Spotlight: Growth capital

The first half of 2017 saw $27.5 bn of growth equity funds reach final close. Rod James takes a look at how it fits into the space between VC and buyout.

In these feverish times, it seems like any company with a good idea and a few Apple Macs can secure some form of seed investment. There are incubators, accelerators and a plethora of angel and venture-capital investors looking for potential winners to back.

For companies that make it through to the next stage of their development, however, fundraising can suddenly become a challenge. Investors from the early Series A and B fundraising rounds are not always able or willing to continue to commit capital. At the same time, the company might not generate enough cashflow to get on to the radar of buyout funds, who would probably want to use asset-backed leverage to finance the acquisition.

Some of these companies will go on to create popular products that successfully produce revenue for five or six years or more, but do not have the cash pile they need to scale as aggressively as they would like. Into this breach steps the growth capital investor.

The term “growth capital”, also known as growth equity, means different things to different people. There are, however, a few characteristics on which (pretty much) all can agree.

Growth capital acts as a bridge between venture capital and buyout. Unlike the former, growth capital investors do not make speculative investments in new businesses, but look for firms with strong revenues and proven models in industries that are undergoing rapid growth. Unlike the latter, growth investors tend not to take majority stakes and do not leverage their acquisitions. The aim is to drive returns through company and market expansion alone, then to seek an exit after five to seven years.

“The use of leverage is usually quite limited because although revenue growth may be high, cashflow may not be strong enough to support much debt,” says Calum Paterson, managing partner at Scottish Equity Partners, which recently sold part of its stake in luxury fashion retailer Matchesfashion.com to Apax Partners. “Growth equity is also quite focused on technology sectors and on companies that have the potential to scale rapidly.”

According to PEI data, growth equity funds worth $27.5 billion closed in the first half of 2017 – and some of those were substantial. For example, the $3.3 billion Summit Partners Growth Equity Fund IX was the joint sixth largest to close in the second quarter.

It’s clear why growth capital is attractive to investors. Entering solid, fast-growing companies at a later stage gives the funds and their limited partners a high degree of downside protection compared with venture. According to one investor who wished to remain anonymous, their fund has a 10 percent mortality rate compared to an average of around 50 percent for VC funds. The chances of a bumper VC-style exit is lower (though it has been known to happen), and the emphasis being more on achieving healthy multiples across a portfolio.

One example is California-headquartered Pontifax AgTech, which makes growth capital investments in the agricultural technology sector. It recently exited Blue River Technology, a robotic crop management platform, to tractor maker John Deere in a deal valued at $305 million.

According to managing partner Ben Belldegrun, a growth capital model allows the firm to reduce its technology risk and focus on execution and commercialisation, strengths that overlap with the buyout world.

“In agtech growth capital has a much better risk-reward pay-out because you are not taking a risk on the question ‘is this technology working?’ but on ‘is this something that can be disruptive to the agriculture value chain or something that is going to be widely adopted by farmers?’,” he says. “It’s not about hitting one or two winners but getting a bunch of companies with a very nice risk-reward profile. In venture you’re looking for two or three companies in a portfolio to knock it out of the park.”

The benefits of growth capital as a diversification play are reflected in a bigger, increasingly sophisticated investor base. When Michael Elias, managing director of London-based, technology-focused growth equity firm Kennet Partners, decided to focus squarely on the discipline back in 2003, even large LPs needed Growth Capital 101. Today, many European LPs are going with managers like Kennet as a way to gain exposure to technology without having to take big risks.

With its $350 million, 2012-vintage Kennet IV fund, the firm targets ‘bootstrapped’ technology companies, firms that have developed with little or no outside funding, relying primarily internal cashflow to fund growth. With more companies choosing to stay private for longer, this should technically increase the available pool of growth capital targets. But given the self-sufficient success of such companies, it can be hard to convince their owners of the benefits of a growth capital investment. Finding companies to invest in is, in fact, a bigger challenge than attracting investors.

“Unfortunately, they [companies] don’t usually go looking,” Elias says. “We have to go and find companies and sourcing is the hardest part of what we do. The reason is that these businesses don’t normally have an urgent need for capital. On the venture end, most companies will go bust unless they raise capital.”

A growth capital fund is unlikely to unearth the new Facebook or Google; its strategy is too conservative. But if an investor is looking for some of the upside of venture capital with less of the downside, they could do worse than to commit to the strategy.