The rise of sector specialists

As domain expertise becomes a differentiator in an increasingly crowded PE market, managers are taking varying approaches to building industry know-how.

In a private equity market that is more competitive than ever, sector specialisation has become a key attribute for buyout firms that want to stand out from the crowd.

“The number of GPs in the market looking to deploy capital has never been higher and the need to differentiate has never been higher,” says Christian Hess, European head of the financial sponsors group at investment bank Piper Sandler. “One of the ways to do that is to demonstrate sector track record and knowledge.”

GPs with industry expertise have found themselves in a strong position to build rapport with management and add value operationally post-deal, while it has become commonplace for sellside advisers to qualify potential buyers based on evidence of sector knowledge.

“Sellside advisers want to construct efficient processes, and sector expertise gets you to the table,” says Aaron Sack, head of Morgan Stanley Capital Partners (MSCP). “As a manager, it is incumbent on you to show how you can add value operationally and help a management team to achieve growth.”

The value of sector specialism in deal processes has also carried across into financial performance and returns. According to Mantra Investment Partners, data from its recently launched Niche Private Equity Index shows that specialised PE funds investing in niche strategies have outperformed generalist managers over the last 10 years, delivering multiples on invested capital of 2.1x versus 1.8x for private equity overall. These findings align with those of earlier studies from Cambridge Associates and Coller Capital showing, respectively, superior returns and LP appetite for sector-specific funds.

The PE industry’s pivot towards sector specialisation is expected to deepen even further in the current environment, as managers grapple with the impacts of inflation and rising debt costs at the portfolio company level, as well as a tougher fundraising market.

According to Bain & Co’s Global Private Equity Report 2023, roughly a quarter of the funds currently in the market will not manage to raise capital again. Cautious fund investors will likely lean more and more towards sector specialists that can meet specific investor risk-return objectives by leveraging industry expertise to find the highest-quality deal targets in niche areas, and then deliver returns using operational rather than financial levers.

“Loading up on debt is not going to work in the years ahead,” says Piper Sandler’s Hess. “GPs have to be prepared to hold assets for longer and have the conviction that they can drive earnings and value in multiple ways. Firms with a sector thesis and ecosystem will be the best placed to do that.”

Building sector knowledge

But while there is now a broad consensus on the value of sector-specialist capability, the pathways to embedding this in practice still vary significantly across the asset class, with managers adopting a range of playbooks to build authentic industry expertise across their organisations.

MSCP,  for example, has put an operating partner model at the centre of its team structure. In what is still a relatively unique approach for a mid-market player – although more prevalent within larger firms – operating partners at MSCP are part of the same incentivisation pool as deal professionals and are involved in each step of the deal process, from sourcing and deal execution through to portfolio management and exit.

“We take the view that it is fundamental to have operational experience and skills alongside financial expertise,” says MSCP’s Sack, “and we require all deal theses to be authored and brought to investment committee jointly by an investment partner and an operating partner.”

Other managers, however, have expanded their sector credentials by building up industry networks. “We work extensively with industry experts from our network, but don’t have an operating partner model,” says Flor Kassai, a partner at mid-market PE firm Inflexion, where she leads its buyout fund. “We wanted to avoid a situation where you are forcing an individual into a business because they are on the payroll. We prefer to bring in industry experts from across our network who are the best fit for each situation.”

Mid-market firm Livingbridge has also adopted a network strategy to build sector knowledge. “We consistently bring in industry experts from across our networks to support deal teams,” says Livingbridge partner Dan Smith. “A good example of how this works in practice is our Software Advisory Board – a group of software operators from different functional backgrounds that can support our companies with the tough challenges they face as they grow.” 

However, as important as sector specialisation, operating partners and industry networks have become, managers still want to have a view on the bigger macroeconomic picture and retain a degree of flexibility to invest in more than one area through the economic cycle.

Livingbridge, MSCP and Inflexion, for example, have all developed teams with deep expertise in specific areas, but through investment strategies that span more than one industry vertical.

Sack says: “Our firm has a broad services lens, drilling down into the consumer, healthcare, industrials and B2B services. The strategy is designed to develop sector expertise without becoming too narrow. You can’t afford to be a generalist, but when the investment focus is too restricted, you can make mistakes.”

Inflexion’s Kassai adds: “For any GP the raison d’etre is to make good investments, and if you are too narrowly focused on one sector at the wrong point in the cycle, there is a higher risk of making a poor investment as a result of a desire to deploy.”

Niche expertise

Finding the ideal balance between sector specialism and flexibility to tilt towards different sectors filters down into deal team structures. At Inflexion, for example, investment teams are organised along sector lines, although younger professionals will move across different sector areas to build a wider perspective, then narrow their focus as they become more senior.

At Livingbridge, dealmakers are also split across the firm’s four areas of sector focus (services, technology, consumer and healthcare), where they spend 60-70 percent of their time, but they will have the bandwidth to support on deals beyond their core verticals. 

This approach, coupled with the firm’s geographical reach across the US, UK and Australia, is structured to provide investors with a strategy that combines the benefits of specialisation and diversification.

“We value the flexibility to shift the balance of the team across our sector areas over the investment cycle,” Smith says. “What we’re offering our investors is a mid-market, multi-geography, multi-sector strategy, where we are really strong in areas that we specialise in.”