The Current Private Equity Dilemma - Value Creation Vs Preservation

In 2022, the previously burgeoning enthusiasm around private equity (private equity) was tempered. Elevated inflation, escalating interest rates and a bleak economic outlook weighed heavily on private equity deal volumes. Simultaneously, protracted investment cycles and holding periods for private equity portfolio firms emphasized the necessity for value preservation and enhancement.

Last year’s market shifts have created a difficult dilemma for private equity firms this year. In today’s climate of plateauing growth and escalating corporate risk, it begs the question: should a general partner’s (general partners) portfolio be concentrated solely on capacity-building for the next upturn? Or should there be an increased emphasis on mitigating downside risk through more robust risk management frameworks?

For a growing number of general partners, the reality is that both are required to maintain a competitive advantage. Three recent trends are beginning to strain the relationship between growth and risk. However, it’s important for general partners to remember that while value creation and preservation initiatives can be at odds, they don’t necessarily have to be. This article explains why.

Growth Slowly Builds Value, but Risks Can Demolish It Rapidly

The value added by growth strategies, such as introducing new products and services, increasing marketing spend or improving gross margin, is often a gradual process. In a recessionary environment, the pace of this growth can slow further. However, wise investments during a downturn can yield superior growth during the following upturn.

Risks, however, can emerge swiftly and have significant repercussions on a company's reputation, finances, assets and human capital over a surprisingly short time frame. The potential damage from risks can be mitigated with rapid detection and implementation of appropriate response strategies. This is consistent with the risk intelligence we’ve gathered by providing private equity risk detection services for general partners at some of the world’s largest private equity firms. You can read more about Kroll Private Equity Risk Detect here.

In our view, there are three recent trends challenging general partner’s ability to successfully balance creating and sustaining value in their portfolios:

  1. Rising Regulatory Pressure Necessitates Robust Risk Governance
    New regulatory policies seek to balance diverse societal and economic needs and define performance standards and their associated consequences. Despite the potential cost and delays due to compliance, regulatory mechanisms are fundamental to shaping a company's risk profile. For general partners, the penalties associated with non-compliance will apply to their portfolio companies and, in some cases, to the private equity firm itself. This has been particularly evident in the application of human rights laws in the U.S., the EU, Germany and the UK.
  2. Increasing LP Demands for Robust Risk Management Along With Growth
    Limited partners have increasingly expected their investments to adhere to environmental, social and governance (ESG) standards and have shown their willingness to withdraw from investments that do not comply. But what might this trend mean for portfolio-wide risk management? Key risk areas include cybersecurity, social media threat detection, early warning of reputational crises, tracking supply chain or third-party partner crises, and monitoring the online activity of key individuals within the company. general partners demonstrating their capabilities to detect emerging risks across a fund's portfolio and their strategies to ensure those funds are more resilient to risk impacts will increasingly become a prerequisite to future LP funding.
  3. Greater General Partners Focus on Risks During Transactions Than During Ownership
    A paradox seems to be taking shape: private equity firms invest significantly in risk due diligence during the transaction phase but rely on portfolio companies to manage risks post-investment. The rapid evolution of risk poses a challenge, but it's possible for general partners to monitor risks in their portfolio nearly real-time, enhancing their visibility of emerging risks and significantly improving portfolio value preservation. This was the case for several portfolio companies recently monitored as part of our quarterly Kroll Global Private Equity Risk Index, which you can learn more about and download here.

Value Preservation and Creation Can Be at Odds, but Don’t Have to Be

Balancing the need for strong growth and effective risk management can be a challenge. As stakeholders increasingly express discontent, companies must also consider the risks associated with change management. The board needs to strike a balance between value preservation and creation, tailored to the unique circumstances of each portfolio company. This requires a comprehensive and realistic understanding of the risk landscape.

To help strike that balance, Kroll has developed specialist expertise over the company’s many years of supporting private equity firms in managing their portfolio risk. Kroll’s Integrated Risk Intelligence solutions offer comprehensive capabilities to prevent, detect and respond to risks as well as deliver deep insight for understanding the likelihood and impact of emerging risks.

Excellence is achieved by being advisory-led, technology-enabled, data-driven and workflow-guided in both approach and execution. Kroll’s capabilities are designed to offer complete risk intelligence across the three critical deal stages of pre-transaction, value preservation/creation and exit and to cover the key risk domains of ESG, reputation, finance, supply chain, security, cybersecurity and macroeconomic. In doing so, we help general partners boost investment returns and ensure future LP funding.

In conclusion, private equity firms are recognizing risk management as a key differentiator in fundraising and in maximizing returns over a fund’s lifespan. With trusted external partners providing risk intelligence across all aspects of a company's operations, general partners are well-positioned to leverage this risk knowledge across their investments, leading to maximized value preservation and creation.

Private Equity Risk Detect

Kroll offers private equity firms risk detection for deal prospecting, pre-deal review, deal due diligence, post-deal management and disposal due diligence.

Comprehensive Due Diligence Solution

Our Comprehensive Due Diligence solution helps clients minimize risks and make the most informed business decisions. We support in the areas of tax, compliance and regulatory, ESG, operations/strategy, M&A, financial and accounting, investigations, disputes and cyber/IT risk.

Cyber Governance and Strategy

Manage cyber risk and information security governance issues with Kroll’s defensible cyber security strategy framework.

Environmental, Social and Governance Advisory Services (ESG)

Advisory and technology solutions, including policies and procedures, screening and due diligence, disclosures and reporting, investigations, value creation, and monitoring.

Cyber Risk

Incident response, digital forensics, breach notification, managed detection services, penetration testing, cyber assessments and advisory.

Digital Technology Solutions

Enriching our professional services, our integrated software platform helps clients discover, quantify and manage risk in the corporate and private capital market ecosystem.