Operational performance improvement takes center stage after paradigm shift in private equity

1. Introduction

For decades, private equity value creation rested on three pillars: financial engineering, multiple expansion and operational performance improvement. In many cases, the first two provided sufficient tailwinds to compensate for potential shortcomings in the third. That environment has fundamentally changed.

Higher interest rates have increased financing costs, lenders have become more selective and leverage levels have generally declined. At the same time, economic growth has slowed, market volatility has increased and valuation multiples have largely stopped expanding. As a result, leverage optimisation and multiple expansion contribute materially less to returns than they did during previous decades.

Alternative financing solutions such as private debt, preferred equity and structured capital remain important, but rather serve as supporting value creation levers. Financial engineering has therefore not disappeared, but it has lost some of the relevance it once had. Instead, operational performance improvement via revenue growth, margin expansion, cost optimisation, business transformation or cross-portfolio synergy realisation are increasingly determining investment outcomes.

The implications are significant. If private equity investors continue to target broadly similar returns, often around 2.5x invested capital over a five-year holding period, and financial engineering and multiple expansion contribute materially less to these returns, operational improvement must compensate for the difference. In practice, this means operational initiatives may need to contribute more than twice the value they historically delivered in order to achieve comparable investor outcomes. Value creation must increasingly be earned through business performance.

2. Why timing and preparation become critical success factors

The growing reliance on operational improvement fundamentally changes the role of timing. Whilst financial engineering can often be implemented relatively quickly, operational value creation follows a different logic.

Revenue growth initiatives require time to influence customer behaviour. Pricing programmes, procurement savings, organisational changes and operational excellence measures all depend on lengthy implementation and adoption cycles. Furthermore, digital, technology and operating model transformations often require years before their full benefits become visible.

This creates a fundamental challenge. If operational improvement must contribute more than twice as much value as before to maintain similar returns within a five-year holding period, the available window for creating value becomes significantly more demanding. Every month lost after acquisition reduces the time available to execute transformation initiatives, realise benefits and demonstrate sustainable results before exit - that is, delays are increasingly difficult to recover from.

As a result, operational value creation can no longer be viewed primarily as a post-acquisition exercise. Investors are developing operational scenarios and transformation hypotheses long before deciding for a buy-side opportunity. Growth opportunities, margin improvement levers, digital initiatives, operating model change options and portfolio synergy opportunities should ideally be conceptualised before due diligence commences.

Due diligence consequently becomes a forward-looking exercise focused not only on identifying risks, but also on validating value creation opportunities and implementation feasibility.

As if the challenge to more than double outcomes from operational improvement initiatives would not be tough enough on its own, it needs to be accomplished early enough for benefits to become visible, measurable and sustainable before exit as otherwise there will not be adequate credibility to be factored into exit values at face value.

3. Operational value creation: organic, inorganic and portfolio-wide levers

Operational value creation broadly falls into three categories:

Organic measures improve the existing business through commercial excellence, pricing optimisation, procurement and supply chain, operational excellence, digitalisation, restructuring and working capital improvements. Their advantage is greater control and comparatively lower execution risk.

Inorganic measures include acquisitions, divestitures, carve-outs and portfolio restructuring. Whilst typically carrying higher risk, they can create more transformational outcomes and reshape an investment‘s strategic position with much more speed.

A third and increasingly important source of value creation is portfolio-wide synergy realisation. Procurement capabilities, technology platforms, talent pools, commercial practices and operational expertise can often be transferred across portfolio investments to accelerate and widen the scope of performance improvement.

As investors seek larger operational contributions to returns, facilitating portfolio-level synergies becomes more attractive. This may further increase sector specialisation amongst private equity firms, as similar portfolio companies create greater opportunities to transfer capabilities and realise value beyond the individual asset level.

The strongest value creation programmes combine all three operational value creation levers with a specific blend tailored to the individual asset.

4. The Challenge: mastering operational value creation

As operational performance improvement becomes the principal driver of value creation, private equity firms themselves must adapt.

4.1. Adjusting the capability setup

Historically, many firms were organised primarily around transaction execution, financing and portfolio governance. However, sponsors now require deeper expertise in commercial transformation, operational excellence, pricing, procurement, technology transformation, restructuring, integration and carve-outs.

Some firms will expand internal value creation teams and operating partner networks. Others will rely on flexible ecosystems of consultants, specialists and interim managers. Regardless of the model, operational capabilities are becoming a core competitive differentiator rather than a supporting function.

4.2. Investing in scenario thinking and planning ahead

The rising importance of operational value creation places a greater premium on scenario-based forward planning. Leading investors are developing multiple transformation scenarios before committing capital, assessing alternative pathways for growth, cost reduction, organisational change, digitalisation and portfolio synergies long before acquisition.

This is particularly important because the most impactful transformation opportunities often require substantial implementation time and investment. Some investors may therefore choose longer holding periods to allow complex or capex-intensive initiatives to create value. However, longer ownership periods and higher investment levels also increase return hurdles, market exposure and pressure on management teams. While this offers more time to create additional value, it also raises expectations for performance.

4.3. Rethinking due diligence and negotiation

One of the most important consequences of the shift towards operational value creation is the growing significance of asset fit.

If operational improvement must contribute more than twice the value it historically delivered, success becomes far more dependent on whether an investor possesses the specific capabilities needed to unlock potential and if the asset bought has adequate inherent value potential. Not every buyer is equally suited to every asset and not every asset is suited to every buyer – it equally holds true in both directions.

Due diligence therefore evolves from a process focused primarily on risk assessment into one equally focused on validating value creation potential and determining owner-asset fit. Sector expertise, transformation capabilities, operational resources and portfolio synergies become increasingly important selection criteria.

The same applies to negotiations of purchase conditions. Purchase price, transaction structure and contractual terms establish the baseline from which value must be created. As financial engineering becomes less powerful and operational improvement remains constrained by implementation timelines and execution risk, there is less room to recover from an overly aggressive entry position. Disciplined signing and negotiation therefore become increasingly critical determinants of investment success.

5. Conclusion

Private equity is entering a new value creation era. Higher financing costs, lower leverage, slower economic growth and stagnating valuation multiples have materially reduced the contribution of financial engineering and multiple expansion to investment returns. Whilst these levers remain important, their relative significance has declined considerably.

Operational performance improvement is moving to the centre of the value creation model. In many situations, achieving traditional return targets may require operational initiatives to contribute more than twice the value they historically delivered. This places significantly greater emphasis on preparation, timing, diligence and execution.

The firms that succeed in this environment will be those that develop a relevant set of capabilities, identify the right assets, rigorously assess owner-asset fit, develop operational scenarios long before signing, mobilise rapidly after acquisition and combine organic improvement, inorganic transformation and portfolio-wide synergies to create lasting value.

Financial engineering remains part of the private equity toolkit. However, its golden age as the dominant driver of returns appears to be over. Future success will depend on operational performance improvement and the ability to execute transformation effectively.

Tobias Huesmann is a Managing Director at Interpath in the Operational Deal Services team in DACH. Based in Munich, Tobias supports both PE and Corporate clients with their most complex portfolio transformation initiatives via M&A and value creation. His experience spans complex cross-border deals in various industries, supporting both on the buy- and sell-side and along the entire M&A lifecycle from M&A capability, target search, due diligence, post-merger integration to carve-out and divestiture programs. Tobias regularly shares his perspectives on recent M&A trends and developments in relevant M&A journals and forums.

Devinder Singh is a Managing Director at Interpath in the Transaction Services team in DACH. Based in Zurich, Dev leads Interpath’s operations in Switzerland. His experience spans supporting Corporates and Private Equity clients on complex cross-border deals in the Retail & Consumer, Industrials & Services, Pharmaceutical and Technology sectors. Helping navigate some of the most critical moments in their M&A journey – acquisitions, divestitures, carve-outs – is what motivates Dev to stay ahead of the curve and deliver value to his clients.