than one-third year over year in 2023, and Apollo's CEO, Marc Rowan, this month remarked on the industrywide predicament.

"Over the last decade in particular, call it 15 years, a lot of what has been produced was not the result of great investing but as a result of $8 trillion in money printing," Rowan said in an earnings call. Now that the Federal Reserve has "stopped printing that magnitude of money," many private-equity firms are seeing that their good performance was a result of a rising tide lifting all boats, Rowan said (though he was clear to differentiate Apollo from the pack).

So how do private-equity firms make money in this new climate? Enter the portfolio-operations executive. Every private-equity firm has a team of people responsible for working with the management of their portfolio companies to run their day-to-day operations. Unlike their jet-setting counterparts in dealmaking, they tend to remain behind the scenes, doing the dirty work of making sure these companies are running smoothly, from the tech to the payroll.

Kevin Desai, a partner at PricewaterhouseCoopers and sector leader of PwC's US operations, told Business Insider that portfolio-operations pros were becoming a lot more important as private equity chases the next wave to big returns: transforming businesses with technology to save costs and increase revenue.

"The culture of private equity is that the investors who are finding the deal and signing the deal are the favorite sons and their portfolio operations are in the background," Desai said.

Kevin Desai, a partner and private-equity sector leader at PwC.



PWC

But in this climate, portfolio-operations professionals are gaining esteem. Firms are bringing them into the deal room to assess the technological-transformation potential of acquisition targets before signing deals — even though it can create conflict when operations teams poke holes in a deal team's plan.

It's part of a shift that Desai describes as private equity 3.0 that has firms relying more on companies' management — and even total transformation of the companies — to generate returns for investors. Under this model, portfolio-operations jobs are more important than ever, said Desai, who spoke with BI about private equity 3.0, how we got here, and what it all means for private-equity hierarchy.

Making money used to be easier

Desai said private equity began as a "cottage industry" in the 1980s before evolving into a "much more sophisticated portion of our economy."

In the early days, buyout funds took corporate conglomerates private and then sold off parts of the companies at a profit. This era, which Desai calls private equity 1.0, was focused on using debt to stretch the returns an investor could get on their equity, borrowing from the theorems of the University of Chicago economists to become maniacally focused on efficiency.

But early success led to more competition and fewer acquisition targets. Suddenly it was a lot harder to generate massive returns through financial magic alone. Instead, firms had to focus on reducing costs and beating industry peers.

This led to private equity 2.0. In this era, efficiency was king as firms turned to cost-cutting strategies like laying off staffers, consolidating businesses, and moving corporate headquarters. The goal was revenue at the lowest possible cost.

Desai described the mindset of the firms of this era as "Can we extract more value or get more return on investments on our capital spend to really drive that cash-on-cash return?"

But competition only continued to increase, leading to what Desai calls private equity 2.5, or using the money generated by a business to buy more growth. One example is the classic roll-up strategy, where an operator of a chain of small businesses, like a car wash, uses cash flow to purchase more of these businesses, growing the size of the business and the return on the investor's original equity.

Private equity 3.0

Rising interest rates nearly 2 1/2 years ago ushered in an economic reality that hit private-equity firms right in the pocket. Cash flow that previously could have been reinvested into a business or disbursed to investors now had to be used to cover the debt that financed the deal in the first place.

Stubbornly high business valuations compounded the problem, making it harder to find a lucrative target.

"If I'm a private-equity investor, I've got a problem because I've got a mom-and-pop seller who's looking at their stock portfolio, and the price-earning ratio of the S&P 500 hasn't really moderated all that much," Desai said. "Why would I sell my business for a lower EBITDA multiple? Because the stock market is telling me that the economy is doing great."

This leaves the industry with two options, Desai said: reduce debt or "do something different to generate outsized cash returns." Since private equity relies on debt to boost returns, the first option is off the table.

What's left over is the new model that Desai calls private equity 3.0, which forces buyout companies to build new revenue streams to generate investor returns.

He said this model tends to start with technology to lower costs and then use the cost savings to find ways to expand a business' ability to make money.

Desai used the example of a car-wash chain that previously would have used its earnings to purchase more locations. With extra cash flow eaten up by high debt costs, ownership has to bring in labor-saving back-office technologies, such as generative AI or chatbots.

Those savings would then be used to roll out new money-making opportunities, like developing an app to drive more loyal business or selling adjacent services at the car-wash locations.

It's one reason private-equity firms have increasingly focused on blue-collar businesses like pest control or cleaning.

"A lot of clients will tell me, 'We have to now start thinking about taking old-economy businesses and bringing them forward to the new economy,'" Desai said.

Enter the portfolio-operations pro

The rising star of this new investing paradigm is the portfolio-operations pro. Instead of just minding companies between their purchase and eventual sale, they're helping transform them into revenue-generating machines.

"We are now surrounding our financial-minded quants, who are the historical engine of private equity, with really smart operators, some of whom have done digital transformation at large-scale corporations," Desai said.

Historically, portfolio-operations partners were former CEOs and chief financial officers who had successfully managed companies. They've grown to include professionals of all major business functions, from human resources and marketing to procurement, and especially chief technology officers and those who have driven digital transformations.

Desai said this was increasing demand for operations talent, including people who, for example, launched an e-commerce platform for Walmart or ran digital for Nike. These people are taking their talents to private-equity firms to manage smaller companies using a playbook for technological transformation.

They're adding value at the shopping stage by assessing how long a transformation might take and what it might cost. If the deal goes forward, they'll actually help run the day-to-day changes at those companies, along with the companies' management teams.

"With unlimited capital, a lot of things sound like a great idea," Desai said. "In a capital-constrained world, we've got to see what is achievable."

Culture clash

The importance of portfolio-operations pros is taking hold.

A study cited by the Harvard Business Review found that operations (increasing revenue and reducing costs) contributed to 47% of all private-equity value creation since 2010, compared with the 25% of value provided by financial engineering. This was a reversal from the 1980s, when operations made up only 18% of private-equity value creation and financial engineering was responsible for 51%.

Of course, Desai said, the operations pro's rising status could lead to more conflicts in the deal room.

"As portfolio-operating teams get under the hood of the portfolio companies, they uncover challenges to the value-creation agenda or perhaps obstacles not known at the time of diligence," Desai said. "This can create conflict within the fund; deals teams and operating teams may not see eye to eye on how appropriately one can realize the PE firm's investment thesis."