Growth Capital Special: Versatile exposure in volatile times

Andrea Auerbach, global head of private investments at Cambridge Associates, writes that growth equity can complement LPs’ exposure to LBO strategies, particularly in turbulent periods.

Andrea Auerbach

Growth equity, the ‘middle child’ between venture capital and leveraged buyouts, has distinctive characteristics that have earned it a permanent seat at the private investment strategy table.

While the lines may blur towards the strategies on either side of it, growth equity investing at its core is a minority equity investment in a primarily bootstrapped company (ie, self-funded with no prior institutional investors and no or low debt). Additionally, this bootstrapped company would have a proven business model growing faster than its peers in a sector growing faster than the overall economy. Because profits are typically funnelled back into the business to fuel growth, growth equity companies intentionally run at or near breakeven in terms of profitability.

Andrea Auerbach
Andrea Auerbach

Growth equity’s return characteristics feature some of the upside potential of venture capital (but not as expectedly parabolic as venture-backed companies) and the lower loss ratios of private equity. Growth equity companies typically have more proven business models relative to most venture stage companies, referenceable customers, and revenue to sustain themselves and attract acquirors. The return profile reflects these characteristics – more expected upside than private equity with less loss than venture capital.

How LPs incorporate growth equity into their programmes depends on their individual circumstances and risk/return requirements. LPs who may be unable to allocate resources towards building a venture capital programme, or LPs who may not have a tolerance for the higher loss ratios and longer time horizons venture-backed strategies often require, may pursue growth equity as a ‘venture proxy’. LPs pursuing that angle need to acknowledge that the exposure isn’t perfectly comparable because growth equity companies are past the ideation, technology risk and market risk stages – so while investors can get exposure to certain sectors and companies, the risk/return profiles are different, as noted earlier.  Since there are bootstrapped and growing companies in every size range, growth equity scales better than venture in terms of fund sizes providing exposure to this strategy and can require less resources to pursue as a result.

For LPs with private equity programme exposure weighted towards leveraged buyout strategies, growth equity, by virtue of its low-to-no leverage characteristic, serves as a complement to that exposure and potentially reduces the leverage component. This can be of benefit during volatile periods.

Growth equity post-coronavirus

Make no mistake, the covid crisis is going to affect all investment strategies in some way and reveal advantages and shortcomings of each strategy. Growth equity will be no different. Growth equity companies, which by their very nature are bootstrapped and self-funded by their founders, should have teams with the necessary grit and determination to prevail in a wide range of market environments. As these companies have no or low leverage, there is no or low lending pressure to influence execution decisions during this crisis.

While we expect the scale of stressed or distressed credit investment opportunity will be substantial, emanating from more leveraged companies – growth equity companies will be largely nowhere to be seen in that tsunami, due to their lack of use of leverage.

In any environment, growth is a scarce resource which has led to increasing valuations in recent years. Any company showing a capacity for growth in the face of covid will be sending a strong signal of resiliency and should ultimately command a premium in an investment transaction. By our definition, growth equity companies are growing revenues by at least 10 percent per annum, usually substantially better than that. Many growth equity companies have recurring revenue, providing a foundation from which to build. As a cohort, according to our 5,000-plus company operating metric database, sustained growth was exhibited through the global financial crisis, which cannot be said for private equity-backed businesses, taken as a whole.

“Make no mistake, the covid crisis is going to affect all investment strategies in some way”

Growth equity investments are typically in the technology, healthcare and consumer sectors. Even growing companies are not immune to pandemics. As we have all seen in recent months, one of covid’s many impacts is that businesses (non-venture stage businesses, mind you) are experiencing a period of zero revenue. Consumer spending drives economies. If consumers have curtailed purchases, services or procedures for any reason, the potential for that revenue vacuum to cause entire sectors to seize up is significant.

Impacted areas within growth equity primarily include consumer and healthcare companies. A growing consumer branded food company reliant on foot traffic in grocery stores for sampling and sell-through may suffer; a healthcare service prevented from seeing patients for what is deemed a non-emergency procedure may suffer. How long these market conditions last is unknown. We are largely in the second quarter of whatever this is going to be, and if past crises are any indication, we have a long way to go.

Growth equity companies have to endure and thrive through this environment, although the definition of growth will be different in a challenging environment and will likely expand to be more inclusive, more relative. When all is said and done, perhaps simply having better (but still meager) revenue growth vis-a-vis competitors will portend a successful growth equity investment in the market environment post-covid.

Resilient, but facing risks

While the bootstrapping element of growth equity may indicate grit and tenacity, it also means the growth equity investor may be the only immediate source of capital for the company. As a byproduct of reinvesting in a growing business, many growth equity companies run at or near breakeven, and this ‘profitability-adjacent’ status may result in growth equity investors not reserving as much capital to support portfolio companies as a venture capital investor would. In a crisis, this could put growth equity companies at greater risk than venture capital-backed companies that typically have multiple investors that have reserved capital in anticipation of future financing rounds.

Growth equity’s primary characteristics have been key drivers of its success in firmly establishing the strategy in the private investment pantheon and are expected to serve the space well going forward. Growth is a scarce commodity in any market environment and growing companies have tended to hold their value. The multi-faceted nature of the strategy allows it to serve an array of purposes in a private investment programme, making growth equity a fairly versatile investment exposure, as more and more investors are learning.

Andrea Auerbach is head of global private investments where she leads a 50-person global team sourcing and underwriting private equity, growth equity, distressed, and venture capital funds, as well as direct, co-investment, and secondaries investment opportunities. Her career with Cambridge Associates spans nearly two decades.