How can you identify the most lucrative PE industry sectors?

I assumed you are referring to top-down analysis, which focuses on macroeconomic factors and broad industry dynamics, before considering individual companies. In that case, a macro view is a good starting point to gauge the attractiveness: economic trends, regulatory changes, technological disruption, demographic shifts, geopolitical stability, competitive dynamics, and market size. Nevertheless, it's important to note that PE firms will ultimately drill down to find individual companies with the best prospects for value creation within these identified sectors.

Thorough due diligence on founders and their abilities to sustain in the thundering ocean is the most important. Post funding valuation fall or valuation erosion is the biggest risk of a PE.

Identifying key value drivers is a vital strategy for PE value creation and the formulation of a clear roadmap across portfolio companies. The PE value creation journey crosses three milestones: 1. Acquisition valuation at the entry point 2. growth of the portfolio company during the investment period and 3. valuation at exit. In the first stage, it is crucial to identify value drivers before an investment is executed to focus on promising investments and set a clear roadmap. During the second stage, value drivers are implemented in a consistent manner while making the necessary pivots. At the exit stage, industries that experience a successful value-driven investment cycle are able to attract new potential investors.

From a corporate finance perspective, value drivers are elements that can be adjusted to improve a company's free cash flows, enhancing its intrinsic value. Other than the mentioned value drivers, PE firms typically consider operational improvements, which are non-financial ones. In PE investments, more is needed to identify companies with potential; PE firms must proactively implement strategies to unlock that potential. In my experience, it is uncommon to see PE firms perform rigorous due diligence processes and a clear operational improvement plan to identify and capitalise on these value drivers to deliver substantial returns.

Other than those mentioned, lifecycle specialisation could be one positioning to enable PE firms to tailor their value-added strategies to the specific needs of companies at different stages. Due to the increasing focus on sustainable investing recently, some PE firms have carved out a specialisation in ESG, focusing on sustainable business practices and industries that are likely to benefit from long-term secular trends in resource efficiency, clean energy, and social responsibility.

Based on my experience, PE Firms typically evaluate a few metrics, such as IRR, Invested Capital Multiples, and leverage ratios, before investing in an investee. Incorporating performance data into analysis allows PE firms to reflect on both past successes (or failures) as well as make informed strategies for the future.

Mega trends and innovation are really cool areas to invest, but traditional PE is focused a lot more on the cash generation and EBITDA associated with energy, commodities, financial services, healthcare and education. Everyone has to eat and be healthy, population is growing and aging so these will always be long term plays, supported by private equity and governments.

Some PE firms approached it with pilot investments with smaller, targeted investments before committing substantial capital. Surveys, focus groups, and expert interviews are somewhat used for market research. In terms of financials, PE Firms typically perform financial models to test various business scenarios and their outcomes. These models help in understanding the potential financial performance under different market conditions and assumptions. Finally, reviewing past transactions within the sector provides data that can either support or challenge the investment hypotheses.

I think investors should be very careful when thinking about PE investing from the standpoint of what could be the most lucrative industry. Yes, investing with a trend and cycle can be beneficial - but equally, then "missing the top" of this cycle might mean that the investor has significantly overpaid for an asset relative to its long-term fair value. Accordingly, investors should either try to be countercyclical (i.e. investment in industries after they've reached their cycle peak) or try to be completely cycle-agnostic - i.e. always buying companies in their sector at stand-alone attractive valuations, independently of the view of more sector-agnostic investors.

Specific sectors may benefit from government incentives, subsidies, or regulatory support, making them particularly attractive for PE investments. For example, renewable energy sectors often benefit from such support. On the other hand, sectors that are fragmented with many small players may present opportunities for PE Firms to create value through consolidation, achieving economies of scale, and operational efficiencies. Finally, sectors that align with macroeconomic trends, such as demographic shifts (e.g., ageing populations requiring more healthcare services), tend to offer more sustainable growth prospects.