Generalist vs. Industry Specialist: What are the trends and where does the advantage lie? Generalist vs. Industry Specialist: What are the trends and where does the advantage lie? When we debate the generalist vs. industry specialist approach, what do we Rory B. Smith hope to achieve? In speaking to numerous limited partners, I have learned that they are not interested in specialist funds for the purposes of directly managing their portfolio diversification. Their priority is to find firms who do the best deals and not firms who do the best deals in a narrow space. As one limited Managing Director partner said, We are agnostic on the issue and simply want the best returns possible. That best sums up the point of this debate which is where can limited partners, and general partners for that matter, achieve superior returns in what has become an increasingly competitive market. We are all keenly aware of the growth in private equity as an asset class and industry over the past twenty years. We have all witnessed a dramatic increase in the number of private equity funds, the amount of dollars under management, the efficiency of the intermediary community, the sophistication of sellers, and the resulting competition for transactions in an auction environment. Nautic Partners, LLC Increased competition and efficiency in our industry has lead to a second and related point to finding superior returns which is the desire for differentiation. Limited partners and general partners today seek strategies that will differentiate them from the competition. Some general partners focus on a geographic area, a type of transaction, a process advantage, or a unique investment staff mix of operators and consultants. Differentiation is important in the private equity asset class as there is a wide range of potential returns in this illiquid, risky, and exciting asset class. Exhibit 1 outlines the risk and standard deviation for a variety of asset classes. Exhibit 1 Risk by Type of Fund Type of Fund Size of Sample Risk: Standard Deviation (%) Real Estate 66 8% Mezzanine 71 11% Special Situations 20 13% Balanced 41 15% Fund of Funds 165 16% Buyout 550 19% Distressed Debt 37 26% Venture 769 55% 2005 Institute for Fiduciary Education 1
Alternative Investing 2005 % of Funds by Fund Strategy (1980-2005) % of Dollars by Fund Strategy (1980-2005) Specialist Funds (146 Funds) Focused Funds (93 Funds) 21% 13% 66% Generalist Funds (463 Funds) Exhibit 2 Specialist Funds ($64.6B) Focused Funds ($27.7B) 15% 6% 79% Generalist Funds ($340.8B) Numerous funds in each asset class were evaluated for IRR and multiple returns to determine a benchmark for the asset class. The standard deviation percentage represents the potential for variations in return above or below the respective benchmark. It is no surprise that real estate funds have a relatively low standard deviation percentage of 8% while buyout funds have a high standard deviation percentage of 19%. Buyout funds are a high stakes area where selection of the right fund, the superior fund, the differentiated fund makes all the difference. Perhaps the oldest differentiator is industry specialization. The venture capital industry embraced industry specialization long ago, and the broader private equity industry appears to be turning in this direction in its search for the Holy Grail of differentiation and superior returns. To understand the current state of our industry and the recent trends, we engaged Private Equity Intelligence to analyze their database of 702 USbased buyout funds. We wanted to know what proportion of funds, firms, and dollars could fairly be characterized as industry generalists vs. specialists and what trends that might reveal. More importantly, we hoped to learn which group generated better returns. Funds and firms were sorted according to the Global Industry Classification Standards (GICS) which is a common point of reference when defining the US economy. If a firm concentrated on one industry group or two related groups it was deemed to be a specialist firm. If a firm concentrated on two unrelated industry groups it was deemed to be a focused firm, and if a firm had more than two industry groups it was deemed to be a generalist. The process of categorizing by industry specialization brings to light the fact that industry specialization may best be thought of as a matter of degree or a point on a continuous spectrum. How should we categorize a focused firm with two areas of specialization? At what point do several areas of specialization turn a firm into a generalist? For clarity, most of our analysis will focus on comparing the two better defined and extreme points of the spectrum: that of generalist vs. specialist. As you can see from Exhibit 2, specialist funds represent approximately 21% of total funds vs. 66% for generalists. Similarly, dollars managed by specialist funds represent approximately 15% of the total vs. 79% for generalist funds. Not only do generalist funds dominate the market but, interestingly, generalist funds are much larger with the average generalist fund at $924 million vs. $573 million for 2 2005 Institute for Fiduciary Education
Generalist vs. Industry Specialist: What are the trends and where does the advantage lie? Exhibit 3 % of Funds Raised by Fund Strategy and Vintage Year Specialist Funds Focused Funds Generalist Funds 100% 80% % of Funds Raised 60% 40% 20% 0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 specialist funds. One could speculate that smaller funds, with more competitors to contend with, choose specialization more often as a competitive necessity. A more detailed look at the data also Vintage Year revealed that generalist firms (as opposed to funds) raised more funds during the period suggesting a friendlier market for them. Generalists either deployed the money faster or 100% Exhibit 4 % of Dollars Raised by Fund Strategy and Vintage Year Specialist Funds Focused Funds Generalist Funds 80% % of Funds Raised 60% 40% 20% 0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 200 0 2001 200 2 200 3 200 4 2005 Vintage Year 2005 Institute for Fiduciary Education 3
Alternative Investing 2005 Exhibit 5 Specialist Funds by Industry Group Energy and Utilities (7%) Health Care (6%) Materials (2%) Real Estate (2%) Industrials (25%) Consumer Discretionary (12%) Technology, Media and Communications (15%) Information Technology (17%) Business Services (15%) were more successful in raising follow-on funds. A review of Exhibits 3 and 4, however, indicate a slow but steady increase in the popularity of specialist funds. Exhibit 3 shows that the percentage of specialist funds to total funds raised each year is increasing. Similarly, Exhibit 4 (previous page) shows that the percentage of specialist dollars to total dollars raised each year is also increasing, but at a slower rate given that generalist funds tend to raise larger funds. Interestingly, the distribution of where specialist funds choose to focus is quite even across the industry groupings as evidenced in Exhibit 5. There is no one obvious place of specialization. Nor do specialist funds necessarily avoid competition from generalists by choosing to specialize. Exhibit 6 (next page) shows the most popular industry subsectors chosen by specialist funds and the percentage that specialist funds make up of all funds pursuing that subsector. The point is that specialists by no means avoid competition by choosing to specialize, and they often make up a minority of the funds playing in a chosen space. Superior returns for the specialist fund, therefore, are dependent on maintaining an advantage over its competitors in the space. When considering the tasks involved in a successful private equity fund, there are numerous areas where a specialist should have an advantage. Exhibit 7 (page 6) shows the critical tasks required of a general partner in the value creation process. In sourcing transactions, specialized industry knowledge should identify attractive trends and should result in better 4 2005 Institute for Fiduciary Education
Generalist vs. Industry Specialist: What are the trends and where does the advantage lie? Exhibit 6 Specialist Firms as a % of All Firms Focused on an Industry Subsector Industry Subsector # Of Specialist Firms Specialist Firms as a % of All Firms Software 18 27% Manufacturing 14 13% Distribution 11 17% Communications 11 26% Logistics 11 69% High-Tech 8 47% Environmental Services 8 67% Media 7 14% Business Services 7 15% Hardware 5 9% sourcing contacts and attention from the intermediary community. The specialist approach also argues that industry knowledge gives management teams comfort, reduces the complexities of due diligence, and increases the certainty of closing, all of which result in better execution when completing transactions. Industry knowledge theoretically results in better board decision making when attempting to add value during the monitoring phase, and it should result in better exit planning due to a more intimate understanding of the industry cycles and trends. Finally, and certainly not overlooked by general partners, specialization implies a real or perceived differentiation in a crowded market place that is critical to fundraising and the very survival of general partners. The pitfalls of specialization, however, are just as obvious as its advantages. Most industries have cycles and being trapped to invest in a bad industry in a bad cycle can be disastrous. Some industries are heavily regulated where a change in government policy creates winners and losers overnight despite years of patient and careful investing. The public market, which has provided many fantastic exits, can be as unpredictable as the weather. With industry concentration we should expect volatility, both in portfolio company performance, as well as overall fund returns. We have seen this with the coming and going of internet and telecom funds. Clearly, diversification has its advantages and is a core part of any prudent investment strategy. In light of the above, can we conclude that specialized funds provide superior returns provided you have the patience and courage to absorb the bad years? Unfortunately, the empirical data does not come to such a simple conclusion. In fact, the returns and volatility among specialist funds and generalist funds are surprisingly similar. Exhibits 8 and 9 (page 7) compare the median performance of the fund groups on an IRR and value multiple basis. The specialist funds appear to have slightly lower performance in terms of median IRRs and median multiples. Industry studies often use 2005 Institute for Fiduciary Education 5
Alternative Investing 2005 Exhibit 7 General Partner Value Creation Process Sourcing Fundraising Executing Exiting Monitoring median data to mute the impact of outliers in the sample. When looking at average IRR data, the specialist funds had slightly better performance than the generalist funds. Ironically the focused funds clearly underperformed the group when using average IRR data. One could conclude that a fund should either focus on one area, and do it well, or play the field of the generalist, but should never pretend to be a specialist in more than one area. While this is a provocative interpretation, by removing a few outliers from the focused fund data, the group s average IRR comes close to the benchmark. This reinforces the point of focusing on the median data presented in the exhibits. The volatility of the returns for specialist funds vs. generalist funds also appears to be greater. What portion of this volatility might be explained by a smaller sample size compared to the broader index? A more detailed review of the data again revealed very little difference in the volatility of specialist and focused funds (combined together for a larger sample size) with an 18.2% standard deviation vs. 17.1% for generalist funds. If we conclude that specialization does not provide superior returns, then it is worth pausing for a moment to consider who is driving the growing trend toward specialization. Is it the limited partners who still believe that specialization will provide alpha returns in spite of recent history, or is it the funds themselves 6 2005 Institute for Fiduciary Education
Generalist vs. Industry Specialist: What are the trends and where does the advantage lie? Exhibit 8 Median Net IRR by Fund Strategy and Vintage Year 35% 30% Specialist Funds Focused Funds Generalist Funds Benchmark 25% 20% Median IRR 15% 10% 5% 0% -5% -10% -15% 1994 1995 1996 1997 1998 1999 2000 2001 2002 Vintage Year grasping for any factor that will set them apart from the competition in a competitive fundraising process? One explanation for this inconclusive data may be that specialists are not as specialized as we would like to think. It is hard to imagine that specializing in business services or industrials for that matter is being specialized at all. These areas are large and diverse, and they do not operate under a common set of regulations, trends, and assumptions that make specialized knowledge and contacts so valuable from one transaction to the next. In many cases, specialists have managed diversification and volatility by Exhibit 9 Median Value Multiple by Fund Strategy and Vintage Year 2.2x Specialist Funds Focused Funds Generalist Funds Benchmark 2.0x Median Value Multiple 1.8x 1.6x 1.4x 1.2x 1.0x 0.8x 0.6x 1994 1995 1996 1997 1998 1999 2000 2001 2002 Vintage Year 2005 Institute for Fiduciary Education 7
Alternative Investing 2005 picking areas broad enough to accommodate different investment themes with different cycles. Or perhaps generalists have cleverly obtained many of the advantages of specialization without assuming the pitfalls. While playing the field generalists have recruited operating partners and advisors who provide the kind of industry knowledge that specialist funds hope to achieve internally. With the superior resources of a larger fund, generalists can afford the kind of consultants and other outsourced service providers that give them instant credibility and insight into an area. Alternatively, could the competitive pressures of the current auction environment in fact favor the generalist who is free to focus on the best opportunity based on price, terms, and deal dynamics without regard to industry? Does a rapidly changing business environment favor the opportunist? Being opportunistic in a competitive and dynamic environment certainly has its appeal. Whichever explanation you pick for the similarity of performance between specialist and generalist firms, several things are clear. First, there is a wide discrepancy in performance among buyout funds. Today s less forgiving business environment, combined with increased competition for deals, suggests that this discrepancy will become even greater and makes fund selection all the more critical. We might also conclude, at least from this data, that industry specialization is not a predictor of superior returns. The obvious differentiators of past track record, size of fund, and tenure of the team remain the same. The less obvious differentiators in today s market relate to the strength and cohesiveness of the team, the investment strategy, whatever it may be, and the processes and disciplines employed. These factors will require more due diligence than ever on the part of limited partners to accurately predict who will succeed in the Rory Smith holds a B.A. from Amherst College, magna cum laude, and an M.B.A. from the Harvard Business School. 8 2005 Institute for Fiduciary Education