Recently at Malartu, we conducted research to learn more about GP and LP sentiment regarding current trends in the investment world. I sat down with twelve executives from private equity firms, middle market mezzanine firms, and a handful of limited partners and talked with them extensively about trends such as specialization, operating partners, co-investment, and secondary transactions. Each participant has asked to remain anonymous to protect themselves and their firms from criticism or unwanted attention. This anonymity allowed them to answer honestly without worry of repercussions. I’m going to address my conclusions on private equity firm specialization and operating partners, with other results to be released at a later date. Now, let’s get into it.

What do we mean by specialization?

A “specializing” investment firm is one that invests in only one or two industries. Interestingly enough, despite the interviews I conducted were with randomly selected firms, all of the PE firms I ended up interviewing call themselves generalists while most of the limited partners prefer to invest in specialized funds. Additionally, all of the limited partners and half of the PE executives said that the likelihood of a portfolio company valuing operating partners (keystones of specialization) depends entirely on the situation; it’s no surefire thing. These results made me wonder... who benefits the most from specialization? And why?

Operating Partners Create Added Value

Axial Forum argues that generalized PE firms are “masters of none;” their lack of specialization results in an absence of expertise and a general sense of everything. According to Axial, this generalized knowledge results in slower growth and less valuable aid to portfolio companies. Conversely, the expertise of an operating partner in a specialized PE firm, for example, may be much more valuable to a portfolio company looking for help in the industry.

Operating partners have been on the rise recently, and have certainly helped generalized PE firms gain a little more competence in their portfolio company management. An article by Troy Ungerman, a partner at Norton Rose Fulbright, explains that operating partners add value through specialization and “deep industry expertise” in addition to providing a vital connection to the industry’s network; operating partners are often found in specialized firms for these reasons.

On average, two out of three of the PE firms I interviewed employ operating partners. Considering that all of these firms are generalized, I can infer that generalized firms too must value operating partners. Operating partners allow for generalized firms to gain a little more specialization, attracting not only portfolio companies that need an expert’s opinion but also investors looking for specialization.

Troy Ungerman notes that limited partners “like to see operating partners in PE because it demonstrates expertise in managing the businesses.” One of the PE executives I interviewed stated that “investors think the private equity market should have specialties [e.g. operating partners] and think they should be able to generate better returns” because of them. In fact, all the investors I interviewed said they believe specialized firms produce higher ROIs. From this information, we can assume that a good portion of investors look to operating partners as a sign of more industry expertise and potentially higher returns.

Private Equity Firms

PE firms might get the short end of the deal when it comes to operating partners. Though it seems like they add value and connections to certain industries, an article from PE hub claims that operating partners (especially in generalized firms) are an unnecessary cost and are never specialized to the extent that they actually enhance a firm’s operations. From this angle, it seems generalized firms only value operating partners for their ability to attract investors and new portfolio companies.

Axial quoted a study done by Cressy et al. from 1995 - 2002 that found the average profit of specialized firms three years post-buyout was 4% higher than non-specialized firms. This, Axial argues, compensates for the less diversified and riskier portfolio a specialized firm must commit to.

“Specialization matters because it has been shown, through both research and anecdotal evidence, to enhance each step of the transaction process. LP’s are more confident and willing to give funds, and sellers are more enticed by buyers who know what they’re doing. With these ducks in a row, the experienced team can do what has become second nature, build businesses in specific sectors that generate outsized returns.”

- Marc J.M. der Kinderen, Managing Partner at 747 Capital

While this argument for specialization seems to be substantial, it begs the question why none of the investment firms I interviewed were specialized. Despite the potential anomalies due to small sample size, it still had me wondering.

Let's look at the data

For his master thesis in December 2016, Alexander Leutscher of the Erasmus School of Economics, published a 62-page research study on “the impact of PE involvement and relative investment specialization by PE firms on post-buyout performance of acquired companies during the first 3 years after the transaction.” Contrary to Cressy et al., this research study found that 3 years post-buyout, specialized PE firms experienced “lower levels of turnover growth and profitability” compared to generalized firms. Leutscher concluded that the advantages of PE specialization do not outweigh the costs of a less diversified portfolio. Leutscher also noted, however, that his smaller sample size (50-100 firms) may have resulted in slightly unrepresentative findings (me and you both, Leutscher).

Considering this is a more recent study, I find it to be more compelling than the Cressy et al. study that Axial quoted. And, if Leutscher’s study is correct, it would nicely explain the reason that all the PE firms I interviewed were generalists. The research seems to match up.

What we learned

All things considered, we have some interesting trends happening. PE specialization may indeed incentivize portfolio companies and investors to get involved with a particular firm because specialization seems to invoke added value. Whether or not this added value is legitimate, that is, whether or not portfolio companies have greater growth or investors make a higher ROI with specialized firms, is still unknown. Regardless, investors and portfolio companies believe it to be true, so it doesn’t actually matter if it is. The added value of firm specialization does not seem to extend itself to the actual PE firm. The costs of being specialized (riskier, less diversified portfolio) don’t seem to outweigh the benefits (attracting investors and portfolio companies, having more expertise). This would explain why the firms I interviewed were all generalized, and also why two out of three on average had operating partners. Operating partners seem to add value to a firm because their “expertise” attracts more investors and portfolio companies. Operating partners may provide as much benefit to the fund's business development as they do in growing the fund's intrinsic value.

Of course, like Leutscher, my data set is small, and my findings are certainly not representative of the whole. They might point to some trends, but in the end, it’s all speculation based off a little more than a dozen extensive conversations. Let me know what you think in the comments down below. Who do specializing firms benefit the most? If you have any questions or comments about my research or have any information you feel is pertinent to my research, leave us a comment below!