With tempered U.S. GDP growth expectations and 40-45% minimum equity contributions (as a percentage of total deal sources), it is difficult to expect annual returns much above 20% at any reasonable purchase price for investments in even the most efficient free cash flow generative GDP+ growth companies unless a private equity sponsor can drive incremental value through accretive acquisitions, expansion into adjacencies and/or new products, or superior cost cutting. This differs substantively from the 1990s and most of the 2000s when we had a more robust GDP growth outlook and minimum equity contribution percentages of 20-40%. Therefore in the current environment when a sponsor purchases a GDP+ growth business, the sponsor will not only need to be able to create value, he will also likely have to pay the seller for some significant portion of this value creation.
If today's financing terms make for challenging investing in a slow growth environment, then investing in companies with above average growth prospects could be an attractive alternative. Based upon the high prices currently being paid for growth companies, this realization has not escaped the attention of other sponsors. To make an attractive return on these high priced investments, sponsors will need to leverage intense vertical-specific knowledge to facilitate the selection of subsectors and companies that will generate truly differentiated growth.
Which of these two strategies works best will likely depend on the particular strengths of the sponsor, but in either case, sponsors will need to nurture and capitalize on their competitive advantages in order to generate consistent and attractive returns for their investors.