A piece of research from Cambridge Associates provides supporting evidence for something industry insiders have been pretty sure of all along: sector-focused private investment funds outperform generalists.
The study defined sector specialists as managers that have invested more than 70 percent of their capital in one of four sectors – consumer, financial services, health care, and technology – and looked at investments made over the ten-year period from 2001 to 2010.
According to Cambridge, sector specialist investments between 2001 and 2010 made up 12 percent of the total invested capital in these four sectors during this time period, with the most investments made in the technology sector. While sector-specific funds were mostly mid-market in size, the size of the generalist funds was much more varied.
Taken as a group, sector-focused funds generated a multiple of invested capital of 2.2 and a gross internal rate of return of 23.2 percent. Generalist managers returned an aggregate 1.9x and a 17.5 percent gross IRR.
What’s more, the study shows that sector-focused funds outperformed generalists in nine out of the ten years examined. Only in 2002 did generalists blow the specialists out of the water, returning 3.1x compared to 1.9x.
The research discovered that sector specialists were better able to minimise capital loss. Only 14 percent to 25 percent of sector specialist capital was in investments valued at less than 1x, compared to 28 percent to 31 percent for generalists.
“Through specialisation and domain expertise, the sector specialists appear to be better at avoiding bad investments without hindering their ability to invest in companies that generate outsized returns,” the study says.
Cambridge has identified several areas in which sector specialists appear to have a competitive advantage: sourcing and selecting portfolio companies; adding value post-acquisition; and exiting investments.
“The deep domain knowledge, industry contacts and sheer number of repetitions in a sector leads to higher quality and increased volume of deal flow and better pattern recognition for sector specialists.”
Sector-focused funds, therefore, seem like a no-brainer. However, as the study points out, this strategy is not so easy for smaller LPs. In order to achieve a healthy level of diversification, the investor would have to commit to more sector-focused managers than they would generalists, which means more time – and money.