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..

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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:

  • Founder-owned
  • 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.

Investors’ Perspective

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.

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Top 3 Reasons Angels & Entrepreneurs Walk Away from Deals

It is 11PM on a Friday night.  You just got off the phone with your lawyer and all the paperwork is in order.  The Board has given you 24 -72 hrs to pull the trigger.  You have spent last 3-6 months getting it to the finish line.  Yet come Monday the deal didn’t go through? Either the entrepreneur walked away or we did….

Does this happen frequently? I don’t know; but would say it is infrequent occurrence but heartbreaking when it happens at this late stage. The essential question is : Why? What Happened? What led to both sides devoting time/money/resources but were not able to close the deal? Of course, not all deals get unraveled last minute.  A few fall during enhanced due diligence.  Many fall away during the term sheet negotiations (majority).  But the ones which hurt the most (to the Angel/VC and to the Entrepreneur ) are the ones where only a signature is awaited for executions. The feeling when this happens is like being left alone at the altar – with the whole world watching. The single instance it happened to us – the Entrepreneur team decided to walk away as they wanted to keep exploring more lucrative terms.I wanted to share a few common attributes I came across as I analyzed BVG deals which didn’t get through. I have tried looking at this from different perspectives – the Angel/VC, the Entrepreneur/Founder and my own personal take.

1)     Lack of Transparency:

This is common occurrence  – we can share NDAs, etc., across the board but sometimes we don’t get critical/basic information revealed to us until diligence takes over. This holds true for both sides of the aisle.

The Angel Perspective: Too often we find that the Entrepreneurs are hesitant to share the details of their ‘secret sauce’ with us. This is typical during our enhanced due diligence where we are evaluating offerings especially in the Tech/financial services/clean energy sectors. Come on folks, we signed the NDAs, wouldn’t be talking the details with you unless we understood that your summary level offering had a good chance of making it in the market place – so yes we need to know in detail how that trade algorithm works, how that trough moves in the Solar Space, how secure is your secure chat offering? I don’t want to find elementary things during due diligence. It is a waste of our time and yours and calls into question your integrity? Guess what we are walking!

The Entrepreneur Perspective: We cannot share the details of the ‘secret sauce’ until you show us commitment towards funding. We don’t want you to take our ideas to a bigger firm because you cannot fit us in your fund mandate or deal size. Some factors are non-material to us, why do they matter to you? We want to talk to the analysts and question their assumptions? We want to see the Value -Add along with the $$ if we don’t – then we are walking!

My perspective: Maybe there is an inherent mistrust of the Angel Investor/VC ‘s based on the perception that they are trying to advantage of the hard work/dreams of the entrepreneur. In my mind, it is a simple give and take – you want money, you share your secret sauce, that’s how it goes. Don’t be upset that you have to share your IP in order to get funding, that’s what NDAs are for.Transparency is a two way street. (Maybe some of the hesitancy is due to the cultural/social tag associated with sharing intimate details of successful ideas as a large portion of our deal flows we look at are from the BIM (Brazil, India, Mexico) lack of strong IP protection laws, urban myths with deals gone wrong etc. )

2)     Valuations :

This is an important attribute – Not the Numero Uno though that will be # 3. Angel/VC stage  valuation is considered more of an ‘Art’ rather than a ‘Science’.  Valuation is where you will find divergent understandings and oblique views from both the Entrepreneur and Angel.

The Angel/VC Perspective: How often do we hear numbers for valuations from the Entrepreneur, which range from interesting to incredulous? This is a tricky stage as Valuation is more often than not tied to the Entrepreneur’s own assessment or number in the head as to what is fair value. The big question is how did the Entrepreneur arrive at that number? What benchmarks/metrics were used? Can we validate the assumptions used to arrive to get to the band of our internal own low/high valuation?

At BVG we use a STORC model data grid : Size (market size), Team, Opportunity, Revenue, and Competition as we rank & calculate our internal range for valuation numbers. Please don’t tell us that you think your company is valued at $2M+ because a website says so. At this stage we find that maximum number of walkaways happen as the numbers just don’t co-relate to either our comfort levels or of the entrepreneurs. If the entrepreneur’s are looking at just getting us to fund their Salaries & Expenses – guess what – we are walking!

The Entrepreneur Perspective: We have invested our sweat, hard work, and resources in this offering. This is our gateway of realizing our dreams of making a change in the world, being recognized for our efforts and make money. Not to forget that most of us have left a cushy paycheck and are staring at an uncertain future and have gone through a lot of rejections from Angels/VC’s to get here. We know that our idea/offering works. We need your help and $$ to help us scale up, boost our marketing and sales pipelines, and we are selling you tomorrow’s PE multiples. We are giving you a big chunk of our equity to get us to the next stage and yet we find that all you are interested are in a getting to the exit ASAP and having preferential liquidation preferences. Will you really help us, if we don’t get that comfort level then we are walking!

My perspective: This is a very tough milestone in negotiations. In my own dealings – I have tried to be fair to the Founder/Entrepreneur at the same time be aware of my fiduciary responsibility towards the BVG investors. Since we are usually the first funding opportunity after seed round – a lot of entrepreneurs/founders are looking for a validation of their own idea/offering. In some way they almost feel that a lower valuation or an ‘Angel Valuation’ is a comment on the merit of their offering – which frankly it is not. I encourage the folks to come up with a range for their valuation numbers & not have a set/definite number. When questioned on the range/band of the valuation number they should be prepared to defend and share the metrics used. I do the same and sometimes the chasm between the numbers is too wide to build a bridge to cross, sometimes it is a mere footbridge.

3)     Fit :

Fit is about Compatibility and Chemistry between the teams and alignment on majority of the key strategic and operational milestones. Why is this so important? After passing screening phase –  the period from due diligence to deal terms is an intense 3-6 month period of daily interactions – whether it is via email/chat/Skype or in person meetings. How do we work together – if cannot gel and work as a team at this stage – It will be very difficult to maintain and unwind such a relationship stretching over the years irrespective of the success of the venture.

The Angel Perspective: The most important factor in our eyes – is there a fit ? Does the entrepreneur understand our motivations and work with us? More importantly can we work with the entrepreneur’s team? Is there an understanding of where we both come from? Can we both speak the same language as to the vision/strategy/execution – different dialects are welcome :). We appreciate confidence but don’t like cockiness. We deeply value rare skill sets but we don’t appreciate a superiority complex. We love passion but want you to be interested in all aspects of business. We admire belief in the product/offering but we want you to open your eyes around if there are better offerings. Most importantly are you willing to listen, able to execute and look at us as partners, if not then we are walking and will encourage you to walk too.

The Entrepreneur Perspective: We are looking at you for funding and not tech/offering validation every second day. How does it matter to you that our office is in a building owned by my uncle and it is not papered? He is family and I am bootstrapping. Why are you questioning or challenging every statement we make…I came here looking for help not be interrogated. Yes, I want a salary – who is going to pay my bills? Why is it ok for you to call me/my team on weekends asking for last minute updated numbers? My team and I still own the company but it appears you are the new boss?  That is the reason I quit my old job and became an entrepreneur so that I can be my own boss. Why does every meeting lead to more work for me? Remember I got a business to run. We don’t think that you know more about my business than your team yet we have to defend the assumptions/projections?

My perspective: Angel investing is deeply personal.  It’s both a job and a calling.  It’s a lot like panning for gold: looking for the small bits of gold amongst all the other shiny pebbles.  I take what we do seriously; I am betting with my own chips. I am looking to give back in ways that are both personally fulfilling and economically beneficial. I am going to learn a few things as we go. I am willing to be coachable as much as you are. If we are going to be working together for the next 3-5 years in good times and in ‘not so good’ times we need to have chemistry and understanding that we are all part of the same team and working towards the same goal –  a successful exit with lots of money!!

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BVG Board of Advisors: Introduction

Hello again! How is everyone? It’s been a while since I got time to get my thoughts together for a post. I wanted to take this moment and briefly introduce the current members of the BVG Board of Advisors.  They are phenomenal people, and they each add so much value to the Blackstone Valley Group that I thought it prudent to share a little biographical information about them as well as my own personal thoughts and observations about what each of them brings to the table here at BVG.

Oh… and just a small disclaimer… I will introduce them in alphabetic order so as not to show favoritism… well, unless you count favoritism towards alphabetizing.  Haha!

First, allow me to introduce Mr. John Bosley.  John co-founded Wind River Capital http://wrcpartners.com/ in 1986 and has been instrumental in influencing a lot of companies over a 30-year tenure in various management and board roles including his tenures at GoldK and Bonaire.

I met John during our engagements at Bonaire a few years ago and we slowly built a rapport and understanding which extended beyond the boundaries of working relationship.

As I started my investor meetings and getting a construct of how BVG would shape up to be, I turned to John on his thoughts.  A veteran titan of the AngelInvesting/VC world, he knew the highs and the pitfalls of this game.  He has played an active role in encouraging and mentoring my actions during my first shaky steps in the Angel Investing world – helping with initial contracts, term sheets, due diligence, so on.  He has been generous with introductions, references and sharing his experiences of both the good and, as he calls it, the “not-so good.” For most of the deals coming in to BVG, he is often my go-to Advisor (him being in Boston helps, too) to get a perspective about the opportunity.

John was gracious in agreeing to be the first on the BVG Board of Advisors, an honor and a validation for the thought behind starting BVG.

John is an avid cyclist and every now and then he disappears to take the challenge of the trail he hasn’t conquered!

To read more about John please go to http://www.blackstonevalleygroup.com/about-us/ or visit his profile @ http://wrcpartners.com/people.html

 

Next on the list is Dr. Deepak Kotak… and speaking of the alphabet, Dr. Kotak or “Dee” (as he likes his friends to call him) has almost every letter following his name: MA(Oxon), MBBS, FRCA, MRCP, LLM.

Dee didn’t rest on these accolades and apart from the medical field (Consulting Physician in London Teaching Hospitals) he also practiced as an attorney for four years in civil law.  He is currently an investment manager for a small private equity fund in the US where he concentrates on healthcare.  Deepak is also the CMO officer of a Texas-based medical device company moving into the commercialization stage, advisor to a US bio-tech, investor and a guest analyst for PropThink.

Dee, I tried my best to summarize the illustrious career; if I missed anything, apologies!

I met Dee many moons ago on a Yahoo! Board/Group of a bio-tech company where we both agreed on the probable direction of the company’s stock price, due to different reasons – his being driven from the knowledge of the drugs/pharma industry and mine from a technical chart reading and investing background – that interaction led to e-mail exchanges, invitation to each other’s private investing networks and lot of late-night/early-morning texts, phone calls, face-time/Skype that culminated in a very close friendship and working engagements.

As we worked together on deals and investments Dee’s ability to look at the Forest and the trees at the same time and show me a different perspective left a lasting impression. As BVG started taking shape Dee was more excited and running ahead than me, and in all honesty trying to catch up with him is what got BVG ready for a launch under 4 months!  When I asked him about joining BVG Board of Advisors, he retorted good naturedly, “What took you so long?”

Dee is one of the smartest minds I have met, and yet he carries this brilliance with a humble grace and ready-to-help attitude to anyone who engages with him.

Dee is an avid tennis player and an accomplished chef often experimenting very successfully with blending of cuisines!

To read more about Dee please go to http://www.blackstonevalleygroup.com/about-us/

 

And finally, meet Deepak Shenoy.  Deepak is a serial entrepreneur in the technology and financial market spaces.

Deepak writes and manages CapitalMind.in, http://capitalmind.in/ and you can follow him at Twitter: @deepakshenoy where his uniqueness lies in simplifying the concepts of markets and economics while explaining financial news and opinion.  He has over 10,000 + followers on Twitter, and over 5K people all over the world read his views daily on email. You will find Deepak’s articles in many online and print publications including Yahoo, Jet Lite, Business Standard and Pragati.

He also does an awesome job at breaking down the enormously complicated Annual Indian budget in layman terms by way of his e-book “Budgetnomics.”  I already have my next year orders with him, hoping he does a paper edition this time around, so that a lot more folks can read and benefit from there.

I stumbled along Deepak’s blog a few years ago and was instantly attracted as a reader and became a fan soon after.  A couple of years ago, I responded to a post Deepak had made on Capital Mind (Reading blogs in the BIM markets and asking the bloggers elementary questions has been a valuable experience and a full-time hobby; not sure if the bloggers who I pepper with my questions share the same enthusiasm) and, lo and behold, he came back with a response. We exchanged a few notes and then the conversations dried up.  The cycle repeated over a few times. As I started BVG, I looped in Deepak to get his insights on the Indian investment opportunities and he promised all help needed to get BVG off the ground from deal pipelines to opportunity assessments.

I met Deepak in person on my first BVG sortee to Bengaluru, India, over hot snacks with tea/coffee one evening. We had one hour allocated for our meeting.  We quickly forgot the time as idea and opportunity discussions started getting a rhythm of their own, and by the time we looked up it was past dinnertime.

I floated the idea to Deepak about joining the BVG Advisor Board the next day. After some initial reluctance (due to time commitments) and me twisting his arm, Deepak finally agreed to join the Board of Advisors @ BVG.

During cricket season weekends Deepak, a keen cricket enthusiast, can be found flopped on the sofa taking in every minute of the game and tweeting, responding to comments, blogging, answering his cell and tweeting in that order J!

To read more about Deepak please go to http://www.blackstonevalleygroup.com/about-us/ or visit his blog @ http://capitalmind.in/ or his website http://www.marketvision.in

It is a privilege to know these outstanding gentlemen and count them as close friends and working partners. They have enriched my life in many ways. Thank You, John, Dee and Deepak !

 

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