In today’s challenging climate, private equity firms are increasingly relying on sector expertise to generate deal flow and add value to portfolio companies. Yet as with any widely used expression, there is a difference between operators who use it as yet another marketing phrase that has little substance behind it and those who are able to demonstrate that sector expertise is a fundamental element of their overall investment strategy.
Possession of sector expertise became an increasingly popular stipulation amongst private equity houses throughout the mid–1990s. As private equity firms grew, investment teams developed sector specialisations. Since then, demonstrating a high level of experience in a sector is a common way for private equity firms to succeed in competitive markets where sellers of companies are also increasingly skilled and sophisticated.
That said, it is worth exploring in more detail what is meant by sector expertise as distinct from sector specialisation. Perhaps a good start point is to rewind to the height of the boom in the TMT sector. Back then many investors paid the price for not having a sufficiently strong level of knowledge and experience of the sector before investing and subsequently losing large sums of money. In their rush to jump onto the TMT bandwagon, many of the first principles of sector expertise, chief among them the fundamental principle of valuation were overlooked. At Legal & General Ventures, we were not tempted to enter into the TMT sector because we recognised we did not have the expertise to make an informed investment decision.
Instead, before deciding to target an investment sector, it’s important at the very least to be able to answer the following types of questions: has the sector produced strong returns on an historic basis? What are its prospects over five to ten years? Is there likely to be a healthy deal flow? Is it ripe for consolidation? What are the larger external influences that could impact on it? What size is the sector currently and is it growing or contracting? And what factors may affect it in the long term?
For a buy and build investor, sector knowledge is crucial in helping to identify platform acquisitions and subsequent add-ons as a basis for the ultimate objective of achieving an exit. This involves, firstly, a strong contact base with senior managers and corporate development officers working for the leading companies in the sector. This is crucial in being able to identify and develop relations with strong management teams before the competition has a chance to do so.
In addition, firms who claim to have sector expertise should have experience of investments and exits at all stages of the sector’s cycle. Without having ‘been around the block,’ it is difficult to know whether you are investing and exiting at the right time and through the most suitable channel. It also plays an important role in developing an understanding of the challenges and opportunities faced by management.
For example, our recent MBO of Jeyes, the household cleaning supplier, bears a strong resemblance to an investment we made back in the mid-1990s in McBride, a leading household products supplier to the major UK multiples. That LGV had already confronted similar issues gave us a level of comfort and confidence that can only be earned through experience.
Having a detailed level of sector expertise also pays dividends at the due diligence stage. Over the past few years there has been a trend amongst vendors to reduce the amount of time available for due diligence. This is particularly apparent amongst companies that have decided to rapidly divest from activities that fall outside their core business interests. Thus many firms are unable to conduct the level of analysis that they would in theory like to do. Clearly, the more work that has been done in advance of the due diligence stage the better. It’s the firms that are already au fait with both the company and the sector’s prospects that make the more informed investment decisions.
It’s also at the due diligence stage – when time is of the essence – that having a strong network of sector contacts such as operational management and advisers to draw on at short notice becomes crucial. As the trend towards developing specific sector expertise has grown, so has the accompanying number of industry experts and advisers.
Clearly, no single skill can guarantee success for private equity firms and good deals can just as easily result from opportunism and sheer good fortune. Nevertheless the top houses generate superior returns by getting deep inside their portfolio companies and executing a fundamental change. This can only be achieved on a frequent basis by those firms who have superior knowledge of a sector and the companies within it.
The authors are, respectively, Chief Executive and Managing Director at Legal & General Ventures.