Growth Equity as a Distinct Asset Class
Guest Post by Dr. Dee Kotak
Friends, here is the first guest post in a series of guest posts by BVG
Board of Advisors and without further ado…here we go..
Hello Friends, Raghu had asked me a while ago to think about a guest post for the BVG readers and I had recently been assessing some potential growth investments and had been thinking about what particularly differentiates these types of investments from other private equity investments and recalled some recent work that crystallized my thoughts.
In August, Cambridge Associates published data from the last 10 years that show U.S. growth investors outperforming virtually all major public market indexes over a 3, 5 and 10 year period. Growth equity investors also outperformed venture capital firms over all time horizons measured. Overall, growth investors enjoyed returns of 15.6% over three years, 7.6% over five years, and 12.7% over ten years, compared to 11.4%, 4.1% and 6.9% for venture over the same periods. Growth firms also outperformed buyout firms for over 5 and 10 years, and were on par over 3 years.
What is Growth Equity?
Cambridge Associates defines growth equity as “investment in established companies to accelerate growth”. These target companies share many of the following traits:
- No prior institutional investment
- Proven business model (established product and/or technology and existing customers)
- Substantial organic revenue growth (usually in excess of 10%, and often more than 20%)
- EBITDA-positive or expected to be so within 12-18 months
Company Reasons for Taking on Growth Equity
Although these companies have by definition been growing without institutional capital, there are a number of reasons why it is subsequently considered appropriate to accelerate growth by investing in new product development, human capital, infrastructure, or new geographic regions; other reasons include making add-on acquisitions or to monetize a portion of the management’s ownership.
Growth equity investments will typically be minority stakes using little if any leverage at investment, and often are expected to be the last round of financing needed. They often have built-in safeguards for investors as well. For example, growth equity is typically placed in a more senior position than common equity, and often comes with negotiated negative control provisions and approval rights to mitigate the risks of owning a minority position. For instance, investors may receive the right to approve the annual business plan, new acquisitions or divestitures, and/or the issuance of new debt or equity.
Additionally, a growth equity investor will often have the right to participate in or initiate a liquidity event following a certain period of time, typically three to five years. It is in the area of capital loss ratios that growth equity really distinguishes itself as an asset class. In the U.S. between 1992 and 2008, growth equity investments generated an overall capital loss rate of 13%, compared to 35% for venture capital and 15% for leveraged buyouts. The comparability of loss ratios between growth equity and leveraged buyouts is noteworthy.
According to Cambridge Associates there is often a perception that buyouts, which invest in established companies with stable cash flow, should have superior downside protection. However, financial leverage applied to cyclical businesses adds a degree of risk not typically encountered in growth equity investments.
Looked at in a slightly different way, from 1992 through 2008, growth equity deals generated a gross multiple of invested capital (MOIC) of 2.0, in line with venture capital and ahead of buyouts (1.7). However, as you might suspect, not all MOICs are created equal. For example, nearly 60% of venture capital was invested in deals valued at less than cost, compared to 35% for growth equity; further, nearly 60% of venture capital value was created by the mere 6% of capital invested in deals that generated an MOIC greater than 5, while similarly high-performing deals in growth equity accounted for 9% of invested dollars, but only 37% of total value. In other words, while growth equity has (as noted earlier) delivered historically similar returns, it has done so with far less dispersion, both among managers and deals.
Potential Appeal for Investors
“While growth equity shares some characteristics with other private investments, its potential appeal clearly derives from more than just ‘splitting the difference’ between VC and PE,” said Peter Mooradian of Cambridge Associates and coauthor of the Commentary “Growth Equity is All Grown Up” (link). The Commentary delineates three key reasons for growth equity’s appeal:
- Secular growth focus. Growth equity investors seek out companies with rapid organic growth, often in sectors growing faster than the overall economy, making it a potentially rewarding strategy in a low-growth macroeconomic environment.
- Lower risk profile: Growth equity investments involve no or low leverage; are senior to management’s equity ownership; and have a full set of protective shareholder and governance provisions, all of which mitigates downside risk. Portfolio companies also tend to have lower technology and/or adoption risk than earlier stage VC-backed companies.
- Strong performance. Since 2000, growth equity funds have generated strong returns and have outperformed US venture capital. Moreover, conditions appear to be in place for them to replicate their success going forward.
Growth equity should now be considered a distinct asset class with different characteristics from both venture capital and private equity, even though it shares traits of late-stage venture capital and leveraged buyouts. The realization that growth equity potentially provides a better risk/reward profile than other forms of private equity may lead to greater competition in this sector. Furthermore, now be the time for founders to be less fearful of private equity in general and to consider the many benefits that come with attracting growth equity. In my next blog I will consider some of the challenges faced by a rapidly growing company.