Investment Strategies

If you try to combine two molecules of hydrogen with one molecule of oxygen, it doesn’t work. The three molecules will just coexist as separate entities in a shared space. But, if you introduce an electric current in that same space, we see the formation of a completely new compound.

The jolt of electricity is the catalyst that prompts this metamorphosis.

What if the same thing happens to a company?

Imagine a scenario where Company ABC has been stuck in a certain phase for a while. Growth has plateaued out due to a cash crunch, or inadequate marketing strategies. ABC is stuck in limbo and it is not expanding as per the targets.

In this case, the growth equity strategy can act as the catalyst to jolt ABC awake and help it resume its upward trajectory.

Growth equity funds look for companies that have the potential to scale and renew growth. Unlike buyout funds, these funds take a minority stake to grow the business as much as possible. But – like buyout funds – the goal is to exit at a higher multiple.

In this chapter, we will explore the Growth Equity Strategy and understand it in detail.

A growth equity strategy is another type of private equity investment that focuses on investing in established businesses poised for rapid growth.

Just like buyout funds, Growth Equity funds also invest in the non-publicly traded securities of established companies that have demonstrated stable revenue streams and are profitable or close to profitability. Unlike venture capital, there’s minimal risk that a company will outright “fail” in growth equity; the worst-case scenario is that it grows less than expected.

These investments help the target companies expand into new markets, help in developing new products, or undergo financial restructuring.

Take Sequoia’s investment in Byju’s, for instance. The fund was one of the earliest backers in what later grew to become the leading ed-tech platform in India.

Sequoia entered at an opportune moment when ed-tech was still in its nascency and Byju’s was just finding its footing. It pumped capital and expertise into the company and eventually catapulted Byju’s to new heights.
By 2019, Sequoia’s initial investment of ₹78.8 crores had grown to ₹1,665.33 crores!

Basics of Growth Equity Investment Strategy

• Target companies – Companies that have high organic growth rates and an established business model. They should also show potential for scalability and renewed growth.
• Investment type – Growth equity funds make investments to earn minority stakes, and negotiate protective rights for their investors such as board representations or change of control provisions.
• Improve operations – Growth equity managers typically look to add value by providing capital for growth and expansion. They will also provide strategic advice to management teams and help scale operations.
• Exit strategies – The exit process includes IPO listing, share buyback, or sale to another private equity fund.

Let’s learn how these firms apply this strategy and grow their investments.

1. The first step for the target company is to have proven its value proposition, as well as the existence of a product-market fit. The GE firms find the companies to invest in through various channels, like networking with industry contacts, attending conferences, and reviewing investment proposals submitted by businesses seeking capital.
2. After the fund selects the company or companies to invest in, they perform their due diligence which includes reviewing the company’s financials, business model, market opportunity, competitive landscape, and management team.

   Conceptually, growth equity firms prioritise future growth and expansion potential, above all else.

   

   Validation of Product-Market Fit

   

   Proven Business Model

   

   Pathway Towards Profitability

   

   Target Market and Customer Profile Indentified

3. One of the important factors that the funds look out for is that the selected company or companies should have enough capital to support the expansion strategy. If a company needs capital to survive, the rate at which it burns cash may signal that there is no market demand or that management is misallocating funds.
4. After completing due diligence, the next step is to negotiate the investment’s terms and the structure of the deal. This step involves determining the amount of capital to be invested, the percentage share of ownership, and any other terms and conditions of the investment.

   The terms of the investment may include provisions like liquidation preferences, anti-dilution clauses, board representation, and rights to future financing rounds.

5. Once the investment is done and the GE firm becomes a partner/stakeholder, it gets involved in the business operations and carefully monitors it.

   The fund actively involves itself by providing guidance and strategic advice, introducing potential customers or partners and assisting with other business development initiatives. The experience and expertise they bring in make them a critical asset for the companies they invest in, and may even help them succeed.

   In some cases, they may also provide additional capital in future funding rounds to support the company’s growth as needed.

6. Just like buyout funds, the ultimate goal of GE funds is to exit the investment with substantial returns while allowing the target company to continue to run under new ownership or as a new public company. The exit strategies are simple. They include the sale of the company to another financial/strategic investor, arranging a management buyout, or going public via IPO.

• Capital Support: In certain cases, additional funding is needed for the expansion plan, in such cases, the Growth equity managers invest their capital. This capital can be used to fund new product development, expand the team, or for marketing campaigns, etc.
• Strategic guidance: These managers generally have years of experience and have attained expertise in various fields of their work. Hence they can help guide the company to enter new markets, introduce new clients or business partners through their network, identify potential acquisition targets, or optimise their product offering.

It was in 2017 that General Atlantic led the Series B funding round for the Barcelona-based SaaS company Typeform. The company was valued at $300 million and the investment amounted to about $35 million.

By the time Typeform was ready for its Series C funding round in 2022, the post-money valuation had grown to $935 million! This means it more than tripled in just five years. Not only that, Typeform’s recurring annual revenue also tripled between 2018 and 2021 and reached an amount of $70 million.

• Revenue growth: Under their guidance, the company can optimise sales efforts, scale up production, and identify growth opportunities in new geographies or product lines which may lead to increased revenues.
• Exit planning: Growth equity managers play a critical advisory role in guiding companies toward potential exit strategies. With their expertise and market knowledge, growth equity managers can assist portfolio companies in evaluating the best exit options and identifying the most appropriate course of action.

Investors who are looking for a steady and reliable option to invest their money often choose growth equity. It’s a type of investment that’s known for its proven business model and consistent growth rates, which can be beneficial for investors. Not only does it offer preferred stock, but it also provides a good level of protection against downside risks.

Check out the table below to understand the risk-return tradeoff of Growth Equity in comparison to other stages of investment strategies.

Source: LinkedIn

Return Drivers of Growth Equity Investment Model

When it comes to investing, the concepts of risk and return go hand in hand. Growth equity investments aim to keep risks to a minimum while still generating solid returns, similar to those seen in venture capital.

The target internal rate of return for growth equity is typically around 30 to 40%, which is a great return on investment. This return is expected to be achieved over a holding period of 3 to 7 years.

Returns for growth equity investments are most likely to come from revenue growth, profitability, and strategic value. The risk of capital loss is typically lower than in venture capital, but higher than in LBOs.

Overall, growth equity investments have a solid return profile that compares favourably to other types of investments. In the following sections, we’ll take a closer look at how growth equity compares to other investment options, so you can make an informed decision about where to put your money.

Every investment comes with its benefits and flaws. Let’s see what this strategy brings with it.