Growth private equity is a hot topic in alternative asset management these days but even with all of the attention, growth equity remains ill-defined. Often times, growth equity is defined by what it is NOT: venture capital or buyout. A simple way to explain growth equity is to revisit the classic S-curve of industry evolution. Venture capital focuses on industries that are early in their evolution where buyout generally deals with mature companies. Growth equity deals with those in between.
The Difference Between Growth and Venture – The classic venture model presumes that one or two monster hits per fund will make up for mediocre returns or losses on the rest of the portfolio. Venture capital is best suited to network effect businesses where there will typically be one or two winners in a particular market segment. Such companies require rapid scaling because achieving scale is paramount. However, this “swing for the fences” approach can frequently lead to overcapitalization and poor returns on capital for companies that don’t fit this particular investment model. Growth equity takes a more disciplined, capital-efficient approach to supporting company growth.
The Difference Between Growth and Buyout – Buyout, on the other hand, performs best when dealing with mature industries. Generally speaking, buyout managers seek companies that are earning sub-par returns on capital. Those companies are purchased using financial leverage, and changes are implemented to increase the returns on capital. Because buyout funds must use financial leverage to magnify the returns generated by improving operating efficiency, buyout funds generally take more financial risk than growth equity funds.
While growth equity managers share some skills sets with managers at VC and LBO funds, growth equity managers take less technology and adoption risk than VCs and less financial and execution risk than buyout investors. Growth equity provides capital to invest in product development, asset deployment, sales and marketing and acquisitions for companies as they build market share throughout the growth cycle. These companies have typically developed defensible market positions so the capital invested is not open to technology or customer adoption risk. Growth equity investors strike a balance between capital discipline and revenue growth.
To investors, growth equity is a distinctly different discipline than venture capital and buyouts, but brings the benefits of both.
Industry Expertise Required: Because growth managers help their companies navigate rapidly evolving industries, they need a high level of industry expertise. Industry expertise helps drive superior deal sourcing, deal selection and portfolio company performance. Disciplined growth equity managers that can identify the sectors of the economy that will profitably grow faster than GDP can deliver consistent, strong returns in up and down markets.
Value Add: Growth equity managers add value to their companies by ensuring that their portfolio company management teams maintain the proper balance of focus on both growth and return on capital. First and foremost they must back and build the right management teams that are entrepreneurial, visionary and professional. They must then help their management teams expand their companies by offering advice on product strategy, mergers and acquisitions, competition and exit opportunities, while balancing the growth imperative with attention to performance metrics, long term profitability, capital efficiency and financing solutions.
From a capital markets perspective, growth equity firms invest in companies with less than $500 million of enterprise value that once might have been public earlier in their life cycle. Whether it’s the expense of Sarbanes-Oxley compliance or the lack of middle-market investment banks to provide research coverage, the public market no longer provides the same level of support to mid-market growth stocks that it once did. There are thousands of companies in growth sectors with greater than $10 million of revenue that need growth financing or exit liquidity.
Growth equity managers provide much needed growth financing and strategic guidance to these companies that are not well-served by venture capital funds, buyout funds or the public stock market.
Tyler Newton is Partner and Research Director at Catalyst Investors, a growth private equity firm. He also blogs about the economy and financial markets at www.tylernewton.com and he tweets here. Opinions expressed here are entirely his own.