Growth Equity–Feeling the L-O-V-E

October 6, 2022

In 2014, we invoked Aretha Franklin’s famous line in writing that US growth equity deserved more R-E-S-P-E-C-T. Although it is often viewed as a sub-strategy with no dedicated LP allocation, we argued that growth equity’s attractive risk-adjusted returns and less competitive GP access dynamics warranted more attention from institutional investors. Since then, LPs have come to embrace it. As a result, the strategy has matured and attracted significant amounts of capital. To borrow from Nat King Cole, “growth” is feeling the L-O-V-E from GPs and LPs alike.

Defining Growth Equity

Growth equity can evoke different meanings for different investors. While venture capitalists tend to use the term to refer to late-stage cash-burning companies, the traditional definition we use places growth between VC and buyout where it shares some of the best characteristics of both (Figure 1).

Growth equity investors typically represent the first institutional capital in a founder-owned business. They target growing businesses led by teams that have successfully grown their companies by bootstrapping them rather than relying on VC financing. As a result, these businesses are nearly always profitable or breaking even at entry since they were built in a capital-efficient manner. Furthermore, growth equity investors tend to back companies in higher-growth sectors such as technology, consumer and healthcare rather than asset-heavy
industrials or lower-growth sectors.

Growth equity investors have also tended to target companies and transactions with the following characteristics:

•  Founder- or management-owned, with limited or no prior
  institutional capital raised;
• Maturing business that is at least five years old;
• Proven business model with demonstrated revenue and
  product traction;
• Revenue growth rates above 20%;
• Strong capital efficiency, with positive or near-positive
  EBITDA margins;
• Meaningful minority stake (e.g., >20% ownership) or
  control stake;
• Investment made through preferred shares with structural
  downside protection;
• Limited or no leverage; and
• Expected hold period of 3–5 years and an exit path to
  buyout firms or strategic acquirers.

Fundraising & Market Size

Private equity fundraising increased substantially between 2019 and 2022 as many LPs committed more to private markets at the expense of public markets. In our 2014 white paper, we noted that growth equity fundraising represented less than 10% of total US private equity fundraising historically. Since then, however, it has grown at a disproportionate rate relative to other strategies. According to Preqin, between 2010 and 2017, growth equity represented 10% of dollars raised. By the end of 2022, its share of the fundraising market is on pace to be double that amount (Figure 2).

But increased fundraising for dedicated growth equity funds only partly explains the greater capital inflows. Increasingly, buyout firms have taken to investing in growth equity–style transactions. Adjacent to their flagship products, these GPs have established dedicated growth specific funds with flexible mandates. Many of these firms are also increasingly willing to acquire or recapitalize investments held by growth equity managers even though they may have lower EBITDA margins.

VC-backed companies may receive the lion’s share of publicity, but there is a significant universe of companies that do not utilize traditional VC funding. According to Zippia and PitchBook, there are at least 585,000 technology companies in the US, but fewer than 53,000 angel and seed rounds have been completed over the past 10 years. With over 90% of US technology companies seemingly operating outside the VC ecosystem, we believe that growth equity investors still have ample opportunity to invest in emerging technology businesses.