There is evidence that the old adage about jacks of all trades being masters of none applies even to the masters of the financial universe. The success of the generalist private equity model is largely dependent on the team and their ability to build a robust and data-driven origination strategy. But, as we continue to witness the success and out-performance by managers with acute industry specialization, evidence points to higher levels of engagement and returns for specialist private equity groups.
In a flattening world occupied by virtually infinite iterations of niches and business models, expertise in a specific field is an appreciating asset to all stakeholders in the private equity industry. It may seem self-evident that a seasoned veteran of a specific sector ought to generate better returns than a less experienced player, but there is proof beyond the axiom.
A 2007 study by Robert Cressy, Federico Munari, and Alessandro Malipiero entitled “Playing to their strengths? Evidence that specialization in the Private Equity industry confers competitive advantage” shows, well, just that. They cite reduced information asymmetries and reduced uncertainties as the two main sources of advantage, and “argue that PE firms specialized relative to their competitors possess a deeper knowledge of the competitive environment of acquired companies… and can therefore both select potentially superior performers and also provide more effective monitoring and advice…”
Using data from 122 buyouts in the UK from 1995 to 2002, Cressy, et al. validate their “advantage-to-specialization” hypothesis, showing that specialized shops on average yield 4% higher operating profit than non-specialized firms in the 3 years post-buyout, thus mitigating the concentration risk concomitant with a non-diversified portfolio. The researchers believe initial investment selection weighs slightly more heavily than post-transaction management, leading us to our next reason why specialization matters.
2. Deal Origination
Relationships drive M&A, and the ability to demonstrate acute industry knowledge jumps out to Limited Partners needing to deploy capital. LP’s are cautious and seek firms that can demonstrate a competitive advantage. Overall, specialist private equity firms are better able to contextualize macro industry dynamics to identify hidden value drivers of opportunities that a generalist might otherwise overlook. “Differentiation is no longer using systems and tools for deal sourcing, it’s standard,” says Marc J.M. der Kinderen, a Managing Partner at 747 Capital, a small-cap PE fund of funds.
As a panelist at the Opus Connect conference on September 15th, Marc indicated that he favors firms that have “a specialization strategy and a proven track record.” He assigns more value to a team that can leverage networks and experience more than balance sheets. Marc continued, “I don’t believe the generalist strategy of levering up and waiting for the market to rebound will work.”
Furthermore, evidence from the Axial network illustrates that sellers are inclined to engage buyers who demonstrate a level of specialization through their Transaction Profiles. Sellers want to see an investor with long-standing relationships, deeply entrenched in a sector.
3. Post-Transaction Value
“Make a phone call and now you have 1,000 Walmarts as customers – that’s eye-opening,” der Kinderen said. It’s the ability to open up doors that others can’t.
Sellers are cognizant of this and keen on finding private equity groups with the ability to contribute post-transaction, especially when the seller is retaining an ownership stake in the business. Entrepreneurs and business owners are naturally more comfortable if a GP can slide into management, roll up their sleeves, and offer advice derived from real-world trials instead of MBA case studies. There is no substitute for experience.
Specialization matters because it has been shown, through both research and anecdotal evidence, to enhance each step of the transaction process. LP’s are more confident and willing to give funds, and sellers are more enticed by buyers who know what they’re doing. With these ducks in a row, the experienced team can do what has become second nature, build businesses in specific sectors that generate outsized returns.