Private market firms struggle to balance growth and operational spend

From 2008 to 2022, private funds enjoyed turbocharged growth when their assets under management (AUM) soared five-fold to reach $13 trillion. The AUM metric came to rival returns as the golden benchmark of success and drove a surge in compensation for general partners and their teams. Money rolled into private markets, and with channels to private wealth management opening up for smaller investors, the future looked even more prosperous. 

The mantra for many became “growth at all costs.” Firms added headcount and raised salaries, anticipating continued increases in management fees. Then came 2022 and 2023. The tide turned as interest rates and inflation quadrupled. Fundraising slowed, leaving many funds unable to sustain the management fees that expansion requires.

The current state of private markets

High-interest rates and inflation have dampened the outlook for private funds, and are likely to squeeze their returns beyond 2024. They’ll have limited room to compensate with financial engineering, such as leveraging in the portfolio. All companies face higher costs for both new and existing borrowing. Moreover, the impact on their asset values may not yet be fully recognized by portfolio companies and private equity funds.

This has pushed funds to reevaluate their earnings strategy. After a hard outlook at their profitability models, many have turned to cost-cutting measures. It’s widely reported that VC and private funds pulled back from adding headcount for 2024. Some imposed layoffs affecting 5 to 15% of their workforce. Others are hiring and firing simultaneously to realign internal teams to service their changing clientele. 

Additionally, “early adopter” retail investors, such as high net worth individuals (HNWIs), have gravitated towards larger fund families. That has put more pressure on smaller firms to boost their returns and attract those newcomers.

How to boost profitability in a challenging environment

As 2024 begins, the funds and their portfolio companies are focused on increasing their EBITDA. That’s easier said than done. Macro factors will probably weigh down returns until they are no higher than what more liquid investments like stocks offer. 

If private funds cannot differentiate from their competitors based on better returns, attracting investors will prove more difficult. To improve, many funds will need to follow the advice they often dole out to portfolio companies, including:

1. Operational Efficiency: Accomplish more without expanding headcount. This includes cost-cutting measures across the board and optimizing capital structures.

2. Diversification and Growth: Diversify target markets and product mix while keeping a focus on growth efforts, especially given the potential for retail investor interest.

3. Technology Integration: Leverage purpose-built technology to streamline operations. Automation, especially in workflow and process management, can significantly reduce costs by removing the need to hire additional staff.

4. Headcount management. Cut staff only where it does not interfere with growth. 

Keep up the effort to grow, and tool up accordingly

Strategically, smaller funds should continue pursuing growth, so they don’t miss out on the most compelling shift to hit private markets yet: retail investors. It’s true that funds do spend more per “new million dollars” to attract and service smaller investors. That does not mean growth has to conflict with cost controls. In fact, growth and cost efficiency are both essential this year.

Some funds that target personnel in various operational departments for layoffs could see unwanted results. For example, the investor relations (IR) team—once an afterthought at private equity firms—is essential today. IR is indispensable for engaging with larger numbers of smaller investors. 

So how can funds keep pushing growth without adding to operations staff? The best solution is to deploy workflow and process automation—which come at a far lower cost than hiring people.

Preserve client and investor relations in the face of budget cuts

Private equity has long been a high-margin business. GPs traditionally think of profitability as their management fees—directly driven by AUM—minus operating costs. At first glance, current conditions appear to call for cutting those costs. But to do so while a fund expands its client base will strain capacity and potentially compromise the investor experience. Client-facing and investor relations teams are pivotal to: 

• maintain relationships, given the surge of retail investors

• meet client demand for more transparency from GPs

• guide LPs through longer fundraising timeframes

• fulfill regulatory requirements for increased reporting

Top-line performance no longer sells itself. Transparency of portfolios and liquidity constraints, along with accessible IR and customer service, can also sway which funds investors choose. These characteristics allow funds to differentiate their brand for building momentum and relationships with a growing number of smaller investors.

Some firms, seeing the need for layoffs while staffing up IR, even asked senior partners to resign in 2023. This willingness to reduce the size of the deal team is a departure from traditional practices. It reflects the growing recognition that firms need to retain the professionals who attract and directly support investors—they sustain the fundraising that, in turn, sustains management fees.

Use purpose-built technology

Private funds often struggle to run their operations with vertical-agnostic apps—systems not built with private equity teams and investors in mind. Even modernized systems designed specifically for private equity usually won’t automatically bring about lower headcount. But, they can greatly reduce the need for additional hiring. 

While investor relations grew in importance, the IR technology stack evolved accordingly with automation for back-office operations as well. The help comes at the right time. According to Bloomberg Tax analysis, there’s a shortage of accountants and auditors, whose ranks have shrunk 17% since 2019. The takeaway here is that technology specifically designed for private markets will be most effective in maximizing their team’s productivity.

Manage the people-technology balance to grow profitably

No private equity firm wants to be left behind while its peers grow. That’s a major reason not to let cost controls detract from the blossoming of a better investor experience they have worked to create. 

Private funds’ path to higher profitability with growth does not center on improving their internal cash and debt management. Instead, gains will come from operational efficiencies achieved by digital transformation that streamlines back-office, customer service, and support functions. 

Adroit headcount management will remain key. Several funds have found the right balance of holding staffing steady in a few key areas while expanding IR and customer service teams to support growth in retail investors.

Funds that automate their due diligence and onboarding processes enable IR professionals to focus on what they are best at. This supports multiple goals: greater profitability and efficiency, and faster growth with a better investor experience. When interest rates come down, and funding flows in more easily, the smaller and mid-sized firms that have boosted capability and efficiency will be poised to take full advantage of the retail boom.