In the private equity industry, potential for generation of above-average returns is a crucial factor when selecting managers to invest in. One of the most important considerations for Limited Partners (LPs) is a manager’s track record, as it serves as an indicator of potential future returns.
However, it’s worth noting that past performance is not a guarantee of future results. Identifying managers with the greatest potential for success requires more than just evaluating their historical performance. Another important aspect to consider is a manager’s investment strategy. This encompasses a wide range of variables that can influence a fund’s future performance. A sound investment strategy, coupled with a strong track record, can provide LPs with a more comprehensive understanding of a manager’s potential for generating above-average returns.
Figure 1: Most important factors for LPs considering investment in a new1.
When evaluating managers, investors must consider a variety of key characteristics of the investment strategy that can impact a fund’s performance. These characteristics include the manager’s sourcing strategy for identifying potential target companies, the structure of transactions used to acquire those companies, the prices paid for those companies, the sectors in which the fund invests, the decision-making processes implemented, the experience of the investment team, and the incentive schemes used to align interests. These are just a few examples of the many factors that can influence a fund’s success throughout its life cycle. By carefully analysing these characteristics, investors can better identify managers with the greatest potential for generating strong returns.
Figure 2: Gross return (IRR and MoC) segmented by sector and fund type2.
Statistics indicate that private equity funds with a specialized investment strategy, also known as “sector-focused” or “sector specialists,” tend to generate better returns than those with a wider sector focus, known as “generalists.” A comparison of performance across different industries reveals that specialist managers consistently outperform generalists.
This phenomenon can be attributed to the advantages of specialization in a particular sector. Specializing in a specific industry allows managers to develop a deep understanding of the dynamics surrounding companies, including regulations and competition, and to build a larger network of contacts.
This leads to increased recognition within the industry and access to more investment opportunities, further deepening their knowledge and expertise. This positive feedback loop helps explain the advantage of specialist funds over generalist funds.
Given the clear advantage of specialist funds over generalist funds, one may question the continued existence of generalist funds. It would be logical for investors to prioritize specialist funds, ultimately leading to the disappearance of generalist funds
However, investors continue to include generalist funds in their private equity portfolios. This is due to the unique advantages that these funds offer, which complement those of specialist funds. For example, investing in a generalist fund exposes investors to lower systemic risk as a result of the diversification offered by the fund’s portfolio. It is less likely for multiple industries to experience a simultaneous downturn compared to a single industry. This generalist approach also allows investors to gain exposure to sectors that may not be accessible through specialist funds alone.
On the other hand, diversifying the portfolio across different industries does not mean giving up on replicable investments altogether. In fact, generalist funds may opt to specialize in a specific investment strategy or type of investment, rather than focusing on a single industry. For instance, funds that specialize in complex situations or buy & build strategies can achieve high replicability in their investments and leverage a similar learning curve to that of specialist funds, while also diversifying the portfolio across different sectors.
In conclusion, it is important for private equity investors to understand the advantages and disadvantages of both specialist and generalist funds when constructing a portfolio. By combining both types of funds investors can achieve an appropriate level of diversification and select products that align with their return objectives. The use of a fund of funds structure can also provide a simpler and more diversified way for investors to access the private equity market and gain exposure to different strategies.
Notes:
[1] Percentage of surveyed individuals. Depth of investment history refers to the number of investments the team has made together and the results obtained. Source: Preqin Investor Interviews (2014).
[2] Gross return of funds included in the Cambridge Associates US Buyout and Growth Equity benchmark with vintages between 2001 and 2015. Source: Cambridge Associates LLC Private Investments Database.