FF Alts Feature: Fund Managers Face New Pressure to Specialize
*Originally appeared in FundFire
By Chris Larson
March 9, 2016
Private equity fund managers are splitting into two distinct groups – a cadre of huge firms that do everything in alternatives and a…
*Originally appeared in FundFire
By Chris Larson
March 9, 2016
Private equity fund managers are splitting into two distinct groups – a cadre of huge firms that do everything in alternatives and a teeming collection of specialists and boutiques – thanks to competitive pressures and shifting limited partner demands. While this binary outcome may benefit managers in the long run, the specialist players will also need to be prepared for increased levels of due diligence from investors, market watchers say.
The trend of divergent product sets has been developing for the past few years and is expected to build steam. That’s one conclusion of a recent Ernst & Young report on a survey it conducted for the Private Equity Growth Capital Council, which found strong expectations of a continued “bar-belling” of the private equity industry.
“Investment strategies of larger and smaller firms will continue to diverge,” the report says. That means larger managers will continue to broaden their product offerings, with most “planning significantly more involvement in real estate, hedge funds, fund of funds, or retail and high-net-worth-focused funds.”
For instance, the survey found that 73% of larger private equity managers are looking to increase their exposure to credit and distressed investment strategies this year, 64% planning to add real estate strategies, and another 64% looking at long-dated private equity vehicles. On the other hand, nearly 60% of smaller managers now embrace a specialization in a particular industry or sector, such as healthcare, energy, business services or software and technology. Less than a third of larger managers make this claim.
The survey uses $20 billion in assets under management as the dividing line between “large” and “small” managers. While that precise break point may be open to debate, it’s clear that smaller private equity managers are taking a very different strategic approach than their larger cousins.
The move toward bifurcation has been brewing for the past several years, says Bronwyn Bailey, v.p. of research at PEGCC. “Large firms want to be all to all, while smaller firms are becoming more specialized. They’re becoming boutiques,” she adds.
The two sides of this barbell should be able to coexist without harming each other, in part because they are appealing to different sets of limited partners (LPs), Bailey says. “The larger shops want larger funds, so they attract bigger LPs who write bigger checks. The smaller funds are attracting the LPs who are going to write smaller checks,” she says. “They’re playing in different parts of the market.”
The split creates distinct selling points for large and small managers, says Antoine Drean, founder of placement agent and fund advisor Triago and private equity marketplace Palico.
“The best one-stop shops cut costs for investors through non-fund structures and insure diversity across strategies and regions with a wide range of classic fund offerings,” he says. “Meanwhile, smaller fund groups increasingly get traction with investors by credibly demonstrating that they have a performance edge in highly defined domains.”
Indeed, having a distinct edge is becoming vital for smaller managers, says Michael Rogers, global deputy private equity leader at EY. “For funds without a defined strategy – those that are just doing private equity or growth capital, for example, playing in all different industries – it’s becoming a tougher field to play,” he says. Particularly for smaller shops, he adds, “We see funds having more success if they’re focused around a sector or a geography – that is, if there’s something unique that they bring to the table.”
That’s an approach that Blackford Capital has been using, says Jeff Helminski, a managing director at the Grand Rapids, Michigan-based fund manager. Blackford currently manages about $50 million across two niche strategies focused on middle-market manufacturing companies, and is in the early stages of raising its third fund, a $150 million vehicle focused on opportunities in Michigan, where it markets itself as a local expert.
“The message we try to bring to the marketplace is that we’re in a very focused, specialized and inefficient space,” Helminski says.
Such an approach makes sense for fund general partners (GPs), according to Bain & Co. “With today’s favorable fundraising conditions expected to slow in the next few years, GPs will need to be able to demonstrate to LPs that they have a sharply honed and differentiated strategy for achieving superior performance,” Bain says in its recently released “Global Private Equity” report. “More than ever, a strong strategy will be important for fundraising as the supply/demand balance shifts back to LPs.”
Bain sees two broad ways that managers are emphasizing their investment specialties. Some managers are “sharpening their focus on their investment sweet spots, enabling them to zero in on deals with characteristics that best match the firm’s unique strengths, capabilities and past patterns of success,” the report states. Meanwhile, others are “developing thematic investment insights to capitalize on broad macro trends and gain an investment edge.”
For smaller managers, simple differentiation likely won’t be enough to attract investor dollars, however. Those managers may face higher scrutiny from investors, says Jim Merkel, CEO of Rockbridge, a $2 billion manager based in Columbus, Ohio that focuses on the hospitality industry.
“Savvy LPs generally spend their time focused in the right place – the fund’s track record. With the smaller funds, they will also focus on back office, compliance, and reporting capabilities,” he says. “We think this fact can create a barrier to entry for some smaller fund managers who are ill-equipped to deal with the regulatory and diligence requirements of many sophisticated LPs.”
Smaller managers must also position themselves to compete against the greater capabilities and product sets that the big shops can offer, Triago’s Drean says.
“Investor diversity, as expressed through different needs, constraints and risk tolerances, means there will always be demand for everything from broad, generalist funds to small, niche funds,” he says. “The seduction of one-stop shops does, however, mean smaller funds face more intense competition than ever before from big fund groups.”
The trend toward product divergence may also mean mid-sized private equity managers may have a serious decision to make: go big, go small – or go home.
“There are some very successful mid-sized firms that we would expect will continue to thrive in the future, because they have good track records,” EY’s Rogers says. “But what we’re seeing more and more is that mid-sized funds are either migrating up or migrating down. It is getting tougher to navigate that center ground.”
Not every firm may survive, but the bifurcation ultimately can be a good thing for managers and investors alike, Bailey says. “It offers investors more choice,” she says. “And it lets firms play to their own strengths.”
