Death of the Generalist
If you believe what you read in the marketing spiel, it seems that everyone is a sector specialist these days. In reality, of course, genuine single sector focused funds in Europe remain incredibly rare.
But this is changing. One of the greatest barriers to the creation of European sector specialist firms is being rapidly eroded, as limited partners are forced to realise that they can no longer maintain their returns by blithely re-upping with existing GPs.
Mega-market leveraged buyout relationships will continue to form the core of the largest LPs' portfolios, but anticipating a sharp decline in big buyout performance, many are actively searching for alpha at the margins and appetite for single sector funds has soared.
"LPs are crying out for fresh strategies that can beat the impending downturn," says Alexander Apponyi of placement agent Berchwood Partners.
"The market is changing," adds Alan McKay of 3i. "Most people don't even realise it is happening yet, but sector specialisation is gathering momentum."
This sea change in LP attitudes could prove vital in unblocking a pipeline of sector specialist fundraisings. European private equity's generalist heritage runs deep – the majority of the region's oldest firms were created through spin-outs from financial institutions, unlike the US where most were created by entrepreneurs.
Any sector specialist trying to establish itself in Europe has, by definition therefore, been to some extent a first time fund. This at a time when most limited partners have been too preoccupied re-investing seemingly endless distributions to concern themselves with emerging managers.
On the increase
But as these distributions dry up, fresh propositions promising genuine value creation are gaining increasing appeal and anecdotally a number of new sector specialist firms are expected to arrive on the scene.
"My sense is that our star is rising," says David Porter (pictured), managing partner of healthcare and life sciences specialist Apposite Capital, which raised a $200m (130m) debut 18 months ago. "When we first went out to LPs not only did we not have a track record, but our industry background didn't carry the weight it does today. Now the reception we get is completely different. Partly, we have just got better at putting across our message. But the shake-up in the industry is working to our advantage, too. "
The rationale behind LPs' shift in attitude is clear. With liquidity drained from the market, operational improvement has become paramount, providing the perfect backdrop for honed industry strategies.
In theory, a sector specialist should have the edge at all stages of the private equity investment process; sourcing deals, assessing targets, executing strategic development and maximising value on exit – particularly at this point in the cycle.
"It is going to be difficult to sustain returns with the usual tools of the trade going forward," says Marcus Bracklo, previously of Sal-Oppenheim's healthcare team and co-founder of newly formed European healthcare buyout firm Baigo Capital.
"Transforming the value of a company and making operational improvements to performance is going to become more important, and that is where sector specialists can really come into their own."
"Economic conditions will encourage more sector specialists," adds Joe Giannamore, managing partner at financial services specialist Anacap Capital Partners. "Private equity returns have historically been generated from high leverage and low interest rates – and then some operational engagement as an afterthought. The first two pillars are now severely compromised. So you need to know your industry inside out."
Europe's generalist firms have, of course, evolved with this operational bias in mind and few true pan-Europeans choose not to emphasise their segregated industry expertise. Genuine sector specialists would nonetheless argue that this level of dedication remains, relatively speaking, superficial.
"We are simply more into healthcare than other people are," says Porter. "We spend a lot of time doing things that have nothing to do with private equity per se at all."
For example, Porter sits on a review panel looking at the progress of a government team set up to accelerate UK bio-industry growth. He also sits on committees addressing plurality of provision into healthcare services in the UK and is a sponsor of the most influential think tank in the sector, the Kings Fund.
"You may say why the heck do we do these things? What has that got to do with growing value in portfolio companies? But this is a political business and if we have a sense of where the politics are going we will be one step ahead of the game. It is also imperative for networking. There is nothing like being on government committees for making contacts."
Porter alludes to one of Apposite's portfolio companies, specialised in therapeutic foster care. "I am sure the reason we won that deal is that the founder thought we knew more about healthcare than anyone else because we were in the system. We live and breath the sector."
There are, however, obvious risks associated with the sector specialist approach. History is not the only reason that sector specialism has hitherto failed to gain any real traction in Europe. The US benefits from a single, homogenous and vast domestic market, with sufficient depth of deal flow to nourish a single sector ecosystem. Europe, by contrast, is complicated by its multi-jurisdicational make-up, meaning that in-depth understanding of a sector on a pan-European basis is a far tougher proposition and dramatically more resource intensive.
On the one hand, this has been a deterrent for sector specialists. Single country markets in Europe tend not to offer sufficient scale, while a broader geographical sweep, which must take into account not just different regulation, but different cultures and languages, has proved too daunting. Apposite Capital's life sciences business is global. But its buyout business is UK-focused, for this very reason.
"In healthcare, Europe's multiple jurisdications are a problem," Porter says. "A lot of that comes down to the different payer systems. In the UK, for example, the healthcare system is 90 per cent tax funded, with the remainder either insurance or self-pay. In France that dynamic is completely different and in the Nordics different again."
Porter adds that Apposite had considered a mental health company in Germany when it first raised its fund but had been amazed by how different the approach to mental health was.
"We tend to look at other European countries, and the US, in terms of ideas we can bring to the UK," he says. "Investing globally in the healthcare space is way beyond our scale. Maybe if we had billions under management instead of millions, we could buy in the skill. But at the moment it would be difficult."
Others, however, point out that Europe is, in fact, becoming increasingly homogenous, while Baigo, which is on the road raising a 300m pan-European healthcare fund, believes that the complexities that remain in the European market give a sector specialist an even greater lead over its generalist rivals.
"A true sector specialist can understand and exploit these different market dynamics far better than someone for whom healthcare is just a small part of their business," Bracklo says.
"Private equity firms aim to be experts on every deal they do, but across 26 countries, in three or four currencies, that is unrealistic without sector specialisation," adds Giannamore. "Quite frankly, I don't see how you can invest in financial services without being a sector specialist."
The other fundamental risk associated with sector specialisation is cyclical. A generalist would argue that its model benefits from flexibility. If retail and consumer goods deal flow dries up, for example, or escalates beyond rational pricing, the firm can simply switch its attentions elsewhere.
The risk mitigation inherent in the generalist structure has certainly been a strong lure for LPs historically, but Europe's burgeoning sector specialist community believes its model can present a valid alternative.
Apposite is one of a number of healthcare- and technology-focused firms, for example, to mitigate single sector risks by becoming multi-stage. In a model once advocated by Apax Partners – which has since abandoned its venture activities – Apposite invests across the spectrum from early-stage life sciences to the buyout of care home businesses.
"The binary VC/buyout model mitigates a lot of the cyclical risk," says Porter. "The two have very different market dynamics."
Others argue that the trick to successful sector specialisation lies in the selection of the sector itself. Ideally, the industry in question will contain a sufficient breadth of sub-sector to enable it to ride out any micro or macro downturn. It will also have long-term fundamental growth drivers.
The oil and gas industry is a case in point. "The sector is huge," says Pal Reed, a partner at HitecVision, which closed an $800m oil and gas fund earlier this month, smashing its $600m target. "People tend to just think of the massive oil giants. But we mostly invest in the peripheries: service companies, software companies, consultancies and component manufacturers. There's a huge variety.
"In addition, this may be a vast industry, but it is an industry in transition because of depleting natural resources," Reed adds. "There is more than $300bn of capex spent by the big oil companies each year, and that is set to continue. Everyone is looking for new products and services to enhance exploitation, so this is a breeding ground for mid-cap, high-growth businesses. The long-term growth fundamentals are secure."
Cleantech is another obvious example. As is business services. Giannamore also has a similar vision of the financial services sector.
"On a macro basis, this industry represents 20 per cent of GDP – so in one sense to call ourselves a sector specialist is a misnomer. The variety of opportunities on offer is immense so the risk is minimised."
The same is true of healthcare, which also benefits from long-term demographic and deregulation trends.
"Healthcare is not recession proof. There is no such thing," says Porter. "Cosmetic surgery, for example, is very economically orientated. But healthcare as a whole is not a luxury good. It is not something you are going to stop buying.
"Other than food, water, light and heat, health is the last thing you are going to stop spending on. The fundamental drivers carry on regardless."
Playing it safe
For the most part Europe's fledgling band of sector specialists has – so far – concentrated on these "safe" sectors. Consumer specialist Langholm Capital Partners is a rare exception.
But in the US sector specialisation does not end there. There is a healthy population of single industry funds in every field, including those perceived as high risk.
In addition to Europe's multicultural complexities – retail concepts are notoriously difficult to take cross-border – this is also a result of North America's deeper restructuring roots. Any single sector fund, and in particular one focused on an industry with pronounced cyclical characteristics, must have some turnaround capability. Such firms would argue that their industry knowledge allows them to time even the most cyclical sectors, investing in downturns and exiting at the top of the market.
Merchant Equity Partners, a retail turnaround fund, launched by ex-Deutsche Bank executive Henry Jackson two years ago, remains a rarity in Europe. However, as the economy begins to nosedive, European turnaround specialists are beginning to crawl out of the woodwork. Some are rumoured to be marketing sector specialist funds.
The advisory community has been one of the strongest breeding grounds for sector specialist teams historically – supplemented by entrepreneurs. In addition to Merchant Equity Partners, Baigo and AnaCap are both cases
High net worth individuals who have made their money, and their name, in industry, will be another key source of European sector specialist funds going forward.
Businessmen such as Philip Green, Tom Hunter, Bernard Arnault and Robert Tchenguiz have long gone head-to-head with private equity firms on deals. Now, with the emphasis shifting away from financial engineering expertise to hands on value-add, an increasing number are institutionalising their activities and looking to raise third-party money.
Former Abbey National chief Luqman Arnold is a prime example. Arnold has raised a dedicated banking fund, which recently reached the final stages of the ill-fated Northern Rock sell off.
A group of executives at Shell are making a similar move in the oil and gas sector, while Europe's newspaper industry is rumoured to be lined up for the same treatment.
In addition to advisers and industrialists, sector specialist spin-outs from within generalist firms are another potential source of single industry management teams.
Just as when firms are structured along geographical lines, certain sector teams inevitably perform better than others, giving rise to tensions concerning contribution to shared carried interest.
Performance differentials between sector teams will be one of the key drivers of sector specialisation in Europe. But for some it will happen sooner than for others.
Outperforming groups will inevitably begin to exert pressure on the "generalist" senior management, demanding that they be allowed to raise a dedicated fund. Management must then decide whether to raise the fund in house, condone a spin-out, or realign remuneration.
There have been several spin-outs of this nature in the US, and the European technology team of one major international buyout house is rumoured to have presented just this dilemma to its managing partners last year. In this instance, the sector team was placated with an increased slice of the carried interest pie and greater influence within the organisation. In addition to spin-outs in the next couple of years, some houses will gradually morph into sector specialists in this way, as stronger teams become more powerful within private equity firms.
If this happens we may also see disgruntled weaker teams venturing out alone – these teams are obviously far less likely to encounter resistance to a spin-out. Their success as a stand-alone entity is clearly far less assured.
Other firms will gradually adopt a greater degree of specialisation, simply as a consequence of an evolving track record. Investors are inevitably more likely to back companies in fields where they have had previous success than wandering into the unknown.
Lower mid-market firms such as Sovereign Capital and Lyceum are obvious candidates for this type of transformation.
"There are a number of firms that are already going in this direction," says Porter.
"Looking at some of the most successful private equity firms to date, Welsh Carson is specialised in healthcare and information services, and Benchmark Capital, is a technology only investment firm. This should bring some new perspectives for a lot of European houses."
In fact, sector specialisation in the US not only provides a template for sector specialisation in Europe, it is already proving a more urgent driver. For a long time GMT Communication Partners was one of the only US single industry funds to cross the Atlantic, but now a growing number are trawling Europe for deals.
Financial services specialist Lightyear Capital, for example, recently completed its European debut with a complex transaction, off the radar of the region's generalist contingent.
Several other US investors have scooped up European assets under the radar, fiercely protecting their anonymity as they cautiously scope out the market.
For large, well resourced firms, sector specialisation doesn't have to be an exclusive choice. Significant sector platforms can operate within a single buyout group, as Carlyle has consistently demonstrated in the aerospace industry, and Apax Partners in technology. The question is whether the mid-market generalist – not large enough to really focus on more than one sector – has a long-term future in Europe's domestic markets.
A generation of mid-market managing partners might insist it does, but the weight of history is against them: capitalist systems tend to evolve, almost ineluctably, in one direction – towards specialisation.