As more investors look beyond the traditional 60/40 stock/bond portfolio and toward private markets for investment opportunities, a key question arises: How do alternative investment managers create value? It is clear from historical returns that they do; according to Cambridge Associates, private equity had outperformed major public indices by at least 300 basis points (3%) over 10; 15- and 20-year periods on a net basis as of December 31, 2015. But the ways private equity and venture capital funds add value to their portfolio companies differ significantly, reflecting the differing stages of the corporate life cycle at which they invest.
Private Equity
As shown in Figure 1, private equity creates value in three key ways: First, it optimizes the capital structure with leverage or debt restructuring, also known as “financial engineering.” Second, it makes operational improvements in a company, both with growth initiatives and cost cutting. And third, it offers a “multiple expansion,” allowing a company to be sold at a higher revenue or EBITDA multiple than the one at which it was acquired.