Sector specialisation increasingly appears as an attractive way to stand out in a tough market. But can generalists successfully make the transition – and will it necessarily win over LPs? Greg Gille investigates

Unsurprisingly, nearly half of the 75 managers surveyed by US consultancy McGladrey earlier this year describe their firm as generalist and investing in many different sectors. However, a third of respondents state that while they are generalists, they intend to narrow their focus on specific sectors going forward. Added to the 14% that already define themselves as specialists, this figure would suggest that the sample could contain industry specialists and generalists almost in equal measure a few years down the line.

Extrapolating this result to the wider industry would mean a substantial change for a private equity landscape still dominated by generalist buyout players. But the move does seem to make sense given the current state of the industry, with leverage playing a diminishing part in generating returns as opposed to growing a company's top line and sussing out the best performing assets in a gloomy macro environment.

"The old paradigm is mostly obsolete, and GPs now have to go back to the basics: buy cheap, create tangible value, sell at a higher price," notes Antoine Dréan, founder and chairman of placement agent Triago. "In order to do this, it helps if you know what you're doing - knowing what you're buying, how to price it, creating value without leverage, etc. All this tends to favour GPs specialising in specific markets, industries and types of deals."

The benefits of industry specialisation are not lost on LPs, which increasingly tend to look out for sector-focused GPs when committing to the asset class. Says Adveq executive director Tim Creed: "We already believe in specialisation for private equity managers, and that is something we have been focusing on for several years. Ten years ago, we started looking into industry-specific managers, as we believe they are well positioned to outperform in the future. In 2011 for instance, we have committed to three such GPs in Europe."

Deep market knowledge

PE houses can reap the rewards of sector specialisation across the entire investment process. It starts with deal origination, when industry specialists are often likely to come out on top of corporate financiers' shortlists for the auctions of specific assets. But vendors and management also tend to favour firms that are in sync with their own experience and vision of the business - a sometimes overlooked asset in sale processes: "As part of our due diligence we recently interviewed the CEOs of a fund's portfolio companies," recalls Creed. "One of the executives stated that they had actively chosen this GP over a few others, despite receiving higher offers, because it was an industry specialist. And post-investment, we believe a sector-focused manager can add a lot of value to its portfolio as well."

Evidence of all this translating to higher returns is also starting to emerge. A recent study by Golding Capital Partners and HEC School of Management - looking at more than 4,200 realised private equity transactions carried out in Europe and the US between 1977 and 2010 - argues that fund managers generate above-average excess returns when their portfolios exhibit a high degree of industry specialisation. "The sample size in the early years of our commitment to these strategies wasn't big enough to provide a true statistical evidence of specialist GPs outperforming others. In this generation of fund managers - where they are more heavily represented - we would expect this advantage to become more evident," adds Creed.

One of the main counter-arguments often put forward by generalist players is the lack of portfolio diversification specialisation entails. "The idea that sector-specific strategies are too correlated to economic cycles does make sense," agrees Dréan. "But managers who really know what they are doing can take advantage of these cycles; for instance prospects in the customer sector might look bleak at the moment, but the downturn also creates opportunities in the low-cost segment. Besides, targeting two or three carefully selected sectors allows GPs to invest across the investment cycle."

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