PEI 300: The case for specialised fund strategies

Outperformance, better alignment with LPs and high-quality dealflow have driven some fund managers to narrow their strategies.

From European healthcare and tech services funds, to clean tech and Chinese consumer-focused funds, private equity firms have zeroed-in on specialised investment strategies in the last decade.

Specialisation is certainly not new; PE firms have taken on several forms of it over the years, says Janet Brooks, a London-based partner at placement firm Monument Group.

Early specialisation tended to be around deal size, often with new groups starting out in the gaps created by successful firms moving up scale, she notes. As the industry evolved, firms differentiated themselves based on where they invest in the capital structure or the types of businesses they acquired.

For Hg, it was about getting in early on a long-term trend. The European manager shifted from a generalist mid-market buyout firm into a software and services specialist in the last decade. Managing partner Matthew Brockman says Hg identified software and tech services as a long-term trend.

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“Software, for example, is a very significant part of the economy, it’s growing and adds significant value. Every day-to-day business activity – filing taxes, paying employees, running hospitals – is tech-enabled,” he says.

Hg’s around $10 billion of software and services proceeds have delivered gross returns of 2.6x and 34 percent internal rate of return as at end-December 2019, according to its website.

Research shows sector specialists generate better returns. Per data from Cambridge Associates, sector-focused funds with an initial investment date between 2001 and 2010 have returned an aggregate 2.2x multiple on invested capital and a 23.2 percent gross IRR, compared with a 1.9x multiple and 17.5 percent gross IRR returned by generalist funds in that period.

Getting in line

Aside from outperformance, LPs are also keen to back specialists for better alignment. Sector-focused GPs are often teams that have spun out from bigger managers, says a former global head of private equity at a European investment firm.

“In a way these smaller GPs are better aligned with LPs because they are focused on outperformance [rather] than on fee generation,” he says.

The proliferation of sector specialisation is also a function of increased competition. With the amount of new capital coming into the industry, the ability to extract alpha just from value arbitrage has to a large degree disappeared. GPs wanting to stand out need to show their ability to transform companies through operational expertise.

Sector specialists have deep domain knowledge, industry contacts and a high number of repetitions in a sector, leading to increased high-quality dealflow, according to Cambridge’s study. Post-acquisition, specialists are also better at knowing what to do beyond financial engineering and often employ industry-specific operating and strategic skills to drive value in the business.

Big buyout shops have also adopted specialisation, either by hiring those with industry expertise or by adding new and smaller sector-focused vehicles. In 2008, Carlyle Group launched its first global financial services fund. The strategy is now on its third vehicle. Permira entered the growth-oriented tech market last year with a $1.7 billion debut growth vehicle, while Blackstone set up a dedicated life sciences vehicle in early 2019.