Private Equity’s “Return to Roots” Means the Party’s Over, According to Lee McCabe

In a recent LinkedIn post, Lee McCabe offers a candid assessment of the current state of private equity, suggesting that the industry’s purported “return to its roots” is a euphemism for a market correction after a period of easy money.

McCabe asserts that the era of relying on cheap debt and multiple expansion for returns is over, exposing firms that lacked genuine operational talent. He highlights a significant shift, stating:

“Private equity “returning to its roots” is a polite way of saying the party ended and someone finally turned the lights on.”

McCabe’s analysis delves into several key areas where he believes the industry is facing structural challenges.

Public Markets Are Becoming More Erratic

Contrary to notions of a market becoming “healthier,” McCabe points out that public markets are exhibiting increasingly unusual characteristics. He notes the significant shrinkage in the number of publicly listed companies in the US and the disproportionate concentration of market capitalization within a few large names in the S&P 500. This trend, he argues, is heavily influenced by passive investing flows, which have overshadowed active management.

As McCabe explains:

“Price discovery is increasingly a side quest because passive flows have dominated, with roughly +$4.0T into passive vs about ($2.9T) out of active since 2012.”

The Liquidity Conundrum is Structural

Further dissecting the challenges, McCabe addresses the persistent liquidity problem in the private equity sector. He asserts that the imbalance between capital calls and distributions, which has seen capital calls exceed distributions by approximately $1.5 trillion since 2018, is not a temporary market fluctuation but a fundamental issue. This situation, according to McCabe, reveals that metrics like “DPI (Distributions to Paid-In Capital)” are not easily manipulated and that fund lives are being extended, impacting internal rates of return (IRRs).

McCabe elaborates on this point, noting:

“The liquidity problem is structural… That’s not “temporary market conditions.” That’s the industry discovering that DPI is not a PowerPoint metric you can manifest.”

Past Value Creation Was Largely Market-Driven

A central theme in McCabe’s post is the assertion that much of the value creation witnessed in private equity from 2010 to 2021 was not solely attributable to the skills of general partners (GPs). He posits that approximately 66% of value creation during that period stemmed from leverage and multiple expansion—factors largely outside of the GP’s direct control. With the current market environment, he observes a significant dispersion between top and bottom-performing funds, indicating a greater need for genuine operational expertise.

The Shift Towards Genuine Operational Capability

In light of these market shifts, McCabe outlines what he believes must change for private equity firms to succeed moving forward. He emphasizes three critical areas:

1. Buying Well is Essential: McCabe suggests that the traditional approach of “buy low, sell high” is regaining prominence. Firms that acquire assets at lower multiples are demonstrating superior exit performance, a concept he frames as revolutionary in its simplicity.
2. Operating Teams Must Be Effective: He argues that operational capabilities can no longer be a mere facade. With expensive leverage and slower exit markets, robust “value creation plans” and “speed of execution” are crucial for generating alpha.
3. Exits Require Strategic Capability: McCabe stresses that successful exits must be planned from the outset, with multiple exit paths considered. The ability to return capital earlier and reduce reliance on multiple expansion is key to navigating slower markets.

McCabe concludes that the period from 2026 onwards will favor firms that possess true operational acumen. He anticipates that the superficial approach to operational improvements, often characterized by hiring consultants and rebranding existing processes, will become increasingly untenable.