Greek philosopher Aristotle (384-322 BC) supposedly knew everything there was to know in the ancient world. With all due respect to his intellect, I doubt he could pull that off today. The growth of human knowledge has exceeded even the greatest scholar’s bandwidth, leading most people—especially in their professional lives—to specialize in learning a subset of things very, very well, whether it’s orthopedic surgery, JavaScript programming or even something like healthcare private equity.
As I wrote in a previous post, PE firms are increasingly applying this specialized approach to their investing, whether that means focusing on a specific industry, stage of business, or some other differentiating criteria. In this post I want to outline some of the advantages this may offer and explore the relative performance of specialist vs. generalist approaches.
Specialized or not, all PE firms divide their work into two broad categories: pre- and post-transaction. Pre-transaction work happens before a portfolio company is acquired. It can include everything from raising capital to selecting targets to performing due diligence and structuring deals. Post-transaction work happens after a company is acquired, and can include operational improvements, monitoring and reporting, and exit planning. A PE firm with a deep understanding of its specialized niche may be able to outperform on both sides of this transaction divide.
Pre-Transaction Advantages to Specialization
In the PE world, everything starts with fundraising, and a specialized firm (especially one with a proven track record) may be able to fundraise more effectively, since LPs are often on the lookout for niche investments that will diversify their portfolios. Furthermore, having established industry relationships with founders, management teams, and brokers can increase both the quantity and quality of a firm’s deal flow. Many founders and management teams—especially in technical fields such as healthcare and energy—simply prefer to work with sponsors who already understand their space and are fluent in its language, which can be a real asset in competitive deal processes where specialists are competing with more generalist funds.
Specialists also hold potential advantages in diligence, given their deep understanding of macro forces at play in their selected area of specialization. For instance, being deeply involved in an industry like healthcare means not having to spend as much time figuring out the latest trends—a critical advantage if speed is the key to winning a deal. In addition, specialists may have access to proprietary data sources, tools and sector experts, which help accelerate and improve the quality of information surfaced in diligence. Even raising debt can be done more effectively when a firm has established relationships with industry financiers and understands the right capital structures and bespoke financing that can add value to a deal.
Post-Transaction Advantages to Specialization
On the post-transaction side, a PE firm with deep familiarity and entrenched relationships with potential customers and suppliers may be able to rapidly grow the book of business for a company it buys out. “Make a phone call and now you have 1,000 Walmarts as customers – that’s eye-opening,” says a managing partner at 747 Capital quoted in this Business Insider article (3 Reasons Specialization Matters for Private Equity).
It’s also usually easier to establish credibility and implement improvements in a portfolio company when its management knows that the PE firm brings deep sector expertise to the table. According to the Business Insider article, it’s a matter of fewer “information asymmetries” between the PE firm and its portfolio companies—a fancy way of saying they speak the same language. A study cited by the article found that, in the three years after acquisition, specialized PE firms generated an extra 4% of operating profit in their portfolio companies compared to non-specialized firms.
What about after improvements are made and it’s time to exit? Specialists may have an advantage there as well, given their access and relationships with key players in a given sector, as well as their heightened understanding of industry cycles and when the proper time is to sell.
Clearly, specialization is a potentially powerful weapon in the fight for better returns in private equity. But so far our analysis is mostly theoretical. So what do the numbers say?
The Data Speaks on Specialization
Compared to public markets, getting access to fund-specific return data in private equity is not easy. But studies are out there. This one from Cambridge Associates (Declaring a Major: Sector-Focused Private Investment Funds – Cambridge Associates) found that managers who specialized in one of four broad sectors of the economy—consumer, financial services, healthcare, and technology—generated 23.2% gross IRR versus 17.5% for generalist managers. Per the report, specialists had better Multiple on Invested Capital (MOIC) for 9 of 10 initial investment years (2002 being the exception). In the aggregate, the specialists achieved 2.2x MOIC vs. 1.9x for the generalists.
As an aside, it’s important to note that managers who historically invested over 70% in a single sector were considered specialists for purposes of the study. General partners tend to have broad legal mandates from their investors, and like to retain a certain amount of flexibility for adapting to changing environments. So being “specialized” does not necessarily mean that 100% of investments must be inside the niche.
Another study (Industry specialization of private equity firms: a source of buy-out performance heterogeneity: Venture Capital: Vol 20, No 3 (tandfonline.com)) found that in a sample of 217 companies bought out by private equity in France, those bought by industry-specialized firms experienced a 7.5% greater profit increase than those bought by generalist firms. Interestingly, specialization was most helpful for the businesses that were already significantly under- or overperforming their peers, possibly because those are the situations where it is most challenging for a PE firm to add meaningful value.
Specialization: The Big Picture
Are you seeing the big picture here? Both qualitative and quantitative analysis supports the idea that specializing confers advantages in private equity investing, at least within certain pockets of the market like healthcare where technical knowledge matters more. But that does not mean that all specialist funds are winners, or that you should avoid all generalist funds, either as a place to invest or to work. In particular, it is important to note that some generalist funds—especially deep pocketed ones—employ “pods” of sector specialists as a way to leverage some of the advantages of specialization within a broader generalist mandate.
As a final caveat, remember that, as a general policy, too much specialization always limits diversification, which is critical to maintain in any investing portfolio. It helps you avoid major drawdowns in any single sector or stage of the market. One way to create diversity, if you have the capital, is by investing in multiple differing specialist funds. Another way is by identifying excellent generalist funds that can do the diversification for you. In private equity, as in other parts of life, specialization can be a very good thing, as long as you don’t go overboard and put all your eggs in one basket.