Q3 2019 - Growth Equity Update

September 18, 2019

By Anthony B. Minnefor Jr.

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Introduction

As private equity has matured as an asset class, so too has one of its main strategies, growth equity. As a refresher, growth equity investing sits between classic venture capital and traditional buyout. Growth equity investments are typically the first institutional money raised by a company. And the companies are often thankful to receive the capital; as the name implies, companies in this sector are growing at a rapid clip and need capital to sustain and accelerate their growth. Their product or service offerings have moved well beyond proof-of-concept and are well-received in the marketplace. In summary, growth equity investing can have the strong return potential of venture capital without the risks inherent when investing in a highly-leveraged company as part of a buyout strategy.

Stellar Revenue Growth

When evaluating the growth equity sector for potential investment, the question of how fast growth equity companies are actually generating sales often arises. And the numbers do no not disappoint: According to Cambridge Associates, from 2008 to 2017, growth equity companies generated an average annual revenue growth rate of 17.2%, more than double the growth rate of buyout companies and more than triple that of public companies. Cambridge Associates noted that while this revenue growth is off of a smaller base when compared to buyout and public companies, its strength is still impressive and, notably, growth equity companies generated positive revenue growth even during 2009 in the midst of the global financial crisis.

Growth Equity's Favorable Investment Returns

Growth equity companies are often valued by investors based on a multiple of revenue. While the achievement of positive EBITDA in a reasonable period of time is expected, during the timeframe after a growth equity investment is made, the companies often generate significant losses. Executive teams are assembled or expanded, new systems are put in place, and a myriad of other activities occur in order to professionalize and grow the business. Accordingly, top-line growth is usually essential to a successful investment outcome. A study by Cambridge Associates of growth equity investments exited between 2002 and 2017 clearly supports this premise. In the study, realized multiples of invested capital (MOIC) were grouped by revenue growth rates at exit. Approximately two-thirds of realized growth equity companies with greater than 20% annual revenue growth achieved a gross MOIC of 2.0X or better at exit. In contrast, nearly two-thirds of non-growth companies (those with annual revenue growth less than 20%) were realized at less than cost.

Buoyant Fundraising Demonstrates Appeal of Asset Class

As we discussed in a previous private equity fundraising update, many expressed concerns about overall fundraising as we headed into 2019. However, the first half of the year has clearly been respectable. According to Private Equity International (PEI), $177.2 billion of capital was raised by private equity funds in the first half of 2019. While this was down compared to recent periods, funds expected to be raised in the second half of 2019 should solidify the year’s total and equal it to last year’s.

Growth equity funds are certainly doing their part to buoy the overall fundraising statistics, with the potential strong returns of investing in fast-growing companies via a private equity vehicle no doubt supporting the successful recent fundraising by investors in this asset class. Of the total $177.2 billion raised by private equity, a whopping $50.8 billion was raised by growth equity funds. And such fundraising in the first half of 2019 by growth equity represents an amazing 80% of the asset class’s total fundraising in 2018. This impressive fundraising has been supported by large funds, with the average growth equity vehicle launched in the first half of 2019 at $923 million. This contrasts with an average growth fund size of only $340 million in 2014. According to PEI, the largest growth-focused vehicle in the first half of the year was TA Associates’ 13th flagship fund, which closed on its $8.5 billion hard-cap in May 2019.

Conclusion

A close look at growth equity investing clearly shows an asset class that appeals to many an investor – the risks of early-stage, classic venture capital investing are somewhat mitigated, and investee companies in this strategy typically aren’t saddled with burdensome leverage as is the case with buyout companies. Nevertheless, each asset class always warrants detailed scrutiny before a check is written. Growth equity investors will want to continue to see rapid revenue growth and strong returns.


Engaging Alternatives – Q3 2019

About Anthony Minnefor

Anthony Minnefor is an Audit Partner with experience in the alternative investment industry who leads engagement teams on audits of private equity and venture capital funds and funds of funds.

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