Growth Equity Primer

Growth Equity Investment Structure: Minority Interest

Since the growth equity firm does not typically hold a majority stake, the investor holds less influence over the strategic and operational direction of the portfolio company.

As a result, the three components below are critical for the investor in order to help ensure positive investment outcomes:

Growth Equity Partnership: Importance of Management Team

A critical difference between growth equity and traditional buyouts is the active role retained by the management team, as well as the prevalence of other investors that invested in earlier funding rounds. Unlike buyouts, the strategic and operational decisions remain primarily with management.

Once a growth equity firm has completed an investment, it now owns a minority stake in the company in the form of newly issued shares (or existing shares of prior shareholders who viewed the growth capital investment as an exit strategy).

Growth equity funds invest predominantly in late-stage VC-backed companies – meaning, the founders have already given up a significant portion of their equity and governance rights in earlier funding rounds (e.g., liquidation preferences).

Given the absence of a majority stake, a partnership based on trust is required to ensure the management team can be relied upon to take the company to the next stage of growth.

Due to the structure of growth equity investments, the growth equity firm cannot take matters into their own hands if the direction of the company or decision-making of management differs from their opinions.

Growth Equity Investor: Value-Add Opportunities

The more value a growth equity firm can contribute to the portfolio company, the more weight its suggestions carry in board meeting discussions.

At the commercialization stage, money is not the only thing these companies need.

Just as important is being offered access to a full suite of operational resources to help scale efficiently and navigate inevitable obstacles at this critical inflection point.

The differentiating factor that can make a growth equity firm stand out is its capacity to be more than just a capital provider along for the ride.

Despite only taking a minority stake, growth equity funds can still offer hands-on value to their portfolio companies. Each growth equity firm brings its unique specialization and business acumen to the table, but common examples include expertise in:

• Capital Structure Optimization (Debt and Equity Mixture)
• Mergers & Acquisitions (M&A)
• Initial Public Offerings (IPOs)
• Relationships with Institutional Investors, Lenders, Investment Bankers, etc.
• Business Development and Go-to-Market Strategy Planning
• Market Expansion and Customer Cohort Analysis
• Professionalization of Internal Processes (e.g., ERP, CRM)

Growth Equity Investors: Alignment of Interests

Growth equity investors come in at a time when the company has already accomplished a certain level of success.

Due to this timing, the investment sometimes is less meaningful to management since the market potential and product idea has already been validated.

Establishing trust from management and key stakeholders without a majority stake is the prime hurdle for growth equity funds.

Before proceeding with obtaining a minority stake, a growth equity firm must gather information regarding the near-term and long-term goals of management (and influential shareholders with majority stakes).

Amongst the management team, the key stakeholders, and the growth equity investment firm, there must be an understanding and general consensus on:

• The portfolio company’s estimated market share that can be reasonably attained
• The pace of growth at which the company should attempt to expand
• The amount of capital required to fund the plans for growth, which dilute existing shares
• The planned, long-term exit strategy

The purpose of doing so is to ensure their objectives align with the investment thesis, which is oriented around continued expansion. To ensure an all-around beneficial outcome is structured, the firm needs to confirm the growth targets meet the growth equity fund’s threshold.

Growth Equity vs. Venture Capital vs. Private Equity

Growth equity firms can theoretically invest in any industry of their choosing, but the allocation of capital tends to be skewed towards mostly software and industries such as consumer discretionary and healthcare to a lesser degree.

Venture investments are made across nearly all industries, whereas control buyouts are restricted to mature, stable industries.

In terms of the risk/return profile, growth equity sits right in between venture capital and private equity (LBOs).

• Venture Capital (VC): The funds are intended to test for product-market fit (i.e., the viability of the idea) and product development. The majority of the portfolio is expected to fail, but the return from a “home run” can offset all those losses and enable the fund to achieve its targeted returns (i.e., tail-heavy distribution)
• Private Equity (LBO): The use of debt is one of the primary return drivers – therefore, the fund attempts to minimize the required equity contribution. Differs from growth equity in that most, if not all, of the target’s equity, is acquired post-LBO

Growth Equity vs. Venture Capital (VC)

In most cases, venture capital represents the first injection of institutional capital to fund the market research, product development, and related projects of early-stage companies.

For a start-up attempting to reach the next stage of development, most face the common challenge of raising enough capital before running out of cash.

Once they have moved past the point of just needing enough cash, the focus at this growth stage shifts to establishing a niche and continuing the company’s top-line growth.

Here, common initiatives include refining the product or service offering, expanding the sales and marketing functions, filling in the missing pieces in the organization, and targeting large-scale customer acquisitions.

Early-stage companies usually see growth rates near or far above 30%, whereas growth-stage companies grow at a rate around 10% and 20%. The exponential growth seen at the onset gradually slows down; nevertheless, revenue growth is still a double-digit figure at this point.

Growth Equity vs. Leveraged Buyouts (LBOs)

The returns from a growth equity investment come predominantly from the growth of the equity itself. In contrast, a significant portion of the returns from leveraged buyouts is generated from financial engineering and the paydown of debt.

Thus, the most notable differentiation between growth equity and LBOs is that LBOs focus on the usage of debt in order to achieve their required returns.

Growth equity firms, however, rarely use debt. If the capital structure has any leverage at all (most often in the form of convertible notes), the amount is negligible in comparison to the amount utilized in LBOs.

Another important difference is that private equity firms acquire majority stakes in companies, and their investment thesis does not necessarily include rapid growth. PE firms often just need the portfolio company to perform in line with its historical performance to achieve its required returns.

Like venture capital, differentiation is a critical factor in growth equity, and both are centered around “winner-takes-all” industries that can be disrupted through products that are difficult to replicate and/or proprietary technology.

On the other hand, traditional LBO funds concentrate on the defensibility of the FCFs to ensure all debt obligations can be met on time, as well as confirm there is sufficient debt capacity to avoid breaching a debt covenant.

Thus, companies that generate steady, consistent cash flows while operating in established markets with minimal disruption risk tend to be perceived as higher-quality investments than high-growth, yet risky targets in the context of an LBO.

Unlike companies that undergo traditional buyouts, companies targeted by growth equity funds have neither a defensible market position nor a consistent track record of profitability.

Risks in Growth Equity Investing

• Product Risk: The central risk consideration in venture capital is product risk, which can come in the form of being unable to develop a product that meets the needs of its users, lack of market demand, non-functional products, the existence of an alternative with more utility, etc.
• Execution Risk: For growth equity, the concern shifts to execution risk, which refers to the failure of the plan to achieve the desired outcome. For example, this can be caused by losing out to close competitors offering similar products. Private equity (LBO) also has exposure to execution risk but to a lesser degree. Instead, the main consideration is the credit default risk due to the amount of leverage used.
• Disruption Risk: Additionally, mature companies (as targeted by private equity / LBO firms) may be subject to increased market disruption risks and external competition (i.e., targeted by new entrants).