By Brian RichFrom 2004 to 2007, private equity was one of the top performing asset classes, with average annual returns of 24.1%, according to data compiled by Cambridge Associates. Sometimes success breeds its own demise. As has been well documented elsewhere, a large part of the gains made during those years were the result of innovations in the debt capital markets that enabled the application of higher-than-normal financial leverage. High leverage driven by easy money leads to increased valuation multiples. Increased valuation multiples on top of high leverage leads to strong returns, which draw more money to the asset class, and so on.We all know what has happened since 2007--the debt markets have retrenched, valuations have declined, and the private equity business is sitting on a pile of capital commitments with a business model that will be broken for the foreseeable future. All is not lost for private equity, though, provided the industry gets back to focusing on the roots of value creation: revenue and/or earnings before interest, taxes, depreciation and amortization (EBITDA) growth.Leverage Is Brilliant — Until It Isn?tIn normal markets, the role of private equity firms have been to acquire poorly run public companies to unlock shareholder value by improving operations. Private equity firms also provide liquidity or growth capital for private companies and corporate spinoffs. In certain periods, innovations in the debt capital markets provide the ability to make profits solely through financial engineering. In the mid-1980s, debt capital came from junk bonds, and in the mid-2000s it came from collateralized debt obligations and credit default swaps. Either way, it points to the same thing–a relaxation of credit standards.Whereas in a normal private equity market debt would typically be 50% to 60% of the capital structure, in a period like the mid-2000s the leverage ratio reached as high as 90%. This allows for egregious practices like the “dividend recap” where an already highly leveraged company issues even more debt to pay a dividend to its private equity investors, allowing them to profit even if the company later goes bankrupt. In a normal market, no lender would ever consider allowing a dividend recap of a highly leveraged company. In a hot market, leverage is like gas on an open flame.Blinded By The LightIn addition to the $1.3 trillion of debt that was issued for leveraged buyouts from 2005 to 2007, endowments, pension funds and other institutional investors increased their allocations to the private equity area in an unprecedented fashion. Three recent vintages, between 2005 and 2007, raised in excess of $460 billion, surpassing the amount raised in the previous 12 vintages combined. Equally important is the increase of private equity managers during those years. The sheer number of GPs with capital to invest, each armed with easy sources of debt financing, contributed to the frenetic bidding for target companies and to record prices paid.Students of economics understand that prices rise to satisfy demand. That is precisely what happened. From 1995 to 2008, the average purchase multiple across industries for an LBO was 7.4 times EBITDA. In 2007, it was 9.6 times, or 30%, higher. In fact, almost 20% of the deals were done at a multiple of 13 times or higher. There are not many classic LBO-oriented businesses worth 13 times EBITDA.Fundamentals, Not TradesSo why were the returns so terrific if GPs were overpaying for businesses and overleveraging them?Many of the gains were based on ?trades? and were not replicable. For years, private equity generated returns by buying businesses and improving them either organically or through mergers and acquisitions, reducing costs and finding the absolute best management teams incentivized by a piece of the upside. Typical exits were through an initial offering, sale to a strategic buyer, or by break up and sale to multiple industry purchasers.Now it is déjà vu all over again. The markets are reverting back to the mean. Sellers are realizing that recent valuation multiples were meaningless, and buyers now have to run their models with 50/50 debt-to-equity mixes at best. Prices have come down and will continue to. Now more than ever, GPs need a plan that shows improvement in the core business and, most important, growth. I am referring to revenue and EBITDA growth in a real and sustainable fashion. Additionally, investors must plan on longer holding periods to achieve this growth and be more cautious about the exit multiple assumptions. In short, it is going to look more like the 1980s and 1990s than the first decade of the 21st century.Perhaps The Best Is Yet To ComeLPs are now able to exert more influence and are dictating terms to GPs and are being extraordinarily selective about how they invest in the private equity asset class. Much has been said about excess management fees, lopsided GP terms and excessively sized funds. It is absolutely critical that GPs articulate not only cogent investment theses, but also the differentiators between themselves and their competitors. Only the best-performing funds will receive continued support from LPs.Having said that, LPs should be careful not to miss the upcoming period. It is entirely plausible that the next several years will be fabulous vintages for private equity, if the GPs get back to basics.