Rising prices in tech to benefit sector specialists in private equity

If the pandemic has highlighted one thing within the private equity industry, it’s that specialist knowledge pays off.

The gap between generalists and sector-focused funds are expected to widen even more next year as rising prices of companies make it more difficult to maintain bumper returns.

Funds that were invested in technology and healthcare companies have not only survived but thrived through this year’s uncertain economic environment, according to both investors and managers.

Those with deep sector knowledge have been able to navigate their portfolio companies through the crisis and were also able to continue signing deals, even though many auctions were put on hold.

The two sectors that continued to perform through the pandemic are also where many buyout groups have built specialisms in. Funds with a focus on information technology have raised nearly $200bn in capital since 2015, meanwhile healthcare-focused strategies have attracted approximately $45bn over the same period from investors, according to data provided by Preqin.

Just this year, technology-focused Silver Lake raised $18.27bn for its sixth flagship fund; while Thoma Bravo, another software and tech-enabled services specialist, announced the closing of three funds raising a total of $22.8bn in October.

‘In recent years, we’ve seen a continuation of private equity’s move away from generalist to thematic and sector-based investing,’ said Simon Tilley, managing director at investment bank Stephens Europe. ‘Given continued strong valuations, I think investors have a greater degree of confidence in being able to deliver their target returns if they follow sector themes.

Picking the right spots

For Tilley, a good example is UK-based Hg. He said: ‘[It] has positioned itself as a highly specialised investor in its chosen sectors of software and services and enabled the team to build a deep understanding in industry verticals to give confidence that they can select the winners.’

Hg began focusing on the European software and services sector exclusively in 2012. The firm, which has $30bn under management across several funds, has been a stand-out performer over the years, according to pension fund documents.

Meeting notes published by the Connecticut Retirement Plans and Trusts show the group’s 68 software and services investments generated a net internal rate of return and total value multiple of 22% and 1.8 times respectively, while maintaining a loss ratio of less than 3%.

Meanwhile, the listed investment trust managed by the firm, HgCapital, has been the top performer this year in the Association of Investment Companies’ private equity sector, delivering a net asset value return of 25.6% versus a 9.1% sector average over one year.

‘Building a strong investment thesis and gaining a clear understanding of the key drivers, opportunities and challenges in chosen sectors and sub sectors means that specialised investors have the confidence and ability to focus and go after the best businesses, knowing that they will likely have to pay up, rather than just chase deals that appear in the market,’ said Tilley.

However, the rise in sector specialism, and an increased focus on similar sectors, will push prices up. In 2021, analysts at PitchBook expect 20% of buyouts to be priced above 20x Ebitda.

As buyout funds increasingly target growth-stage technology companies, these businesses will trade at a much higher multiple of earnings than the traditional private equity target, according to PitchBook. 

Buying opportunities

This has already been the case. Thoma Bravo acquired UK-based cybersecurity business Sophos for about 46x TTM Ebitda in January this year. ‘Many of these internet-native businesses have seen bottom-line improvements from the accelerated move to a digital economy during widespread lockdowns.

‘Even if pricing stays the same for most businesses, a higher proportion of buyouts taking place in sectors such as software and biotech should boost the proportion of deals taking place in this pricier range,’ lead analyst Dylan Cox wrote in a recent report. 

That’s why Tilley believes having deep sector knowledge will be crucial for returns going forward. ‘As valuation expectations rise, then it probably filters out some of those generalist investors that would like to be invested in some of these companies but don’t necessarily have all the expertise that’s required in order to be able to pay up and still generate the desired returns.

‘That’s particularly true from an international perspective where the complexities of cross-border M&A are involved.’

It has been previously documented that sector specialists outperform generalist funds. Last year, research from global investment group Cambridge Associates found that investments by sector-specialist private equity funds between 2001 to 2014 outperformed those made by generalists by 4.7%.

Splitting the industry

For some, this will continue to be the case going forward. Helen Steers, head of Pantheon’s European investment team, said the pandemic has resulted in a further bifurcation between different industry sectors, with funds focused on technology and healthcare becoming the best places to be invested through the crisis.

‘You’ve got to be partnering with the best GPs, who know the sectors, the sub-sectors and micro-sectors within those areas really well. You don’t want to be investing with generalists who are trying to invest in technology and healthcare.

‘It’s a specialist skill. So, picking our way through those sectors and finding the best places to invest in, I think that’s probably one of the biggest [challenges],’ Steers said.

Steers, who foresees an even bigger dispersion of returns between the top managers who have the operational expertise and those who do not have the same capabilities, believes private equity can still offer great returns, but it will all depend on selecting the right managers.

Source: City Wire