Growth Equity – An Explainer
A distinct asset class with different characteristics to growth stocks and private equity
Although the term “growth equity” became popularized many years ago, there is still some confusion about what it is outside the private-markets investment community. Consequently, it may add clarity if we begin by describing what growth equity is not.
It is nothing to do with investing in the growth stocks component of publicly-traded equity markets. This may be a relief to investors in the so-called FAANG stocks, who experienced a particularly brutal year in 2022. And it is not just the nature of the securities, but also the attitude of investors participating in these two market segments that is different.
“The stock market is a device for transferring money from the impatient to the patient.”
Warren Buffett, legendary investor
As Warren Buffett points out above, typical stock market investors trade on fear and greed, particularly when it comes to high-growth companies. Investors may jump on the bandwagon solely through fear of missing out, continue to hold on long after valuations have become stretched, exit at the first sign of volatility, or seek to ‘buy-the-dips’.
Conversely, growth equity investors are more committed to the enterprise(s) and are content to harvest the value creation of an industry-disrupting pre-IPO business over the medium term. Nevertheless, it is necessary to acknowledge that 2022 has been a disappointing year in terms of both the number of IPOs and late-stage funding rounds. However, the dynamics of the growth-equity asset class remain firmly intact. Technological innovation will continue to create opportunities for fast-scaling companies, especially in industries that are poised for dynamic disruption.
The terms “private equity” and “growth equity” are not interchangeable…
Private equity typically involves taking a controlling stake, often partly funded using significant amounts of debt, in relatively mature (but pre-IPO) companies, with more stable cash flows but lower growth potential than earlier-stage enterprises. Conversely, growth equity practitioners typically invest minority stakes in companies with rapid growth potential. As positions are purely equity-based, there is typically no leverage involved, and the return is solely determined by the success of the enterprise rather than the company’s ability to meet pre-prescribed debt repayments.
Attributes of a growth equity enterprise
Source: Stableton. Schematic illustration
However, ‘earlier stage’ does not imply investing in companies with dubious potential in the hope of an outsize pay-off – equity growth investing is far more pragmatic than that.
The key to success is to identify industry-disrupting enterprises with a robust business model and a clear target market that are already growing at pace. In other words, we aim to harness rapidly expanding and proven winners in the growth stage of their evolution.
At the prevailing stage of the economic cycle, deals to harvest medium-term value creation can be secured at substantial discounts. At the same time, participating investors are much less likely to head for the exits at the first hint of difficulty. These two attributes (increased growth potential and lower volatility) are the essential ingredients of superior risk-adjusted returns.
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