The benefits from building deep industry expertise are powerful.
In deal generation, it marks a buyout firm as a serious player,
putting it in regular contact with key people in the industry and
increasing the volume and quality of deal flow. In due diligence,
it speeds up a firm's ability to identify good deals and screen out
bad ones, and brings to bear proprietary insights and credibility
with the targets' owners and managers that provide an edge in
auctions. Following an acquisition, it helps the firm quickly set
the right strategic direction to improve performance and build
value, recruit seasoned professionals, and challenge management to
hit operational targets. When the time is ripe to sell, a firm with
sector expertise is better able to identify the right buyers and
present the sale in the most compelling light.
Yet, while many buyout firms already claim to be sector focused,
few do it well. Their attempts suffer from two common pitfalls.
First, some overspecialize by targeting sectors that do not require
the level of expertise that firms try to build around them. Sector
focus works best in areas like health care, media,
telecommunications, and energy that are characterized by outsized
risks, regulatory minefields and complex business models. Others
define the sectors they pursue too narrowly (and commit scarce
resources to them), which limits the number and quality of deals
they see.
The second major shortcoming: Many firms end up paying only lip
service to the idea. It is one thing to rearrange organizational
boxes, assigning professionals to become sector specialists, but it
is quite another to make the commitment stick. Too often, when a
new deal materializes, teams are pulled out of their sector work to
jump on the new opportunity for weeks, if not months.
Define the Right Sector Approach
From our work with leading buyout firms around the world,
we've found that those that successfully specialize around sectors
follow several best practices in defining their approach
upfront.
They first identify sectors in play, aiming to define them
clearly but keeping them broad enough to ensure they will yield a
healthy number of potential investments within a reasonable
timeframe.
Then, they select sectors by weighing their inherent
attractiveness, looking at such characteristics as their size and
rate of growth, ease of entry, competitive dynamics, and
availability of targets. In parallel, they take a cold-eyed look at
their firm's ability to win in each of those sectors. Here, a firm
must consider its deal experience and track record; too many firms
create specialization out of thin layers of experience. The firm
should also evaluate whether the investment opportunities in each
sector suit its deal preferences. Many buyout firms shy away from
certain types of deals, such as ones in businesses with
fast-changing technology or high cyclicality.
A potent multi-sector strategy requires the scale and resources
that only the largest firms can bring to bear. Typically, a fully
staffed sector requires at least two managing directors supported
by a team of principals and analysts. Smaller teams simply don't
have the bandwidth to build true expertise, and their members tend
to be deployed when the deals come in. Mid-size firms (typically
less than $2 billion of capital in their last fund) can be caught
in the middle. To avoid being sidelined, these firms can follow a
hybrid approach by building expert teams in two or three sectors,
while assigning other professionals as generalists or only loosely
affiliated. They can also dedicate managing directors and more
senior members of the firm to a half-dozen sectors and tap a common
pool of more junior talent to support them. However, mid-size firms
must strike a careful balance between maintaining a commitment to
their preferred sectors while preserving sufficient flexibility to
generate a healthy deal flow.
Once they've winnowed their choices, buyout firms make a
multi-year commitment to the sectors that pass scrutiny and do not
allow their teams to invest outside them. To guard against the
pressures of getting a deal done, they give sector teams time to
build deep expertise and bring deals to fruition. They offer team
members compensation guarantees in case the right deal doesn't come
up or a sector falls out of favor over a two-year or three-year
period. Recognizing that sectors are cyclical and deal flow can be
uneven, some firms assign partners to oversee two sectors, one a
primary focus of their efforts, the second, a back-up.
Finally, firms tailor their sector approach to the firm's style
for sourcing and investing in deals. For example, Apollo Advisors,
a value-oriented fund that seeks out its own deals, uses its sector
teams' expertise to scout potential acquisitions and build
relationships that enable it to beat the competition with
pre-emptive bids. The Blackstone Group has built a formal
sector-focused organization with the depth and breadth to win in
auctions. For its part, Goldman Sachs's private equity unit
participates as a co-sponsor in the majority of its deals. It
supplements its sector teams' coverage with the research resources
of the investment bank.
Master the Right Skills
With the cornerstone of their sector approach in place, buyout
firms that execute best cultivate these six key disciplines through
good times and bad:
1. Zero in on the right sub-sectors. They create sector "heat maps"
that enable their teams to concentrate on the most promising
segments and geographies within their sector where they can add
value.
2. Develop a point of view on target subsectors. They build deep
proprietary insights about impending shifts in relative market
share, earnings volatility, emerging new profit pools and other
industry-shaping trends.
3. Identify investment themes. They translate observed sector
trends and dynamics into investment themes and flesh out concrete
investment theses.
4. Exploit investment opportunities. They build a network of
industry insiders that they work aggressively to source and screen
targets compatible with their investment themes. They then devise
plans to approach those targets and cultivate relationships.
5. Define what makes you different. They don't dabble. They
determine which activities along the investment value chain are
proprietary, and they select ones where they will want to develop
distinctive capabilities. They outsource the activities that are
either too expensive to replicate or are commoditized.
6. Build an operating model. They develop a deep bench of internal
talent, external partners and technical advisors whom they can draw
upon to source deals, advise on due diligence, and work with
portfolio companies. They also proactively address issues that are
likely to arise between sector teams, clarifying procedures for
sharing resources like analyst teams and portfolio experts.
Conversion into Investment Themes
Expertise in a sector is a necessary but not sufficient
precondition for identifying highvalue investment targets, a
crucial element in sector-strategy success and a thorny
implementation challenge.
To get ahead of the investment curve, smart sector teams take a
fresh-eyed look at their areas of interest. They gather unbiased
information from the field by interviewing customers, suppliers,
competitors and creditors to build a deep enough understanding of a
sector that can point them to concrete, counterintuitive investment
theses, types of deals and investment targets. Recognizing that it
can be risky venturing too far ahead of the competitive curve, they
test their investment themes by looking for successful precedents
in similar sectors before committing to a novel idea. They
continually gather new evidence to challenge and fine-tune their
investment themes.
For example, a leading European buyout firm converted insights
in the specialty chemicals industry into a profitable investment
thesis that caught the sector's consolidation and globalization
wave. Through research and direct contacts with industry executives
in early 2001, the firm liked what it found: a stable market,
strong cash flows, high profit margins and relative resistance to
business cycle gyrations. When a major conglomerate announced in
late 2001 that it would sell off its specialty chemicals division,
the buyout firm was ready to pounce. Beating stiff competition from
strategic and financial buyers, it landed the deal in mid-2002 and
merged it with a smaller competitor it simultaneously acquired. The
firm had no trouble convincing management of both companies of the
merits of a merger, thanks to its deep knowledge of the sector and
well thought-out investment thesis. Continuing to mine the
consolidation theme, the firm engineered further selective
acquisitions and used its scale to achieve top-supplier status with
more key customers. In 2006, the firm sold part of its majority
stake in the company, by now the world's fourth biggest producer in
its sector, through an IPO worth more than one billion euros. The
stock sale, combined with an earlier dividend recap, netted the
firm a return of approximately 110 percent on its initial equity
investment over four years; and through its remaining stake, the
firm continued to reap the rewards of its investment.
Buyout firms that successfully retool themselves around industry
sectors will be well positioned when the credit clouds lift and the
deal market rebounds. Tomorrow's winners will be those that are
ready to execute best.
Hugh MacArthur is a partner at Bain & Company and leader
of the Global Private Equity practice. Based in the Boston office,
he is a founder of the practice and works with a variety of private
equity and alternative asset funds, including traditional buyout,
venture capital, hedge funds, infrastructure funds, distressed
debt, real estate funds and banks. Tom Shannon is a partner in the
Chicago office. He is a member of Bain's Industrial Goods &
Services and Private Equity practices. Based in the Toronto office,
Catherine Lemire is a manager at Bain, responsible for the
development of intellectual capital in the Global Private Equity
practice.
