Growth capital: how to stand out in a promising market

Mike Reid: A lot of people only think of private equity on one hand and venture capital on the other, and I have spent a good 12 years of my life explaining that there is a really interesting space where companies are beyond the VC/early-stage arena (and the volatile risk/return profile that entails) but clearly not yet at the buyout stage. Interest in this has risen in large part because of the tech boom, with the term “unicorn” in particular giving the wrong idea of what growth equity actually is. It’s a much more stable product, appealing to limited partners (i.e. investors in private equity funds) as it gives them more upside than their buyout portfolio, but not vastly more risk. And with the original players active in that space (such as Vitruvian, Highland Europe and others) having been so successful and subsequently raised much larger funds and moved up the value chain, investors have come back around to looking for new players doing the thing they originally liked back then.

Tom Hughes: We’ve seen a lot of VC and PE firms launching growth funds; but while the return profile can be very attractive, the challenge we have found is in implementing a vastly different strategy than what the team is used to; a different skillset and ways of thinking are required, whether you are coming at it from PE or VC originally. Some of the firms that came into the growth capital space under a generalist AUM-increase strategy didn’t necessarily have the networks and the experience will struggle on the value creation side, especially sector-specific value creation. Sector-specific firms can have huge value-add, but leveraging the operational networks and expertise, at scale, is a challenge for everyone - how many boards can you sit on and how much value can you truly add? What are the strategies that you can implement to really leverage what you are good at across your whole portfolio?

MR: The real challenge is the operational deployment of know-how, and how do you come across to the management team in a way where the deal is priced well, but also you are clearly the best choice in terms of establishing the best partnership? You have to build the relationship with the management team, and have that chemistry right from when you sign the deal, so you can hit the ground running in implementing your plan. And during the actual investment period, it is also difficult to strike the right balance: how do you avoid that situation where the value creation team will have lots of ideas to implement but the management team will be really busy dealing with everything and wish they would just back off? Developing that sort of relationship is difficult, even for the best funds. Sometimes you need to back off a bit, you need to have the right relationship with the chair and CEO for them to be able to say that they need some space to work.

TH: One of the greatest assets a firm can have is their collective knowledge and networks. What everyone is really focusing on now is operating as a single unit, where everyone from partner to associate can leverage that combined knowledge and information. Technology is key in this; VCs and growth funds are equally guilty of investing in tech, but not investing in their own tech internally. All the DD processes, investment-committee decision-making, origination etc. have to be brought up to speed and use technology and data better. As a VC/growth investor, you could be cultivating relationships that will not pay off for years. Using technology to maintain these relationships is very important. It’s not a transactional business, it’s a relationship business.

MR: The fund management teams with clearer positive purpose will also find it easier to attract and retain talent. What that means is broad, but it is one of those things where you get up on a Monday morning and you know you are going to work and make a difference. We have made a deliberate effort to back companies that are making a positive impact on society, and in turn this will be a really interesting theme for investors themselves: we are going to see the ESG theme shift from a bit of a box-ticking exercise into a real-world consideration, particularly for younger team members.

MR: Resilience and sustainability are key parts of our scale-up methodology. Our belief is that good companies, when they are in that growth capital phase, should always have the ability to go profitable and take control of their own destiny. Then they have the choice to push on faster and raise more money. That optionality is fundamental to growth equity, because relying on further rounds in a market like this can be deeply problematic.

MR: The recent phase of very high valuations will lead to a real “back to basics” phase. Some of the players that got into doing earlier-stage deals in recent years, mainly as a way to grow assets under management but without having it as their core focus, will think back and want to return to what made them successful in the first place. There is a lot of risk in straying out of your core competence and core passion. It’s a really good reset for the market and there will be a great cohort of new investments over the next two years.

Valuations are down, but underneath that you will see a stretch between a small bracket of top-quality assets that will still command very strong multiples, because there are incredible growth opportunities, and a larger cohort of solid businesses that will get funding at a 7-8x EBITDA valuation. That is still a good price, and businesses should be happy to raise at that valuation. Finally, under the surface, we will also see a lot of companies that just can’t raise. So deal volumes probably won’t beat last year, but they will remain solid. If you’re selling a profitable tech business growing at 20-30% per annum, private equity will still buy that, big-time.

TH: Europe is uniquely positioned; we have had some really amazing stories and healthy companies. The European IPO market is not really there, as we know, so companies will stay private for longer and there is still a big role to play for private capital. It might take longer, certainly in Europe, but the good companies will always manage to raise - maybe not at the same multiples as before, but that’s probably a good thing. Most of the high-quality companies saw all this coming and were raising 12 months ago; hopefully that will give them a long enough runway.