Growth equity has long been described as the private investment strategy occupying the middle ground between venture capital and traditional leveraged buyouts. While this is true, the asset class has evolved into more than just an intermediate private investing approach.
Growth equity has long been described as the private investment strategy occupying the middle ground between venture capital and traditional leveraged buyouts. While this is true, the asset class has evolved into more than just an intermediate private investing approach. Growth equity’s unique risk-return profile, driven by a focus on organic growth, low leverage, and downside protection, has resulted in the creation of dedicated allocations across many portfolios and made the asset class one of the brightest spots in today’s investment landscape.
Growth equity funds seek to invest in companies that have proven out their business models and exhibit significant revenue growth, usually in excess of 10% and often more than 20%.1 The fact that these companies are generating revenue and have established product or service offerings minimizes technology and adoption risk, and differentiates them from the typical venture capital investment. At the same time, typical growth equity investment targets have significant scope to organically scale their businesses, and cash flows that generally are not yet large or stable enough to support much debt, distinguishing them from leveraged buyout candidates which tend to be characterized by incremental growth and steady cash flows.
Unlike venture capital deals, which are often made on fairly speculative Total Addressable Market and other assumptions, growth equity investments are typically underwritten on relatively defined profitability milestones and are either already EBITDA-positive or expected to be so in the near term. Companies seeking growth equity capital tend to have limited, quantifiable future funding needs to achieve their goals, in contrast to companies seeking VC financing (who are too early stage to be able to project the timing or quantum of their future funding needs with any certainty). The two, not mutually exclusive, imperatives that often catalyze a growth equity financing are (i) founders’ desire to monetize a portion of their stake, and (ii) the need for capital to accelerate growth through new product development, add-on acquisitions, geographic expansion, enhanced marketing, or more robust human capital and other business infrastructure.
Companies considering overtures from growth equity investors are often still owned by their founders or early management teams and have not yet taken any institutional capital. As such, growth equity investors are essentially betting on existing management, unlike buyout firms who frequently replace CEOs as part of their value enhancement strategies. As the growth equity asset class has evolved, however, these firms have begun to establish in-house benches of operational talent and other more traditional private equity resources that can help portfolio companies increase profitability.
An attractive growth equity investment target will tend to be growing faster than both its industry competition and the broader economy. This is because, unlike many venture capital firms who take a view on potentially industry defining trends and make small investments in several companies in the same space, growth equity investors generally wait until the landscape is more mature in an effort to back the market leader. Similar to venture capital, however, growth equity firms focus their sourcing on sectors positioned for meaningful secular growth (in contrast to traditional LBOs, where the emphasis is often more on improving operational efficiencies and the use of debt to generate returns). This has resulted in a high proportion of tech investments within growth equity portfolios, which, combined with growth equity’s comparatively low risk, has made the asset class very appealing in today’s macroeconomic environment.2
Growth equity investments are typically minority stakes using little to no debt. The lack of financial leverage allows these businesses to be more flexible in the face of cyclical headwinds and mitigates risk for investors.
In addition, while both VC and growth investors will almost always take preferred equity or otherwise structure the investment to be senior to management’s ownership, growth equity investors typically also benefit from a set of protective provisions and redemption rights. While these rights will vary from investment to investment, they generally include the right to approve material changes in business plans, new acquisitions or divestitures, capital issuance, the hiring or firing of key employees, and other operational matters. Redemption rights are heavily negotiated and generally based on either time elapsed since investment or testing business results against pre-set performance milestones or financial covenants.
These built-in safeguards can significantly reduce the risk associated with a minority stake in a not-yet-mature business. The unique characteristics of growth equity, shown in Figure 1, drive a distinct risk-reward profile that offers investors target returns between those of VC and PE with a modest loss ratio.3 Growth equity investors do not have to deal with leverage or technology / market adoption risk, while they enjoy the security of existing cashflow, comprehensive shareholder rights, reduced cyclicality and higher average secular growth rates given the sectors in which they invest. This combination of factors is compelling in any environment, and even more so in the latter stages of the market cycle. Especially in light of its favorable risk-adjusted dynamics, growth equity may be one of the best strategies to capture true economic value creation today.
(1) Cambridge Associates, US Market Commentary, Growth Equity is All Grown Up, June 2013.
(2) Cambridge Associates, US Market Commentary, Growth Equity is All Grown Up, June 2013.
(3) Cambridge Associates, US Market Commentary, Growth Equity is All Grown Up, June 2013.
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