Private Equity – operational value creation and outperformance in the mid-market

Gentlemen, let’s start with introductions!

Andrew Carnwath: I am an Investment Director and Deputy Manager of CT Private Equity Trust PLC, a London listed investment trust. Columbia Threadneedle manages over USD 600 billion globally, with USD 2bn in private equity. We focus on lower mid-market buyouts in Europe and the US, investing in primaries, secondaries and co-investments.

Christopher Dunn: I lead the investment management practice for Europe at Crisil Coalition Greenwich. We conduct market research within the institutional community to help our clients, asset managers, with their business strategies. In our interviews with institutional investors, we ask about important trends impacting their portfolios and how they work with managers to address them.

Jannick Hunecke: Deutsche Beteiligungs AG, or DBAG for short, is a mid‑market Private Equity investor focusing on German‑speaking countries and Northern Italy. We pursue multiple investment strategies: a small‑cap fund, a mid‑market buyout strategy, a long‑term investment programme and two credit funds. We position ourselves as a financing partner with a broad range of equity and financing solutions for mid‑sized, mostly family‑owned companies that are often leaders in their segments.

Trutz Rendtorff: I have been one of two CEOs of the Karg Foundation since 2018 and am responsible for legacy and new investments. Our legacy PE portfolio comprises 35 PE/PD funds, half via feeders – primaries, secondaries, fund‑of‑funds, in effect market coverage at end‑client fee levels. Experience makes me highly sceptical as to whether PE is suitable for foundations.

How is the market environment for Private Equity developing at present?

Jannick Hunecke: Private Equity is a long‑term asset class, so let me elaborate a bit. From 2017 to early 2020, fundraising in the industry – including in Germany – went very well: demand was high, fundraising cycles shortened, AuMs rose, and there were many attractive deals and exits. During the Covid years 2020 and 2021, investment continued at pace, often at high valuations. The expectation was that things would return to normal after Covid. But challenges emerged: semiconductors, other intermediate products and raw materials became scarce and more expensive, labour costs increased, and from 2022 interest rates rose rapidly. As a result, fewer exits were achieved – in Germany already from 2021 – and capital distributions to LPs were correspondingly lower. At the same time, LPs continued to allocate to PE, creating an imbalance between high investment activity and few exits. Fundraising cycles consequently slowed. In addition, due to the denominator effect, many LPs had less free capital available for new allocations. However, the main driver of low liquidity was less the interest rate increase or new investment alternatives and more the lack of distributions from exits. Today the market is still in a cycle of too few exits and muted fundraising. The latter has therefore been challenging, and some GPs have recently failed to reach their fundraising targets. Sentiment is improving this year. We see this in rising interest from foreign investors in allocating to Germany. In particular, the mid‑market is seeing more exits again, including in our own practice. The large‑cap segment remains more dependent on IPOs, of which there have been relatively few recently.

Christopher Bär: I largely share this analysis. In the past six to eight years, it was often said that dry powder in Private Equity keeps rising, competition is increasing and returns are increasingly under pressure. That cycle is currently interrupted. Between 2022 and 2024, dry powder has developed in a stable manner – investment and fundraising activity are once again in a sensible balance. However, a large part of the available capital is concentrated at the top end of the market. In the lower mid‑market, less capital is available to invest against a far larger investment universe, which naturally benefits funds in this segment.

Andrew Carnwath: Exits in Europe and the US slowed from late 2022, reducing liquidity and creating well-publicised challenges. Yet the best time to invest is often when others hesitate. Difficult vintages often produce the best returns. Today deals are taking longer, allowing more time for due diligence, to really get to know management and align on growth plans. In addition, most GPs have raised the bar and will only close a deal when they have very high conviction. It is also worth highlighting that there is a bifurcation of exit markets. Top-teir companies are still able to secure exits at premium valuations. For the other companies, exits take longer and require good preparation.

Christopher Bär: High‑quality, resilient companies are traded at attractive prices even in challenging market phases.

Jannick Hunecke: The market is indeed divided. On the one hand, there are very attractive companies that are traded at very high valuations, in isolated cases up to 30x EBITDA or more. On the other hand, parts of the market are very subdued. A few years ago, you could sell almost any company; today things are different. This split is also evident in financing: in some cases, very high financing volumes are provided with very accommodating covenants, while financing options for certain sectors are very restricted.

Hardly any fund has been liquidated to date. What remains are tail positions whose exit has not been possible to date. Smoothed volatility is a mirage. And now GPs are extending holding periods via continuation vehicles, offering a choice between a 30 per cent discount or topping up while fees continue to run.

Andrew Carnwath: That performance is not representative of the broader PE market, which has proven highly resilient. It does, however, highlight the wide dispersion between top performers and weaker performers – and the critical importance of manager selection in private equity.

Can private markets value a company better than public markets?

Andrew Carnwath: Yes, I would say so. In private markets, companies are valued in a very different way, anchored on historic earnings, near term forecasts, and benchmarked to sector valuations over economic cycles. By contrast, listed markets are influenced by sentiment and investment flows. In private markets, very thorough due diligence can be conducted on companies and their management, a level of due diligence and access that is not possible in public markets.

Trutz Rendtorff: But if Private Equity houses can determine a company’s value so precisely, I don’t understand why some portfolio companies or LP stakes are now traded on the secondary markets at a 30 per cent discount to NAV? Apparently the buyers and the broader markets do not share the GPs’ valuations. An example from our portfolio, Amentum – effectively the successor to Blackwater – has fallen 40 per cent post‑IPO despite better figures. The market price beats the sponsor story. The secondaries with “IRR pickup” have also not delivered; the supposed discount at acquisition evaporated entirely. We are currently experiencing a valuation reality in which returns arise only from model assumptions, not market pricing.

Andrew Carnwath: We need to differentiate within secondaries. Many secondaries are traded at NAV, some at a premium, while others trade a discount. With very old vintages you often have to accept a significant discount because most of the growth has already occurred. This does not necessarily imply that these companies are overvalued; rather, that a buyer needs to purchase with a discount to achieve their required return as they do not expect significant further value growth prior to exit.

Jannick Hunecke: As part of a planned investment process, we naturally think intensively about valuation and also consider it in the context of capital market valuations. At the same time, we typically acquire controlling stakes and pursue a clear, consistent value‑creation plan. Especially in the lower and mid‑market, implementing a buy‑and‑build strategy is front and centre as a means of value creation. At exit, our companies regularly differ significantly from their starting position at entry. This strategic positioning creates sustainable added value and makes companies particularly attractive to strategics. Good PE managers can outperform the equity markets. This applies above all to the mid‑market segment, which is less efficient and where companies are often less optimised. With very large companies, the focus is more often on cost efficiency.

Christopher Bär: In the lower mid‑market – which we define as companies with EUR 5 to 25 million EBITDA – the question of market access also matters for LPs. Due to their size, very few companies in this segment are listed on the stock exchange. Access to their growth potential therefore comes through Private Equity. The fund managers we invest in often buy such companies directly from the founder. This entails certain risks, such as key‑man risk, i.e., strong dependence on one key individual. But it is precisely in such structural inefficiencies, which are more common in this market segment, that Private Equity can play to its strengths; for example, by complementing a founder with an experienced management team and by building systems for data‑driven performance management that were previously missing. This enables the company to operate more professionally and scale better. This does not usually mean that they are ready for an IPO. However, they are certainly interesting targets for strategic buyers and larger Private Equity houses.

How is LP demand for Private Equity developing at present? Are investors seeking primaries, secondaries or co‑investments?

Christopher Bär: Primaries still typically form the core building block in investors’ portfolios. Co‑investments and secondaries are added as complements. The latter have seen noticeable inflows recently. However, older portfolios acquired on the secondary market naturally face the same challenging exit conditions.

For decades, German institutional portfolios were probably the most conservative in Europe, but this year, allocations to alternative asset classes have doubled. Performance expectations have risen as institutions try to push their risk-return profiles higher up the curve, so institutional demand for private equity has seen a boost as a result. Demand from corporate pensions has particularly increased.

Do you attribute the increased demand for Private Equity to falling interest rates?

Christopher Dunn: It is both supply and demand. Certainly, the interest rate environment helps the attractiveness of private equity options, but many German pension institutions recognise that they need to diversify their portfolios more and are lagging in international comparison. They need more firepower in their portfolios and therefore look at private equity’s broader investment profile.

Andrew Carnwath: We are seeing a shift towards the lower mid-market not just in Germany but also in other countries. This segment has not been as in demand as it is now at any time in the past three decades. Many large LPs recognise that returns in the very large PE funds are potentially under pressure, meanwhile there is genuine outperformance in many smaller funds. The lower mid-market is therefore attractive for large investors, but they have an administrative problem as they need to deploy large amounts of money and to do so in smaller funds is administratively burdensome.

Christopher Bär: The lower mid‑market is compelling in the long term due to its outperformance versus other market segments. At the same time, returns are considerably more widely dispersed. Combined with generally less publicly available data in private markets, this increases the requirement for investor experience to navigate this segment successfully.

Jannick Hunecke: In the mid‑market, the succession question also arises repeatedly on the GP side. Some founders of mid‑market funds did not organise their succession early enough; as a result, there have been consolidations over the past two decades. Investors do not want to end up stranded in a small “zombie fund” within their PE portfolio, but rather want a manager who is sustainably and well organised for the long term as a partner.

Christopher Dunn: Right now, we see many large investors channelling their free capital into smaller segments, too. Similar to the trend we are seeing on the index side, private markets investors are often tempted to follow the leader and push their money in the direction of least resistance, but that herd mentality can come at a cost. Simply put, there is less commoditization happening in the smaller segments of the market.

Christopher Bär: In the large‑cap segment, debt traditionally plays a greater role than in the lower mid‑market. In a good market environment, where leverage is cheap and abundantly available, its return profile therefore approaches that of the lower segment. Once the macro tailwind fades, structural differences show. In the lower mid‑market, value creation comes less from debt leverage and more from operational and strategic development of companies, and the return potential is correspondingly stable across market cycles. In addition, there are further structural advantages such as lower entry multiples and more exit options. Investors are increasingly recognising this. Surveys clearly show that lower mid‑market buyouts are the most in‑demand segment within the Private Equity asset class.

Banks have become significantly more cautious in lending, and in some areas, lending is restrictive. The market is also characterised by debt funds providing a larger share of financing.

Trutz Rendtorff: I would contend that owner‑managed mid‑sized companies in traditional sectors in Germany still have sufficient access to financing and banks. It looks different in the US, where mid‑cap companies do indeed have to knock on the doors of private debt funds for financing.

Jannick Hunecke: I would like to disagree with Trutz Rendtorff. Financing for mid‑market companies in Germany has become more demanding in recent years, as traditional financiers are more restrictive. Our financings alone are 80 per cent provided by debt funds, no longer by banks. Back to succession. Even 20 years ago, Germany, with its owner‑managed mid‑market, was said to be a huge succession opportunity for PE. This forecast did not materialise for a long time, but times have changed. After Covid, plenty of new regulation and other challenges, some owners have re‑thought and now view financial investors as partners. A new generation is also taking the helm in many companies. Founders of tech companies, in particular, are more willing today to sell their company.

Andrew Carnwath: Many PE deals we see and like are not about de-risking or succession, but about accelerated growth with a partner. Typically a company grows well in a niche and management says: we need a partner to expand regionally, or to extend the product line, or to accelerate growth. They then take some money off the table, but maintain a significant stake in the business with a view to making substantial gains over the next four or five years in partnership with a private equity firm. For us it’s about aligning everyone towards the same end goal.

Trutz Rendtorff: I analysed many PE deals with Professor Kaplan at the University of Chicago. Almost always, the value driver was not operational excellence but the tax shield through debt pushdown. That was not a management miracle, but financial engineering. Over four decades of falling interest rates, leverage simply worked – every lever looked like skill.

Jannick Hunecke: In the early 2000s, financial engineering was the focus. The industry has evolved, however. Multiple expansion was at times an attractive driver, but today it is no longer a reliable key to value creation. On average, we pay higher entry multiples than before. At the same time, it cannot be assumed that multiples will systematically expand at exit. Value creation therefore requires a clear operational plan and its consistent execution. Given interest rate levels and moderate leverage, financing is no longer the central factor in value creation.

Christopher Bär: Multiple expansion still plays a role in the lower mid‑market. It is usually not formally planned, but should occur systemically. When fund managers buy mid‑sized companies, essential elements of a professional management set‑up and the structures needed for further growth are often still missing. In such cases, a valuation discount is quite justified. Through subsequent operational and strategic development, a company with a different foundation emerges. This also changes market perception, and the company becomes attractive to new buyer groups – for example from larger market segments. In that sense, multiple expansion should also be present at the end. In our portfolios, we see both EBITDA growth and multiple expansion following professional transformation as relevant value‑creation levers.

Over the past few challenging years, sector specialisation and operational value creation—not leverage—have been the real differentiators.

Trutz Rendtorff: If everything is so well valued and improved operationally, why the exit backlog? Why don’t professional investors buy instead of selling LP stakes at a discount? And why is retailisation being pushed? For me, that’s a warning signal.

Andrew Carnwath: Nobody says everything is rosy. If we measure private equity performance over the last two or three years against the listed markets or more specifically the “Magnificent Seven”, we have underperformed. But looked at long term, the statistics clearly demonstrate massive outperformance by private equity. I expect private equity to come back strongly. If you look at the difference in valuation multiples between listed and private markets the discount of private equity to listed markets is at an all-time high.

What returns can investors expect in primaries and secondaries?

Andrew Carnwath: We invest in the lower mid-market and target 25 per cent IRR, i.e. 25 per cent per annum, on individual deals. In our recent co-investment fund we made 22 investment. We have now realised half of these returning over 3x cost and 30% IRR. Strong returns and exits are still posible in these more difficult markets.

Christopher Bär: At the deal level in the lower mid‑market, we typically see target returns between 2.5x and 3x. The GPs in our fund‑of‑funds portfolios have achieved an average multiple of 3.6x across more than 120 exits to date. This shows: the market segment offers enormous potential. Fundamentally, the dispersion of these returns is broader than, for example, among large‑cap GPs. This makes selection and access to the best funds all the more important to capture the available alpha.

Jannick Hunecke: I fully agree. In our mid‑market strategy, we achieved a capital multiple of around 2.5x and an IRR of roughly 35 per cent over the long term, and we aim for that going forward. In the small‑cap strategy (ECF funds) we work towards tripling our invested capital.

Trutz Rendtorff: For foundations, DPI matters, not IRR. I cannot feed the children on IRR – I want the cash. Good funds have a DPI of 2.0 over twelve years, which corresponds to 6.3 per cent per annum geometric return (CAGR). That is far too little for an illiquid, high‑risk asset with an indeterminate term. The broad equity market generated double‑digit returns over the same period. In typical PE structures, 40 per cent of the commitment or more flows into fees over the term. If you want to keep up with liquid markets, you need 30 to 40 per cent IRR in PE. But such results are the absolute exception, not the rule.

Andrew Carnwath: No, we need to compare like with like. We manage a listed investment trust that has invested in the lower mid-market private equity since 1999, and has a portfolio of around 500 underlying private companies. The share price total return and NAV total return, are both are about 10 per cent per annum since inception. That is well above the return of equity markets over that period, for example it is over four times the return of the FTSE All Share over the same period.

And what role does Private Equity play in the portfolio, in the SAA of institutional investors?

Christopher Bär: The asset class is a central return driver and diversification building block in institutional portfolios. Moreover, Private Equity typically reduces portfolio volatility, as valuations are usually conducted quarterly and, unlike daily market moves in listed assets, are more strongly based on fundamentals.

Andrew Carnwath: In addition, private equity gives investors access to companies they cannot reach via the listed markets. These include agile tech and healthcare companies with new business models. Good companies are tending to stay private for longer: the only way to access them is via private equity.

Christopher Bär: The trend does not favour the listed market either. In the US, there were around 7,000 listed companies in 2000. Their number has fallen to roughly 4,000 by 2024. This shows that more and more value creation is taking place outside the stock market. Diversification is decreasing in public markets and increasing in private markets.

Trutz Rendtorff: When professional investors such as Harvard, Yale or pension funds sell en masse at a discount, the democratisation of PE is nothing but a sales pitch. Now retail investors are supposed to buy what institutions no longer want. For foundations this is poison. Capital calls typically come in weak markets, while distributions stall at the same time. That is a clear asset‑liability mismatch. We finance multi‑year education programmes and know fairly precisely that we will need around 5 per cent per annum in returns over the next three to five years. But PE does not deliver predictable cash flows. Private Equity, Private Debt and co. depend on the same exit windows. If one is clogged, all stall. Without internal specialist knowledge and without ticket sizes that enforce favourable terms, Private Equity below around EUR 1 billion AuM quickly becomes an administrative fee nightmare without adequate compensation for the considerable risk.

Christopher Dunn: From the perspective of an institutional portfolio, passive investments in liquid asset classes are the polar opposite of private markets, but I believe the focus on passive also increases the focus on private because the entire middle thins out. Thus, an investor can get their beta, their baseline, and cover all the fundamentals. This gives them a completely different perspective on how they can and want to invest in private markets. The investor, of course, has a performance expectation and a diversification expectation, but the colossus of passively managed capital currently flooding the market changes their private-side calculus.

Andrew Carnwath: I completely agree. We recently saw again that bonds and equities moved in the same direction rather than being negatively correlated. Therefore investors are rethinking portfolio construction and increasingly turning to private equity to generate alpha.

Christopher Dunn: That is, in fact, the strongest trend we have observed in the past 15 years. Either asset management firms chase scale and try to compete with the BlackRocks of the world, or they specialise in a niche and focus on alpha and outperformance. Over time, the middle of managers has thinned out, and many traditional asset managers who focus solely on listed markets have started to disappear.

Jannick Hunecke: I expect such a development for large‑cap funds, into which large GPs, sovereign wealth funds and other institutions continuously allocate large amounts of capital. In this market segment, some very large GPs can thus form a kind of “standard” segment within Private Equity through the continuous provision of extensive capital allocations; returns tend to be somewhat lower there, but remain sufficiently attractive for large institutions. At the same time, the democratisation of Private Equity in this area is progressing to tap further capital. This segment differs markedly from the small‑ and mid‑cap area, where alpha can still be generated with focused strategies.

What about sustainability and impact in Private Equity?

Andrew Carnwath: Private equity is an ideal asset class for impact investing, offering access to pure-play, innovative and entrepreneurial companies driving real-world change. We have just had a first close on an impact co-investment fund to target this opportunity. It is investing in companies whose products or services are addressing key environmental and social issues aligned with the UN Sustainable Development Goals. Impact companies are particularly attractive because, in our view, they offer the best risk-adjusted returns. This is because they address fundamental needs, not wants. There is therefore non-cyclical demand for their products and services. Additionally they are often able to attract and retain the best talent – a key bottleneck of growth. As a result many are invested in by regional and sector specialists rather than impact players. Our fund will co-invest with these regional and sector specialists and to provide access to these impactful companies. With the help of our market leading Responsible Investment team we will then help the companies measure and articulte their positive impact, which we beleive will further accelerate earnings growth and add value at exit.

Christopher Dunn: Private equity is by nature the perfect vehicle for impact and sustainability goals. Institutional investors often have to achieve certain impact or sustainability goals to meet the demands from internal stakeholders or external regulators, but they also want to find higher-yielding investment opportunities. When these things come together, many investors in Europe see private equity as a win–win situation–it ticks the boxes on the pure investment side, but also for achieving wider goals.

Christopher Bär: However, a GP does not have to be an impact investor to achieve impact. Classic Private Equity can also generate a positive effect. What matters is that fund managers actively integrate ESG factors into their ownership agenda.

Andrew Carnwath: Some investors are willing to give up a bit of return for impact, but that is not necessary and is not the area in which we invest. Our new fund, Castle Mount Impact Partners LP, is targeting a net 20 per cent IRR for our investors: market-leading returns with a real, verifiable positive impact on the world. We are confident of achieving this as looking at our track records, the impactful companies have significantly outperformed, with realised returns of >3x cost and 30 per cent.

Christopher Bär: We now launch Article 8 funds, but have indeed consistently integrated ESG criteria into our investment process since 2014, as we are convinced that sustainable action and returns are generally not in conflict. Primarily, however, investors view our products as a return component in the portfolio.

Jannick Hunecke: Performance comes first, and sustainability is an integral part of our investment philosophy. Already in due diligence we review ESG aspects, identify potential risks and derive measures that we integrate into the value‑creation plan. The aim is to position companies in a modern and sustainably sound way for the long term; that also supports the exit.

Is transforming a brown company an investment objective for PE firms?

Jannick Hunecke: We would not buy a “brown” company to make it “green”. In process industries, the necessary transformation is often a major technological challenge with high investment needs; that typically cannot be implemented as a PE case.

Trutz Rendtorff: Impact only arises where capital is scarce, for example in brown companies that want to become greener. For us, ESG is primarily a risk instrument, i.e., whether the company is exposed to particular risks or has opportunities. We account for it via the discount factor. The less the challenges of the future are addressed, the higher the risk premium.

Jannick Hunecke: It would also be difficult to sell at an appropriate valuation after such a transformation. That is why we focus on cases where operational value creation, scaling and strategic positioning under PE ownership are realistic and efficient to implement.