There are really three general asset classes in private equity: buyouts, growth equity and venture capital. So why is growth equity the best risk/reward among the three in my estimation?
1. The downside protection of leveraged buyouts is exaggerated. The lure is that LBO firms are buying highly profitable companies with consistent cash flows, levering up the balance sheet, and ultimately trading the business while covering the debt for multiples on its equity. The challenge with the model is that the equity of the LBO firm is not the senior security on the cap table. Clearly, the debt is senior. Every LBO investment is a bad quarter away, a tripped covenant away, or a bad economic cycle away from being under water from an equity perspective. That’s the reason so many LBOs of all different sizes and shapes have been written off completely during this down cycle. As it turns out, despite the perceived safety in leveraged buyouts, in reality, there is little room for error. The loss ratios in LBO portfolios are higher than one might think.
2. The upside potential of venture capital is exaggerated. By venture capital, I mean traditional early stage venture capital. Firstly, the large venture funds run into the law of large numbers – no matter how good you are, turning a good multiple on a large fund is hard especially when you have modest ownership levels in your portfolio. Secondly, traditional venture models justify their investments based on upside scenarios (i.e. swinging for the fences). The reality is the vast preponderance of venture-backed exits are at modest outcomes so often times the investment case is divorced from the reality of where exits tend to take place. That’s why venture capital has become more dependent on bubbles to make the math work. Thirdly, venture-backed companies often take multiple rounds of financing thereby diluting both the ownership and governance of the early investors. Finally, venture investments are often done at the very early stages of a business’ lifecycle where the risks are high and little is proven. It’s a high risk asset class with moderate reward potential at the fund level.
3. So, why is growth equity such a great risk/reward in comparison? Growth equity doesn’t run into the problem that LBOs have being junior on the cap table to the debt. These are mostly non-levered equity only investments thereby making sure the investment is senior on the cap table. Growth equity investments are traditionally done in companies that haven’t taken prior institutional investment and don’t require future institutional investment. Therefore, the problem traditional venture firms have of diluted ownership and governance generally does not apply. In addition, growth investments are traditionally made at a point in time when strong financial growth is proven in the business – this removes much of the early stage concept risk. Finally, growth equity investments are, to state the obvious, growth companies. So, they have tremendous upside potential, but the investment case is not dependent on the upside scenario happening like is often the case in venture.
There will be winners in all three asset classes for sure. And for full disclosure, Volition Capital is building its franchise in growth equity. Nonetheless, I’ve seen winners and losers in my career in all three asset classes, and in my opinion, the best risk-adjusted asset class of the bunch is growth equity.
Larry Cheng is a partner with Volition Capital (fka Fidelity Ventures). Visit his blog at www.larrycheng.com