Growth equity – The base case doesn’t cut it anymore

Yesterday, Pitchbook published a series of charts summarizing the state of private equity in the US. The basic message was how cutthroat the industry is becoming. The key points I picked up from the article are summarized in my somewhat gloomy tweet below:

tweet

I haven’t delved into the full report, but I’d be interested to learn more about strategies that differentiate successful managers. After all, alpha/expertise is the reason managers enter this business. A relevant takeaway for me is how growth equity has become increasingly attractive to “visiting investors” with core expertise in other asset classes/investment strategies and looking to compensate for softness in key drivers for their models (leverage, yield, etc.).

I recently attended a conference where a panel of seasoned growth equity investors shared perspective on the pitfalls encountered by visiting investors in growth equity. Whereas the discussion took a combative tone often used by incumbents in industries encountering disruption, there were some tidbits that could probably help entrepreneurs evaluating an investment from large hedge funds vs. growth investors:

  • Tourists don’t have home advantage: Visiting investors don’t often possess the skillset, temperament and rolodex that are critical to invest successfully in growth equity since these ingredients take a long time to accumulate. For example, a visiting investor might misprice the risk of an asset due to the typical absence of clean historical data often used as basis for valuation. Inability to emotionally stomach the chaos and rapid change associated with high-growth businesses might result in conflict (e.g., when hedge funds publish large markdowns for their holdings in private growth companies). Also, visiting investors may still need to amass value-add strategic resources e.g., network
  • Liquidity overhang can hang you: As the queue for realizing returns keeps getting longer, business models are increasingly becoming exhausted before they are exited resulting in value contraction. For example, early investors in digital media platforms were able to exit on the promise of “monetization of audience/microtransactions” but as those models became harder to execute, investors increasingly questioned whether these platforms were primarily b-2-c/branded consumer or b-2-b/advertising. Visiting investors rarely have a complete playbook to help entrepreneurs either pivot from low-value models or install additional high growth channels to preserve value
  • Base case doesn’t cut it anymore: Because of pricing pressure, investors can’t simply value a business based on the base case. The growth model used to be about a profitable businesses promising to deliver incremental growth with additional funding. Today, businesses ask investors to fund operating losses in exchange of future growth. The best solution however, is when investor/entrepreneur teams sit together and develop a shared growth plan. Unfortunately, this creates logistical challenges e.g., the entrepreneur having to choose an investment partner ahead of discussing valuation. Many growth teams have invested in incubator structures, designed to partner with entrepreneurs from the start before approaching the broader market

Returns are increasingly harder to come by in private equity. However, this is also an opportunity for good investor/entrepreneur teams to stand out from the crowd and win!

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