Substantial changes in the private equity industry have occurred in the last few years. PE firms are quickly adapting to compete with other PE firms and with strategic acquirers for capital and deals. Mergers & Acquisitions’ Special Report on Private Equity contains three components: we identify 10 young and thriving PE firms to watch; we interview top dealmakers who weigh in on the changes; and, below, we outline 7 ways the PE industry has evolved.

1. Firms specialize on sectors to compete
Value creation through operational changes is very much on the minds of limited partners. This has led to specialization by private equity firms, operating on the theory that more specialization means more knowledgeable professionals who also may be better able to make operational changes. Even the larger generalist firms have divided themselves up by sector verticals. The data suggests that specialization does drive higher returns.

A Cambridge Associates report, titled Declaring a Major: Sector-Focused Private Investment Funds, says sector specialists—those who historically invest more than 70 percent of capital in one of four sectors—enjoyed a 2.2 times multiple on invested capital (MOIC) return and 23.2 percent gross internal rate of return (IRR) from 2001 to 2010. Those returns handily outweighed the 1.9 times MOIC and 17.5 percent gross IRR returned by generalist funds invested in the same sectors.

As the benefits of sector specialization became proven through data, private equity firms have realigned along industry verticals. “The proliferation of sector-focused funds continues and we don’t expect that to change,” says Andrea Auerbach, managing director and global head of private investment research at Cambridge Associates and co-author of the Declaring a Major report. “The industry is over 30 years old now and continues to evolve towards specialization,” she says. “Our data shows firms with sector specialization have a competitive advantage. We know that now.”

There’s no question as new funds are raised, many are sector specific. In the first half of 2017, First Alpha Energy Capital launched to focus on energy deals, Moonlake Capital launched to focus on industrial and consumer services sectors and former NBA player Rick Fox and his partners formed Vision Venture Partners, a private equity firm that will focus on sports, video gaming and digital content production.

Additionally, according to the Probitas Partners’ Private Equity Institutional Investor Trends for 2017 survey, 51 percent of responding limited partners said funds focused on single industries are the most appealing in the middle market. Healthcare- and technology-specific funds are garnering the most interest from limited partners these days, according to the survey.

Sector specialization is on the rise, but globally only a minority of private equity firms organize themselves by sector, says Kelly DePonte, a managing director with Probitas Partners. “In the U.S., sector is a way to differentiate yourself, but globally most funds are organized by geography and fund type,” he says. The industry is seeing funds raised with different mandates, and there has been an increase in private equity funds raised to make minority investments and private credit deals.

2. Portfolio companies need operational expertise
Operational expertise has been a hot topic for quite some time and that’s not changing. “It was hot 10 years ago and it’s still hot,” says DePonte. “For LPs, it’s like motherhood and apple pie. No one relies on financial engineering anymore, operational expertise is a given.”

What’s shifted is how limited partners are approaching private equity firms about operational expertise. The investors are now telling the general partners to show them exactly how they are affecting change through operational expertise and they are taking a hard look at the data, not just relying on the word of the general partners.

Over the last 20 years, fund managers and investors have increasingly focused on making money, not solely through the use of leverage or relying heavily on multiples expansion, but by increasing earnings. Today, most private equity firms tout relationships with professionals that offer operational expertise. Private equity firms far and wide began hiring these people or forming partnerships with them after 2008. Industry veterans certainly know about the Vista Playbook, a how-to of sorts for Vista Equity’s portfolio companies, and KKR’s Capstone division, a captive consulting arm to KKR, which works closely with KKR dealmakers to create value after acquisitions through operational changes.

These types of efforts are very important to the limited partners. Eighty-one percent of respondents to Probitas Partners survey say they want to invest in U.S. middle market funds that focus on operational improvements heavily staffed with professionals with operating backgrounds. That’s up from 61 percent the prior year.

Limited partners are doing more due diligence than ever before to insure private equity firms are making operational changes. “LPs want to know how GPs are making operational changes and they want to see the returns at a very granular level so they can identify where the operational changes came into play,” says DePonte. “They aren’t just looking at fund returns, but will look at specific deals, which is a shift.”

Rightfully so. According to data from Cambridge Associates, from 2008 to 2015, PE-owned companies with enterprise values of $1 billion or more grew revenues by an average of 2.9 percent, while the Russell 3000 grew 4.8 percent. However, private equity-owned companies $250 million or less in size saw an annual average revenue growth rate of 8.7 percent. “Larger private-equity backed companies aren’t growing as fast as their smaller brethren, but they were also growing at a slower speed than public companies. Firms with operating partners should be demonstrating their capabilities in revenue growth, as well as margin expansion. GPs have to prove how their operating partners are improving the businesses and it’s not that easy to do, especially at the larger end of the market,” says Cambridge’s Auerbach.

3. Fundless sponsors and other alternatives models challenge PE
Over the last decade, firms doing deals without dedicated private equity funds or through non-traditional methods have proliferated.

“Ten years ago most independent sponsors were fundless because they couldn’t raise a fund,” says Dan Lipson, a partner with Rotunda Capital Partners. “Today, many new firms are choosing to be independent. More and more family office investors and institutional capital sources are looking to co-invest and put money to work outside of the traditional GP/LP structure. There are pros and cons to being fundless. One of the biggest drawbacks is a potential inability to raise capital in a market downturn. It might be a great time to acquire in a depressed-valuation market, but your capital sources simply might not be investing.”

For these reasons and more, Rotunda Capital got creative. The firm adjusted its model slightly in 2016: It did not raise a traditional fund, but partnered with a large endowment for some permanent capital so it could close deals faster. “The new approach allows us to maintain our independent sponsor model and raise capital on a deal-by-deal basis from our existing investors. In addition, having a funded partner providing non-portfolio company fees allowed us to hire two new senior associates and expand both the D.C. and Chicago offices,” says Lipson. “Lastly, it gives prospective acquisition targets greater confidence in our ability to close.”

The firm didn’t move to a totally traditional private equity model because it likes the flexibility of being independent. “Our structure allows us to invest in a variety of capital structures, minority and majority, as well as doing larger or smaller equity check sizes,” says Lipson. “We don’t get boxed into a specific type of deal and can be more flexible on hold period. In addition, we can be opportunistic. Not being forced to do deals under the limited investment period of a traditional fund allows us to do deals that are right for both us and the investor.”

Other types of non-traditional private equity models are also becoming more common. In 2013, NewSpring Capital formed a new fund called NewSpring Holdings. While the fund executes on deals like traditional private equity firms, it raises money differently. The lower middle-market private equity firm has raised permanent capital. “It’s not really a new approach, but it’s not the pervasive approach anymore. The 2 percent management fee and 20 percent of returns with a 10-year hold period structure is outdated. It’s left over from when there weren’t a lot of means for investors to get liquidity,” says Skip Maner, a general partner with NewSpring Holdings.

The firm’s strategy has resonated with family offices and high-net-worth individuals who are partial to seeing a company grow and get sold based on what’s considered the right time, not an artificial hold period. “We are about selling the company when the time is right and have the opportunity to maximize value. Most of our investors are former operators and they don’t love the buy-and-churn mentality. We are seeing an increasing trend toward longer holds,” says Maner.

NewSpring Holdings focuses on tech-enabled businesses in a variety of vertical markets and has completed four deals.

4. Family offices invest directly
The Pritzker Group Private Capital is probably one of the most well-known family offices that decided to invest directly into deals without the help of private equity firms. As their model became more established and the number of professionals with private equity investing skills increased, so did the number of family offices that decided to invest directly.

“This is definitely a trend,” says Paul Carbone, a managing partner with Pritzker Group. “Family offices are staffing up their capabilities to invest directly. There is evidence that this is where family offices are headed.”

About 80 percent of family offices now have at least one full-time employee sourcing and evaluating direct investments, according to an annual survey by the Family Office Exchange that was completed in May. The 118 family offices surveyed had an average of three employees involved in the investment process, two of which had some responsibility for direct stakes. More than half of the families surveyed plan to increase their direct investment practice.

Investing directly can appeal to both buyers and sellers. Sellers are more likely to get a long-term partner with industry expertise, because most family offices invest in sectors where they generated their original wealth. Additionally, family offices are more inclined to take legacy issues to heart, which often makes sellers feel more comfortable with a sale, especially if they are not fully exiting the company. Family offices increasingly like to invest directly because they have the industry expertise to do so and they don’t want to lock up their money in a blind pool and pay the 2 and 20 percent fee structure of a traditional private equity firm. Additionally, the returns are typically better in private companies than they are in the public market.

Julia Karol, president and chief operating officer at Watermill Group, sees increased competition for deals from direct-investing family offices. “One of the primary changes in the private equity industry is the rise of the family office,” says Karol. “We are seeing more family offices that are going direct because it’s easier to go to direct.”

5. PE firms sell minority stakes
At the top of every cycle it seems that asset managers start selling minority non-voting shares in their firms. In 1999, right before the venture capital bubble popped, venture firms sold minority stakes in their firms. And at the height of the private equity market, before the financial crisis in 2008, both the Carlyle Group and Blackstone Group sold minority stakes in their firms. Considering the market has been hot for a number of years, private equity professionals are not surprised to see a surge in minority stake deals for private equity firms.

“If you take a look at the past 20 years of history there is usually an uptick in this activity before the bubble burst. This is happening because of the part of the cycle we are in,” says DePonte, the Probitas managing partner.

In addition to market cycles, there are other reasons for sales. As it becomes harder for firms to raise funds and grow their businesses, some may look to buy private equity firms, which may allow them to offer new specializations or lines of business. Additionally, there is a consistent need for capital at the fund level. General partners have to make commitments to their funds, and as older general partners funnel out and newer general partners have to put up capital, there can be a gap if the younger ones can’t hold up their end of the bargain. Many times the older general partners are lending capital to the new generation of general partners. However, capital gained from a minority sale can help fill that gap. Additionally, private equity firms need capital to grow.

“In the 2007 era you had a lot of private equity firms taking on minority investors and it seems like that moment is back. That said, a lot of private equity firms formed in the 1980s are thinking through their legacy and how they will transition, and these minority sales can help private equity firms institutionalize and enable broader ownership,” says Auerbach.

In April, the Riverside Co. sold a minority stake to Parkwood LLC, a private trust company. Riverside intends to use the capital to expand its new debt-lending business and its deal businesses in Europe and Asia, along with buying other private equity firms.

Over the past two years, a number of private equity firms have taken this route. In 2015, Vista Equity Partners sold a less than 20 percent stake to a consortium led by Dyal Capital Partners—a division of Neuberger Berman that focuses on making minority investments in private equity firms and hedge funds. In 2016, Dyal also made a minority investment in KPS Capital Partners. Wafra Investment Advisory Group, a $15 billion money management firm owned by the Public Institution for Social Security of Kuwait, acquired a 10 percent passive interest in private equity firm TowerBrook Capital Partners.

Indicating that there are more deals to be completed, Dyal Partners raised a $5.3 billion new fund in December 2016 to continue buying minority stakes in private equity firms. Just last year, Goldman Sachs (NYSE:GS) through its Goldman Sachs Asset Management Petershill program jumped into the business, raising $1.5 billion for minority interests in private equity firms. In 2016, Littlejohn & Co. LLC sold a less than 10 percent stake to the firm. The Petershill group also bought a minority stake in ArcLight Capital Partners. Also in 2016, Blackstone officially closed a $3.3 billion fund to buy minority stakes in hedge funds and private equity firms.

“We are not the first to do this, and we won’t be the last,” says Bela Szigethy, co-CEO of Riverside Company. “It will be something we see more of going forward.”

6. Mid-market funds offer more products
As the private equity industry has matured, it’s become harder for PE firms to produce the outsized returns and to compete with other private equity firms for capital from limited partners. Recognizing this trend, many private equity firms have branched out to offer more products than what they have traditionally been known for. Like many trends, this strategy started with the largest private equity firms, which now commonly offer a wide array of products such as large- and mid-market funds, geographically targeted funds, sector-focused funds, private debt funds and real estate funds.

The middle market doesn’t have such a diverse offering, but PE firms are expanding their focus. Over the years, middle market firms like Leeds Equity Partners expanded by launching Leeds Novamark Management, a debt arm, and Bain Capital bought and rebranded Sankaty Advisors to offer leverage on deals. THL Credit, the credit investment arm of Thomas H. Lee Partners, closed in June on $511 million in investor commitments for its third directly lending arm focuses on mid-sized companies in healthcare, financial services and software.

“Putting two or three related strategies on has become a trend in the last three years and it continues to spread,” says DePonte.

Riverside is a middle market firm that recently diversified its product offering. In the last couple of years, the firm has added the capability to do non-control investments, micro cap investments and credit investments. That said, Pam Hendrickson, chief operating officer at Riverside, says that while there is expansion, there are constants that remain.

“We have diversified, which is driven by investor demand and our continued desire to leverage our strong back office. Investors have different needs and risk return profiles so we invest in strategies that can meet our investor bases’ needs,” says Hendrickson. “But we continue to focus on private investing in small companies. Ultimately, we want to be the place investors can come to get exposure to small companies in different parts of the capital structure based on their risk appetite, as well as the place that small companies can come for capital and help with anything from how to protect their IT environment to merger integration. You will not see us do public deals, large-market deals or other types of assets. We started expanding with the premise we should stay at the lower end of the middle market.”

Other firms are looking for ways to expand. Lipson said his firm is approached regularly to partner exclusively with debt providers while other firms are consolidating to offer two or three sectors under the same roof.

Auerbach warns that while launching new products is fine, they should be in areas where private equity firms can be successful. “We get the calls all the time. A firm calls and says they are launching something new. While relationships matter, we will compare the new strategy to all other available options in that strategy. Brand counts for something, but the ability to generate competitive returns is most important,” says Auerbach.

7. Co-investments become important
Some would argue that the very first buyout funds were raised because they garnered co-investment dollars. Over the years, co-investment became less common, until recently. Today there are more co-investment arrangements than ever before, which has led private equity firms to become more prepared to offer the option to investors. According to Pitchbook Data, in 2012, private equity firms brought in $2.4 billion for co-investment deals, and by 2016 that number had jumped to $4.8 billion.

“Co-investment has become more commonplace. Every fund manager we meet with says they have co-investments available. It’s part of the landscape and it’s not going away anytime soon,” says Auerbach.

According to the Probitas Partners survey, interest in co-investments is strong with 55 percent of respondents having either an active internal or outsourced co-investment program. Larger investors with more capital to deploy are even more active, with 84 percent of them having either an active internal or external co-investment program.

“More and more LPs are looking for co-investments, however the opportunities are skewed toward the larger end of the market. Also, a lot of LPs do not have the staff to handle co-investment opportunities, so it can be challenging,” says Sheryl Schwartz, a managing director with Caspian Private Equity.

Some of the larger limited partners, such as the California Public Employees’ Retirement System, Teacher Retirement System of Texas and Alaska Permanent Fund Corp., count co-investments as critical components of their private equity investment platforms.

Caspian also has an active co-investment program with private equity firms that it has invested with and firms that it has not invested in. Since 2008, the firm has aimed for about 10 co-investments a year. According to Schwartz, the key to Caspian’s success as a co-investor is that it’s staffed appropriately for direct deals and can spend time assessing the opportunities.

“To be successful you need an experienced staff to evaluate opportunities quickly. If you can’t make a decision quickly, GPs will stop shopping your deals. Our team is staffed with people who have done direct deals in the past, so they are knowledgeable,” says Schwartz.

Interestingly, Caspian finds a lot of its co-investments from independent sponsors. “That’s a common way to build a track record and we have always generated a lot of deal flow from independent sponsors,” says Schwartz.

“The industry is over 30 years old now and continues to evolve towards specialization,” says Andrea Auerbach, managing director and global head of private investment research at Cambridge Associates. “Our data shows firms with sector specialization have a competitive advantage.”
“The industry is over 30 years old now and continues to evolve towards specialization,” says Andrea Auerbach, managing director and global head of private investment research at Cambridge Associates. “Our data shows firms with sector specialization have a competitive advantage.” Cambridge Associates