The world has long understood the power of specialisation. As it relates specifically to private equity, data from Cambridge Associates confirmed five years ago that sector-focused funds materially and consistently outperform their “generalist” peers. Still, while the advantages have been well told, sector-focused funds in Europe have historically struggled to take root and flourish in a manner that has been typical in other geographies.
Globally, sector specialisation is hardly new. In the US, firms such as Providence Equity Partners, TSG Consumer Partners, and L Catterton have focused on one or a handful of related sectors since the 1980s. And even avowed generalists have conceded certain advantages that come with specialisation, ranging from more credibility when sourcing investments to understanding and executing upon the operational levers that support value creation. This is why so many sponsors – generalists and specialists, alike – have bolstered their operating partner capabilities with industry practitioners in recent years.
Yet, in Europe, true sector specialisation has largely remained an exception to the rule. The slow uptake seems even more glaring today as sector-specific funds in the US attract mainstream appeal. Witness Thoma Bravo’s $12.6 billion haul for its latest software fund in January or Vista Equity Partners’ ongoing $16 billion fundraise. Recent developments, however, suggest this could be changing. 2018 saw a string of hugely successful fundraising efforts in Europe’s middle market, including vehicles from ArchiMed SAS and GHO Capital Partners, targeting healthcare, and Main Capital Partners and Keensight Capital, leaning toward tech. Taken together, it seems to offer mounting evidence that specialised funds are finally beginning to break through on the continent.
The path to specialisation
Private equity’s maturation has seen the industry transition from a financial engineering model to one driven by value creation. This has occurred as the number of firms and amount of capital dedicated to PE have grown exponentially, pulling entry valuations higher and raising the bar to generate performance in line with historic returns. This, by itself, speaks to some of the advantages enjoyed by those who can bring to bear a proven playbook to drive portfolio company growth. But over the past 30 years, as private equity has transcended its cottage industry beginnings, specialisation has taken on several different forms.
For instance, early specialisation tended to be around deal size, often with new groups starting out in the gaps created by successful firms moving up scale. As the industry further evolved, specialisation also saw firms differentiate themselves based on other factors, from where they invest in the capital structure to the types of businesses acquired, be it founder-led companies, sustainable businesses, or any other defining characteristics. In the US, the predominant form of specialisation saw emerging managers typically formulate a value proposition centered around the experience and skillset of operators from a certain industry, creating a sizeable population of sector-specialised funds. in Europe, this failed to materialise.
An obvious question, albeit without an obvious answer, is what were the obstacles standing in the way of sector specialisation in Europe and have they now changed?
Perhaps one of the obviating factors has been a mature and contented base of LPs, who were happy with the products already on offer. Early investors in the asset class in Europe developed successful relationships with some of the longest-tenured names. As the consultancy Bain & Co has identified, PE returns in developed Europe have largely performed as well as or, in some cases, better than their US counterparts, while enjoying an even larger performance gap over public equities in Europe. In this regard, there hasn’t been the need to fix something that wasn’t broken.
Another obviating factor is that the default geographic focus of many European firms has historically offered another form of specialisation by geography. From an LP’s perspective, if they’re seeking diversification across their PE allocation, these geographic exposures can be valuable. It also sits hand in hand with the argument that business owners in the targeted European markets may have preferred to deal with local buyers. As a result, European GPs have had to fight to get the sector specialisation story to be heard and accepted.
Research has documented that specialisation does indeed translate into higher profits for PE-backed companies, but it is not just a value-creation story. In sourcing investments, focusing on a specific sector builds networks that can produce higher quality dealflow. Sellers will generally know the GP’s story; they may know peers who have worked with the firm; and they’ve likely had conversations, sometimes over the course of years, that serve as the basis for a more substantive relationship. If this doesn’t yield proprietary dealflow, it can at least give sponsors a leg up in a competitive auction. Against the backdrop of the digital revolution and the growing need for transformation, business owners are increasingly prioritising a GP’s “value add” as the key differentiator. And this can be more important and more valuable than being local.
On top of the advantages at entry, research out of Italy’s University of Bergamo has also shown that specialisation generally yields a more expansive universe through which to exit an investment. This is particularly the case for those seeking realisations through sales to strategic buyers or initial public offerings.
But one characteristic of specialisation that seems to be true across geographies is how rare it is for the string to ever be pushed back once the trend gains momentum. Again, look at the generalists today. Many of the larger firms are in fact made up of teams of specialists, albeit across multiple sectors. Apax Partners, for instance, zeros in on the tech, services, healthcare and consumer industries, whereas Nordic Capital targets specific industries within certain regions, citing healthcare, technology, financial services, consumer and industrial services as its core focus areas.
What many “hold out” generalists may soon discover, given the movement towards specialisation, is that their narrative no longer resonates in an environment that’s only becoming more crowded and more demanding. Given some of the names already in the market with a new fund, it’s likely a small number of the very largest firms will absorb the lion’s share of available allocations in 2019. GPs need a distinguishing feature to stand out, and sector specialisation in Europe could be about to have its day.
Janet Brooks is a partner in the London office of Monument Group, an independent global placement agent. Brooks has investor coverage responsibility in the UK, France, French-speaking Switzerland, the Benelux region and Asia. Previously, she spent 15 years with ECI Partners. She has also served on the investor relations committees of the BVCA and EVCA.
A version of this article was published in Private Equity International.