Private equity's new strategic imperative

Private equity's new strategic imperative

Growth has been a well-worth path to success for PE firms, but now differentiation is required, too.

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Private equity's new strategic imperative

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Private equity (PE) firms have long prided themselves on their ability to grow and prosper through good times and bad. But as we discuss in Bain & Company’s latest Global Private Equity Report, the nimble tactical maneuvering that enabled them to surf through PE’s cyclical ups and downs will not suffice in the more competitive post–financial crisis environment.

Traditionally, the single-minded pursuit of growth has been all the strategy many PE firms felt they needed. Growth still matters, but Bain believes that hewing to a growth strategy by itself is no longer a path to success open to most firms. Going forward, PE firms most likely to generate superior returns and win over limited partners (LPs) are those that differentiate themselves through their relentless focus on being the very best in particular sectors, regions or types of deals. Within those focused areas, they strengthen and deepen the capabilities that make them distinctive and build a repeatable model for sourcing deals, applying fresh insights before and after acquisitions. Differentiation breeds growth through demonstrated success that attracts more capital from LPs. It also points the way to sustained growth through moves into markets, sectors and deal types adjacent to the firm’s core areas of strength.

A strategy built on differentiation is not in conflict with a growth strategy, but for those that will emerge as PE leaders, it is the most promising route to the same destination (see Figure).


PE firms that follow only the growth imperative and ignore the differentiation imperative run the risk of being stranded in midstream—not yet big enough to enjoy the benefits of scale, on the one hand, and a little good at many things but outstanding at nothing, on the other.

Where to play. Leading PE firms flesh out their growth-through-differentiation strategy by drawing a tight ring around the investment areas where they will hunt for the vast majority of their deals. The “sweet spot” for a particular PE firm may lie along any one of several dimensions—from industry sector or deal size, to the degree of control the firm seeks in the deals it does, to whether to focus primarily on growth opportunities, turnarounds or cyclical plays.

Defining the sweet spot is crucial. By providing greater focus and knowledge of where to look, it enables deal teams to identify potential investments earlier and evaluate them faster than other investors. It sharpens the firm’s due diligence by highlighting core issues that need to be tested in every deal. It takes advantage of the firm’s experience and expertise, enabling deal teams to stretch their bids to secure deals they are best qualified to convert into winners. And it guides the firm’s internal investments to build capabilities it will need to reinforce its distinctiveness or move into attractive adjacencies as the firm grows.

Through our work with leading PE firms, we have found that getting the sweet spot right is one of a PE firm’s most consequential decisions. Defining it too narrowly can result in a shortage of deals. Defining it too broadly can undermine clarity, resulting in poor investment decisions and organizational confusion.

The rewards reaped by firms that carefully articulate their investing core and stick to it can be profound. Bain’s analysis of the portfolio returns of one major PE firm found that when it invested within the boundaries of its sweet spot it generated returns that were 2.2 times invested capital, vs. just 1.3 times when it strayed.

How to win. Successful firms not only draw a map around the territory where they will concentrate their fire, they also develop an angle for how they will attack it. Avoiding just a few underperformers can have a dramatic, positive effect on a fund’s total returns. Bain estimates that a general partner (GP) that can convert just one deal out of 10 in its portfolio from a money loser to one that returns more than three times the initial investment would boost its overall fund IRR by a full three to four percentage points.

The angle that will improve a firm’s odds needs to be grounded in a deep understanding of what it takes to succeed in the sweet spot and must be consistent with what the firm has been good at historically.

In Bain & Company’s work with PE firms, we advise them to undertake a comprehensive, 360-degree assessment, both to capture the positive interplay of where-to-play and how-to-win decisions quickly and to build enduring competitive advantages. The process looks internally at the firm’s strengths, weaknesses, opportunities and threats. It probes the team on where they think they stand out and where they have greatest appetite. Then, looking externally, it benchmarks where the firm stands relative to its leading competitors.

Some of the sharpest insights come from a detailed, deal-by-deal forensic diagnostic of the sources of the firm’s winners and losers. For example, a European PE firm used more than 50 hard and soft metrics to unearth six winning factors common to the best deals and seven warning signs shared by underperformers.

Leading GPs apply these insights to strengthen their investment processes across every link of the PE value chain. They can improve deal sourcing by taking advantage of their deep sector expertise and extensive advisory network to pursue targets proactively. They bring rigor and structure to their due diligence and investment committee processes. They elevate their portfolio management by getting a fast start integrating an acquired company’s leadership team and executing on their plans to add value. They build their exit strategy into their ownership plan from the outset, planning their exit options and developing an actionable plan to realize the assets’ full potential.

PE firms that parlay their core capabilities by making them a platform for growth will deliver superior returns and steadily pull away from their rivals.

Written by Hugh MacArthur, Graham Elton, Bill Halloran and Suvir Varma, leaders of Bain & Company’s Private Equity Group.


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