One of the important trends in private equity during the recent downturn was an increase in so-called “growth equity” investments. Because they share some characteristics of both buyouts and venture capital deals, such investments present significant challenges for firms moving into them for the first time.
In some cases, traditional leveraged buyout investors reacted to the tight credit markets by migrating downstream into smaller, unleveraged companies. In other cases, traditional venture capital firms moved upstream seeking investments with reduced risk profiles. The result: The number and type of investors interested in the growth equity space has surged, with growth equity transactions representing approximately 20 percent of 2010 and 18 percent of Q1 2011 private equity transactions, according to data provider Preqin.
In a recent survey, advisory firm Duff & Phelps reported that approximately 75 percent of private equity firm respondents expect to make new investments in the next 12 months in growth equity transactions, which respondents described as having “greater upside potential” and “the best risk-reward ratio.”
Growth equity transactions are defined as minority investments into relatively mature, profitable (or nearly profitable) companies. In these transactions, proceeds are used to fund expansion or acquisition (like VC investments), and sometimes to provide liquidity to founders and early investors (like LBO investments). As such, growth equity sits at the intersection of traditional LBO transactions and late stage VC investments, borrowing key elements from each, but differing in important ways. Successful growth equity investing depends on a nuanced understanding of these similarities and differences.
Type Of Security
When choosing a security for any investment, investors seek both downside protection (an acceptable return even if the company underperforms) and maximum potential upside. The relative importance of these considerations, and the resulting selection of a security, varies based on the nature of the transaction and the stage of the company’s development.
In an LBO transaction, investors normally employ either a simple preferred security, with basic downside protection, or common equity. Unlike other investments, in an LBO capital structure, where the investor already owns most of the equity, there is minimal benefit to more sophisticated preferences since the investor will receive most of the proceeds anyway. Investors in LBO transactions also focus less on downside protection because they control the timing of any liquidity event and can wait for an advantageous time to sell. The more mature nature of most private equity targets further reduces the need for downside protection because the targets have a longer financial history and more predictable future cash flows. Investing in a simple preferred or common securities also enables LBO investors to create a perception of alignment of interests with their management team.
In contrast, late-stage VC investments are normally structured as senior preferred securities, sometimes with a participation feature. In these investments, protecting the investor’s downside with a meaningful preference is critical. As only one of typically several institutional investors, the investor lacks control over the timing and terms of a liquidity event. Although the interests of the various VC investors may be aligned, they often invest at different times and valuations and hold different series of securities, creating divergent incentives. Moreover, by the time a late-stage VC investment is made, which is often at the highest valuation, the capitalization may include several series of preferred stock, some or all of which may themselves be participating.
Growth equity investments are most often structured as participating preferred securities, often combined with substantial dividend rates. Because these securities represent a minority position, and because there is usually no earlier series of preferred, these securities offer investors the unique opportunity to lock in an attractive minimum return through a preference that, in a downside scenario, is paid out of the existing value of the company’s other securities. In some cases, the preference and preferred dividend represent the principal source of the economic return, with dividends in the 5 percent to 10 percent range combined with a disproportionately smaller share of upside value. In others, the dividend and preference only ensure an acceptable minimum return, with targeted returns dependent upon sharing in future appreciation with the common equity. While these structures are attractive to investors, they can be justified by the larger size of the investor’s investment, coupled with less ability to control the timing of a liquidity event. Further, because growth equity targets are often not sufficiently mature to obtain significant debt financing, these structures are necessary to help a growth equity investor obtain a market return in the absence of leverage.
Finally, to mitigate what can seem like overly investor-friendly terms, some investors offer a cap or reduction of their liquidation preference if they achieve acceptable target returns at exit, better aligning their interests with management in an upside scenario.
Redemption Or Put Rights
Within the VC community, there remains a split as to whether preferred stock issued to investors should be redeemable at the option of the holders, with redemption more common on the East Coast than the West Coast. When used, redemption is often spread over three years and at original cost plus dividends.
By contrast, LBO investors do not need redemption rights because they control the company and can force liquidity at their option.
In growth equity investments, the investor can typically require the redemption of all of its securities in a single tranche after a specified date. In some instances, that date will accelerate if the company breaches important covenants. Generally, the redemption price is the greater of (1) original cost plus dividends and (2) fair market value, on an as-converted basis, with fair market value sometimes determined using an agreed upon formula (e.g., a multiple of EBITDA, less debt). Unlike most VC investments, the remedies for failing to honor the redemption request may include more drastic steps, including an increased dividend rate or penalty interest rate and, often, a unilateral right to force the sale of the company and control the board. Sometimes, growth equity investors will also negotiate for a true-up if the company is sold within a limited period after the redemption (e.g. 12 months) at a value that would have netted a higher redemption price.
The ability to trigger and then control a sale transaction, and to block an undesirable sale transaction in which they can be dragged-along, are important to investors across the private equity spectrum. In late- stage VC transactions, individual investors normally do not have those rights. Rather, a majority of the company’s stockholders, which often includes holders of different series of preferred, can force or prevent a sale of the company. In LBO transactions, the sponsor controls the timing of sale and typically can force other equity holders to participate in the transaction.
In growth equity investments, investors will often obtain both the unilateral right to force a sale of the company (often, as noted above, after the company fails to honor a required redemption) and the right to block a sale. Where growth equity investors do not secure these rights, they need to rely on redemption or registration rights for liquidity, and will often negotiate for limited protections against unattractive sales. One common way to bridge this gap is to permit the growth equity investor to be dragged-along earlier than a specified date only if the transaction will result in the investor realizing an acceptable minimum return on investment (e.g. a 25 percent IRR or multiple of invested capital).
Restrictions On Transfer
LBO investors generally take the view that, with the exception of liquidity going to the founders from the LBO transaction itself, investors, founders and management should exit the investment together. As a result, with limited exceptions for estate planning, LBO investment documents typically include an absolute restriction on transfer for as long as legally permitted, and rights of first refusal and co-sale afterwards.
Late stage VC investors, perhaps because founders typically have not yet received any liquidity, are generally more willing to allow some founder and management sales, subject to rights of first refusal and co-sale.
Growth equity investors tend to follow their LBO peers in this regard, especially where the proceeds of the investment provided stockholder liquidity. As a result, multi-year complete bars on transfers are relatively common even though founders and early investors retain meaningful stakes in the company.
VC investment documents often simply provide that the representations, warranties and covenants of the company survive closing. Because the proceeds of the investment usually remain in the company, investors accept that their remedy for breach is against the company. On the other hand, LBO transactions generally include heavily negotiated contractual provisions under which the sellers agree to indemnify the private equity fund for breaches of the company’s representations and warranties and covenants, subject to certain limits.
Growth equity investors have a choice between the VC and the LBO approaches, with many opting for the VC approach. The combination of breach of contract claims, plus expense reimbursement, provides sufficient protection to the investor, and by omitting indemnity language from the agreement, the issues of caps, deductibles and other limits may simply not come up. This is especially true when most of the investment proceeds stay in the company. Where proceeds provided seller liquidity, and the remedy for breaches should be against the owners who received proceeds, explicit indemnification is more common and is likely to include some of the limits found in LBO documents.
The increase in growth equity investing is here to stay. It’s less dependent on credit markets, provides more protection in downside scenarios if structured properly and has been proven to provide compelling financial returns. For investors and lawyers schooled in the LBO and VC worlds, it’s important to recognize that growth equity, while resembling both, is not exactly like either. To be done successfully, one must understand and appreciate the distinct attributes of growth equity transactions.
Jolie M. Siegel and T.J. Murphy are partners in the Boston office of Choate, Hall & Stewart LLP. They can be reached at firstname.lastname@example.org and email@example.com.