New report finds flimsy correlation between industry specialization and returns

More than 50 percent of the 550 firms that RCP includes in its lower middle-market database have carved out niches as specialists in one or two industries. That specialization differentiates them from generalist firms that invest opportunistically across a variety of sectors.

Industry specialization allows limited partners to build up investment exposure to specific sectors such as energy or healthcare by directing commitments to managers that specialize in those industries. While targeting industry specialists has its advocates – and its advantages, from a portfolio diversification standpoint – it has not necessarily led to superior returns within RCP’s portfolio, managing principal Charles Huebner told Buyouts.

“We still live by the notion that each manager has to be uniquely good at something and the most tangible differentiator is that you’re an industry specialist,” he said. However, “the data didn’t show a demonstrable boost to returns just because of that.”

GPs that specialize in one or two sectors tend to invest across market cycles, whether or not their industry of focus is performing well. That can negatively impact returns, Huebner said. He added that even industry specialists can be poor fund managers.

“On one hand you’re an expert, on the other, you could have blinders on” to sector-specific problems, he said. “It’s still very much a manager-specific game. And relying on someone just because they are an industry specialist isn’t alone a path to returns.”

Although specialization has not been found to deliver outsize returns, few GPs describe themselves as generalists “due to competitive positioning and their attempts to show a differentiated strategy,” according to the white paper.

In addition to highlighting issues with industry specialization, the white paper addresses the ways in which lower middle-market private equity firms generate outsize returns compared to their peers at the larger end of the market. (RCP defines lower mid-market firms as active GPs with less than $1 billion of capital.)

Citing Preqin, the RCP white paper reports that top-quartile lower middle-market buyout funds raised between the years 2000 and 2009 netted a 20 percent internal rate of return as of December 31, compared to 18.2 percent for upper middle-market funds and 16.2 percent for mega-funds. RCP cites lower purchase price multiples, as well as firms’ strategic emphasis on operational improvement and portfolio company growth, as key contributors to performance.

A PDF of the RCP white paper can be found here.