Private equity (PE) has long been a powerful asset class, steeped in a history of market-defying returns, operational alchemy, and savvy financial engineering. But as highlighted in this recent case study by Nori Gerardo Lietz and Philipp Chvanov, the narrative around PE as a tool for consistently outperforming public markets is shifting. The landscape has evolved, revealing critical insights that invite PE firms to reconsider traditional strategies and explore bold new directions—such as incubating internal projects to achieve differentiated growth and enhanced EBITA.
Over the past decade, the fundamentals that initially attracted institutional investors to PE—superior returns, low correlations with public equities, and enhanced operational performance—have been tested. While the PE industry saw exponential growth, both in terms of assets under management (AUM) and the sheer number of funds, average returns have not consistently beaten public market equivalents (PMEs). This has raised pointed questions about whether the touted value-add of PE is driven more by market beta and multiple expansion than actual transformative operational improvements.
The Real Picture of PE Performance
Historically, PE’s appeal was rooted in the idea that fund managers could secure undervalued businesses, leverage them strategically, and exit at impressive multiples. But data post-2008 tells a different story. The median PE funds, despite being awash in capital, have not substantially outperformed PMEs when accounting for fees and adjusted risk. The case study details how the North American PE market, which commands the lion’s share of global PE activity, has seen significant convergence between private market IRRs and public market benchmarks. This is particularly evident when examining median PE returns against customized PME indices over recent years.
Part of the narrative focuses on leverage. The industry’s debt-to-EBITDA ratios often hit a high 7x, compared to a 2x ratio for the Russell 3000. While leverage can amplify returns in a bullish market, it also introduces significant risk when market conditions sour or when interest rates rise—a scenario becoming all too familiar in today’s economic climate. Such reliance on heavy financial structuring raises the question: are these firms creating true value, or just engineering returns through risky capital structures?
Leveraging AI and Emerging Technologies for Enhanced Performance
In addition to traditional approaches, PE funds are increasingly turning to advanced technologies like artificial intelligence (AI) to boost portfolio company performance and drive EBITDA growth. By integrating AI across their portfolio operations, firms can unlock new efficiencies, optimize supply chains, and forecast demand with precision. AI-enabled predictive analytics empower decision-makers to identify areas for cost reduction, streamline processes, and prioritize value-adding activities.
PE funds have already started incorporating AI for automated financial modeling, enhancing due diligence with deeper data insights, and leveraging machine learning for improved customer targeting in consumer-focused businesses. These technological capabilities, when combined with internal incubation of products or services, offer a robust pathway to sustained EBITDA growth that moves beyond traditional methods of value extraction.
Why Incubation Could Be a Game-Changer
To truly enhance portfolio performance and EBITA, private equity should look beyond its conventional playbook. The current investment environment, marked by compressed valuations and competitive entry multiples, demands that firms identify unique growth pathways. Here lies an opportunity for PE firms to incubate their own internal projects—ventures that build on existing expertise and deploy capital in innovative ways, enhanced with AI-driven solutions.
Incubating projects internally shifts the value-creation model from one of reactive adjustments to a proactive, growth-oriented strategy. Instead of seeking growth purely through acquisitions or adding leverage, PE firms could develop new products or services that complement existing portfolio companies. This approach taps into operational synergies and drives a proprietary source of revenue growth, diversifying income streams and bolstering overall portfolio performance.
The Data Behind Incubation, AI, and Operational Value
The case study underscores that many PE firms have struggled to deliver superior operational improvements, despite significant claims to the contrary. The period between 2010 and 2021, for instance, saw median PE funds attributing over half of their value creation to market-driven multiple expansion rather than genuine top-line or EBITDA growth. This calls into question the depth of operational expertise often touted by GPs. Internal projects and incubated initiatives, especially those that leverage AI, provide a controlled environment where firms can align incentives, deploy resources efficiently, and foster innovation. For example, implementing AI-driven tools within supply chain management can significantly reduce operational costs and optimize inventory levels—boosting margins and supporting long-term EBITDA growth.
Furthermore, AI can enhance human capital strategies through predictive workforce analytics, enabling PE firms to improve hiring practices, reduce turnover, and increase productivity within portfolio companies. Combined with the incubation of projects that drive these technological solutions, PE firms can create a differentiated operational advantage that leads to both short-term gains and long-term growth.
The Strategic Advantage of Incubation and Technology
Beyond just the financial upside, incubating internal projects enriched with AI and other technologies adds strategic flexibility. PE firms that successfully create proprietary technology platforms, services, or operational methodologies not only enhance the immediate EBITA of their portfolio companies but also position themselves as value-added partners in future deals. The brand equity gained from being perceived as an industry innovator can attract better deals and command premium valuations upon exit.
The process of incubating projects requires a shift in mindset—from one focused solely on extracting value to one aimed at creating it. This requires dedicated teams, resource allocation, and a culture that supports experimentation. Yet, the payoff can be significant. Proprietary internal projects integrated with cutting-edge AI can become key differentiators in a landscape where average fund performance increasingly mirrors public markets and where competition for quality assets is fierce.
The case for PE incubating its own internal projects, augmented by AI and emerging technologies, is clear. As traditional methods face mounting scrutiny and as returns converge with public markets, PE firms need a reinvigorated strategy that drives growth from within. By fostering internal innovation, developing new business lines, and embedding AI-driven solutions, private equity firms can enhance EBITA, create sustainable value, and differentiate themselves in a crowded market. This not only aligns with long-term growth objectives but positions firms to better weather economic cycles, reducing reliance on external financial engineering and market timing.
Comments