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Growth Equity Outperforms Venture Capital

Growth equity, an investment strategy that shares traits of both late-stage venture capital and buyouts, has struggled with an identity problem for years. Now, the asset class is getting some assistance in carving out its place in the private equity spectrum.

Cambridge Associates announced this week that it has begun publishing quarterly performance benchmarks for growth equity as a distinct asset class. The data, which goes back ten years, shows U.S. growth investors outperforming virtually all major public market indexes over a 3, 5 and 10 year period.

Growth equity investors also bested venture capital firms over all time horizons measured. Overall, growth investors posted 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.

Cambridge defines growth equity as investments in portfolio companies for the purpose of accelerating growth. Portfolio companies generally have established products, technologies and customers, as well as substantial organic revenue growth. Most companies also are founder-owned and have typically had no prior institutional investment. Additionally, growth equity investments are typically minority stakes that use little if any leverage.

Growth equity funds look similar to venture capital funds in terms of sector allocations, with significant exposure to technology. Between 1992 and 2008, Cambridge reports, nearly 50% of growth equity dollars were invested in technology, including media and communications companies, followed by consumer/retail (20%) and financial services (15%). This is fairly similar to venture capital, where over the same period 63% of total capital went into technology companies, followed by life sciences (27%). Buyout managers, on the other hand, tend to invest across a broader range of sectors, topped by technology (30%), consumer/retail (25%), and industrial and manufacturing-related sectors (14%).

It is perhaps in the area of capital loss ratios where growth equity shines most brightly. Between 1992 and 2008, Cambridge says, growth equity investments generated an overall capital loss rate of 13%, compared to 35% for venture capital and 15% for leveraged buyouts. (Loss ratio is defined as the percentage of capital in deals realized below cost, net of any recovered proceeds, over total invested capital.)

The comparability of loss ratios between growth equity and leveraged buyouts is noteworthy, Cambridge researchers note, because 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.

The report on returns for venture, growth and buyout assets is here, and a commentary from Cambridge Associates researchers on the growth equity asset class is here.

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