Private equity has matured into a mainstream – if not cornerstone – allocation for institutional investors. Following years of record fundraising and valuation expansion, the asset class now faces a more challenging backdrop – marked by higher interest rates, muted exit activity, and heightened scrutiny around transparency, ESG practices, and fees. Yet amid these headwinds, new opportunities are emerging through secondaries, continuation vehicles, and co-investments, while operational value creation has become a key driver of returns, according to Linsay McPhater of Industriens Pension.

Market Dynamics and Shifting Return Drivers

“The private equity industry has grown substantially, attracting larger pools of capital from institutional investors seeking higher returns, which in turn has led to funds seeing record fundraising levels,” says McPhater, who is a senior portfolio manager for private equity at Industriens Pension. Today, private equity is a core allocation in many pension and sovereign wealth fund portfolios. However, “the private equity industry has evolved significantly in recent years, with several notable structural changes and trends that reflect its maturity and adaptation to a more complex global environment.”

“The private equity industry has evolved significantly in recent years, with several notable structural changes and trends that reflect its maturity and adaptation to a more complex global environment.”

In particular, the industry has come under pressure from macroeconomic headwinds and evolving market dynamics. “Private equity firms are facing increased risks,” notes McPhater. “Sustained elevated interest rates are raising financing costs and reducing returns, ongoing conflicts and global instability are disrupting supply and tougher rules on cross-border deals, ESG compliance, and tax reforms are increasing operational and compliance burdens,” she elaborates. At the same time, the industry is experiencing shifting return dynamics.

Private equity activity has slowed notably since 2022. “With valuations rising, buyers have become more cautious, and the cooling IPO markets have led to reduced exit activity,” according to McPhater. This has created a liquidity bottleneck, causing many private equity firms to hold assets longer than initially anticipated. As a result, the average holding period for portfolio companies has extended beyond the typical four to five years. “This lengthening of holding periods affects IRR calculations and constrains private equity firms’ ability to return capital in line with investors’ expectations,” McPhater explains.

“This lengthening of holding periods affects IRR calculations and constrains private equity firms’ ability to return capital in line with investors’ expectations.”

The reduced exit activity has resulted in fewer distributions to limited partners, including Industriens Pension, which has impacted cash flow planning and limited the ability to recycle capital into new commitments, says McPhater. Consequently, Industriens Pension, like many other investors, has adjusted its pacing of new investments.

Challenges Bring Opportunities

McPhater goes on to point out that current challenges are driving innovation and new opportunities in the private equity market. “With investors seeking liquidity, the secondary market has seen a surge in activity, offering both buyers and sellers more flexible options for portfolio management,” she notes. “Additionally, private equity funds are also adopting tools such as continuation funds or NAV-based credit lines to provide interim liquidity and manage longer holding periods.”

“Additionally, private equity funds are also adopting tools such as continuation funds or NAV-based credit lines to provide interim liquidity and manage longer holding periods.”

Private equity is indeed navigating a more complex environment, where traditional drivers of returns – such as multiple expansion – no longer play the same role. With valuations high and financing costs rising, firms are increasingly relying on operational value creation, digital transformation, and hands-on portfolio management to generate returns. “As multiple expansion becomes less reliable, private equity funds are focusing more on operational improvements, digital transformation, and margin expansion to drive returns,” confirms McPhater.

Therefore, McPhater expects the private equity industry see a “more divided risk-return profile” among managers. “Top-tier firms with strong operational capabilities and disciplined capital deployment will continue to generate attractive risk-adjusted returns,” expects McPhater. “Conversely, weaker players may struggle to raise funds, exit investments, or generate returns due to macroeconomic headwinds.”

“Top-tier firms with strong operational capabilities and disciplined capital deployment will continue to generate attractive risk-adjusted returns.”

In today’s market environment, certain segments of the private equity landscape stand out, according to McPhater. Industriens Pension, for example, focuses exclusively on the mid-market – specifically, lower mid-market buyouts. “We believe this segment offers the most compelling opportunities, even more so given the current market environment,” she explains. “Valuations in this segment are more reasonable and there is less competition from large-cap managers.” McPhater notes that “these managers are more grounded in active value creation, where there is strong potential for the managers to create value through operational improvements by hands-on management, digital transformation and through buy-and-build opportunities.”

Manager Selection: A Key Differentiator

The increasing importance of operational value creation makes manager selection more critical than ever, as only those with strong teams, disciplined processes, and demonstrated value-creation capabilities are positioned to succeed. Industriens Pension evaluates managers across several key dimensions, including performance, people, process, strategy, ESG integration, and costs. “No single factor dominates our assessment,” McPhater explains, “but we prioritize top-performing managers who combine a stable, experienced team with a disciplined and consistent investment approach.”

Industriens Pension places significant emphasis on a manager’s track record, as strong historical performance remains a critical baseline demonstrating their ability to create value. “However, performance should be analyzed in context,” McPhater stresses. “We review risk-adjusted returns, vintage year cycles, and results across different market conditions. A manager who consistently delivers resilient returns through downturns demonstrates true skill rather than mere luck.”

“No single factor dominates our assessment, but we prioritize top-performing managers who combine a stable, experienced team with a disciplined and consistent investment approach.”

When evaluating the people behind a fund, the quality, experience, and stability of the investment team are essential, as they are the ones responsible for executing the investment strategy. “The team should have deep expertise, and there should be a collaborative culture, working together to drive value creation within portfolio companies,” notes McPhater. Additionally, continuity and succession planning help mitigate key-person risk if any team members depart. “Alignment of interests is also very important,” she adds, with Industriens Pension looking for significant personal capital commitments from the senior team, which ensures their incentives are fully aligned with those of the investors.

“Process is another critical factor,” McPhater explains. Managers need to demonstrate a disciplined, repeatable approach to value creation within their portfolio companies. “A rigorous, well-defined investment process ensures disciplined decision-making and risk management.” Industriens Pension also evaluates a manager’s ability to adapt their processes in response to changing market conditions. Equally important is the manager’s strategy – their focus and differentiation. “The strategy must be clearly articulated and differentiated,” McPhater emphasizes. “We look closely at what sets a manager apart from their peers, whether it’s a unique sourcing advantage or a particular operational focus that drives superior returns.”

Fees and cost efficiency are also key considerations for Industriens Pension. “We carefully analyze management fees and carried interest structures to ensure that teams remain truly performance-driven, rather than focused solely on asset gathering,” says McPhater. “We also review legal documents to confirm the fund promotes transparency and adheres to fair reporting practices,” she adds.

“Strong performance driven by capable people, a disciplined process, a focused strategy, and ESG integration, gives Industriens Pension the highest conviction in a private equity manager’s ability to succeed long term.”

Last but not least, ESG has become an increasingly important part of the selection process at Industriens Pension. “More recently, we have implemented a more rigorous ESG framework within our investment analysis,” McPhater explains. This includes evaluating how effectively a fund integrates ESG factors into its investment process and how this influences risk management. McPhater expects ESG considerations to “move from being a “nice-to-have” to a core component of investment decisions.”

“Balancing these considerations is about finding alignment and consistency across all dimensions,” concludes McPhater. “Strong performance driven by capable people, a disciplined process, a focused strategy, and ESG integration, gives Industriens Pension the highest conviction in a private equity manager’s ability to succeed long term.”