Sector specialisation taking hold in Europe

European private equity funds have invested in fewer sectors every year since 2012, according to analysis run by Unquote (see methodology at the bottom of this page). Part of the explanation for this is the emergence of single-sector funds, a phenomenon observed in North America for more than a decade now, but which has been slower to catch on in Europe. However, even generalist funds have been narrowing their focus across vintages in a bid to stand out from the crowd.

One thing every investment professional that Unquote spoke to regarding this article agreed on, is that it is harder than ever to make money in private equity. This is perhaps not surprising, given the level of competition and the pressure to deploy capital into an expensive market.

Also relatively uncontroversial was the idea that, in this environment, it is important to have a clear point of differentiation from other private equity firms. However, how this difference should be articulated, and to what extent a sector focus or specialisation should be integrated into it, was somewhat more divisive.

“We are definitely seeing more sector-focused funds, or funds focusing on just one or two sectors, than we have ever done previously,” says Janet Brooks, managing director at placement agent Monument Group. “Our take on it is that with asset prices as high as they are and competition so fierce, firms really need to be prepared to make bold calls in terms of which processes they get involved with, and having sector knowledge really increases their chances of getting those calls right.”

Archimed was among Europe’s first healthcare specialists. Founding partner Denis Ribon says Europe’s cultural and political diversity is part of the reason for the slow adoption: “In the US, sector specialisation started 10-15 years ago – five years ahead of Europe, and that is because country fragmentation didn’t originally play the key role in fund organisation in the US that it did here. Sector specialisation has come to Europe a bit later, but it is already proven based on what has happened in the US.”

Most concentrated funds in sample (source: Unquote Data)

Fund Name	Vintage	Final Close Amount (€m)	Fund Country	Concentration Ratio
Siparex Midcap 2	2011	130	France	0.17
Alto Capital III	2011	100	Italy	0.17
Main Capital III	2012	40	Netherlands	0.17
Apposite Healthcare Fund II	2016	199.07	UK	0.2
Primary IV	2014	271.13	UK	0.2
Accent Equity 2012	2011	415.13	Sweden	0.21
Equistone Partners Europe Fund V	2015	2,000	UK	0.23
Carlyle Europe Partners IV	2014	3,750	UK	0.25
PAI Europe VI	2014	3,300	France	0.25
Ciclad 6	2018	180	France	0.25

Medical pioneers
Nicolas de Nazelle is managing partner at placement agent Triago, which helped launch Archimed in 2014. “We started looking at sector specialists in Europe in 2012. We had success in healthcare, consumer and technology in the US, so we started looking at those sectors in Europe. Consumer was essentially the only one we could find with the likes of Ergon, Lion, L Catterton and Change Capital.”

Undeterred, Triago broadened and continued its search: “The next thing we looked at was whether there were groups that wanted to create a fund that came from healthcare,” says de Nazelle. This led to the discovery of the team that would become Archimed, consisting of three ex-3i professionals and senior operational executives from the healthcare industry.

This capitalised on an increased need for operational improvement to drive returns. EY’s 2018 report Creating value throughout the private equity investment cycle in the digital era claims that 60% of returns are now driven by operational improvement, up from 36% in the early 2000s.

“It is inevitable that operational improvement drives returns now,” says de Nazelle. “Leverage is not really a value add and everyone buys expensive, so you had better transform that company. If you buy a company at 16x and don’t do anything to it then good luck making money.”

It is not only sector-focused funds that have adopted a more hands-on approach, as a proliferation of buy-and-build strategies will attest. However, Archimed’s Ribon argues that sector funds have the edge over the longer term: “On a single deal, a generalist fund could be as good as a specialised fund because they could have a good operations partner or an adviser that focuses on that specific sub-sector, but the challenge is to have a consistent, long-lasting performance because you will not always be investing in the same sub-sector. In a healthcare fund you will have a few team members for each sub-sector.”

This logic has led to a proliferation of healthcare-only buyout funds in Europe, from practically none when Triago first started looking in 2012 to a handful today, including GHO Capital, G Square Capital, Gilde Healthcare, Apposite and SHS Beteiligungsgesellschaft.

Ribon also highlights the advantages for deal sourcing, highlighting the gene therapy sector: “Everybody is rushing into gene therapy right now. There have been a few high-profile deals, so it is on the radar. Sector funds had already identified this trend and understood there was a major opportunity a long time in advance. This allowed them to pursue companies in the space much earlier, pay lower prices and acquire the best targets.” Archimed did a gene therapy deal of its own in 2016, acquiring French business Polyplus in an off-market transaction.

With asset prices as high as they are and competition so fierce, firms really need to be prepared to make bold calls in terms of which processes they get involved with” - Janet Brooks, Monument Group

Keeping an open mind
Sector specialists have the advantage of deeper sourcing networks and the type of industry knowledge that enables them to do deals that generalists never could. On the other hand, there are instances where keeping a wider perspective and employing a more pragmatic approach can mean the same is true in reverse.

Equistone is one pan-European GP that has decided to stick to a pragmatic, generalist approach to investing so that it can be reactive to any opportunities that arise in its key geographic markets. However, the firm does have deep experience of investing in certain sectors, such as support services, consumer, and travel, healthcare and specialist engineering. This philosophy has allowed it to do deals in the past that a GP focused on just one sector would not have been able to. For example, Sunrise Medical was an electric wheelchair and mobility scooter manufacturer that it held between 2012-2015, before it was sold to Nordic Capital for a 4.1x return. The acquisition is described by Christiian Marriott, Equistone’s head of investor relations, as “drawing as much on the firm’s experience with engineering investments as with healthcare investments”.

This type of synergy has convinced some LPs that differentiation is more important than a sector focus. Munich-based fund-of-funds MPEP’s managing director, David Schäfer, says: “We don’t really see a trend of more sector-focused funds in Europe. What we do see is funds being a bit more focused and building up sector know-how, and the large funds across different regions have built up in-house sector teams.

“Many GPs are a bit concerned about the macropicture, so they implement in their base case what will happen in a downturn, talking about multiple contraction. So, the question they ask is: ‘How can we do 2x, if we buy at 7x and have to sell at 5x?’ Value creation is much more dependent on operational involvement and improvement.”

Argentum’s Joachim Høegh-Krohn echoes this prioritisation and adds emphasis to Schäfer’s point about sharper focus: “We have not officially observed an increase in sector funds, but I think there is a shift towards it. There are still a number of generalists, but they take a narrower approach to the market. It is quite a natural development in the market; the deals that work out for you, you emphasise when you fundraise and plan to do more of in the future.”

This is true for Equistone, which invested across four or five industry segments for its second, third and fourth funds, but narrowed to just two for its fifth, according to Unquote Data. This was driven partly by performance of previous deals, and partly by the firm reacting to the availability of suitable opportunities in its target markets during the time the funds were being invested, says Marriott: “Fundamentally, we assess opportunities and build our portfolio from the bottom up, so we definitely do not feel our investment committee has made any conscious decision to become more focused in recent years.”

However, some of its competitors have made a conscious effort in this area, the most notable example being Hg, which had invested broadly for previous vintages of its fund but now explicitly targets only TMT and industrials, and has so far deployed its latest fund almost exclusively in technology deals.

Hg is not alone in having performed well in this segment. According to a Bain study, more than half of sector-specialist funds focus on technology or healthcare, which have the highest average exit multiples when compared with other sectors (2.2x for healthcare, 2.1x for technology).

Bifurcation
This trend has driven some of the platform extension funds that larger managers have launched, such as Bain Life Sciences, where GPs use sector funds as an opportunity to raise more capital from their existing LPs. Monument’s Brooks acknowledges that the theme of sector specialisation can be used in this way: “The issue is that for some LPs it is difficult to find and diligence those smaller managers because they are small and highly sought after. They may find it easier to access sector funds through their existing managers where they do not have to do the same level of diligence. As long as those teams are high-calibre, well-incentivised and any conflicts are handled well, that can be a valid way to access the sector.” However, she adds: “At Monument Group, we want to see thriving, smaller, sector-focused and independent groups because they are the groups we are more likely to be fundraising for.”

This fits into the trend of bifurcation of the European buyout fundraising market. However, there is hope for the early adopters, says Archimed’s Ribon: “There are more sector-focused funds, so as a sector-focused fund we become less differentiated. However, if you look at what happened in the US, the pioneers are still leading the race. There will be more but the first movers should keep an edge.”

This is good news for sector specialists launching now, especially in sectors that seem out of fashion, such as industrials. Nordic Alpha Partners is one recently closed fund that is focused purely on the digitalisation of the northern European industrials sector. The GP raised its debut fund from LPs including ATP, Vækstfonden (the Danish growth fund) and assorted Danish industrials groups with a volume of €130m at the end of 2017.

Founding partner Laurits Bach Sørensen explains how the sector focus is integrated into its operational model: “Our sector focus is a little opportunistic, in that we invest in hard tech because it is a bit undercatered by private investors at the current point in the cycle. The focus is on the hypothesis-based investment model with a strong operational focus.”

Sørensen does not rule out that this model could be applied to other sectors, but sees the merits of keeping the teams and vehicles separate to create focus: “I like the logic of sticking to one sector per fund because going from hard tech to healthcare or software would be difficult. In order to be a truly value creating fund, it makes sense to keep them separate.”

Whether this is the correct approach remains to be seen, but it seems to be the current direction of European private equity. Many in the industry argue that private equity has become a science, and Nobel prize winner Konrad Lonrez would no doubt agree: “Philosophers are people who know less and less about more and more, until they know nothing about everything. Scientists are people who know more and more about less and less, until they know everything about nothing.”

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• Equistone Partners Europe
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