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A Private Equity Deep Dive: Why Not All Value Creation Is Equal
When assessing how a diversified multi-asset portfolio is positioned today, private equity exposure is often measured through the level of unrealized value in a fund (or single investment). In many cases, this unrealized component represents a meaningful share of the total value and is reflected in the total value to paid in capital (TVPI) multiple.
2.5x. 3.0x. 4.0x.
When a fund’s performance is driven largely by unrealized value, measured through the residual value to paid in capital (RVPI) multiple, these headline multiples can shift from being meaningful portfolio appreciation drivers to potential sources of risk.
This risk is no longer marginal as the industry is currently sitting on a record $3.6 trillion of unrealized value across roughly 29,000 unsold portfolio companies, increasing the sensitivity of reported returns to valuation assumptions and exit conditions. A full decade after launch, 77% of capital in 2014-vintage buyout funds remained unrealized, highlighting this risk of unrealized value.
Elevated unrealized returns can introduce concentration risk, particularly when a position carries material weight in the portfolio or when other investment decisions implicitly depend on that value ultimately being realized.
This has pushed us at Blue Ocean Capital Advisors to focus less on how much value was created and more on how that value was created and how durable it actually is, which in turn has led us to work on a return attribution and risk framework that systematically challenges the sources of value creation, starting from the portfolio company level and building our way up to the fund level.
The Simplified Framework We All Use
My old boss only had to say this once and it stuck with me because of how simple it was: “There are only three ways you can create value in private equity.”
Nearly every investment memo, IC discussion, and portfolio company update ultimately comes back to the same three levers:
- EBITDA growth
- Debt paydown
- Multiple expansion
At a high level, this framework is intentionally simple, yet highly explanatory. Where analysis often stops too early is in treating these levers as interchangeable. In reality, each carries very different risk characteristics, particularly when value remains unrealized.
If investors want to monitor private equity risk more effectively, they need to look beyond performance outcomes and start monitoring the quality of value creation itself.
A Risk Weighted View of Value Creation
Over time, I have come to think about value creation through a quality and risk matrix, rather than a checklist.
If I were to rank these levers by durability and reliability:
- EBITDA growth represents the highest quality form of value creation. It is observable on a quarterly basis and can be dissected in ways that allow investors to assess sustainability rather than momentum. Growth can be organic or inorganic, recurring or one off, margin driven or volume driven. Pricing power can be structural or cyclical. These distinctions matter because they help separate durable operating improvement from temporary tailwinds. When EBITDA growth is operationally driven and repeatable, it tends to survive market cycles.
- Debt paydown comes next. Reducing leverage improves equity value by lowering financial risk, but the quality of this value creation depends on how it is achieved. Gross debt is often more informative than net debt, which can be flattered by transient cash balances. Investors should ask whether debt is being paid down through sustainable free cash flow or through asset sales and balance sheet optimization. They should also assess whether leverage is structurally lower or simply appears so under current conditions. Debt paydown is real value creation, but it is not risk free.
- Multiple expansion is the most fragile and highest risk contributor. It is highly sensitive to valuation cycles, public comparables, and broader shifts in sentiment. While it can materially enhance returns, it is the least controllable lever from the manager’s perspective and the most likely to reverse. This does not make it inherently bad, but it does make it riskier, especially when it accounts for a large share of unrealized value.
This risk-weighted perspective is increasingly important in today’s environment, where the relative contribution of each value creation lever shifts as the macro and financing landscape evolves. Several recent trends that are important to highlight:
- EBITDA growth is more frequently being manufactured through acquisitions, with nearly 76% of U.S. buyout deal volume now coming from add-on transactions, up from roughly 30% in 2018, requiring investors to separate repeatable improvement from roll-up optics.
- Debt paydown, while beneficial, no longer carries the same return-enhancing power it once did (70% of return pre-2000s) given the reduced role of leverage in post-GFC value creation.
- For over a decade prior to 2022, private equity exits benefited from consistent multiple expansion, with exit multiples exceeding holding multiples by 0.1x to 1.1x. Since 2022, that dynamic has flipped. Through Q3 2024, exited assets have traded at median discounts of 0.5x to 1.1x versus the multiples of companies still held on fund balance sheets.
What the Headline Returns Don’t Tell You
Not all value creation is equal.
A company can grow EBITDA and pay down debt and still deliver muted equity returns if the entry multiple was too aggressive or if exit multiples compress due to structural industry changes. A lot can happen in an industry over the course of 5 to 7 years, the typical hold period.
High quality operational progress can be real and still be overwhelmed by valuation risk.
This is why headline returns and benchmark rankings are insufficient on their own. Matching or beating a benchmark does not tell you whether the value supporting that performance is resilient.
Why Private Equity Risk Monitoring Needs to Evolve
If investors want to measure unrealized value reliably, they need to improve their risk monitoring on the value creation side.
This requires more than periodic performance reviews or benchmark comparisons. It requires a systematic way to challenge the assumptions embedded in reported valuations across all managers.
How much of the value is driven by operational improvement versus market re-rating? How sensitive is reported equity value to changes in multiples, margins, or exit timing? How consistent is value creation across cycles?
A private equity risk monitoring tool that focuses on the quality of value creation, rather than just outcomes, is becoming increasingly necessary. Without it, investors are left reacting to performance rather than proactively understanding the risks embedded in unrealized returns.
The Takeaway
Private equity returns have long benefited from a period where multiple expansion could rival operating growth as a driver of performance. Over the past decade, 47% of buyout returns were driven from multiple expansion, supported by an environment of cheap leverage and favorable valuation tailwinds, according to Bain & Company.
Going forward, value creation should not be taken at face value. If investors want to assess unrealized returns and understand impact on overall portfolio with confidence, they need to move beyond headline multiples and begin actively stress testing the quality of value creation.
In practice, that means asking the PE fund manager for more granular information:
- How were returns actually generated across funds? Request return attribution that separates EBITDA growth, debt paydown, and multiple expansion, and assess how consistent those drivers have been across vintages. Heavy reliance on multiple expansion, especially when value remains unrealized, deserves closer scrutiny.
- What is the quality of EBITDA growth? Understand how much growth was organic versus inorganic, how repeatable the drivers are, and whether margin expansion came from operational improvement, pricing power, or temporary actions.
- How is leverage managed through the cycle? Evaluate whether debt reduction is driven by recurring free cash flow or balance sheet actions, and how leverage has behaved in prior periods of earnings stress.
- How does unrealized value evolve over time? Some managers show how unrealized multiples change throughout the holding period and only crystallize at exit. This transparency helps distinguish real value creation from assumed valuation.
- How sensitive are valuations to downside scenarios? Assess what happens to reported value if exit multiples compress or timelines extend, and how exposed unrealized returns are to changes in market conditions.
In private equity, unrealized returns are only as good as the assumptions that support them. Investors who want to rely on those numbers need to monitor how value is being created, how it is being marked, and how it behaves under stress, not just whether it clears a benchmark.
References
[1] CAIS Group. “How Do Private Equity Firms Create Value?” https://www.caisgroup.com/articles/evolving-drivers-of-private-equity-value-creation
[2] Dealroom. “Private Equity Statistics 2026.” https://dealroom.net/blog/private-equity-statistics
[3] Bain & Company. Referenced in “Add-On Acquisition Strategy For Private Equity Growth.” https://privateequitybro.com/add-on-acquisition-strategy-for-private-equity-growth/
[4] BDO. “PE Add-Ons Drive M&A Transactions.” https://www.bdo.com/insights/industries/private-equity/pe-add-ons-drive-m-a-transactions
[5] MSCI. “Troubling Signals for Private-Equity Exits.” https://www.msci.com/research-and-insights/blog-post/troubling-signals-for-private-equity-exits
[6] Bain & Company. Referenced in “Private Equity’s Record Holdings.” https://e78partners.com/blog/private-equitys-record-holdings-navigating-the-next-era-of-value-creation/
[7] CEPR. “Private Equity Struggles as Investors Pull Back.” https://cepr.net/publications/private-equity-in-the-doldrums-and-out-of-favor/
