The Greek philosopher Aristotle (384-322 BC) was said to know everything the ancient world knew. With all due respect to his intelligence, I doubt he would be able to pull it off today. Human knowledge has grown beyond the reach of even the greatest scholars, leading most people (especially during their careers) to specialize in learning just one thing, whether it’s orthopedic surgery, JavaScript programming, or something like healthcare private equity .
As I wrote in my last article , private equity firms are increasingly applying this specialized approach to their investments, whether that means focusing on a specific industry, business stage, or some other differentiating criterion. In this article I would like to outline some of the advantages this may offer and explore the relative performance of specialist versus generalist approaches.
Specialized or not, all private equity firms divide their work into two broad categories: pre-deal and post-deal. Pre-deal work occurs before a portfolio company is acquired. It can include everything from raising capital to selecting targets to conducting due diligence and structuring the deal. Post-transaction work occurs after a company is acquired and can include operational improvements, monitoring and reporting, and exit planning. A private equity firm with deep knowledge of its area of expertise may be able to perform well on both sides of this deal divide.
Advantages of specialization before trading
In private equity, everything starts with raising capital, and specialist firms (especially those with a strong track record) may be able to raise capital more efficiently because limited partners often seek out niche investments that can diversify their portfolios. Additionally, building industry relationships with founders, management teams, and brokers can improve the quantity and quality of a company’s deal flow. Many founders and management teams (especially in technology fields like healthcare and energy) prefer to work with sponsors who already know their space and are fluent in its language, which can be a real asset in a competitive deal process, as experts Competing with more people for generalist funds.
Experts also have a potential advantage in diligence, given their deep understanding of the macro forces at play in their chosen area of expertise. For example, being deeply involved in an industry such as healthcare means not having to spend too much time keeping up with the latest trends – a key advantage if speed is the key to winning deals. In addition, experts have access to proprietary sources, tools and industry experts, which can help accelerate and improve the quality of information presented during due diligence. Debt can even be raised more efficiently when companies develop relationships with industry financiers and understand the right capital structure and customized financing that can increase the value of a deal.
Post-trade specialization advantages
On the post-deal side, private equity firms that are very familiar with and have strong relationships with potential customers and suppliers may be able to quickly grow business for the companies they acquire. “You just made a phone call and now you have 1,000 Walmart customers — that’s really eye-opening,” said a managing partner at 747 Capital quoted in the Business Insider article (3 reasons why specialization is important for private equity).
It is also generally easier to establish credibility among portfolio companies and implement improvements when portfolio company management knows that a private equity firm has deep industry expertise. According to the Business Insider article, this is a matter of reduced “information asymmetry” between private equity firms and their portfolio companies – which is a fancy way of saying they speak the same language. One study cited in the article found that within three years of an acquisition, specialist private equity firms generated an additional 4% in operating profits at their portfolio companies compared to non-specialist private equity firms.
What should I do if I quit after the improvements are completed? Experts may also have an advantage here, given their exposure and relationships with key players in a given industry, as well as their in-depth understanding of industry cycles and when the time is right to sell.
Clearly, specialization is a potentially powerful weapon in private equity’s bid for better returns. But so far our analysis has been primarily theoretical. So what do these numbers say?
Data description specialization
Obtaining private equity fund-specific return data is not easy compared to public markets. But the research is there. This is from Cambridge Associates (Declared major: Industry-focused private investment funds – Cambridge Associates) found that managers who specialized in one of four economic sectors (consumers, financial services, health care, and technology) generated an aggregate IRR of 23.2%, while generalist managers generated an aggregate IRR of 17.5%. According to the report, experts had better multiples on invested capital (MOIC) in 9 out of 10 years of initial investment (except for 2002). Overall, the specialist’s MOIC is 2.2x, while the generalist’s MOIC is 1.9x.
Incidentally, it is worth noting that managers who have historically invested more than 70% in a single industry are considered experts in this study. General partners often have broad legal authority from investors and want to retain some flexibility to adapt to changing circumstances. Therefore, “specialization” does not necessarily mean that 100% of investments must be within a niche market.
Another study (Industrial Specialization of Private Equity Firms: Sources of Heterogeneity in Acquisition Performance: Venture Capital: Volume 20 Issue 3 (tandfonline.com)) found that among a sample of 217 companies acquired by French private equity, companies acquired by industrial specialists had a profit increase of 7.5% higher than those acquired by generalists. Interestingly, specialization is most helpful for businesses that are already significantly underperforming or outperforming their peers, possibly because in these cases it is difficult for private equity firms to add meaningful value.
Specialization: looking at the big picture
Do you see the big picture here? Both qualitative and quantitative analyzes support the idea that specialization gives private equity an advantage, at least in market sectors such as health care where technical knowledge is more important. But that doesn’t mean all specialty funds are winners, or that you should avoid all general funds, whether as an investment or as a workplace. Of particular note, some generalist funds (especially those with deep pockets) will hire “teams” of industry experts as a way of leveraging the benefits of specialization within a broader generalist mandate.
As a final note, remember that as a general policy, too much specialization will always limit diversification, which is critical to any portfolio. It can help you avoid major losses in any single industry or market phase. If you have the funds, one way to create diversity is to invest in several different specialist funds. Another approach is to identify good generalist funds that can provide you with diversification. In private equity, as in other areas of life, specialization can be a very good thing, as long as you don’t go to the extreme of putting all your eggs in one basket.
