Specialist managers are difference-makers in private equity

In his seminal work, On the origin of species, the English naturalist Charles Darwin posited that it is the “perfect adaptation of species” that allows them to survive in the environments in which they live.

By Darwin’s standard, the private equity (PE) industry has adapted and therefore thrived in the years since its beginnings. In its formative days, PE was known as “bootstrap” investing, conveying its almost cottage industry character.

Nowadays, it’s a mainstream asset class valued for both its high return potential as well as diversification attributes, and found in the portfolios of institutional investors, sovereign wealth funds, family offices, and endowments. Private equity’s progressive democratisation means that it is now increasingly available to retail investors too.

Today, the issue is not whether an investor can access PE, so much as how they may choose to participate in it. Investors are spoilt for choice and have before them everything from venture capital funds to buy-out funds, secondaries, mid-market funds, generalist funds, closed or open-ended funds, and so much more.

Return premium from specialist managers

The beauty of investing is that there isn’t an exclusive correct method or formula for success. This is equally true in private equity: many approaches can succeed.

That said, in the PE space, specialist managers with deep expertise in specific industries have tended to outperform their generalist counterparts over lengthy time periods. This is not surprising as intense competition means that operational expertise becomes more prized than financial engineering skills.

One study reported that “Over the past two decades, sector-specialist PE funds have consistently outperformed multi-sector funds across various industries, particularly in technology and healthcare.”¹

More specifically, Niche Private Equity Index return data, for the 2011 – 2021 decade, revealed that specialist PE managers bested generalists, represented by the PitchBook average, on multiples of invested capital (MOIC) by vintage, each year.² All up, the Niche Private Equity Index 10-year MOIC averaged 2.4x versus the PitchBook 10-year average of 1.7x.³

We think specialist PE managers’ success stems, in part, from their sophisticated value creation playbooks. One-size rarely fits all in the PE world and our long experience of working with specialist managers has given us front-row seats to observe them devising and executing discrete strategies to transform the operational and financial performance of investee companies in industries in which they have deep knowledge.

In healthcare, for instance, a typical specialist value creation playbook could be broken down into five broad parts:

1. Strong systems to support leading clinical outcomes
   
2. Focus on reduced cost to serve patients
   
3. Simplified straight through processing of patient management, billing, and reporting
   
4. Align doctors with remuneration and incentive plans
   
5. Acquire additional practices at lower multiples to scale, manage their integration and growth.

The value creation model applicable to healthcare may be inappropriate for the technology or consumer industries, by way of contrast. Each industry requires its own value creation model, and that’s best understood, developed, and executed by true industry specialists.

In medicine, while your local GP can assess you for a heart condition, that’s no substitute for seeing an experienced cardiologist specialising in heart health. In the same way, if you want the best managers to transform operating companies, you want to partner with specialists who have hands-on experience running similar companies, rather than generalist PE managers.

True industry experience matters

Our analysis reveals that executives with expertise and strong records of accomplishment in highly specialised industries are best placed to source attractive investment opportunities and understand sector-specific investment risks, allowing them to analyse investee companies prior to acquisition, as well as drive post-acquisition changes to lift value.

Some years ago, Motive Partners, a United States PE manager specialising in financial technology, acquired Dun & Bradstreet, as part of an investment syndicate. Motive Partners appointed one of its co-founders — who had previously been a CEO of global financial services data provider IDC (Interactive Data Corporation), and Morgan Stanley’s Global Head of Operations, Technology, and Data — to run Dun & Bradstreet.

As can be imagined, this executive brought exceptional industry knowledge to lead the charge to transform Dun & Bradstreet and position it for its eventual public listing.

This is the value of specialists in PE.

The mid-market advantage

A corollary of preferencing specialists is to preference mid-size companies, where specialist capabilities are particularly valued, given the generally lower sophistication of these growing businesses.

In our view, there are more operational efficiencies to be achieved in the mid-size company arena over a typical PE holding period, than among larger companies where transformation can take longer to realise, or where operations are already highly efficient and growth prospects may be limited.

Because of these inefficiencies, it is possible to have a greater impact on companies towards the middle and smaller end of the spectrum through transformation and growth programs.  

From our experience, transformed mid-size companies often become so attractive to larger companies or other PE managers that they get bought at attractive prices, giving investors an ideal way of realising value.

Digging deeper and being more specific – one of the attractions of the mid-size company realm is the valuations they offer compared to their larger counterparts.

Data reveals that valuation multiples for middle market buyouts with transaction sizes under US$1 billion were between  8.8x and 10.2x, on an last-12-months EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) basis, over the past five years⁴, which is about 25% lower on average than the range of 11.6x to 13.9x for larger companies.⁵  We believe this gap creates greater opportunities for valuation growth at exit as these mid-sized companies scale in size.

The mid-market segment offers potentially greater growth too with the Compound Annual Growth Rate (CAGR) of revenue and EBITDA being 8% and 10% respectively, while in the large cap space the figures are lower at 5% and 7%.⁶

Mid-cap advocates would argue that these firms provide more room for growth with accretive bolt-on acquisitions, and more value creation opportunities. Lower mid-market companies also tend to have less debt on the balance sheet and as a result are nimbler and better positioned to adapt to market disruptions.⁷

The mid-market also benefits from an abundance of potential targets compared to the large cap space. For instance, in the US, there are around 210,000 companies that have between $10 million and $1 billion in revenue, providing a target-rich investable universe, compared to only 5,000 companies with over $1 billion in revenue.⁸

We would argue that there are often more value-creation levers available to private equity investors in smaller companies. Think of the ability to drive margin improvement through operational management, supply chain management, IT implementation, data science, better enterprise reporting, and acquisition integration.⁹

By the time firms have reached large company status, they are closer to the ceiling in all arenas, in our view. They have reached levels of maturity where revenue growth is slower. There is less low hanging fruit to target.

This means there is greater reliance on the final value-creation lever available to private equity firms – capital markets. Mega firms tend to rely much more on financial engineering and higher levels of debt, which can be more challenging in higher interest rate environments, such as those of the past few years.

All up, we believe that investments in the mid-market segment, led by industry specialists, represents a source of potentially strong long-term PE returns.