The Business Times

PE firms should build up on sector expertise

Private equity firms that use the downturn to identify and build relationships with sector-leading...

By Hugh MacArthur and Suvir Varma

First published on septiembre 09, 2009
min read


Even before the recession started to bite early last year, private equity firms were feeling the full effects of contracting credit and declining asset values. New deal activity ground to a standstill, long-planned IPOs were put on hold, and highly leveraged portfolio companies began to strain against lending covenants. Private equity investors often serve as harbingers of big swings in business cycles and the recovery from this downturn should be no exception. At the end of the second quarter, PE firms were sitting on more than $500 billion in undeployed capital, earmarked for buyouts but sidelined until market conditions improve. When the upswing arrives, however, PE firms will be operating by new rules where lenders are more circumspect, limited partners supplying investment capital are more demanding, and competition for the best targets is more intense. In this new climate, deft financial engineering skills won't be enough to salvage value from beaten-down portfolios. Instead, leading firms have started to recognise that they need stronger teams and deeper industry expertise. Specialisation gaining momentum Many expect to focus on specific industry sectors and organise around them. How well they execute this shift will be important not only to the PE industry but to the global financial system in which private equity is still a powerful force. The move towards sector specialisation has gained momentum because its benefits are powerful. In deal generation, it marks a buyout firm as a serious player, increasing the volume and quality of deal flow. In due diligence, it can speed a firm's ability to identify good deals and bring to bear proprietary insights that provide an edge in auctions. Following an acquisition, it helps the firm quickly set the right strategic direction, improve performance and build value. When the time is ripe to sell, the firm can better identify the right potential buyers and present the sale in the most compelling light. Firms that specialise 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 timeframe. Because they no longer have the winds of growth at their backs, PE firms will select sectors by weighing their ease of entry, competitive dynamics, and availability of acquisition targets. Building these sector skills will be especially challenging for European private equity firms that operate across national boundaries. Beyond barriers of language, regulation and business cultures, firms will need to overlay their local country focus with transnational sector expertise. As firms start to increase their activity, they will pick their spots carefully. Instead of trying to land deals across a wide range of companies and industries, they will zero in on attractive industry sub-sectors. Identifying promising sectors Some firms work from sector 'heat maps' to help identify the most promising segments and regions where they can add value. They also mobilise sector teams to gather unbiased information from the field by interviewing customers, suppliers, competitors and creditors who help to get an early read on impending shifts in relative market share, earnings volatility, profit pools and other industry-shaping trends. They use this intelligence to develop concrete, and sometimes counterintuitive, investment theses. In this new environment, powerful analytical skills will remain important, but they won't be sufficient by themselves. Look for the managing directors of sector-oriented firms to be more visible in the industry segments they cover. Instead of waiting for bankers to pitch deals, activist directors will spend more of their time cultivating relationships with industry insiders, trading the latest sector intelligence. Most importantly, they will work to earn the trust of management teams at companies that are high on their target lists. That's not new to private equity, but the added objective is to become so deeply in tune with the sector's business metabolism that PE firms will be ready to jump when promising deal opportunities mature. Private equity firms that use the downturn to identify and build relationships with sector-leading companies should be well positioned to pull away from their rivals coming out of the downturn. Our analysis has found that an acquirer can typically purchase a sector leader for a lower price relative to its competitors just before a cyclical rebound. As they help lead the economy out of recession, PE firms wielding well-tuned sector expertise will be holding a trump card. Hugh MacArthur, a partner in the Boston office of Bain & Company, leads the firm's Global Private Equity Practice. Suvir Varma, a Bain partner and leader of the firm's SE Asia Private Equity Practice, is based in Singapore. (c) 2009 Singapore Press Holdings Limited

Even before the recession started to bite early last year, private equity firms were feeling the full effects of contracting credit and declining asset values.

New deal activity ground to a standstill, long-planned IPOs were put on hold, and highly leveraged portfolio companies began to strain against lending covenants.

Private equity investors often serve as harbingers of big swings in business cycles and the recovery from this downturn should be no exception.

At the end of the second quarter, PE firms were sitting on more than $500 billion in undeployed capital, earmarked for buyouts but sidelined until market conditions improve.

When the upswing arrives, however, PE firms will be operating by new rules where lenders are more circumspect, limited partners supplying investment capital are more demanding, and competition for the best targets is more intense.

In this new climate, deft financial engineering skills won't be enough to salvage value from beaten-down portfolios. Instead, leading firms have started to recognise that they need stronger teams and deeper industry expertise.

Specialisation gaining momentum

Many expect to focus on specific industry sectors and organise around them. How well they execute this shift will be important not only to the PE industry but to the global financial system in which private equity is still a powerful force.

The move towards sector specialisation has gained momentum because its benefits are powerful. In deal generation, it marks a buyout firm as a serious player, increasing the volume and quality of deal flow.

In due diligence, it can speed a firm's ability to identify good deals and bring to bear proprietary insights that provide an edge in auctions. Following an acquisition, it helps the firm quickly set the right strategic direction, improve performance and build value.

When the time is ripe to sell, the firm can better identify the right potential buyers and present the sale in the most compelling light.

Firms that specialise 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 timeframe.

Because they no longer have the winds of growth at their backs, PE firms will select sectors by weighing their ease of entry, competitive dynamics, and availability of acquisition targets.

Building these sector skills will be especially challenging for European private equity firms that operate across national boundaries. Beyond barriers of language, regulation and business cultures, firms will need to overlay their local country focus with transnational sector expertise.

As firms start to increase their activity, they will pick their spots carefully. Instead of trying to land deals across a wide range of companies and industries, they will zero in on attractive industry sub-sectors.

Identifying promising sectors

Some firms work from sector 'heat maps' to help identify the most promising segments and regions where they can add value. They also mobilise sector teams to gather unbiased information from the field by interviewing customers, suppliers, competitors and creditors who help to get an early read on impending shifts in relative market share, earnings volatility, profit pools and other industry-shaping trends.

They use this intelligence to develop concrete, and sometimes counterintuitive, investment theses.

In this new environment, powerful analytical skills will remain important, but they won't be sufficient by themselves.

Look for the managing directors of sector-oriented firms to be more visible in the industry segments they cover. Instead of waiting for bankers to pitch deals, activist directors will spend more of their time cultivating relationships with industry insiders, trading the latest sector intelligence.

Most importantly, they will work to earn the trust of management teams at companies that are high on their target lists.

That's not new to private equity, but the added objective is to become so deeply in tune with the sector's business metabolism that PE firms will be ready to jump when promising deal opportunities mature.

Private equity firms that use the downturn to identify and build relationships with sector-leading companies should be well positioned to pull away from their rivals coming out of the downturn.

Our analysis has found that an acquirer can typically purchase a sector leader for a lower price relative to its competitors just before a cyclical rebound.

As they help lead the economy out of recession, PE firms wielding well-tuned sector expertise will be holding a trump card.

Hugh MacArthur, a partner in the Boston office of Bain & Company, leads the firm's Global Private Equity Practice. Suvir Varma, a Bain partner and leader of the firm's SE Asia Private Equity Practice, is based in Singapore.