Strategy Drift vs Style Shift: The risks and opportunity surrounding your evolving investment strategy
In our prior 60 Seconds with Sixpoint, we discussed how best to communicate your firm’s evolution story and specifically addressed two key topics: team turnover and fund performance issues. The third leg to the “evolution stool” is strategy drift, or what we prefer to call “style” shift. We are averse to the term strategy drift because it seems to imply an unconscious or haphazard series of decisions are responsible for leading sponsors off-course. In reality, we know that this is rarely, if ever, the case. GPs are known for carefully weighing all decisions before taking actions, so to suggest that any of their investment choices are the result of mere happenstance just isn’t accurate or credible, which only makes the ability to communicate these changes to LPs that much more critical.
In the halcyon days leading up to the Global Financial Crisis (GFC), the abundance of capital being committed to private equity funds spurred many GPs to raise outsized funds. The ensuing pressure felt by these sponsors to put that capital to work led investment teams toward non-core sectors where they lacked experience and a trusted network. The risks of entering new sectors and industries became only too apparent during the GFC as many GPs struggled to rescue troubled companies in sectors where they didn’t thoroughly know the lay of the land. In the aftermath of the GFC, investors concluded that GPs that specialize in a limited number of sectors outperform their generalist counterparts. The sponsor community has acknowledged this shift and the vast majority of sponsors returning to the fundraising market today are noticeably more focused in their approach.
The most important concept to remember when explaining your firm’s style shift to an investor is that you need to “own” the full track record. It can be tempting – and convenient – to distance yourself from the underperforming assets in a prior portfolio, but LPs are wary of sponsors that lack the necessary sense of accountability for mistakes that were made. Frequently, GPs will look to attribute poor deals to professionals that have departed the firm (sometimes with good reason) or will try to dismiss all of the mistakes with a blanket statement about how they have eliminated that sector from their investment strategy on a go-forward basis. These can be elements of the style shift narrative, but LPs won’t be satisfied with high-level explanations. It is also essential that the senior investment professionals speak to their underperforming assets in the right way. If approached correctly, each underperforming transaction can be used as an opportunity to highlight “lessons learned” by the investment team and can serve to underscore the reasons behind the style shift. A thoughtful explanation of why the GP’s model wasn’t successful in a particular sector demonstrates an understanding of the limitations of the firm and a focus on putting the capital to work in areas where the team is best equipped to maximize value.
Finally, while explaining the rationale behind investments that may not be part of the firm’s go-forward strategy, it’s important not to lose sight of all the areas that have remained within the investment approach (e.g. size of company, geography, investment type, etc.). LPs are looking for inconsistencies, so often the bulk of due diligence meetings will be spent focused on areas of incompatibility. It is incumbent upon the GP to look for opportunities to remind investors that while there are always areas of change within a firm, the core elements/identity of the strategy remain the same. That being said, the proof is always in the pudding and whether or not a GP has learned their lesson and has the ability to be successful in a more narrowly focused strategy can only be substantiated by executing on deals and proving out that the style shift in their new fund. As we all know, private equity is a “don’t’ tell me, show me” business and this is likewise true when addressing style shift.
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Sixpoint Partners, LLC, is a registered broker/dealer, member FINRA (http://www.finra.org) and SIPC (http://www.sipc.org). Sixpoint Partners Asia Limited is licensed by the Securities and Futures Commission (http://www.sfc.hk).