By Francesco Marino and Giacomo Coriani
Growth stage private equity is an asset class that stands at the intersection between venture capital and buyout deals. As opposed to venture capital, which targets start-ups that still have an undeveloped business model, growth equity backs companies in established markets with proven unit economics. On the other hand, contrary to buyout funds, which invest in mature and sometimes listed target companies, growth equity funds invest in companies that have a short track record of cash generation. These companies have often reached an inflection point and need capital to scale up a proven business model, aiming for substantial revenue and profitability growth. The majority of growth equity deals and funding is deployed in the Internet sector. For example, in 2013 the Internet sector accounted for about 40% of total growth equity deals and funding.
Whereas buyout deals handle the purchase of majority stakes in the target company, growth equity often acquires a minority position in the target. Due to the lack of a majority control, constructing a trustworthy and collaborative relationship between investors and existing owners is essential to achieve desired objectives. Indeed, when acquiring a target company, growth equity funds need to perform a series of structural changes to enhance the profitability of the target. This involves procuring resources, infrastructure, systems and new corporate functions to support the business toward successive expansion. This stage of growth is often greater for growth equity firms than for their buyout counter-parties. According to Cambridge Associates, between 2008 and 2018, growth equity companies generated an average annual revenue growth rate of 17.2% after acquisition. This is double the growth achieved by PE-owned buyout companies. Growth equity also provides superior gains compared to buyouts in terms of EBITDA improvement – albeit less pronounced than the revenue growth juxtaposition. It follows that when growth equity companies are purchased, high expenditures are made to achieve the desired structural changes, which result in lower EBITDA margins in the initial one to two years of the investment. Only after a few years, if sales react positively to the structural changes, will revenues and profits rebound. This approach differs to the one used by leverage buyout companies when entering investments. In the buyout case, EBITDA growth typically experiences no hesitation due to prompt cost-cutting procedures aimed at achieving operational efficiency.
Source: Cambridge Associates LLC
The higher returns offered by growth equity are also coupled with a satisfying level of risk involved in the investment, lending growth equity an attractive risk-return profile. Whereas asset classes such as venture capital also tend to offer higher returns compared to buyout deals, they oftentimes entail a significantly higher level of risk. Whilst VC firms retain the potential for disproportional gains, they are also likely to suffer from unsuccessful ventures. On the other hand, growth equity investments select companies that have eliminated or mitigated early stage risk, leading to lower impairment and capital losses compared to venture capital investments. In fact, the relative size of impairment losses and capital losses for growth equity investments are comparable to buyout ones. Furthermore, opposite to buyouts, growth equity is able to provide significant returns without funding transactions via dramatic amounts of leverage. All available capital can therefore be used to fund new growth initiatives rather than being used to meet debt obligations. Using lesser amounts of leverage also makes growth equity investments more resilient during downturns – as evidenced by growth equity companies generating positive revenue growth even in 2009 during the financial crisis.
Source: Bain 2019 Global Private Equity Report
Given the attractiveness of this asset class, the types of investors providing growth capital to companies are not limited to the private equity sector, but also include a variety of debt and equity sources such as family offices, sovereign wealth funds, hedge funds, business development companies, and mezzanine funds. Growth equity has historically been represented in Asia, but in the last years it has expanded widely in both Europe and the US. The attractiveness of this asset class is demonstrated by the high amount of funding it received in the first quarter of 2019. According to Private Equity International, $177.2 billion was raised by private equity funds in the first half of 2019. Of this figure, around $50.8 billion was raised by growth equity funds which implies the largest Q1 fundraising for growth equity in a decade. As a consequence of this increased interest in the asset class, entry valuations for growth equity companies have risen in recent years. Between 2010 and 2017, the average purchase price multiple for equity investments has increased more than 75% to 18.0x LTM EBITDA, as opposed to buyout investments that only increased by 50% to 11.2x. As growth equity backed companies typically self-fund themselves prior to receiving institutional capital and therefore tend to operate at artificially low EBITDA levels, using multiples based on revenues (although crude) may be more useful in gaining reliable insight on valuation fluctuations. Revenue multiples confirm the above-mentioned trend, with LTM revenue purchase price multiples for growth equity investments increasing from 2.9x to 4.9x between 2010 and 2017. This is significantly higher if compared to public companies in the Russel 2500 Index, which have generally been in a range between 2.0x and 3.3x LTM revenue.
However, higher multiples are not braking the influx of investors entering the asset class, which is already made up of large investors such as: Institutional Venture Partners, General Atlantic, Newspring Growth Capital, Catalyst Investors, Apax Partners, H.I.G Growth and Canaan Equity.
Source: Private Equity International
For further discussion on topics surrounding growth equity please join the BSPEC event “Growth Investing: The Link between VC and PE”, December 4th with panelists Soheil Mirpour – Head of Growth and PE at Global Founders Capital – and Mauro Pretolani – Senior Partner at Fondo Italiano D’Investimento. Admission is free and tickets are available at https://www.facebook.com/events/480477125902256/.
Editor: Eric Peghini
Authors: Giacomo Coriani, Francesco Marino