PrivateEquityInternational: Why the balance is tipping in growth equity's favour
Strong returns and accelerated digital transformation are among the factors giving weight to growth strategies.
By Claire Coe Smith
Growth equity fundraising hit record levels in the first quarter of 2021 as investors channelled more money than ever into the asset class. With $32 billion raised in the first three months of the year alone, compared with $19.2 billion in Q1 2020 and $18.6 billion in Q1 2019, per Private Equity International data, the asset class is on course for a bumper year.
Sarah Sandstrom, head of Campbell Lutyens’ North American private equity fund placement activities, says: “Historically, an LP had one or two managers in growth equity and a whole portfolio of buyout managers. What we have seen over the last year is people re-evaluating that to buildout more of a portfolio in growth and shift that balance.”
There are several reasons, chief among them likely the changing role of technology in our lives and the way Covid-19 has accelerated those trends. “That’s resulted in incredibly strong performance for a lot of existing growth players and has driven others to look to get into the space,” says Sandstrom.
“We are at a stage where many growth equity managers have really overperformed and been able to return capital to investors through sales and IPOs. That historically was a bit of a question; investors were concerned that growth equity meant longer hold periods. That concern has been addressed in the past year.”
At General Atlantic, the global growth equity firm that has been in this market since the 1980s, global head of capital partnering and member of the management committee Graves Tompkins points out that the firm completed six initial public offerings in the first four months of 2021, having never previously done more than six in a year.
“We are clearly in a golden age of innovation and entrepreneurship, where so much of what drives the opportunity set in growth equity is digital transformation,” says Tompkins. “Coming out of Covid, things we felt had a five to 10-year runway have seen rapid adoption and acceleration in just a year. Today, over 80 percent of our portfolio is truly digital and for the other 20 percent the opportunity is to help those companies become more digital.”
It is the fact that growth is driving returns in the asset class – where GPs take minority positions in high-growth companies – that is proving so appealing to investors.
“What is perhaps most compelling about growth equity as an investment opportunity is the risk-adjusted performance,” says Tompkins. “At General Atlantic, revenue growth drives more than 70 percent of our returns. Two-thirds of our companies have net cash or effectively no debt. If you can offer anything above 20 percent net, while taking less risk, that’s incredibly compelling for any kind of investor in today’s market.”
Jan Bruennler is managing partner and co-founder of Bregal Milestone, which launched in 2018 as one of Europe’s first native growth equity specialists. He agrees that it is the source of returns that so appeals to LPs right now.
“If you think about how we create value in our portfolio, the companies we invest in are late-stage growth companies that are riding a structural growth trend. That’s really attractive in creating value,” he says.
“These are founder-led companies that are maybe quadrupling in size every three or four years. Any business will have to transform during that period, and it’s this transformation that we can help – our operating team is very hands-on in supporting companies to create value in a way that you cannot do in more established businesses. Because we create value through growth, we don’t have to use leverage so the financial risk is lower.”
Growth equity is taking a growing share of private equity allocations. In the first quarter of 2021, growth attracted 18 percent of allocations compared with 11 percent in full year 2020, according to PEI data, as buyouts and venture both lost out. Only 1 percent of growth equity funds failed to meet their fundraising targets in the first quarter of 2021, and 71 percent closed with more capital than they were seeking.
General Atlantic is reportedly raising its fourth flagship fund, having secured more than $3 billion from investors for its third in 2017. It is understood to be nearing a close with a target of $5 billion this time around. Tompkins says only: “We have seen more interest and demand from a broader set of investors than ever before.”
At Hamilton Lane, which helps institutional investors access private markets, a key feature of the firm’s latest annual market overview is a focus on the attractiveness of growth equity. The document reads: “In the private markets, buyout has been historically viewed as ‘value’ and venture as ‘growth’. Tilting your portfolio one way or the other was generally more of a function of your access to top-tier venture than of your view of growth versus value. That dynamic has changed. Our view is that investors need to lean into growth more than they have in the past, particularly in a risk-on environment such as this one.”
Richard Hope, managing director and head of EMEA in Hamilton Lane’s global investment team, tells PEI: “Our view is there is a role for growth equity in portfolios. One of the big things we hear is about downside protection in private markets, but perhaps that isn’t the right place to focus given private markets have broadly done a good job in not losing money. Instead, the question is how do you capture upside.
“Growth equity has been performing very well for years on an internal rate of return basis but has not been great at getting money back. In the last 12-24 months we have seen a trend to distributions by growth equity. If you marry that with the upside capture story, that makes it more investable for institutions.”
In volatile markets, understanding the growth drivers of businesses has come to the fore. While private equity’s story over the past decade may have been about making companies more profitable, today the question is how you do that in falling markets.
Hope says: “We are in an economy that has been flat or declining for the last 12 months, so never has there been more focus around growth and companies that have the ability to grow. Those with growth-focused assets and sustainability-focused assets have performed extremely well versus more value-focused investors. You can no longer just assume you can take costs out, you need to be doing other things to get revenue and profitability growing.”
While most growth equity investors do not start with a sector perspective but rather pick companies based on their structural growth trends, there are several parts of the economy proving particularly compelling for the asset class right now.
“Probably the hottest areas are technology and healthcare,” says Karsten Langer, managing partner at Riverside Europe, which favours growth buyouts as a strategy and typically takes a control position in high-growth mid-market businesses. “Software, and particularly software as a service, is a space that is attracting a lot of attention. We also have a number of investments in e-commerce businesses and that’s an attractive space because it has probably leapt forward five years’ worth of progress during the year of the pandemic.”
Olivia Steedman is senior managing director of Teachers’ Innovation Platform, formed in April 2019 by Ontario Teachers’ Pension Plan to make late-stage venture and growth equity investments in companies using technology to disrupt and create new sectors. The platform generated a 16percent return in 2020, with investments including a stake in Elon Musk’s SpaceX.
Steedman points to four particularly attractive opportunities for growth investors at the moment, naming med tech, cybersecurity, logistics and autonomous vehicles as areas of focus for TIP.
So why did Canada’s largest single-profession pension fund, with some $220 billion in net assets, launch an innovations platform?
“There are a few reasons,” says Steedman, “but the first is returns. We believe that by investing in disruptive technology, and companies about to move into this compelling growth phase, we can access those great returns.
“It is also about diversification: growth equity gives us this opportunity to deploy fairly sizeable cheques that can potentially move the needle at fund level while being less correlated to some of our other investments.
“Then, we thought TIP could be a very interesting source of insight into emerging technology that could have value for other parts of our organisation, allowing us to share those insights back,” says Steedman. “And, finally, there’s also a sustainability and impact point, because many of these businesses are solving really profound problems using technology, like matching doctors to patients, and that can get us inspired and help us deliver on our own impact priorities.”
Such opportunities are attracting more and more managers into the growth equity space. In March, Blackstone closed fundraising for its debut growth equity fund on its $4.5 billion hard-cap – claiming to be the largest first-time growth fund ever raised – while EQT is set to launch its debut growth vehicle soon, seeking more than €1.6 billion. Carlyle Group’s multi-year fundraising campaign reportedly includes a growth equity vehicle dedicated to mid-size North American deals.
Sandstrom says: “As the big brand-name growth equity firms have continued to grow and continued to outperform, there has been more interest in the asset class. The sense I get from managers is there is still ample opportunity to deploy capital in really interesting deals. While there are more private equity dollars being raised in growth, the total addressable market is also increasing as more and more companies look to stay private longer.”
As Riverside’s Langer notes: “It’s a great time to be a founder of an attractive growth business. A lot of money is being invested in companies that promise to solve problems and a lot of GPs are – either because of deliberate strategy or because of the competition – being more creative and more open to looking at things like non-control deals.”
A changing picture
The opportunities targeted by growth strategies are continuing to evolve, both in terms of geography and sector.
Graves Tompkins at General Atlantic argues the definition of growth capital has changed in recent years, first to become more international. “You’re seeing a proliferation of innovation and entrepreneurship around the world, so while growth equity was probably more of a developed market opportunity historically, it has become a more global opportunity,” he says.
In Europe, Bregal Milestone sees a real opening.
“Our thesis was that this market is really under-served,”
says co-founder Jan Bruennler.
“At venture stage, the US and European markets are about the same size in terms of capital available to companies. By the time you get to growth stage, Europe is about a quarter of the size of the US, so the support wasn’t there. There were US funds active in this space and it was a strategy that was well understood in the US but not in Europe. Covid has focused a lot of eyes on the space here, and there is still an unmet demand.”
The hardest thing for LPs is securing allocations in Europe, says Richard Hope at Hamilton Lane. “Funds are smaller and they raise faster, so for institutional investors it has been hard to get access,” he explains. “Growth equity has been more of an American phenomenon, but we will certainly now see more growth funds develop in Europe.”
Tompkins says growth equity has also evolved in other ways: “We are seeing it across more sectors than ever before – historically it was probably more tech, consumer, healthcare and financial services, whereas in the last five years we have seen the creation of a life sciences sector, for example, that has become a great growth equity opportunity too.
“The last thing is the breadth and scale of the opportunity set. If you look at raw numbers, there are more growth companies than ever before, larger growth companies than ever before, and therefore the needs of those companies and the opportunity set for investors like us is larger than it ever has been.”
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