What Private Equity’s Shift Means for Investors, Business Owners

Private equity is in flux as the threat of consolidation looms and more expensive debt reduces firms’ ability to rely on deal structure and leverage to deliver outsized returns.
Economic conditions have changed, and private equity needs to change along with them, focusing less on financial engineering and more on traditional business-building principles.
Private equity’s boom years
Since interest rates peaked in the 1980s, U.S. financial markets benefited from a secular decline in interest rates from 19.0% to 0.0%. Declining interest rates create accommodating conditions for high-risk assets, creating the foundation of several decades of success for the private equity industry.
Low interest rates also enabled high leverage, allowing companies to use additional debt capacity to create the lowest cost of capital in the financial markets.
That strategy served the industry well for years, generating returns in excess of those available in public markets. A PE-owned company’s ability to carry and service debt became almost as important as its underlying customer value proposition.
The cost of capital advantage allowed private equity firms to outcompete even public market investors for assets, leading to a significant decline in the number of public companies per capita, down by nearly 70% from the late 1990s to today.
This private equity structure proved the most attractive form of business ownership over the past 20 years.
The cost of cheap debt
Despite the gains for limited partners, however, the ecosystem around these companies suffered; customers, suppliers and employees were left worse off thanks to private equity’s financial engineering.
A company could be bought, merged with smaller businesses using significant debt facilities and then sold in less than three years without improving its underlying human capital, technology or operations.
The focus of business ownership shifted from expanding productive capacity at attractive profit margins toward debt-funded market share expansion at a high cost to ecosystem participants.
The pursuit of businesses with low-cost debt facilities also brought private equity firms into unfamiliar industries, ranging from accounting firms to car dealerships and sandwich shops.
Any company of sufficient earnings could act as a platform for private equity firms to perform debt-financed M&A on a huge scale.
But increased interest rates limited the debt capacity of companies, diminishing PE return prospects along with them. The ability to create value purely through debt-financed M&A has diminished, challenging the