Why I Believe Private Equity Will Play “The” Role in the Transition to an AI-Driven Economy
After the invention of the printing press, the cost of producing a book dropped ~80%1. The steam engine dropped the cost of freight transportation from 15 pence per ton-mile via canals to 1 pence per ton mile using steam locomotives2. With each revolution, costs dropped.
These lower prices increased demand and saved resources. This allowed households to allocate money to drive further growth. In the year 1400, the average person could not afford a book, as they were often hand-copied manuscripts costing the equivalent of thousands of dollars today. After the invention of the printing press, the cost of books dropped by approximately 80%, making them much more affordable to a broader audience. People used those books to gain additional skills, which created further returns. This was only possible because of the price drop.
The economies and companies that will be most effective will drop costs faster than their competitors (all things being equal).
Ok, so why the role of Private Equity?
In capitalism, companies bundle inputs to create outputs for the customer. Those input arrangements are decided by management.
Running companies by AI is a serious step change. It is akin to a train company, like New York Central Railroad in the 1950s, trying to pivot into becoming an airline such as TWA with jet engines because they saw the decline of railroads3. The leadership of the train company was not equipped to make such a radical transformation. Similarly, adopting AI requires a fundamental shift that incumbent management is not designed to conduct.
What is the case that incumbent management will not make this change?
Selection Bias - A person who rises to senior ranks of Procter & Gamble, General Motors, etc. does so because they tend to be risk averse. They possess a skill set tailored to navigating existing internal political dynamics and optimizing for stability. That worked in the existing ecosystem. It will not be transferable to the change required4.
Core Competency - I have witnessed billions of software purchasing in my life. I can attest that most senior leadership is making technology purchase decisions based on career risk downside mitigation and very willing to trade off enormous efficacy and even savings for that downside protection. This increases as market place confusion increases. By and large, the existing ranks of CEOs and CIOs will not be equipped for these technology decisions.
Intrinsic Incentives - In my anecdotal experience; many of the leaders of large companies derive great value from status symbols5. These include large workforce sizes, jets, etc. This transition to AI-driven efficiency threatens those status symbols, as it often involves reducing workforce sizes and changing the nature of operations. It will also face large workforce frustration and dislike.
Why won't management consulting coupled with management be the driving force?
Management consulting, by and large, gets its paycheck from management6. As identified, management will be reticent to take aggressive action. Additionally, consulting often involves perverse incentives. In technology consulting, many large consulting practices are incentivized to prolong billing7. As a result, projects are often made unnecessarily complex, focusing on generating 'activity' rather than delivering meaningful outcomes.
I predict many corporations will go down this path. I also predict most will not be successful in doing so.
Ok, so really, why PE?
#1 History
Step change transformations - by and large - have been driven by the investor (principal) rather than management (the agent). We have seen three main themes in P&L transformation, including:
Capital Structure Optimization (1980s-2000s): The main lever PE firms pulled in this period was optimizing the capital structure. By leveraging debt, PE firms create financial discipline and improve return on equity. During the 1980s to early 2000s, PE firms often restructured balance sheets post-acquisition, taking on leverage to distribute cash back to investors while still ensuring enough capital for operational improvements. Traditional management was often hesitant to add debt due to concerns about financial risk and instability. In theory, PE-driven capitalization strategies created a sharper focus on cash flow management, cost discipline, and ultimately increased returns8.
Moving Manufacturing Overseas (1980s-1990s): During the 1980s and 1990s, PE firms led the charge in relocating manufacturing to low-cost regions, significantly reducing cost structures. Management often resisted this due to the challenges of supply chain complexity and fears of quality issues. PE owners drove the change by underwriting the cost savings and providing the strategic vision to make global supply chains efficient.
Business Process Outsourcing (BPO) (2000s): PE firms were instrumental in the rise of BPO during the 2000s, pushing companies to outsource back-office operations like customer service, payroll, and IT to specialized firms in countries like India and the Philippines. Traditional management resisted this due to concerns over losing control and cultural differences. However, PE-backed firms pushed for BPO to unlock value through lower operational costs and improved focus on core competencies.
#2 - Incentive
Traditional management is often incentivized to improve their quality of life and those in their immediate vicinity. This is at odds with improving value for the customer and/or returns for the investor. The rise of passive investment holdings has only increased this principal vs. agent divide9.
In contrast, PE (and activist investors) are incentivized to overcome the challenges associated with the change. They are also compensated to do so with speed.
Other parties including management, employees, board members, and consultants often do not face the same incentive as someone compensated on speed of change.
End Note
This is not to advocate replicating these step changes exactly as they occurred in the past. There are real human costs (as well as benefits), which I will explore further. While these methods were effective in their historical context, they could create significant risks if not adapted to current conditions. Nevertheless, similar transformations are likely to happen, driven by investors with control, risk appetite, and the ability to underwrite meaningful upside.
Future essays will address questions such as: What steps should be taken now to become a winning PE firm? What factors will determine whether PE firms succeed or fail? What does the 'From -> To' transformation look like for companies? How will this vary by industry?
Eisenstein, Elizabeth. The Printing Revolution in Early Modern Europe (1983)
Szostak, Rick. The Role of Transportation in the Industrial Revolution: A Comparison of England and France (1991)
The New York Central Railroad (NYC) fell into decline in the 1950s and 1960s due to competition from highways, automobiles, and the rapid rise of jet air travel, which siphoned off both passenger and freight traffic. By 1968, NYC merged with the Pennsylvania Railroad to form Penn Central, but the diversification and merger failed, leading to one of the largest corporate bankruptcies by 1970.
IBM is a perfect case study of this. The management team over decades has missed the largest recent tech booms. https://www.reddit.com/r/IBM/comments/1fqt826/why_are_any_of_us_still_here_ibm_is_dying_and_we/
The case of Beatrice Foods and the KKR leveraged buyout (LBO) in the 1980s offers a strong example of how status symbols and intrinsic incentives within large companies can contribute to their downfall. Beatrice, under CEO James Dutt, accumulated massive debt while acquiring Esmark and other unrelated businesses, driven by a desire for growth and status, including maintaining a fleet of corporate jets. This focus on prestige rather than operational efficiency ultimately led to financial instability. By 1986, Beatrice's mounting debt made it an easy target for KKR's LBO, and the company was broken up and sold off in parts to reduce the debt load, marking the end of its dominance https://americanbusinesshistory.org/from-milk-duds-to-samsonite-the-beatrice-foods-saga/
Management is the “agent” as opposed to the “principal.” The agent does have different intrinsic and extrinsic incentives than the principal.
Unless hired directly by the principal in an outcome driven compensation structure.
A prime example is the leveraged buyout of RJR Nabisco by KKR, where the balance sheet was restructured to support significant debt, and the resulting capital was distributed to investors. This aggressive approach to capitalization is something that typical management teams tend to avoid, but it drives substantial value creation when executed effectively.
Index fund managers have little incentive to invest in stewardship, as they earn a small percentage of assets under management and capture only a tiny fraction of any value increase in portfolio companies. Additionally, if one index fund manager's stewardship efforts raise a company's value, competing index funds also benefit without sharing the costs. This dynamic limits their motivation to improve stewardship, as outperforming rival index fund managers provides no direct incentive to invest in such efforts. Competition with actively managed funds does not resolve this issue, leaving index funds underinvested in stewardship. https://columbialawreview.org/content/index-funds-and-the-future-of-corporate-governance-theory-evidence-and-policy/