A Look at Growth Capital
Growth capital has consistently been one of the most popular private equity fund strategies in terms of investor demand. Of the 950 private equity mandates collected in 2011, 427, or nearly 45%, specified an interest in growth capital.
As the name suggests, funds that employ this strategy inject much-needed cash into companies that are looking to grow or expand. The companies these funds seek have a mature business that they are looking to take to the next level. Such growth may include entering new markets, changing their operational structure, financing a major acquisition, or any number of other efforts. However, these companies find themselves stymied because they lack the capital to finance such plans.
There are notable differences between growth capital and VC and buyout, and it’s instructive to examine the strategy in this context.
First, and perhaps most important, growth capital funds usually take a minority, non-controlling stake in companies. In a conversation with BHA analysts, a large growth fund mentioned that it frequently takes a minority stake of up to 40%. By comparison, VC funds tend to focus on building a controlling stake in a company, and buyout funds take a majority stake from the outset.
A second distinction can be seen in how these three strategies assess opportunities. VC funds tend to look for opportunities with less established companies with a single breakthrough idea or product, while buyout funds lean toward established companies with high gross margins. In contrast, as the managing director of a Chicago-based growth fund discussed with BHA, growth capital funds seek companies with compelling expansion plans. Managers focus their due diligence on the feasibility and profitability of the expansion they are financing, rather than on the long-term health of the company as a whole.
This brings up a third difference: the expected holding periods and means of exit. VC funds typically invest in companies for many years, exiting only after a public offering or sale of the company. Buyout funds hold companies for an average of six years. By contrast, growth capital funds generally make shorter-term investments. Funds invest with the expectation that the growth or expansion will increase the profits of the company, and a portion of those profits will be used to return capital to the fund.
In many cases, the profits are generated organically from the success of a company’s expansion. However, in cases where this doesn’t happen, or in situations where the fund has acquired a company and is looking to exit, some growth capital managers will employ a kind of add-on strategy, which calls for providing the capital to finance the acquisition of smaller companies, thus making the primary company a more significant player in the respective industry. Free cash flow from the company’s acquisitions can then be used to return capital to the fund or to increase the value of a fund’s stake within the parent company when the fund decides to sell its interest at a later date.
Under other circumstances, leverage may be employed. Unlike VC and buyout funds, which rely on leverage to acquire their stake, growth capital funds rarely take this approach. However, the companies they invest in sometimes take on debt to repay investors.
In 2012, many expect the growth capital space to see continued interest. In discussions with BHA, a DC-based growth fund noted that deal flow has been robust and the outlook seems favorable. This manager expects interest especially from family offices, noting that this investor category makes up about 40% of the firm’s investor base. BHA analysts concur, although they also anticipate continued interest from wealth advisors, consultants, and government pensions.