Differentiation: The key to success in 2025

So far in 2024 private equity deal flow has been uneven, fundraising tricky, and exits scarce. Looking ahead to the remainder of the year and into 2025 though, there seems to be more optimism – albeit cautious – as inflation continues to ease, interest rates start to come down and recession fears ease.

As GPs work to take advantage of the improving outlook, they still face an incredibly challenging and competitive market, where a differentiated proposition supported by a strong narrative and communications can get a firm on the front foot for success. Here are five areas where firms can stand out from the crowd.

Specialist funds

According to a Bain’s 2024 Global Private Equity Report, over 40% of PE firms are actively pursuing new strategies, with a strong focus on specialist funds [1]. Many investors are finding the edge they are looking for in managers who can leverage deep domain expertise to secure diamond-in-the-rough assets and execute on targeted value creation strategies. LPs can achieve diversified exposure to emerging pockets of opportunity – whether that’s high-margin specialist practices in the recession-resistant healthcare space, future-proof technologies in energy infrastructure, or the common thread of sustainability that’s embedding itself across portfolios amid regulatory and investor pressure. According to Mantra Investment Partners' Niche Private Equity Index, private equity funds investing in niche strategies have outperformed generalist managers over the last decade, with multiples on invested capital of 2.1x versus 1.8x for private equity overall [2].

The success of these funds rests on the manager’s sharp focus on a particular industry, sector, geography or strategy – communicating this through clear, compelling brand messaging will be key to securing LP commitments in 2025.

Exit environment

Global private equity exits totalled $155.3 billion in the first half of 2024, down 26% from $209.4 billion a year earlier, according to Preqin data, while total exit value for this year is on track to be around one-third lower than 2023's $460.3 billion. However, there are signs the IPO window will crack wider in the coming year as interest rates stabilise and economic conditions improve. The value of PE-backed IPOs topped $10 billion in both the first and second quarters of 2024, the first time that has happened in consecutive quarters in over two years, Preqin data shows [3].

Still, geopolitical uncertainty lingers and hold periods are getting longer. The days of buying low and selling high through financial engineering are gone – operational value creation takes time. So GPs are pursuing alternative ways to return capital to LPs, from continuation vehicles in the secondaries market to partial exits with rollovers. Indeed, exits via secondary transactions spiked to a 10-quarter high of $44.1 billion in Q2 2024, according to S&P Global data [4].

With LPs clamouring for distributions and DPI fast becoming the performance metric of choice, successful private equity exits should be communicated loud and clear. Well-crafted case studies, investor materials, and timely press releases can help cement a GP’s credibility at returning capital. Sharing the full story of a value-driven exit – from investment thesis, to value creation plan, operational levers pulled, key growth milestones hit, and ultimately capital returned – helps build confidence in both the process and the outcome. Portfolio company success stories lend themselves well to being told in different ways. For example, social media and video content can showcase expertise and results in a more dynamic way to a wider audience.

Middle Market opportunities

The middle market, especially at the lower end, is the heartland for value creation strategies; where businesses are ripe for operational enhancements, digital transformation and expansion. From lower valuations and reduced leverage to wider exit windows, mid-market private equity firms tend to have more flexibility to generate higher alpha compared to their larger counterparts. The top quartile of mid-market funds outperformed the top quartile of large-cap funds by 719 basis points since 2013, according to Preqin data [5]. Funds in this space have further proven their resilience in recent times and LPs are eager to capitalise on the outperformance they offer.

One growing trend in this segment of the market is the rise of GP stakes funds – vehicles dedicated to taking minority stakes in private equity firms to create a diversified portfolio of GP stakes. Such funds are becoming a valuable source of capital for managers at an inflection point in their growth, in need of cash to finance acquisitions, new GP commitments, or expansion into new strategies or customer channels. Other perks of this strategy include operational expertise and strategic alignment, not to mention steady cashflows for distribution-starved investors. Investors in GP stakes funds can enjoy multiple income streams, including recurring management fee revenues, carried interest and stake appreciation.

In the race to grow, consolidation is also becoming more prevalent among mid-market private equity firms. This accelerating trend provides managers with more and better resources to deliver operational efficiencies and economies of scale in order to compete with larger firms, while maintaining the agility that defines the mid-market.

Players in the growth capital and mid-market space, which has more than doubled in size over the last decade [6], must differentiate themselves sufficiently and succinctly – whether through specialisation, unique sourcing strategies or operational value-add – and carefully articulate the rationale behind any organisational change to fully capitalise on the opportunity.

Emerging managers

The fundraising landscape is challenging enough right now, without the lack of a track record that comes with being a ‘new kid on the block’. LPs have tended to gravitate towards the larger, more established GPs who can demonstrate sustained outperformance, making life even more difficult for emerging managers. But, while manager experience counts, so does innovation and there’s still a place for emerging managers. Those that can provide some kind of track record, for example spin-outs from established names or industry veterans who have left to set up their own firms to offer differentiated strategies, can offer the best of both worlds. Probitas Partners' 2024 Institutional Investors Private Equity Survey found three-quarters of respondents are targeting spin-outs [7], where the team has a history of success together.

Worth noting – emerging managers can be an important source of diversity, as a growing number of seasoned women dealmakers are setting up their own shops. And firms with diverse leadership teams have proven their ability to unlock differentiated deal flow. According to a recent BCG analysis, around 30% of transactions completed exclusively by diverse-owned firms are not accessed by non-diverse firms. What’s more, they are more likely than their non-diverse peers to invest in early-stage deals as well as in overlooked companies [8], and therefore offer potential alpha.

Emerging managers who can effectively communicate their operational strengths, differentiation and prior achievements will be primed for success as appetite for fresh faces with innovative approaches and compelling opportunities picks up.

Leveraging the brand

There is a clear and growing trend of private equity firms moving into new spaces to stand out in an increasingly competitive landscape. They are doing this through specialist funds, different strategies, secondaries, sustainability, even new asset classes and targeting new types of investors. But in doing so, they should be mindful of dilution risk. If your main fund has performed well, you’ll have goodwill from investors, but you still need a good story about why they should back you in a new field. The key will be articulating how any new ventures align with core competencies and aren't mere asset grabs.

For the generalists, it’s important to define and articulate what sets you apart from your peers – be it your origination model, value creation approach, distribution channels or use of advanced technologies. As we enter the home-stretch in what’s been a difficult year for the industry, those managers who can credibly present their unique value proposition and back it up with results will be best placed to thrive in the challenging but opportunity-rich environment ahead.

With thanks to BackBay Communications for their contribution to this article.

References

[1] https://www.bain.com/insights/topics/global-private-equity-report/

[2] https://www.privateequityinternational.com/florida-sbas-bradle-top-quartile-returns-are-not-enough-today/#:~:text=Data%20from%20Mantra%20Investment%20Partners,x%20for%20private%20equity%20overall.

[3] https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/private-equity-exits-pacing-for-5-year-low-after-slow-h1-82435868

[4] https://www.spglobal.com/marketintelligence/en/news-insights/blog/banking-essentials-newsletter-september-18th-edition

[5] https://www.pinebridge.com/en/insights/why-we-think-the-middle-market-can-beat-out-large-caps-in-private-equity

[6] https://www.pinebridge.com/en/insights/why-we-think-the-middle-market-can-beat-out-large-caps-in-private-equity

[7] https://probitaspartners.com/wp-content/uploads/2023/12/Probitas_PESurvey_final_1204_2023.pdf

[8] https://www.bcg.com/publications/2024/diversity-in-private-investment