The specialists

As we all adjust to the new paradigm for private equity (PE) investing, it goes without saying that GPs’ and LPs’ investment strategies are under closer scrutiny than ever before. While LPs remain committed to the asset class (in a recent survey, nearly four-fifths of investors said their commitment to private equity would remain unchanged or increase this year*), they expect increasingly to shift money into new areas, such as specialist funds. So, with the same weight of money needing to find a home but without the mega funds to suck it up, are sector funds part of the solution for the LPs’ allocation dilemma?

While generalists will perform well in rising markets, sector focused investors are better placed to add value every time. An INSEAD report that tracked the performance of portfolio company returns in relation to the level of sector specialisation of the manager, found that specialists yielded significantly better returns over time than generalists. A recent study by BCG and IESE also found that industry knowledge was one of the three most important factors in determining private equity funds’ success in becoming a top quartile performer (alongside ability to make operational improvements and a firm’s network).

In these tougher times, only those with specialist industry knowledge will be able accurately to identify high quality investments among the duds. Understanding sector-specific trends and developments; being able to create real value in portfolio companies by implementing the right business transformation strategy and shaping a company to become more attractive to prospective bidders; being able to win over the best management because they speak the same language; being able to avoid auctions as their broad and deep industry relationships mean they hear about opportunities earlier; all of this is what gives them an edge over more generalist competitors.

Diamond hunting

Importantly, many sub-sectors throw up high quality investment opportunities which offer revenue and earnings growth prospects that will generate returns that make sense for equity-only deals; a premium in this debt constrained market.

When debt becomes more available, however, sector funds are likely to find banks more willing to lend to them, reassured about non-auction pricing, the depth and quality of due diligence and the ultimate success of the investment strategy.

Recent research has confirmed that the best returns can be achieved after market corrections, with the diamonds often emerging a good while after the event. Knowing where to invest and when is what sector-focused fund managers offer as a clear differentiator. A successful investor is one with the patience to hang back and wait until the right investment comes along, at the right price.

With the new market valuation rules coming into effect, and with investors anticipating significant year-end write downs, at least part of the answer for the LPs’ allocation dilemma could well be sector-focused funds.