With the global financial meltdown leaving its mark on private equity (PE) deal volume, leading PE firms are rethinking the basics about how they do business.
One fundamental question they are grappling with is how do they differentiate themselves post-crisis as deal activity slowly begins to pick up and money, sidelined during the downturn, starts competing for the most attractive investment opportunities?
For funds operating in India, the question is particularly relevant. PE firms have historically invested across a wide variety of industries as well as in deals of a broad range of sizes and asset classes. But when the upswing arrives, these firms will be operating by new rules where limited partners supplying investment capital are more demanding and competition for the best targets is more intense.
In the new climate, leading PE firms will pick their spots very carefully and focus on building expertise around sectors. This move towards sector specialization will gain momentum because its benefits are powerful.
In deal generation, organizing around sectors marks a PE firm as a serious player, putting it in regular contact with key people in the industry, increasing the volume and quality of deal flow. In due diligence, sector specialization can speed a firm’s ability to identify good deals and screen out bad ones, and can bring to bear proprietary insights and credibility with the targets’ promoters and managers, giving the firm an edge in competition.
After an acquisition, it helps the firm quickly provide strategic direction to improve performance, build value, recruit seasoned professionals, and challenge management to hit operational targets. When the time is ripe to sell, the firm can better identify potential buyers and present the sale in the most compelling light.
Firms that specialize around sectors begin by identifying high-potential sectors in play, defining them clearly but keeping them broad enough to ensure they will yield a healthy stream of investment opportunities within a reasonable time frame. They select sectors by weighing their ease of entry, size, rate of growth, competitive dynamics, and availability of acquisition targets.
Simultaneously, they take a cold-eyed look at their firm’s ability to win in each of those sectors—too many firms create specialization out of thin layers of experience. A firm needs to evaluate whether it will be able to genuinely add value in a given sector before pursuing it. It should also assess whether the investment opportunities in each sector suits its deal preferences. For example, many PE firms shy away from acquiring stakes in businesses characterized by fast-changing technology and high cyclicality.
Some winning firms work from sector heat-maps to help identify the most promising segments and regions where they can add value.
They also mobilize sector teams to gather unbiased information from the field by interviewing customers, suppliers, competitors and creditors who help identify impending shifts in relative market share, earnings volatility, profit pools and other industry-shaping trends. They translate observed sector trends and dynamics into investment themes and flesh out concrete investment theses.
Smart sector teams recognize that it can be risky to venture too far ahead of the competitive curve and, therefore, test their investment theses by looking for successful precedents in similar sectors before coming to a novel idea. They continually gather new evidence to challenge and fine-tune their investment themes.
Winning PE firms develop a deep bench of internal talent, external partners and technical advisers, whom they can draw upon to source deals, advise on due diligence and work with portfolio companies. Some PE firms in India have built teams around operating partners or advisers who are industrial specialists to build sector strength. Look for sector-oriented firms to be more visible in the industry segments they cover. Instead of waiting for bankers to pitch deals, they will spend more of their time cultivating relationships with industry insiders.
Given that the opportunities in India for PE investment are so wide-ranging, it may make sense for PE firms to have two investment lists—a primary list of target companies that are the principal focus of their interest and a secondary list of companies they track, should attractive investment prospects present themselves. The objective is to become so deeply in tune with the sector’s business metabolism that PE firms will be ready to jump when deal opportunities ripen. PE firms that fight the continuing headwinds by building relationships with sector-leading companies and focusing on the right investing theme should be well positioned to pull away from their rivals coming out of the downturn. As they help lead the economy out of slowdown, those funds wielding well-tuned sector expertise will be holding the trump cards.
David Mountain leads Bain & Co.’s financial services practice in India and is based in Mumbai. Sri Rajan leads the firm’s private equity practice in the country. Graham Elton is a partner based in London, where he leads Bain’s European private equity practice.