The private equity industry’s dramatic growth has spurred specialisation at both the fund and the deal professional level. In a world where even the slightest edge is treasured, specialisation directly connects to five elements critical to a private equity firm’s success: attracting capital, identifying targets, closing transactions, operating efficiently and selling effectively. While not without risk, specialisation, like private equity itself, is a trend that only will grow.
A principal tenet of successful investment is diversification of risk. Institutional investors have always attempted to balance their exposures to private equity, initially by dividing their investments among venture, buyout and distressed funds. The funds themselves could, if they chose to, invest in a wide range of various industries or markets. Some did, while others concentrated their investments to varying degrees. This approach led to a somewhat random mix of industry investments for the institutional investors, leaving them overor under-weighted in certain sectors.
As out-sized returns, good or bad, flowed from this random approach, institutions wanted more control over the end-use of their capital and the potential for improved returns from a tighter focus on industries of particular interest. Consequently, more industry-specific funds have sprouted, and even generalist funds today readily claim focus industries.
For fund sponsors, specialisation has attracted this industry-targeted capital. It has also given them a variety of advantages in an increasingly crowded and competitive environment.
- Responsiveness and agility: A generalist fund making its first investments in a particular industry will need to spend substantial time and energy evaluating the risks inherent in that industry. By contrast, a specialised fund already will have a deep understanding of the industry’s fundamental trends and inherent risks. Usually, it also will have a waiting stable of industry-specific advisors ready to commence due diligence. Taken together, these factors allow a specialised fund to move more quickly, to evaluate a greater number of deal opportunities and to execute on promising ones more efficiently than a generalised fund.
- Deal precedent and volume: A successful track record of closing deals in a particular industry makes a specialised fund more attractive to a seller as compared to a generalised fund with few or no deals in that industry under its belt.
Where the transaction involves the provision of “rollover equity” to the original owners, a history of growing similar companies and positioning them for resale is an important credential that can set a specialised fund apart.
- Managerial expertise: Specialised funds that invest exclusively in a discrete industry generally have greater success at recruiting professionals with expertise in that industry. These funds differentiate themselves from the pack by selling their ability to bring operational and managerial improvements to the target company. These improvements can help the target grow faster than if it partnered with a generalist fund.
- A more developed network of deal sources: Industry focus also narrows the field of players, allowing specialised fund managers to more easily develop a network of deal sources. Usually this will include relationships with boutique M&A investment banks, as well as lawyers, accountants, lenders and angel financiers who are active within the industry.
- Investment synergies: When one portfolio company of a fund offers a unique, industry-specific service, that unique service can be leveraged to help differentiate the fund from other potential buyers. For example, if a target company that provides rural hospital services needs better access to professional services, its management might favor a fund that has a portfolio company that provides health care staffing services.
At the same time, the staffing company could see the other portfolio company as a captive source of new business and a way to quickly grow its revenues. Sellers getting rollover equity or an earn-out as part of a deal have a tremendous incentive to select a fund whose portfolio can offer such synergies.
Deal professionals also benefit from the narrower focus, utilising hardearned industry knowledge on multiple fronts, rather than starting from scratch in vastly different regulatory, economic and business climates on each transaction. The symbiotic relationship of more capital to do deals and more expertise and experience to get them done effectively has supported, if not demanded, the rise of specialisation at the fund level.
When It Works…
A classic example of specialisation has been the health care sector. Given its prominence in the worldwide economy and its relatively non-cyclical nature, health care has long been a key target for private equity investment. Early generalist buyout funds helped form hospital groups that have long since become market leaders in the United States. Similarly, broad-based venture capital investors funded many infant biotech companies, much like any other technology-based start-up.
Today, few fund investors will consider any significant health care investment without an in-depth understanding of the relevant regulatory issues, legislative prospects and market trends applicable to the sector. To provide that insight on a consistent basis, generalist funds have devoted significant manpower and resources to their internal health care teams, and specialist funds have sprung up throughout the sector. Moreover, even within the health care industry, the need for additional knowledge, contacts and history have led deal professionals, and in some cases, even entire funds, to further concentrate their focus on specific subsegments of the market—such as health care services, pharmaceuticals, medical devices or health care-related IT products.
The trend towards health care specialisation, therefore, appears limited only by the availability of worthy investment opportunities in the areas of concentration.
…and When It Doesn’t
While the advantages of specialisation may seem obvious, the risks posed by the trend are often quite subtle. A narrow investment focus is ideal in a “target rich” environment, but is less than ideal when opportunities are scarce. A fund sponsor feels a constant pressure to employ the capital it has been allocated. While poor investments will rarely result in happy investors, the inability to employ capital will not please them either. In a specialist fund, this can translate into a steady stream of investments, regardless of business cycles or the availability of highly attractive opportunities. The same forces apply within a generalist fund that has specialist industry groups.
There, investment professionals face marginalisation if they do not produce worthy investment candidates, but, at times, industry fundamentals can prevent the specialist team from developing appropriate investment candidates. These strictures can lead to a broadening of the investment focus to ensure that capital can be deployed promptly for the investors, even if such broadening has the effect of blurring the fund investors’ industry focus and portfolio diversification goals.
Industry specialisation is a phenomenon that is here to stay. Particularly in highly technical and regulated industries, such as health care, a narrow focus enables fund sponsor personnel to harness sufficient experience, expertise and capital to be successful in the long term in a highly competitive environment.
Conversely, the limited horizon of a specialist necessarily means that attractive transactions in other fields will be ignored, while capital is employed in the targeted industry come rain or shine. While fund investors appear to appreciate the benefits of specialisation, it remains to be seen whether the trend will result in sustained, improved long-term returns for them.