In December 2024, the Private Equity Reporting Group (PERG), in its 17th Annual Report on the Performance of Portfolio Companies, noted that while private equity (PE) portfolio companies had experienced trading growth “in 2023 the portfolio companies performed lower than the benchmark comparatives for long-term (since acquisition) and year-on-year growth measures for revenue, EBITDA, employment, compensation and labour productivity”.
This contrasts with the long-term return outperformance consistently reported by the BVCA in its annual Performance Measurement Survey, which noted a 12% per annum return by the UK private equity and venture capital industry since 2005 and 14.5% since 2015, compared to 6.6% per year since 2005 from the FTSE All-Share Total Return Index and 7.1%from the MSCI Europe Gross Total Return Index.
So, what’s going on and how does UK private equity need to evolve its approach if it is to continue supporting outperformance from the small and medium-sized enterprises (SMEs) it backs?
Setting the scene
What could be described as the ‘modern’ UK private equity mid and lower-mid market (the segment focused primarily on UK SMEs) is around 20-25 years old, as the above stats suggest, and has evolved significantly over that time, with many early players developing from plucky upstarts in the late 1990s/early 2000s to successful, large institutional platforms today with long track records and significant assets under management.
In the latter half of this period, notably the period post recovery from the 2008 financial crisis, the UK PE market enjoyed an unusually benign corporate environment, with (relatively) abundant capital for fundraising, low inflation and historically low interest rates. As a result, there were low debt costs for an extended period.
The bar for success was lower as cheap leverage helped support returns – the same PERG report concludes that circa 41% of returns outperformance from PE-backed companies is attributable to private equity strategic and operational improvement, with the majority coming from additional financial leverage.
The reasons for the reported slowing of growth are clearly multifaceted, but there are several contributing factors in a more complicated environment. Materially increased international and domestic volatility has combined with the long-lasting effects of government policies post Covid, alongside the return of inflation to Western economies, to create a far more challenging market than in most PE professionals’ lifetimes (financial crisis aside).
As a result, sustainable growth requires a far more active approach than many firms have been used to. With interest rates at levels last seen in 2007 and 2008 and hence higher debt costs, in today’s market environment companies need to make material changes and drive better performance to avoid going backwards.
UK mid and lower-mid market private equity investors need to add more value than just equity capital and a shareholder restructure to drive the returns their investors have become used to in the past two decades.
The route to a successful investment is more than just numbers
A key challenge for UK mid-market and lower mid-market private equity firms in adapting to this tougher environment is that we have historically primarily recruited from traditional professional services environments – banking, consulting and accounting.
Whilst these industries have provided a ready stream of professional, driven and dedicated individuals, the majority have no real-world experience of running an SME, certainly in the challenging environment UK SMEs now face.
The result, in many cases, is a natural retreat to where they are comfortable – numbers and spreadsheet-based analysis.
However, in a tougher business environment a broader understanding of the challenges and barriers to growth that UK SMEs face is required and active operational support for PE-backed SMEs is essential.
While they have their place, the traditional professional services skillsets of the majority of PE recruits have created a gap – portfolio management has become portfolio monitoring with some PE decision makers now sitting atop large institutional players a long way from the coal face of the SMEs they back.
This creates the risk that decisions are not motivated by what sustainably drives each portfolio business forward, but instead by the internal dynamics of the PE firm itself, its fundraising cycle and so on.
To counteract this, UK private equity firms need to engage with operators who have made their careers growing companies and embed them in their firms.
With 20-25 years now of institutionally backed UK SMEs there is a proven group of high-calibre business leaders who have driven growth and success in PE-backed firms. They understand the PE model and how it works and have been senior leaders in their own right.
The traditional route to accessing this has been to bring a chair onto the board of an investee company, but while this should remain part of the approach, embedding this experience further into the PE firm itself, its investment committee decision-making and portfolio management, provides the means to drive sustainable success in a more challenging environment.
Although it is still rare, forward-thinking firms are integrating the advice and support from proven operators at their core, bringing them in as shareholders, rather than holding them at an arm’s length.
With a stake in the PE firm's overall returns, not just specific investments, this model better embeds operational expertise within the way the PE firm approaches its investments and can provide real-world support, not just capital.
The true role and value of an operator led model
Whether offering market, financial, or operational support, in house operators are one of the best ways to add real value to SMEs. With successful careers across a variety of sectors and significant cumulative experience, they are invaluable to an SME that’s ready to move onto its next phase of growth but lacking some of the perspectives and understanding of the next steps and the resources to deliver the changes needed.
By creating an internal resource of operational experience, PE firms are best placed to overcome the challenges facing their investee firms.
Ultimately, if a company is looking for an investor to help them grow – then businesses and management teams need to look beyond the numbers and pay close attention to the added operational value the PE company is bringing to the table, and UK PE needs to up its game.
Miles Otway is founding partner at Ama Capital. The views expressed above should not be taken as investment advice.