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This article was featured in Pitchbook's 2024 Annual US PE Middle Market Report.
The evolving landscape of private equity
The Gibson LBO of 1982 is often cited as the dawn of modern private equity, which for the next few decades thrived on carveouts, LBOs of sleepy conglomerates, and uncontested founder transitions. However, those halcyon days are long gone. Today, with over 10,000 private equity firms and hedge funds competing for deals and Pitchbook reporting that global PE dry powder exceeded $1.6 trillion in June 2024, the investment landscape has become significantly more competitive.
Founder transitions beyond the lower middle market are becoming increasingly rare, while prevailing multiples imply robust underlying growth assumptions. In this mature environment, where first-round bids frequently attract 10 or more interested parties and multiple contenders continue to the second round, the ultimate victor needs to identify a value creation opportunity that eludes other bidders—or, distressingly, convince themselves of a value creation opportunity that does not actually exist.
While commercial diligence remains essential, its effectiveness depends on the strength of the underlying investment thesis. A compelling approach relies on a proprietary perspective—an insight that differentiates a bidder from the competition. Conviction in a deal is not just about validating market size, segmentation, and growth rates; it requires a firm belief in an angle other investors have missed.
The power of specialization: From vertical to subsector focus
Recognizing the need to have proprietary perspectives, most PE firms have specialized in a limited number of verticals or structured themselves behind vertical markets. Verticalization offers clear advantages: deeper market knowledge, stronger competitive insights, robust and interlocking relationship networks, and a sharper instinct for unlocking value. Industry experts agree that specialization correlates with better post-acquisition returns. But as more teams adopt this model, wherein lies differentiation? What defines true verticalization? Are broad categories like consumer or healthcare really verticals or do investment teams need to dig deeper?
Leading PE investors excel by diving into subsectors to develop winning investment theses. To gain a competitive edge, they:
- Go beyond the surface: Sharpen insights at the subsector level where assets truly compete.
- Prioritize with precision: Classify subsectors as “retreat, watchlist, and high conviction” to allocate effort efficiently.
- Make the right “friends”: Cultivate deep relationships within chosen subsectors, ensuring a strong network and early access to opportunities.
1. Go beyond the surface
When we work with deeply subsector-focused PE firms, commercial diligence takes on a different hue. While we still document market trends and competitive positioning, our clients—already well-versed in these broader assessments—have long been active in the space. As a result, our focus has shifted to specific proprietary investment theses, such as:
- A company with low market awareness, where a revised go-to-market strategy—featuring a doubled salesforce and invigorated marketing—could drive accelerated growth.
- A firm struggling with weak cross-selling due to uncompelling bundling and poor incentive structures, creating an opportunity for optimization.
- A business with a clear runway in its current sector but evident potential to expand its solution into hospitals and clinics.
In a competitive landscape where five or six firms will coalesce on similar views of market size, segmentation, growth rates, and market shares, the winning bidder needs strong conviction around a proprietary perspective—sufficient conviction to underwrite the cross-selling opportunity if they are to win the bid.
Breaking down the education sector
With a career focused on education and government, I’ve seen firsthand the importance of subsector specialization. Simply identifying as an “education and workforce-oriented investor” is a start, but true differentiation comes from breaking down the sector into subsectors.
Education spans early childhood education, K-12, higher education, corporate training, continuing education, and workforce development. While this broad taxonomy outlines the landscape, it overlooks the unique forces shaping each segment. Early childhood, K-12, and higher education operate under distinct dynamics, and even within K-12, instructional materials, services, and technology—each face different market drivers, competition, and growth potential.
This breakdown still lacks granularity. K-12 technology solutions further fragment into categories such as:
- Student information systems and human capital solutions—driven by district-wide operational efficiencies, long sales cycles, and integration needs.
- Web filtering, parent communications, and critical event management—governed by compliance mandates, safety priorities, and evolving user expectations.
Investors who focus on subsector trends gain deeper insights, refine investment theses, and allocate resources more effectively. Success hinges on data-driven analysis to distinguish high-value opportunities, requiring deep sector intelligence, strategic focus, and a commitment to uncovering real value drivers.
2. Prioritize with precision
A strong subsector fact base supports efficient resource allocation, and at Stax, we tend to classify opportunities into three categories: retreat, watchlist, and high conviction.
- Retreat: If a subsector is classified as “retreat,” we would advocate not allocating time and effort. If a confidential information memorandum comes across the desk, read it, but investing more than a nascent amount of time and effort to these subsectors is unlikely to yield an opportunity that will survive investment committee scrutiny. However, maintaining relationships is key—what’s a retreat today may be a high-conviction opportunity in a few years.
- Watchlist: These subsectors are more complex. The investment team already views the space as lukewarm at best, but if an interesting asset is coming to the market, kick the tires and check it out. But the asset will need to be a clear leader to overcome a tepid perspective on the underlying market and it is unlikely the team will develop sufficient conviction to submit a winning offer.
- High conviction: Investment teams focus their efforts on these high-priority subsectors, developing deep expertise, tracking buyer behaviors, monitoring regulatory issues, and analyzing competitive dynamics to shape proprietary investment theses.
3. Make the right “friends”
Deep subsector understanding is necessary but insufficient; investors need to cultivate strong relationships with key players—including executives, owners, lawyers, bankers, regulators, and customers—well before deals come to market. While the gold standard is an uncontested process, a more realistic goal is threefold:
1. Anticipate market activity: Know in advance when a prized asset is likely to come to market.
2. Develop a proprietary investment thesis: Have a clear, differentiated point of view on the asset’s value creation potential.
3. Become a trusted partner: Build credibility with management teams and owners long before a transaction occurs.
The best investment teams I have worked with over the past 25 years maintain a deep pipeline of opportunities, which they have been tracking for years. I am amazed at the patience and persistence some investors have within subsectors they really like. One investor, for example, focuses on only a handful of subsectors and routinely closes deals where initial conversations started over a decade ago. This methodical approach has consistently driven post acquisition value creation.
Achieving long-term success through subsector conviction
In today’s competitive deal landscape, winning bids require more than broad sector expertise—they demand deep, subsector-level conviction. Successful investors go beyond traditional verticalization, developing insights at the subsector level, strategically prioritizing opportunities, and fostering long-term relationships within their chosen markets. This approach sets firms apart and drives profitable outcomes. Learn what sets Stax apart by visiting www.stax.com or by clicking here to contact us directly.
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