Specialization and Diversification

“Don’t put all your eggs in one basket!” you may have been counselled. “Stick to your knitting!” others may have countered. English abounds with adages bombarding us with such advice. Are we to hone in on a niche and play to our strengths? Or broaden our horizons and expand our areas of interest? Specialize too much and one ends up “knowing everything about nothing”; spread too thin and one becomes the proverbial “jack of all trades, master of none.”

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This dichotomy also exists in investing, as investors try to balance specialization and diversification. Specialization allows an investor (or a GP or an LP) to concentrate its investments in particular industries, geographies, or stages, and to develop its competencies accordingly. This allows it to reap the benefits of its specific expertise. On the other hand, diversification leads a fund to disperse its investments across these dimensions to reduce the risk of excessive concentration. This trade-off introduces a tension between the two forces when formulating an overall investment strategy. In a sense, specialization is the GP’s accelerator pedal, whilst diversification is the brake. Without the former, you’ll never get off the line. But without the latter, you may well crash and burn.

The importance of specialization

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For a GP to distinguish itself and generate top-quartile returns, developing a focus (or several) is key. This is particularly true given the hyper-competition of today’s private equity and venture capital landscape. The literature emphatically corroborates this conventional wisdom; one study finds that specialized firms with specialized investment professionals outperform generalist firms with generalist professionals by 3.1% in terms of deal success rate. [1]

A fund best positions itself for success when all of its specialized knowledge, experience, information-sharing networks, and personnel - that is, its most valuable assets - are utilized fully. [2] For example, a seasoned veteran in early-stage Chinese tech has a unique knowledge set of trends, personalities, history, and a range of possible futures. This specialization, along with the continuously accumulating experience and knowledge in its chosen niche, allows value creation and outperformance. The development of specialization and expertise over time drives the general increase of PE fund performance in later funds.

However, it is possible to go too far - as the experiences of many VCs specializing in early-stage tech and semiconductor companies during the dot-com era may attest most dramatically. [3] Moreover, when matters within a chosen niche turn sour for prolonged periods, a fund might need to consider investing less dogmatically and more opportunistically - insofar as the terms of the LP agreement might allow.

The importance of diversification

As anyone introduced to Modern Portfolio Theory (MPT) in an introductory finance class might well be keenly aware, the significance of diversification for investment decisions cannot be understated. MPT asserts that diversifying allows an investor to minimize the level of unsystematic risk (the risk specific to individual assets as opposed to the entire market) for a given expected rate of return. The investment parameters that can be diversified across include industry, geography, stage, vintage year (for LPs), investment type, and time of investment.

While diversification is as important a consideration in private equity as in any other asset class, the waters can be muddied by the potential misalignment of GP and LP objectives. LPs often seek to diversify their PE and VC holdings on their own and prefer to diversify across private equity or venture funds that are themselves highly specialized. In this way, the LP diversifies the risk on its end, whilst also maximizing the returns from the market. However, the ability and willingness to do this varies across LPs, further complicating matters for GPs.

How does one strike a balance?

Actively balancing these two forces is a delicate but critical undertaking. While developing focused expertise is key to generating value, going too far would overly expose a fund to risk with no upside to compensate. Theory advises that diversification must be embarked upon once the yields to specialization have been exhausted. But how is this applied practically?

It is possible for even a highly specialized fund (such as early-stage south-Indian tech) to diversify away some of its risk. For example, a recent Bella study found that, while specializing at the sector and industry levels was conducive to outperformance, it was better to diversify at the sub-industry level. Furthermore, our figurative south-Indian fund could also disperse its investments across time, or type (i.e. minority/majority position, etc.). More significantly still, in the long-term, a GP can diversify by developing adjacent specializations. That is, developing expertise in areas where existing knowledge stocks have some degree of carryover. The multiple fields of focus that a GP develops can be instituted within a single fund, or eventually spun out into multiple funds.

The bottom line

Reconciling the twin forces of specialization and diversification is an involved task for both fund managers and investors. Generating value and top-quartile returns hinges on the ability of the fund to specialize and develop focused expertise and competencies. However, an appropriate level of diversification must temper this specialization to reduce potentially catastrophic risk. From a birds-eye view, disentangling the complexities of the problem requires an overall decision-making framework that considers the target level of return and acceptable risk, along with an assessment of the available knowledge stocks and competencies of the firm. This could materialize in various gradations of sophistication, from rules-of-thumb and back-of-the-envelope calculations to mathematical, data-intensive models.

One tool that Bella has produced to help clients tackle the problem is a sectoral correlation matrix. The correlation coefficients between a pair of sectors or industries gives us an idea of how interlinked they are. Armed with the knowledge of how the different sectors in a market move together, an investor is able to quantify the risk inherent to a particular portfolio composition, and how different deals might affect this risk. This is one method for active management of risk that could be a key piece in the wider strategic framework. Alongside this decision-making system, a concerted effort to expand the expertise of the firm in strategic directions is vital to striking the balance between diversification and specialization, and thus long-term success.

So, we find that with specialization and diversification, we must follow the dictates of the fairy take Goldilocks: Not too specialized…not too diversified…but “just right.”

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[1] Gompers, Kovner, and Lerner (2009)
[2] Edgar Norton and Bernard H. Tenenbaum, “Specialisation vs Diversification as a Venture Capital Investment Strategy”, Journal of Business Venturing 8 (1993):431-42
[3] Lerner, Josh, Ann Leamon, Felda Hardymon, "Venture Capital, Private Equity, and the Financing of Entrepreneurship", John Wiley & Sons, (2012):298-299