Growing wild: growth equity needs some pruning

Growth equity is having a moment.

Propelling – and propelled by – historic technology adoption across the economy, growth equity is rubbing shoulders with buyout as one of the most popular asset classes with LPs.

Not long ago, it was not even part of private equity’s lexicon. Emerging in the 1980s and 1990s as a niche – growth-stage minority strategy lodged between control buyout and early-stage venture – growth equity then “wasn’t even a moniker we widely used,” Anton Levy, co-president of General Atlantic, tells Buyouts.

Today, the story is very different. Growth equity pioneers like General Atlantic, Summit Partners and TA Associates now mix with scores of global peers that have broadly diverse approaches and investment styles. They include the newly minted arms of buyout and VC shops, emerging managers and so-called “crossover” investors, most of them drawn by a fascination for tech.

“Nowadays, growth equity is a bit of a Rorschach test,” Jon Korngold, head of Blackstone Growth, says. “Everyone calls themselves growth equity.”

Spurred by digitalization, private equity’s rush to the middle was never so apparent as last year.

The deal market was hot, capping a decade of expansion, Pitchbook data shows. US growth equity activity rose sharply, with 1,508 deals closed at values topping $125 billion in 2021, up 61 percent from 2020. Companies backed in the flurry of investing included app security tester Invicti, document automation platform PandaDoc, physical therapy provider PT Solutions and womenswear brand Spanx.

In 2021, growth equity firms were also raising unprecedented amounts of capital. Managers had a record run in the North American market, according to Buyouts data, as 121 funds secured an all-time high of $109 billion, almost one-quarter of the total raised.

But if growth equity was last year enjoying halcyon days, the strategy might soon face a major test.

Clouds, in the form of inflation, higher interest rates and supply-chain disruptions, have cast a shadow over the market, bringing uncertainty and potential volatility. Economic challenges were reinforced by Russia’s invasion of Ukraine and covid-19’s still lingering threat.

In addition, public tech stocks, long viewed as over-valued, have met with a reckoning. Facebook owner Meta in February saw the largest single-day slide in value for a US company, Reuters reported. A month later, Nasdaq was in bear territory, as the index fell 20 percent from a November peak.

Jittery public tech stocks hold meaning for growth equity. Until recently, fast-paced investment in the space was also driven by lofty valuations, as category-leading tech companies often obtained in deals whatever price they sought. Buoyant fundraising added fuel to the fire.

It is expected a correction in listed tech values, together with over-arching macro factors, will impact growth equity investing and portfolios over the next six to 12 months. What is less clear is the impact’s size and dimensions.

“It has been too easy to be in growth equity. The market got way ahead of itself. In so many parts of growth and technology, valuations at times were divorced from fundamentals” Jon Korngold, Blackstone Growth

One thing that seems set to change is “a growth at any cost mentality” that neglects profits, Mark Shulgan, head of OMERS Growth Equity, says. “An imperative in the market that revenue growth is all that matters created a stilted viewpoint.” For those with this focus, he says, “there could be a rude awakening.”

“It has been too easy to be in growth equity,” Korngold adds. “The market got way ahead of itself. In so many parts of growth and technology, valuations at times were divorced from fundamentals.”

GPs interviewed by Buyouts say that while the market may be in for rough sailing, this should be temporary. Once the downdraft has happened, they say, growth equity’s ascent, powered by secular trends in innovation and entrepreneurship, will continue. Some GPs, in fact, welcome a pullback as a way to restore core growth equity principles after a period of multiple expansion and high spirits.

Among them is Peter Chung, CEO of Summit Partners: “In the long run, this sort of correction is healthy and necessary. While painful, it’s necessary. We think it’s required for the asset class to deliver sustainable, risk-adjusted returns to LPs.”

Winners and losers

As growth equity firms try to anticipate the shape a correction will take, there are already early signs of a shakeup in dealmaking. First-quarter data from Pitchbook reveal softer US growth equity activity, with 327 deals done and values totaling $29 billion, down 20 percent year-over-year.

In contrast with the high-valuation market of 2021, “some businesses are now deferring processes until later in the year because they are not getting the price they want,” Shulgan says. Deal terms are also becoming “less commoditized,” he says, as growth equity firms “return to sane structures” to gain more price protection than was usual in the immediate past.

“The best tech companies,” Shulgan adds, “are still likely to get whatever terms they want.”

This suggests that in the large population of growth-equity-backed businesses, the potential effects of a correction, including multiple compression, will be felt differently. There may be winners and losers.

While the negative impact of the public tech slump “could affect the performance of growth-stage companies, many are going to be fine,” General Atlantic’s Levy says, “especially relative to those which are venture stage.”

“Venture capital is blurring into growth and growth is blurring into buyout” Jill Shaw, Cambridge Associates

The majority, he adds, “should be able to raise capital, while the strongest will have M&A opportunities involving weaker competitors.”

This argument is supported by Cambridge Associates data comparing value declines of US VC-backed public companies with US public companies backed by private equity (buyout and growth equity) in last year’s second half. VC-backed public companies showed an 80 percent drop, while their PE-backed counterparts showed a 50 percent drop.

Of those VC-backed public companies that declined, 37 percent fell by more than 50 percent. In contrast, among PE-backed public companies that declined, less than 15 percent were down by more than 50 percent. This data indicates that in a private market correction, growth equity valuations might be less sensitive, Jill Shaw, a Cambridge managing director, says.

Certain qualities of growth equity-backed businesses, such as low input costs and little-to-no leverage, make them “more insulated” from factors like inflation and rate hikes, Graves Tompkins, General Atlantic’s global head of capital partnering, says. They also benefit from “very strong unit economics,” Chung notes, and the fact that many companies reside in non-cyclical industries.

Another sign of turbulence in 2022’s first months is the perceived withdrawal of crossover investors.

Crossover investors are made up of hedge funds, as well as mutual funds, sovereign wealth funds, VCs and others. Lured by the tech sectors preferred by growth equity, they played an aggressive, opportunistic role in the space in the past five years, “betting on themes” and “placing multiple bets,” says Hugh MacArthur, partner at Bain & Company.

“If you look at the number of deals done by growth equity firms, they’re about four times the number of the buyout market,” he explains, with much of the volume attributable to crossovers. This, GPs interviewed by Buyouts say, contributed to a feeding frenzy that pushed up values.

Crossovers are essentially passive investors, Levy says. “Unlike dedicated growth equity firms, most are not active partners or company-builders.”

Investors “active at the top of the market,” such as crossovers, will likely “feel the whiplash when volatility hits,” Shaw says. “When times get tough, it is growth equity firms with experience – with curated, value-adding strategies – who are best positioned.”

“In the long run, this sort of correction is healthy and necessary. While painful, it’s necessary. We think it’s required for the asset class to deliver sustainable, risk-adjusted returns to LPs” Peter Chung, Summit Partners

Blackstone’s Korngold agrees. He says much of the recent growth equity investment has been “venture capital at scale,” carrying inherent risks. “The ability to create value through operational acumen, as opposed to just broader sector exposure, is going to be the source of alpha in growth equity.”

The same view is held by Shulgan. “Venture capital is about doubling down on winners,” he says. “Traditional growth equity is a lot closer to buyout than the VC model, as it is measured by cashflow and profitability. And profitability is more of a focus today.”

All about disruption

If growth equity firms are feeling sanguine about the other side of a market correction, it is because of their belief in the long-term disruptive power of digitalization. The strategy’s dealmaking and fundraising has closely tracked tech’s emerging role and influence in the economy. This was most apparent in the years after the financial crisis, when ground-breaking advances like cloud migration and SaaS models gained prominence.

“Growth equity’s rise came on the back of an explosion in innovation and entrepreneurship,” Levy says. “And that innovation and entrepreneurship continue to expand today.”

Since 2020, digitalization has accelerated dramatically. Owing to the pandemic, businesses sped up tech adoption in their customer and supply-chain interactions, internal operations and product portfolios. In the process, a 2021 McKinsey and Company survey found, executives stopped seeing tech as a mere cost saver and began seeing it as a key to competitive advantage and differentiation.

Covid-era events “caused a tremendous realization among a lot of investors that we probably had multiple years of acceleration and acceptance of technology as ways to do things,” Bain & Company’s MacArthur says. With the realization, he adds, has come further bets on growth.

PitchBook data shows a greatly enhanced tech share of US growth equity deals over 2020-21, including 29 percent of values in the latter year. Other favored sectors, such as financial services and healthcare, also have an innovative component, highlighting the ongoing disruption taking place in major traditional industries with little to no tech exposure.

Tech’s durability as a theme, MacArthur says, is particularly evident in financial services. “We still have 19th- and 20th-century outdated financial systems for just about everything and that’s about 20 percent of global GDP.” With a sector of this size “in the early innings of being disrupted,” he says, “the amount of opportunity for investment is absolutely enormous.”

This point is reinforced by Korngold, who says growth-equity-backed companies focused on tech enablement are “more likely than not to end up on the right side of history.”

In large, well-established industries, “the disruptors themselves are being disrupted,” he says. “Fifteen years ago, Yellow Pages was really great until it wasn’t. Then Google came along. And taxi medallions were wonderful, stable, stalwart investments until Uber came along.”

Facilitating the ambitions of the new disruptors will demand more of growth equity, Korngold says. “The scale of capital and operational resources required to take regional champions and make them into big global players has begun to tap different capital pools and support needs than growth equity has traditionally been associated with.”

Another important variable in the opportunity set is companies staying private longer. While they are not eschewing public markets, a substantial number of businesses are taking more time to develop and mature before launching an IPO. As a ready source of private market capital, growth equity assists that choice.

Summit Partners’ Chung calls this “a virtuous cycle.” Companies stay in private hands due to access to abundant capital, while managers raise fresh resources to address a wider universe of opportunities.

Many private companies reject a control buyout option because founders want to hang onto their equity upside. “For a tech business that is doing extraordinarily well, it is not clear why an entrepreneur would want to sell,” General Atlantic’s Tompkins says. This enlarges growth equity dealflow, he says, as such owner-operators “find a better fit in minority value-add partnerships.”

As big as buyout

Survey after survey has called attention to a robust LP appetite for growth equity. In Private Equity International’s LP Perspectives 2022 study, it matched buyout as the top pick, with 76 percent of investors saying they will maintain or shift more capital to both over the next 12 months.

This is a fairly new trend, Tompkins says: “Even five years ago, many LPs did not see growth equity as its own asset class. It didn’t have a defined category. It was often lumped into venture or made part of buyout.”

Cambridge’s Shaw adds: “Allocations to growth equity in LP portfolios are increasing because LPs see a need for a growth engine and want exposure to tech.” Growth equity, she adds, has also been a solid performer relative to buyout and other strategies.

“We are in the golden age of growth equity” Graves Tompkins

Growth equity returns have consistently outpaced buyout returns over time, according to Cambridge data. Outperformance is especially strong in short time horizons, reflected in a one-year pooled horizon net IRR of 52 percent and a three-year net IRR of 29 percent.

While a pullback impacting growth equity investing could also affect fundraising activity, Shaw is not expecting LPs to panic or give up on the strategy. Investors, however, “must be very careful about what they’re buying into,” she says. “It always comes down to the underwriting. It always comes down to picking managers who have a competitive edge.”

This favors dedicated growth equity firms who “know the space,” she says. It also provides an advantage to brand-name buyout and VC shops that establish their own growth equity arms, as “LPs will now have two strategies with a long-term partner.”

Along with Blackstone, buyout firms who have taken this step include Brookfield, Carlyle, KKR, Thoma Bravo and TPG.

Another significant, if perhaps overlooked, growth equity player is emerging managers. First-timers are typically more diverse and introduce sophisticated methods of originating deals, Shaw says. “They are helping to redefine the market.”

With private equity’s rush to the middle, there has been some blurring of lines between strategies.

“In an effort to access companies at all stages of development,” and generate returns “wherever they may be,” Shaw says, “venture capital is blurring into growth and growth is blurring into buyout.”

Chung agrees, noting one measure of this evolution is “the frequency with which growth equity firms make control investments.”

GPs interviewed by Buyouts nonetheless believe growth equity will remain a distinct strategy. It will be “a singular label for a broad stylistic landscape,” Chung says. “It can be segmented across deal and fund sizes, sector focus or geographies, all of which might be described as ‘growth equity.’”

With a future that is intertwined with digitalization trends, growth equity is likely to further evolve. This, General Atlantic’s Levy says, includes a greater international presence because “innovation and entrepreneurship are going global.”

Once centered in Silicon Valley and the US, he says, “the world is catching up with growth.”

All of this suggests growth equity might as an asset class get a lot larger, perhaps one day even rivaling buyout in size. Together, growth equity and VC assets managed have already expanded at twice the rate of buyout AUM in the past 10 years, Bain & Company’s Global Private Equity Report 2022 found, and in 2021 comprised 82 percent of buyout’s total.

Tompkins is among those who believe the strategy will – in time – be as big as buyouts. “We are in the golden age of growth equity.”

 

‘Interesting time’

Tech investment has been a powerful driver of the growth equity bonanza, particularly as a result of the covid era and post-covid supply chain disruptions, writes Obey Martin Manayiti of affiliate title PE Hub.

There is demand for products, services and software that few would have envisioned just three or four years ago.

One typical example: FTV Capital is investing $180 million in LogicSource, a provider of procurement services and technology, in a deal announced in early April. The transaction comes at a time when many companies are looking for ways to circumvent supply chain challenges that are slowing the smooth flow of goods.

FTV Capital, which backs companies in enterprise technology and services, financial services and payments and transaction processing sectors, says there are vast opportunities. “It’s a really interesting time to be investing in procurement,” says FTV principal Alex Malvone.

Procurement, often mired in inefficiencies, has become a key enabling factor in the success of many businesses. LogicSource focuses on sourcing and procurement of indirect goods and services. The company aims to mitigate risk and ensure supply chain continuity through better buying.

FTV reached out to LogicSource’s management to learn more about the business last year. In the past three years, LogicSource’s revenue has grown by almost 220 percent, earning accolades such as being named one of Inc’s fastest-growing companies in 2020 and 2021.

Malvone is joining the LogicSource board and expects to support more investment in innovation. “When you look at just the record levels of inflation and the supply chain challenges that we have seen, having a partner to help an organization navigate that has become more important, and that is one of the things that drew us to LogicSource,” he says.