Operational improvements adds more value as the impact is far more permanent than temporarily playing around with the capital structure. Strategic shifts or operational improvements may last a lifetime, while capital structure changes and financial engineering will only affect the company until the PE firm sells the company.
This kind of question is usually asked by mid-market PE funds, which are typically more involved with driving their portfolio company’s strategy. In fact, they may be extremely hands-on with deciding on which growth strategy to pursue and which segments or geographical markets to expand in. They may also be heavily involved in improving margins and efficiency, as mid-market companies haven’t implemented best practices, especially in the areas of finance, accounting, and IT, while PE firms have lots of experience with that and can easily replicate these best practices in any portfolio company. They may also monitor management closely and even make staffing changes in senior management if it will improve the organization.
Financial engineering may help a PE firm win the deal in a hot auction by leveraging more than the competing bidders, as well as implementing unique capital structures, management options or earn-outs that incentivize management to both perform and stay. However, even though this can enhance returns, it’s unlikely that it will add as much permanent value as fundamental changes to the company and its strategy. Financial engineering is usually more self-serving, while fundamental changes to the company may last for the entire lifetime of the firm even well after its sale.