Baillie Gifford's Kelly: buyout needs 12% earnings growth

Buyout sponsors need 12% earnings growth at portfolio companies to meet return targets, up from 5% a decade ago, according to studies Brian Kelly cites in a HedgeNordic outlook on private companies.

The three tailwinds behind two decades of buyout returns now risk slowing or reversing, Kelly writes: economic growth, rising deal values as a multiple of earnings and cheaper financing. Forty years ago sponsors risked just 10% or 20% of equity in an acquisition, and a few points of margin expansion could multiply returns two to three times after leverage. As buyout grew more competitive, sponsors paid higher prices and internal rates of return fell; in many cases, Kelly writes, the winning bidder is now the one willing to accept the lowest return.

For allocators, the change is in what a manager's model has to prove: cutting costs and raising prices is no longer enough to generate target returns, so the 12% has to come from earnings a company can actually compound. That shifts the comparison between buyout funds from what leverage and margin expansion can add to whether the underlying businesses can grow that fast. Kelly still expects buyout to hold an anchor position in portfolios at a lower return, which changes what the sleeve is for in a selector's line-up: risk profile first, outperformance second.

The need for stronger earnings growth has pushed the asset class further into technology and software, areas Kelly says now face fresh disruption from large language models.

On venture, Kelly writes that the asset class was a cottage industry historically, raising $3 billion to $5 billion a year in aggregate through the 1980s and 1990s. From his family office days, he says, small venture capital fund investments increased family wealth by about 10%.

His conclusion is about expectations rather than exits. "In future, buyout's risk profile will secure its place as an anchor allocation in portfolios, but investors should expect less from it," he writes.