To specialize or not to specialize? If that is the question, then the world of private equity is responding with the former. According to Bain’s 2023 Global Private Equity Report (Global Private Equity Report 2023 | Bain & Company), limited partners and deal teams have been pursuing increasingly specialized strategies in recent years, and this trend away from a general approach is “sure to continue.”
Research by Mantra Investment Partners helps explain why. For the 2010-2020 period, Mantra found that PE funds it classifies as “niche” achieved an average IRR of 38%, while mainstream PE funds only achieved 18%. Now, as with so many things, it’s hard to say for sure whether this relationship is more causation or pure correlation (for instance, niche funds tend to have lower assets under management, so this could also speak to a benefit of smaller size). However, with so much new money flooding into private markets (we called it a “tsunami” in a previous post (Private Equity in a Recession | A Simple Model)), specialization does offer a way to stand out from the crowd and to appeal to limited partners looking to diversify their exposure in interesting and less-picked-over niches of the buyout space.
What Does Specialization Mean in Private Equity?
In private equity, specialization can take different forms, from focusing on one or a few related industries (agriculture, tourism, etc.), to a certain sector (services, manufacturing, etc.), a particular stage of business development (startup, late stage, etc.), a defined geographical area (country, region, etc.), or even a specific investing approach (turnarounds, roll-ups, etc.).
Last March, HEC Paris and Dow Jones released a new ranking of mid-market private equity firms (The 2022 Midmarket HEC Paris). Specialist funds—from Accel-KKR to Water Street Healthcare Partners—were well represented in the top 20. Accel-KKR, for instance, specializes in technology, leveraging its global familiarity with the sector to introduce portfolio companies to potential service providers, partners, and customers worldwide. Accel-KKR also employs a proprietary model—built from data on over 300 B2B technology firms—that allows its portfolio companies to compare themselves to peers and identify ways to improve.
For another good illustration of the power of specialization, let’s delve into the case of Riverstone Holdings, which focuses on the energy sector. The firm has succeeded by taking industry experts who aren’t necessarily investors and blending their expertise with a set of highly skilled investors. Partner Elizabeth K. Weymouth calls the result “a highly sophisticated team in the energy world that has a lot of know-who in addition to a lot of know-how.”
The essential skill of a private equity investor is comprehending and comparing the quality of alternative businesses and opportunities. Acting quickly and confidently to beat out the competition is crucial. Understanding nuances and being fluent in the same language as the management of a target company is a leg-up to success. And in the current economic environment, fewer new deals are being done, so operational improvements at existing portfolio companies are more important than ever. That situation—which is likely to continue as long as interest rates remain elevated—also benefits from nuanced expertise.
How Much Specialization Is Too Much?
With all of that said, there is still an important question we must ask: how much specialization is too much? At what point does an incredibly in-depth knowledge of certain trees prevent you from seeing the forest? It’s a legitimate concern, because being too narrowly specialized limits diversification and can prevent investors from adapting when conditions begin to favor an industry, sector or approach outside their niche.
The best advice I can offer is this: if you are just starting out in private equity, be open to a wide variety of experiences, at least early in your career. Build a broad network. Think about how your work and the places you end up can overlap with your personal interests and passions, as well as areas where you see promise in the market long-term, and don’t be afraid to explore a variety of areas and investing styles as you go. Over time, you will find the niche that’s right for you. My friend Adam Rodman is an incredible example of this. Rodman’s conviction around a single idea grew until he was comfortable betting his career on it. In early 2013 the depressed price of uranium drew his attention, and in 2018 he restructured his hedge fund to focus exclusively on the radioactive metal’s resurgence. It has proven to be a wildly successful venture. (Adam Rodman Interview: Starting a Sector-Focused Hedge Fund.)
At the end of the day, there are plenty of successful investors who never specialize, but if you find a niche that particularly appeals to you, think long and hard about whether it could be something you want to build a career around, since having a specialty can be a real asset when job hunting or trying to start a fund later in life. With that in mind, I will have more to say about the advantage of specialization as it relates to fund performance in a future post. Stay tuned!
Related: Private Equity Industry Focus
Related: Breaking into Private Equity with a Nontraditional Background (if you are working in a niche industry and want to break into private equity)
Learn more about private equity transactions with ASM’s Private Equity Training course. The Private Equity Training course at ASimpleModel.com was developed by industry professionals. The content below goes beyond the LBO model to explain how private equity professionals source, structure and close transactions.