Financial engineering as a key value creation level in private equity is steadily giving way to operational improvements and EBITDA growth.¹

“But only a few managers who excel in this area are pulling further ahead, while others struggle to adapt,” says Lawrence Terracciano, Moonfare’s Investment Manager.

In a recent conversation, Lawrence explains what he believes sets these alpha-generating firms apart from the rest, how to identify them and why many are emerging in the mid-market space.

It’s well known that return dispersion in private equity is much wider than in public equities.² Is this gap between the best and worst PE managers widening or narrowing?

The performance gap is widening. The end of the low interest rate era has fundamentally changed the return profile of the asset class.³ In the past, some sponsors were able to rely heavily on financial engineering, such as leverage and multiple expansion, to drive returns.⁴ But in today’s higher-rate environment, those levers are less effective.

As a result, we believe value creation is increasingly dependent on operational improvements at the portfolio company level which requires real expertise, industry insight and active management. These capabilities are also more difficult to execute and harder to replicate, meaning that the few managers who excel in this area are pulling further ahead, while others struggle to adapt.

This dynamic will help differentiate the best firms from the mediocre ones, since top-firms will not rely heavily on financial engineering,⁵ which may result in their returns standing out more than they did in the past.

Improving companies and growing top lines or increasing profitability is easier said than done. What strategies do operators use to try to optimise businesses they invest in?

The most important differentiator is a combination of a clearly defined strategy and strong team expertise. Top-quartile funds tend to take a sophisticated approach to portfolio construction, from sourcing through to value creation, which enables them to acquire assets at more attractive EBITDA multiples compared to the market average while unlocking greater value through deep operational know-how. This advantage often stems from a well-developed network, providing access to off-market opportunities and the ability to mobilize the right resources to help portfolio companies succeed.

We are also seeing that leading managers are narrowing their focus on three or four core sectors,⁶ ⁷ where they can build proprietary insights and drive market-beating performance through specialization.

How do firms develop capability to be able to drive these operational improvements?

Many firms have built large teams internally or have networks of partners who are purely focused on improving the performance of portfolio assets and driving long-term value creation. These are often individuals who are experts in specific areas such as pricing, go-to market strategies or cost optimisation. Many are former CEOs that have run businesses in the same space and may now effectively operate as a bridge between the PE sponsor and the management team at the portfolio company.

Some specialist firms we work with even have most partners coming from business backgrounds, so they bring more than just private equity expertise.

How do you quantify this operational know-how?

The essential indicator is the value bridge which explains how a company's value changes from entry to exit. This value can come from different levers, such as multiple expansion, deleveraging, revenue growth and EBITDA margin expansion. The first two point to a financial engineering play, while the second two indicate that the sponsor has made business more efficient and successful.

What about measuring performance more generally? What key metric do investors typically use to identify managers who are able to generate alpha?

Many investors typically assess outperforming managers by looking at a combination of key performance metrics, including TVPI (Total Value to Paid-In), IRR (Internal Rate of Return) and DPI (Distributions to Paid-In) — the latter is something we’re particularly focused today given how difficult and critical it is for fund managers to generate liquidity.

These metrics provide insights into value creation, capital efficiency and cash return profiles. They are then benchmarked against market peers to identify outperformers. However, no single metric tells the full story. A collective view across multiple fund vintages is essential to evaluate a manager’s consistency and ability to generate returns through different market cycles.

Alpha returns are generated by the top quartile funds, which outperform public benchmarks,⁸ while funds in the bottom quartiles typically don’t produce any premium above beta performance and can significantly underperform compared to listed equities.

As you’ve pointed out, private equity seems to be moving towards increasing specialisation. What future do generalists have in this world?

There’s consolidation going on at the top end of the spectrum. I think we will likely end up with a handful of mega buyout funds that investors will see as one-stop shops, allowing them to invest across geographies and strategies, anything from infrastructure to credit.

In my view, being able to invest in these mega-funds is important and it will become increasingly critical to be able to access mid and lower mid-market opportunities where potential for alpha may be even greater. One segment may complement the other in terms of risk return profiles.

Lately, PE mid-market seems to have emerged as an attractive space to invest.⁹ ¹⁰ In the context of alpha generation, what’s the appeal of this strategy?

There's only so many companies that you can buy at the large-cap level, which translates into more competition and higher prices. On the other hand, in the mid market and especially lower mid market, there's a greater pool of opportunities, with less competition.¹¹

It's also easier to turn a $10 million EBITDA company into a $30 million EBITDA company than it is to grow from $500 million to $1.5 billion. At the larger end of the spectrum, businesses may start to approach the natural limits of specific markets or geographies that they operate in, and will usually already have a highly professional and experienced management team at the helm.

On the other hand, smaller companies can be family owned and have significant low-hanging operational improvements and growth opportunities for an experienced management team and sponsor to execute on.

Is there also scope for alpha in secondaries?

In secondaries, the alpha in the LP-led space comes from the discount,¹² particularly at the lower end of the market while the top end is again quite competitive.¹³ Another point of differentiation is access to GP and the ability to evaluate LP-stakes. But the benefits of secondaries go beyond discounts; investors may benefit from J-curve mitigation and diversification.¹⁴

In the GP-led side of the market where managers choose to hold to a single asset or a handful of assets for longer, investors may expect a higher potential for alpha given these are usually trophy assets with significant remaining upside potential.¹⁵

Let’s circle back to where we started. With the widening gap between top and bottom performers, manager selection feels more critical than ever. How are you approaching this at Moonfare?

At Moonfare, we have built our entire investment framework around rigorous manager selection. We apply a highly institutional due diligence process that evaluates GPs across multiple dimensions: not just historical performance metrics like IRR, TVPI, and DPI, but also consistency across vintages, team stability, sector focus and demonstrated ability to create value beyond financial engineering.

Ultimately, our goal is to curate access to top-tier managers — often those that are oversubscribed or difficult to access — and to offer our investors the ability to build a diversified portfolio across cycles, geographies and strategies, with confidence in the quality of each underlying manager.

The opinions expressed by individuals are solely their own and do not reflect the views of any affiliated organizations. Liquidity is not guaranteed in private equity.