Article

Sharpening sector focus to succeed in tough times

Organizing around industry sectors can deliver powerful benefits.

Par Hugh MacArthur, Tom Shannon, and Catherine Lemire

First published on janvier 05, 2009
min


With the global credit crunch leaving its mark on private equity deal volume, today's tough times have leading deal-makers rethinking the basics about how they do business. Are they concentrating on the most promising asset classes and regions? Do they have the right capabilities to achieve and sustain a competitive edge? Are their operating processes as productive as they could be? Among these fundamentals, buyout firms increasingly find themselves grappling with a question that's been on the agenda of many of them for years: Does it make sense to focus on industry sectors and organize around them? 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.

With the global credit crunch leaving its mark on private equity deal volume, today's tough times have leading deal-makers rethinking the basics about how they do business. Are they concentrating on the most promising asset classes and regions? Do they have the right capabilities to achieve and sustain a competitive edge? Are their operating processes as productive as they could be?

Among these fundamentals, buyout firms increasingly find themselves grappling with a question that's been on the agenda of many of them for years: Does it make sense to focus on industry sectors and organize around them?

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.