Is All Growth Investing “Growth Equity”?

No. In recent years, many private investment fund managers (GPs) have painted themselves with a growth equity brush. Limited partners (LPs) need to be increasingly diligent to determine if they are accessing the truly differentiated and attractive investment profile offered by actual growth equity.

Back in 2013, we shared our definition of growth equity as investments in founder-owned businesses that had no prior institutional capital, proven business models with established products/technology, substantial organic revenue growth (20%+), and were profitable or demonstrating profitable unit economics. Additionally, growth equity investors typically acquired minority ownership stakes, using little, if any, leverage at investment, and expected to be the last round of financing required for companies to scale their profitable businesses prior to an exit (typically mergers & acquisitions). Employing this growth strategy resulted in a return profile that captured some of the upside of venture capital, while offering a risk profile akin to buyouts. An attractive proposition indeed.

Fast forward ten years and growth equity (at least in name) has become ubiquitous, which is not surprising given the strategy has delivered. As of June 30, 2023, US growth equity net internal rate of returns have equaled or exceeded both those of US venture capital and US buyouts over the five-, ten-, 15-, and 20-year timeframes. Realized growth equity investments also have loss ratios in line with buyouts, and less than half those of venture capital. ¹ Investing in capital-efficient, high-growth businesses, in sectors growing faster than the overall economy (e.g., technology, healthcare), supported growth equity investors’ ability to produce venture-like upside. Partnering with primarily bootstrapped companies with proven business models that are early in their scaling and at valuations that are more tethered to company performance than prior fundraising rounds have also produced the buyout-like risk profile of low loss. Today, with private investing operating in a capital-constrained environment and moving well away from a “growth at any price” approach, we believe growth equity’s focus on fast-growing (and largely profitable), lightly levered companies should continue to be a key return driver in private investment portfolios.

The challenge investors face is accurately identifying managers that are employing the growth equity strategy described above. In today’s marketplace, growth equity’s middle ground between venture capital and buyouts has become muddied with many funds (venture and buyouts alike) adopting a growth nomenclature but not actually pursuing a growth equity investment strategy when you look closely. It doesn’t help matters that many established growth equity firms have shifted their strategies to tilt toward venture capital, or control-oriented investing, or both. As a result, LPs are tasked with sorting through the noise to fully understand who is providing what exposure, regardless of the naming convention employed by their GPs.

To be clear, for LPs to embed growth equity’s differentiated return profile into their portfolios, we maintain there is only one distinct flavor of growth equity, despite the industry’s current overuse of the term. Using an evaluation framework based on the core characteristics of growth equity outlined above will help LPs determine what types of companies are in their managers’ portfolios. For example, has the business been bootstrapped/lightly funded, or are there rounds of venture capital funding already present? Does it have a proven business model/product with real customers? Is the business growing in a capital-efficient way, or will it require substantial additional funding to maintain its growth? If reinvestment in growth is shut off, would the business still become profitable in relatively short order? Lastly, is the GP primarily taking minority stakes using limited leverage, or is it acquiring control with leverage? These are the kinds of questions LPs need to ask to arrive at a better understanding of their growth equity exposure.

As the private investment landscape continues to evolve, when committing to a growth equity manager, investors need to be clear whether that GP is delivering an actual growth equity strategy, with its expected risk and return characteristics, or something simply masquerading as one.

Josh Zweig, Co-Head of North American Private Equity

Andrea Auerbach, Head of Global Private Investments

Caryn Slotsky, Senior Investment Director, Private Investment Strategy Research

Footnotes

1. Capital loss ratio is defined as the percentage of capital in deals realized below cost, net of any recovered proceeds, over total invested capital.