What creates a Moat in Private Equity?

The essence of successful PE fund managers' moats lies in their distinctive strategies and strengths

Having had the chance to have conversations with, and deep-dive into various investor presentations and marketing documents from, PE fund managers around the world, I've distilled the common thread of what some of the most successful firms point at when describing their own moat:

• Pro-active Deal Origination: Cultivating robust relationships with business owners in sectors aligned with their thesis. Proactivity ensures fund managers are executing a well-defined investment strategy, rather than merely reacting to inbound opportunities
• Sector Experience: Many PE firms specialize in specific sectors, boasting teams with deep knowledge and a successful track record in those domains. This expertise proves invaluable when investing in and exiting from businesses within those sectors.
• Geographic Focus: Funds focused on specific countries or regions would usually build teams with decades of experience in those markets. Team members with on-the-ground experience in (often the most successful being those who are actually from) those regions possess the critical nuanced understandings of the social infrastructure, economic dynamics, political risks, regulatory factors, and tax considerations.
• Fund Strategy: Some fund managers excel in executing particular strategies, potentially outperforming their peers. Identifying two or three strategic strengths, such as expanding into new geographies, vertical integration, roll-ups, buy-and-build strategies, etc., can further solidify a PE firm's moat.

In essence, these factors ensure that the top PE fund managers have privileged access to outstanding companies, wield a competitive edge within specific sectors and regions, and execute a coherent strategy.

For seasoned fund managers with a strong track record—measured by realized exits rather than mark-to-market valuations—it's crucial to demonstrate that their success is replicable and rooted in the quality of their team and their established moat.

To safeguard their moat—largely founded on human capital—deal teams are incentivized through carried interest structures linked to specific deals or fund performance. However, preserving this moat has become increasingly challenging.

According to Pitchbook data, there are over 24,000 fund managers, many of which offer highly competitive carry structures. It's worth noting that larger private equity firms (as measured by their AUM) often enjoy an unfair advantage in attracting top talent.

The fight for talent is fierce, and when high-performing team members depart, a wealth of knowledge departs with them.

Looking ahead, with rising interest rates and heightened competition in the PE sector, the evolution of the moat is a critical question. What role will data and AI, in particular, play in shaping the future of this landscape?