Private equity adjusts rules of engagement

Doom-mongers would have use believe otherwise, but the investment climate as we knew it before the big crash is simply evolving.

Debt and equity markets remain unstable, with investors still pondering the lessons of the financial crisis.

The financial system is still trying to work its way out of the abyss into which it plunged three years ago. Debt and equity capital markets remain unstable. Banks are still more focused on beefing up their capital ratios than on lending. A business culture built around leverage is being severely questioned. The prospects for private equity remain unclear.

It is tempting to claim that the days of this unique asset class are over. Some investors are pressing fund managers to reduce fees, commitments, or both; others have elected to circumvent them and to invest directly. The industry is also facing an uphill battle to invest committed but uninvested funds. In addition, companies in which an investment is held nowadays require far more attention than they required in the past.

Many investment cases have been delayed by a year or two, while others have simply become unviable. In summary, fund managers' economics are under pressure. And it seems they will remain that way, at least in the short term. Despite this challenging prognosis, it seems there is still a future for private equity. Leverage, a key industry driver, is temporarily missing from the equation. However, it appears that private equity firms have succeeded not only thanks to their access to cheap funding, but also because of their ability to pick industry winners, to align interests of the various constituencies in a transaction, and to marshal resources around their portfolio companies.

Private equity will emerge from the crisis. Its value proposition of active ownership to maximise long-term returns for investors remains sound. However, firms that hope to survive must adapt to a new reality, a new norm. The absence of financing has redefined the rules of engagement in private equity. Cash-strapped corporations are refocusing their portfolios and carving out non-core assets. Buyers, on the other hand, are shying away from cash deals and seeking alternative sources of financing, given the temporary absence of attractively priced financing. The search for top-line growth has been replaced with the pursuit of earnings quality.

The industry focus has shifted from financial engineering to industry know-how. The industry's landscape must adapt to this new reality. The market is moving towards a model in which global superfunds co-exist with niche players focused on a specific sector, on a well-defined region, or on both. Global funds will be industry leaders. They will raise and manage the largest pools of capital, which they will deploy across multiple industries and geographies.

Sector and geography specialists will not be as large. They will establish their positions in regional markets or in specific sectors. Specialists, it seems, will prevail in emerging markets and co-operate with global funds in certain transactions. The shape and form of such relationships between titans and specialists will vary, and the benefits of such relationship are obvious. Small and mid-sized private equity firms must reconsider how they will differentiate.

Successful fund managers will remain selective and they will focus on building expertise. This migration towards sector specialisation has already started and it will continue to gain momentum. Specialisation allows fund managers to keep in regular contact with key industry players. These relationships give them access to a vast, focused deal pipeline. More importantly, it allows them to anticipate potential opportunities and to proactively originate high-quality deals.

Specialists also have an edge in identifying potential winners thanks to their stringent screening criteria, their discipline and their expertise. They are ideally positioned to reach out to various industry stakeholders who are able to identify shifts in industry trends. In doing so, they develop proprietary insights that make them better prepared to screen out less promising opportunities at an early stage or during the due diligence phase.

Sector specialists typically identify high-potential sub-sectors in which to zoom in based on their size, growth potential and profitability, on the availability of targets, on the existence of potential exit avenues, and based on the firm's ability to create value in each sub-sector. This razor-sharp focus allows successful sector funds to be closer to the ground, better-equipped to interpret localised trends and dynamics, and ready to fine-tune their investment thesis based on their observations.

Once they have invested, the benefits of specialist fund managers over generalists become compelling. Specialists are better equipped to create value, to provide strategic guidance and direction tocompanies in which an investment is held, to develop relevant key performance indicators to challenge their ability to deliver, and to assess their operational and financial performance. Additionally, given their broad industry relationships, they are able to attract the best professional talent to fill crucial positions in those companies in which an investment is held. This ability to source well-trained talent is priceless.

Finally, specialist funds also have an edge as they seek to exit their investments. They can better assess potential buyers' interest, and they are well prepared to present the most compelling case for each of their portfolio companies. In summary, the private equity industry is far from finished. In fact, it is simply changing and adapting. To survive, small and mid-sized firms must think about how they position themselves in a new landscape.

In this battle for survival, specialists have a sustainable competitive edge.

Kristoff Puelinckx is group managing director and Francisco Sosa del Valle an associate partner at Delta Partners, a TMT management advisory and investment firm in emerging markets.