Before the momentous events of recent months, the collapse of WeWork was headline news and rattled the market. The oft-hyped company boasted several high-profile growth investors, but ultimately, and spectacularly, it failed. It was a sign that an early thesis around growth and technology investing – find a theme and become an expert – was not enough for success, especially after an initial run-up in valuations deflated. A few casualties of this strategy have led to a different approach to growth investing overall, which, before covid-19, was flourishing and is was one of the steadier areas of fundraising for private equity. As a result, growth investors are evolving their approach.
Instead of simply investing behind a theme, the focus of growth has shifted more toward finding companies in niche segments and digging in to tweak and enhance operations. “The only way that you can structurally address these changes is to start with a blank sheet of paper and reimagine what growth equity needs to be in order to consistently add value to companies across cycles,” says Jon Korngold, senior managing director at Blackstone and head of the firm’s growth equity team.
Buyouts started talking to growth equity investors before the coronavirus pandemic hit. A few months into the global quarantine, the focus on operations, which was gaining momentum even before the turmoil, has become sharper than ever for most growth equity firms.
Investors spend most of their time with their portfolios, providing operational support for CEOs and rethinking their companies’ downturn-positioning and economic runway through the recession.
Korngold, who started Blackstone’s growth equity investing arm in early 2019, is has always been focused on value creation through operational support.
The firm has over 100 operating professionals available to work with the growth fund’s portfolio, which is expected to comprise 20 to 30 companies, versus 100-plus companies that traditional growth equity firms tend to have, he says.
“Our emphasis on operational excellence and our ability to support our companies with the arguably unparalleled base of Blackstone’s global resources will become even more critical right now,” Korngold told Buyouts in May.
Korngold is also using the firm’s scale to add value to its portfolio companies and to create operational savings for its companies.
As soon as Blackstone makes an investment, its companies enter into the Blackstone group-purchasing program, which leverages the buying power of their full portfolio – a combined $150 billion in revenue and nearly 500,000 employees. This helps to save on spending across 75 categories ranging from freight expenses to IT software, hardware, service or office supplies. Through last year, the program has achieved over $1.58 billion in cumulative annual savings, according to Blackstone. One example of this type of synergy: in 2014, Blackstone led a $20 million Series B funding round for Cylance Cybersecurity. In the first year after the investment, many Blackstone’s portfolio companies began using Cylance software.
“Given Blackstone’s significant global scale and reach, we are uniquely able to minimize the execution risks that growth-stage companies face as they seek to become global industry leaders,” Korngold says.
In a similar vein, during another crisis era, Blackstone launched Equity Healthcare in 2008, the management group within Blackstone portfolio operations that uses the combined size and insights from the portfolio to help get price discounts and more customized and unique insurance products for companies of all sizes. This is particularly impactful for small and midsized companies, which can get the same prices and options as the biggest companies in the US. The firm has saved $900 million for employers across its portfolio since 2008.
Blackstone is hardly alone, as other growth-oriented firms are approaching the strategy in similar ways as they angle for an advantage in the competitive sector. The idea is that firms can no longer depend solely on multiple expansion for their returns, and that growth must come through digging into operations.
And valuations are a big issue these days, when multiples have shrunk amid the uncertainty and lower demand. In a survey compiled by the investment bank Stifel, almost every tech-focused PE and VC respondent said they expect valuations for companies in 2020 to decrease. Most respondents, 65 percent, also said they will delay any portfolio company exits planned for the first half of this year to 2021.
Shock to the system
The pandemic has many customers scaling back on tech spending for the first time in a long time, according to Darren Abrahamson, managing director at Bain Capital Tech Opportunities fund. “The shock to the system will force corrections, with some businesses needing to run themselves differently in a tougher macro environment,” says Abrahamson. “This will include a requirement to improve capital efficiency.”
The investor says he expects the deal landscape to be quieter in the short-term, while in the longer-term, the valuations will be lower.
“In addition, as we come out of this downturn, we expect to see some truly high-quality tech companies emerge, rather than just companies that are growing with the rest of the market,” Abrahamson adds.
Korngold relates to that sentiment and expects to partner with entrepreneurs to help them take advantage of the transformational growth opportunities at the expense of their lesser-capitalized competitors. “Blackstone Growth is fortunate in that we do not have a legacy portfolio and, instead, can focus on making new investments during this period,” he says.
Before covid-19, technology growth was experiencing one of its strongest eras ever, with $25.1 billion pouring into the strategy last year alone. Now GPs are working hard to find ways to extract value beyond financial engineering, finding a playbook that will change the way the industry approaches growth.
One of the biggest problems with growth equity in the technology sector over the last decade has been the reliance on trend picking, GPs tell Buyouts. That approach worked while technology as an asset class was experiencing outsized growth.
But now, the strategy has gotten much harder, Korngold says.
“Everyone in growth equity has looked smart because virtually all strategies have worked over the past decade. If you further increased your bets to include emerging markets and China, you looked like a genius. This strategy of making a bunch of passive bets while all boats rise is good until it’s not,” he says.
“Now, given how competitive the environment has become, it is no longer enough to just pick the winning companies; instead, you must have the operational resources to ‘make the winners’ post-close – this poses a massive challenge for traditional stand-alone growth equity firms that have five to 10 times the number of companies as they do full-time operating professionals on staff.”
In the recessionary environment, some growth equity-backed companies may struggle to make it to the other side without additional injections of growth capital, and fundraising in this environment will be much more challenging.
“Covid-19 will significantly impact nearly every industry and will also create great challenges for many traditional growth equity firms that are now encumbered and distracted by their sprawling, legacy portfolio companies that suffer from cash-hemorrhaging financial profiles after having been instructed to ‘grow at all costs’ for the past five years,” according to Korngold.
Wreckage in the fast lane
This approach to growth investing has driven up valuations and led to several casualties.
For instance, high-profile, consumer-facing companies, such as the aforementioned WeWork or Casper, come to mind.
WeWork lost nearly 80 percent of its value within a six-month period last year. Softbank invested in the real estate and workspace firm at a $47 billion valuation in January. But investor skepticism led the company to consider a potential IPO with a valuation as low as $10 billion. That IPO was later canceled altogether.
Casper, which had its IPO on February 6, lost nearly half of its value in a little over a month. The Casper stock that opened for trading at $14.50 was trading at $6.75 per share on May 12.
These valuations for these companies were wrong from the get-go, says Bain’s Abrahamson.
“Through 2019, there were a set of investors, who invested in and valued consumer-facing companies with structurally lower margins as if they were higher margin growth B2B companies,” Abrahamson says. “These are not bad companies, but they were probably overpriced.”
Part of the reason is the increased desire of CEOs to be running high-valued companies, or, in the ideal scenario, companies that have achieved a unicorn status, says Eric Crowley, banker at GP Bullhound. The valuation of the companies has become so important as a form of “eye candy” that in order to deliver those valuations some investors had to stretch their terms and payouts to protect their returns, he says.
“CEOs are pushing for higher valuations and in exchange for higher valuations, investors are pushing for structure or preferential treatments, anti-dilution provisions or increased structure on the term sheet,” he says. In which case, the preferred shareholders will be guaranteed the above-and-beyond return compared to common shareholders.
But that trend has lost its hype after the WeWork saga and the difficulties other Softbank companies had in regard to truly figuring out their business models and market positioning, Crowley says. Instead, companies are now looking to take time and raise smaller rounds with a partner who can help them grow more efficiently.
However, with more growth capital chasing the same opportunities and new players continuing to emerge, growth deals are becoming more competitive and there is a natural inflation of prices, David Zhang, vice-president at TCV, tells Buyouts.
The value of all US-based growth equity investments in 2019 increased by nearly 26 percent, to $23 billion, compared with $18.3 billion, in 2018, PitchBook data show.
At the same time, the number of growth equity transactions went down. Growth investors completed 336 investments in 2019, compared with 406 investments in 2018.
Drilling down into growth, certain sectors see similar movement. The value of all growth equity fintech investments in the US in 2019 increased by 30 percent, to $2.1 billion, compared with $1.6 billion, in 2018. The number of investments, however, decreased to 36, from 44, over the same period, PitchBook says.
According to Bain’s Abrahamson, with the arrival of covid-19, being a flexible, value-added investment partner is even more important.
“You have to bring something to the table besides capital to drive outperformance – leveraging networks, operating teams, and bringing other resources to bear on how to improve and grow,” he says.
Bain Capital, which launched Bain Tech Opportunities Fund in 2019 to invest in growing technology businesses across application software, infrastructure and cybersecurity, fintech, internet, and digital media, wants to differentiate itself in the market by picking the highest growing sub-sectors within thematic investing.
“Cybersecurity broadly continues to be a very interesting area. Within it, we are focused on finding pockets where we think the highest growing areas are. For example, companies that secure networks or securing data and applications companies,” Abrahamson says.
Tech Opportunities will utilize cross-platform and vertical sector capabilities to enhance technology companies. For example, with an enterprise resource planning (ERP) business for the government sector, Bain may layer on a vertical embedded payments technology, Abrahamson explains.
“Vertical software is not a novel idea or theme, but you can identify emerging disruptors in those markets and take them to the next level,” he says.
Accurately picking the winners is becoming increasingly important, according to TCV’s Zhang.
TCV, which invests out of TCV X that closed on $3 billion in January 2019, has created a list of questions to consider during due diligence for a potential investment, Zhang says: “Has the product established a market fit? Is the product truly replacing or solving a pain point for consumers? Is there a focus of management teams and founders that we are backing? What is the value creation and customer delight here? Is this company built upon a sustainable sensible business model with sustainable economics? Is there a technology that truly differentiates this product?”
Whether the conversation is about insurance, lending, payment, or any other sub-sector, TCV thinks a lot about those “sweet pillars,” Zhang says.
Competition for growth
Some firms are also rethinking their equity check sizes, sometimes favoring less popular corners of the growth equity universe, sources tell Buyouts.
According to Korngold, the market has become oversaturated with investments ranging in size from $25 million to $100 million coming from traditional growth firms and new players.
“On a risk-adjusted basis, this is probably the most polluted part of the market,” Korngold says.
“You have every VC firm in the world in that space, you have the growth equity arms of those VC firms, you’ve got crossover funds, you’ve got the big growth firms moving downstream, you have sovereign wealth funds, you have hedge funds, you’ve got mutual funds, family offices – you’ve got everybody there. So, it’s not bad to be there, but it is bad to be there if you don’t have engines to bring you up to smoother air, where you can use your scale to create an operational advantage that, in turn, creates a sourcing advantage.”
Blackstone is set to serve the larger end of growth equity market instead, Korngold explains.
For instance, in March, Blackstone Growth acquired a majority stake in the healthcare IT company HealthEdge. The firm injected more than $600 million of equity into the company, valuing HealthEdge at nearly $730 million, sources familiar recently told sister title PE Hub.
The type of company likely to benefit from Blackstone’s growth capital is a profitable business with a level of operational ambition well suited for Blackstone’s scale, Korngold says. This kind of company is also one step closer to having a business model maturity that doesn’t require an investor to take business-model risk, he says.
Even in a highly competitive environment, Blackstone hasn’t had any real competition for some of its recent deals, including its investment in Ultimate Software, Refinitiv and Magic Lab, the owner of the dating app Bumble, Korngold says.
“When we bought Magic Lab, there was no auction process, there was no sale process,” Korngold says. “It’s just one where through our thematic work we were able to get in front of the company and consummate a transaction.”
Magic Lab, which took in more than $2 billion from Blackstone, would be too hefty a check for a traditional growth equity firm. Blackstone consistently uses its scale to create new opportunities for which traditional growth firms can’t compete, Korngold says.
Bain Capital Tech Opportunities also is focused on a less-concentrated area of growth equity.
The firm has created a flexible mandate to pursue late-stage growth equity deals, as well as more established mature companies and even small buyouts, with equity checks ranging from $50 million to $200 million. The firm has identified this range as a gap in software investing where there is less capital available, Abrahamson says.
Insight Partners, in part, also uses its operating success to get in front of the best companies early. Ryan Hinkle, managing director at the firm, tells Buyouts: “Our strategy has long been we want to see as many opportunities as possible and we want to have the best possible answer to what we can bring to the table besides capital.”
Insight has an established value-add team called Insight Onsite to assist portfolio companies with all aspects of their business, including sales, marketing, hiring, product, R&D, M&A and pricing, Hinkle says.
The Onsite team, of more than 50 operating experts, is structured into groups called centers of excellence, Hinkle says. Each group is focused on a different functional area critical to the success of a high-growth software company.
“By partnering at the department level and understanding where [their] pain points are, we can help them get access to other [companies] that had gone through similar journeys, we can get their benchmarking on what the right commissioning strategy is, or the quote structure, or territory planning,” he says. “And really help them through every aspect of what makes a software company actually create revenue.”
Onsite has engaged in more than 20,000 advisory hours across 120 companies, which included 750 introductions to C-level corporate buyers to support top line revenue, Hinkle says. More than 4,000 employees received access to Onsite’s training and resources, he says.
Despite the increasing demand from investors for high-growth software companies, the supply of such opportunities continues to grow, too, Insight’s Hinkle says.
“The number of new software companies being created has never been greater than it is right now. Today you can start a company with a limited number of developers hosted on some cloud solution and very quickly get a real market feedback from customers. If you created something that’s highly attractive it can get from $0 to $10 million annual recurring revenue faster than ever before,” he says.
There is a “huge” number of companies that are raising money, Bain’s Abrahamson agrees.
“There has obviously been a lot of interest in this category… The reason for the that is the number of companies that have exploded,” he says.
VC vs growth
The line between VC investing and growth equity deals has blurred in recent years, which makes some investors nervous.
According to Korngold, that phenomenon may also affect LPs that do not have a clear idea of the risk or diversification exposure they are backing.
With VCs raising larger funds and writing bigger check sizes, some LPs are getting a “toxic combination of VC risk and growth equity scale,” Korngold says.
Besides, most growth equity firms do not have the tools or the scale to offer their LPs a true diversification, which is so important during a downturn, Korngold says. Often, growth equity firms would also share the same companies through series A, B, and C, he adds.
The reason bears within the model of investing and the vestige roots, necessitating consistent investing in new companies year over year, Korngold says.
According to Korngold, it’s not uncommon for a traditional growth equity firm to make 20-25 investments per year, which adds around 125 new companies to the portfolio over the five-year horizon.
“When you have 125 companies and five or 10 people on the operational team, you’re kidding yourself if you think you are anything rather than an index fund in that environment, because you are not really in the position to add value,” Korngold says.
The structure of the deal – whether it’s VC or a PE investment – does not necessarily reflect the value-creation strategy, argues Insight’s Hinkle.
According to him, investors like to put companies into label “buckets” such as “a VC company” or “a PE company,” while the main idea around investing is built around a working strategy to find great opportunities and scale them.
Insight Partners recently raised Insight Partners Fund XI, which closed on $9.5 billion in April 2020.
The firm is less focused on the label of the investment and does deals that look like venture capital deals or deals that look like private equity.
“To limit yourself on what style of investing you are doing limits a big chunk of the universe,” he says.
“We see growth existing in all flavors of companies’ scale and we know we can help companies extend that growth, sustain that growth, or increase that growth by partners with our onsite colleagues.”
Update: The story was updated to reflect that Insight Partners has raised Insight Partners Fund XI, which closed on $9.5 billion in April 2020. Ryan Hinkle’s quote was updated.