As they scour the globe for their next round of investments, private equity (PE) firms find themselves facing a shifting and perilously uncertain landscape. The forces that drove business expansion and underpinned investment returns since the PE industry's earliest years are winding down, bringing the global economy to a major inflection point.
China's three-decade-long surge of economic growth is over, but the transition path that China's economy will take and where it will end up remains unclear. The baby boomer generation's consumption patterns are evolving as its peak period of earnings and savings ebbs and its sizeable cohort ages into retirement. Meanwhile, how vibrant and different demand will be as the "echo boomer" millennials reach their consumption peak will not be apparent for another decade. The breakthroughs in computing and telecommunications that powered the decades-long information technology revolution have matured, but the advances in robotics, genomics, artificial intelligence and nanotechnology that will give rise to the next wave of commercial development are only just beginning to emerge from the labs.
As Bain & Co reports in its Global Private Equity Report 2016, many leading PE firms are getting ahead in this challenging environment by taking a thematic approach to investing that enables them to get an early read on emerging macro forces, organise around them and incorporate a deep understanding of their potential impacts on the deals they choose to make (or walk away from). The themes that firms adopting this approach embrace are big ideas that will unfold over a decade or longer. Thematic investors take a top-down view of one or more of the macro forces they focus on and anticipate how they will play out across sectors, industries and geographies. They bring their deep analytical skills to bear, quantifying how an overarching investment theme will influence consumption patterns and capital flows, reconfigure supply chains and affect results at the individual business level.
The practical benefits that thematically oriented PE firms can capture are considerable. First, by sizing up macro forces that will shape the investment landscape, they build a more confident understanding of the types of opportunities they want to pursue and assemble a network of contacts and industry relationships that will help the firm find suitable deals.
Second, a thematic approach helps streamline due diligence, enabling firms that apply it to quickly size up whether possible deal opportunities satisfy the macro criteria they have prioritised, double down on the few that pass the macro screens and dismiss the many that fall short.
Third, having a well-developed view on priority investment themes gives PE dealmakers greater confidence in selecting when to bid aggressively to acquire an asset with a favourable macro profile and when to hold back.
Finally, as its understanding of macro investment trends deepens, the thematically oriented firm can align its entire organisation around a common macro thesis and develop distinctive areas of competence that cut across conventional geographic and business sector boundaries.
All successful thematic investors follow sequential steps for converting themes into actionable investment criteria:
Identify and analyse: Thematic investors cast a wide net to pick up the early threads of an emerging macro force that will move the economy, taking care not to confuse a high-impact theme with a passing trend that can quickly unravel. They look for bold, counterintuitive investment opportunities, recognising that to settle for obvious approaches risks generating obvious answers that are already fully priced.
As firms select from among the ideas that they weigh, they look for ones that best fit their firm's expertise and prior investment successes. They focus on themes whose impacts they can quantify and whose likely evolution they can chart over time. They convince themselves that the themes they commit to will have clear impact across several business sectors, geographies or both, pointing the way to specific classes of asset targets.
Drill down and codify: Exploring high-level themes is a crucial first step, but only by diving deeper can general partners (GPs) marry the top-down pockets of opportunities to specific areas where the fund can find investing success. This deeper analysis of how the fund's specific capabilities can make the themes actionable enables GPs to sort out what truly suits them from what is merely interesting.
Probing beneath the surface of the powerful demographic transition unfolding in the US, for example, enables a PE firm to track its concrete impact down to specific business sectors. Deeper investigation can also help turn up intriguing second- and third-order effects of a macro trend beyond the most obvious opportunities. For example, the larger population of older drivers that demographic changes will bring means more safe drivers on the roads. The result: fewer accidents and lower car insurance premiums. The effects of this trend will compound with the addition of more passive-safety technology in the fleet of passenger cars cruising the highways. For owners of chains of automotive shops, the consequences flow in both directions -- fewer repairs overall but higher-value ones.
The disciplines of thematic investing are beginning to be rolled out by GPs around the world. The clarity and confidence that PE firms are gaining by taking a thematic approach to building their portfolios will help power superior performance for years to come.
The article was prepared by the authors at Bain & Co as part of its Global Private Equity Report 2016.