PwC recommends buyout firms diversify, focus on portfolios

The study dovetails with broad changes already affecting the private equity industry as GPs hire more operating partners and raise families of funds.

Private equity firms must focus on growing the earnings of their portfolio companies and diversify into other alternative asset classes to succeed in the altered financial environment, according to a study from PricewaterhouseCoopers.

The study confirms a trend that is already taking place in the industry, in which firms are hiring more operating partners to work closely with portfolio companies. Advent International, Nova Capital Management, Duke Street and Morgan Stanley Private Equity are among firms that have augmentes their stable of operating partners in the past year.

Firms also have been adding to families of funds as they manage capital across strategies. Kohlberg Kravis Roberts, long a private equity-only shop, is now targeting infrastructure, fixed income, mezzanine, real estate and public equities. The Blackstone Group, which has traditionally pursued multiple lines of business, is adding an infrastructure group as well as a clean energy platform.

The study said the changes are necessary now that the “benign” environment of the past few years, during which credit was easy to come by and the valuations of companies sky-rocketed, is over.

“Private equity firms are working their portfolio companies harder and making solid business management skills a core competency,” the report said. “Those that did not already have appropriate in-house expertise are hiring operationally experienced managers and specialists in organisational change and turnarounds.”

Business-line diversification will likely accelerate as firms seek investments in companies and markets untouched by the economic downturn.

“There is an even greater logic in having a diversified product range – as some asset classes are more suited to generating investment gains through the trough of the cycle than others,” the report said.

Along these lines, Goldman Sachs closed its debut senior debt fund on $10.5 billion this month, and Alchemy Partners confirmed that it would likely raise its second distressed debt fund in the spring. The fund would target $1 billion, according to media reports.

The report said other issues on which firms should focus to adapt to the changing environment include understanding and implementing corporate responsibility standards; strict adherence to fair valuation standards and understanding the risk of investing in emerging markets.

The combined issues present challenges to private equity firms that will force them to fundamentally change the way they operate.

“Just as the benign conditions of the past five years fostered a phase of growth when large buyouts became increasingly dominant, so in the coming years the industry will re-shape itself again to adapt to the new environment,” the report concludes.