Private Equity Firms and Evolution

As I was writing a section on evolution and adaptation as a feature of complex systems for my upcoming book, I couldn’t help but draw parallels with the current situation faced by private equity firms. In fact, according to recent Financial Time articles, the industry is going through some tough times. Firstly, the high interest rate has made leveraging buyouts for increased return more arduous than what than the industry has experienced in the past 13 years. This had led to stockpiling cash, known as dry powder reaching a whopping $2.59 trillion as general partners await better deals. Secondly, investors have been waiting for cash to be returned through exits, but deals have been ageing and 2023 didn’t help. Some initiatives have been pursued here and there to financially engineer higher returns whether through debt-like equity or selling portfolio companies to themselves through continuation funds, but this seems to be isolated in occurrence.

The private equity industry has been going under major stress due to environmental forces, inflation, high interest rate, supply chain disruption and so on. This compels firms to adopt novel approaches – a classic case of evolution through adaptation. But what the science really says about this phenomenon and what predictions if any can be drawn? I know, we are at the beginning of 2024 and the prediction game is full-fledged among the so-called experts and pundit. So, let’s examine what insights evolution can provide.

Well, evolution occurs when random mutations produce a diverse array of specimens subjected to natural selection in response to a changing environment. This selection is based on fitness, leading to a great diversity that becomes the foundation for the innovation necessary to address new challenges. In the world of biology random DNA mutations are responsible for a wide variety of phenotypic characteristics. Specimens displaying those characteristics find the best solution to the new problem and get to dominate the species and others, despite their fanciness just fade away.  

Also, as it turns out, evolution does not guide a species towards peak performance through natural selection in a linear fashion. Things are more complex than that, and this is where the creativity of problem solving happens. The evolutionary terrain resembles more a landscape with its various peaks and valleys where peaks can be seen as better solutions to the problem. There are however many peaks with different heights. A specie might be at certain evolutionary peak, but it might be a poor solution to the problem in comparison with even higher peak. So, through genetic drift, combination and recombination, the same species can wander off the peak toward a better evolutionary path and better solution which mean going sometime through tough times (valleys).

What this has to do with the current situation of private equity firms. A lot actually. If there is any prediction that can be made for the future is the fact that an increasing diversity of the way private equity firms will be seen, evident in initiatives like financial engineering. More innovation will emerge, new ways of setting up funds, new value creation techniques, new deal structures, new governance and beyond. This is just the beginning of the landscape explorations. New ideas, new people doing new things and the solutions will emerge. So, my message to private equity firms is explore further, bring in people with different background, test, combine and recombine even outside traditional private equity boundaries and find your balance between exploration and exploitation. This is the only you can outperform. Sticking to the status quo and incremental steps may only lead to reaching a high peak of poor solutions at best.

At mentioned by the evolutionary biologist Andrea Wagner, “Today we know that the robotic hill climbing of natural selection is a poor strategy for solving hard problems. Conquering a complex landscape needs autonomous explorers, be they organisms with DNA mutations or human trailblazers, who take off in different directions to create diverse solutions…. It needs mechanisms….that can descend a landscape’s many valleys and create poor solutions that become stepping-stones for better ones.”