Leverage's Retreat: Operational Value Creation Takes Over

The traditional drivers of private equity returns (low purchase prices, multiple expansion, and cheap leverage) are largely spent.

McKinsey/StepStone analysis showed that leverage and multiple expansion together accounted for 59% of buyout investment returns for deals done between 2010 and 2022, with the remaining 41% coming from revenue growth and EBITDA margin expansion.

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KKR's analysis of value creation in global buyout investments tells a similar story. The analysis shows that leverage's contribution to buyout returns has fallen from 61% in deals done before 2000 to just 39% in deals done since 2008, while operational improvement (revenue growth and margin expansion) has remained a persistently strong driver of returns throughout.

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PE firms are not alone in focusing on operations. We've seen productivity gains at the aggregate level in the public market as well.

S&P 500 companies' inflation-adjusted revenue per worker, a proxy for operational efficiency, is up roughly 8% since late 2022, following two decades of essentially zero growth, as automation and AI tools begin to take hold. Small-cap companies, which typically lack the same access to capital and technology, are seeing no such gain.

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That shift is translating into a capability build-out for GPs. GPs have more than doubled the size of their operating teams on average since 2021, independent of fund size, and increased specialization along with it.

GPs are also leaning more on external consultants: engagements with portfolio companies have climbed, most sharply in IT and technology infrastructure, procurement and supply chain, and digital and AI.

The build-out is paying off in fundraising terms too: 53% of LPs now rank a GP's value creation strategy among their top-five manager-selection criteria. It's now the third most important factor behind performance and team quality, which makes operational capability a genuine differentiator, not just a return driver.

Still, market conditions matter. When asked what would most drive fund performance over the next 12 months, market participants cite an improved exit environment far more often than manager-driven operational improvement, a reminder that operational skill is necessary, but many are still counting on the market cycle to help too.

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