Growth Equity - a growing asset class

Growth Equity refers to investments in growth companies in a scale up phase, often (but not always) involving taking a minority stake only, as opposed to a majority or 100% of the company. According to a recent piece in the Financial Times (Financial Times, January 7, 2022), there is more than USD 920 billion in growth equity capital available as of March 2021. The segment is the fastest growing in the VC and PE industries, with 21% annual growth, according to the same source.

Potential takers in the Norwegian growth equity space are mostly PE funds, funds with scale-ups as a specialty and a number of family offices, having in common flexible mandates allowing them to take minority positions. As a recent example, Summa Equity's, latest fund of NOK 23 billion which closed in January 2022 has a mandate for investments in growth companies at a stage earlier than for typical buyout funds (Article in E24, January 20, 2022).

What are the drivers for growth within growth equity?

There is significant capital available in the VC and PE sectors. In the US alone, there was over USD 976 billion in available capital in 2020 (Numbers from Preqin). In the same year, Norwegian PE funds raised NOK 20 billion (Figures from the Norwegian Venture Capital Association, The Value Creation Survey 2021). Based on feedback from PE and VC funds, there is reason to believe that these funds have continued to raise increasing amounts of capital in the Nordic market also in 2021 and so far in 2022. The Norwegian Venture Capital Association received estimates in November 2021 showing that Norwegian fund managers (both VC and PE) have around NOK 121 billion under management (The Value Creation Survey 2021, November 30, 2021).

Low interest rates and institutional investors seeking higher returns on invested capital have for a long period been key drivers behind increasing amounts of committed capital within the PE and VC sectors. However, despite having significant dry powder available, the number of interesting targets have not increased at the same rate, resulting in fierce competition for the right type of targets. Against this backdrop, growth equity is interesting because the risk is typically lower than for VC investments - as a growth equity target company is normally established in its market with a proven service or product. At the same time, there is still considerable upside if the growth plan and the scale up succeeds.

What are the typical characteristics of a growth equity case?

There is always a great deal of specifics for each target company. However, growth equity investors will often look for companies already established in a market, but in a strong growth phase and in need of significant capital to enable and accelerate further growth. These companies often have a steady cash flow which is, or is at least close to, being cash positive and little or no bank debt.

Accordingly, a key feature is that the business model has been proven, but additional capital is needed to realize an upside. Such growth can be directed against top-line growth, increased market shares or geographical or market expansion. The most attractive targets operate within industries with growth rates that exceed the market in general, such as technology/software, health, business services and finance (e.g. fintech).

Growth equity investors are often attracted to business models which are based on recurring revenue and customers, such as software companies, in particular companies with a disruptive business model where significant scale up makes long term sense rather than focusing on short term profitability. Such companies will often need significant capital to execute the business plan before reaching profitability. Autostore, Oda and Kahoot are some Norwegian examples of these types of companies.

The starting point for a growth equity transactions is usually a company with shareholders that are not yet ready for an exit, combined with a financial investor willing to take a significant stake without necessarily gaining control through a majority stake.

The target company and its shareholders will focus on the financial investor's value add beyond capital - in the form of know-how, industrial expertise and network. The holding period may be between 3-7 years. The basis for the investment will be that the investor and the current shareholders agree that significant upside can be realized by injecting additional capital. The most successful growth equity transaction are likely to take place in "the winner takes it all" industries, where unique technology or other barriers of entry exist and hence in which significant growth can be realized utilizing the injected capital.

Main negotiation issues – potential "showstoppers "

The investor should seek to demonstrate that it can and will contribute to realizing the target's growth plan. An experienced investor may take a company to the next level by professionalizing the organization, providing expertise within M&A, capital market transactions or other large transactions and assisting the target to achieve improved corporate governance. The investors may bring to the table discipline and a systematic approach to contracts, negotiations and project management. Optimization of working capital and insight into relevant and appropriate debt financing structures is also a core competence with these types of investors, and not necessarily something the current management excel at.

From the investor's perspective a key condition for these types of investments is to complete a thorough assessment of the execution risks of the growth plan and of the management's ability to perform and deliver as expected. The target will present its plan to achieve aggressive growth or a transformation of the company, and the investor will have to assess the risks of these plans not succeeding. It is fair to say that a growth equity minority investment is more a type of partnership agreement than a takeover. Such transactions, therefore, usually assumes a level of comfort and confidence between the financial investor, the existing management team and the existing shareholder (including earlier phase financial investors). The investor will seek to mitigate the worst case scenario risk of destructive disagreements or conflicts post-closing.

Since the financial investors often will not gain control, growth equity negotiations will normally be focusing on the following topics:

• Business Plan: Ensure that the financial investor, the existing shareholders and current management team agree on the goals, the updated business plan and not least the overall exit strategy.
• Exit mechanisms: PE and VC funds will expect a clear path to exit. Discussions must be expected in terms of drag along rights - who to exercise the drag, at what time and if there are certain conditions for an exit, which may not be at a point in time all shareholders agree is optimal. Redemption rights are common in international VC and PE practices, incentivizing an exit to be completed within an agreed deadline. In Norwegian market practice this type of mechanism is not as common. Norwegian exit mechanisms often focus on which party that can trigger the exit process and what conditions (if any) to apply. Finding balanced exit solutions will be a key feature in the negotiations.
• Board representation: A growth equity investor will normally expect a board seat.
• Reserved matters: The financial investor will often expect certain veto rights, such as changes to the business plan, acquisitions, capital increases and similar equity changes, hiring and terminating key employees, etc. Generally, the discussion will be whether the financial investor shall have control over operations and business decisions in addition to standard protective covenants relating to the financing and share capital. The size of the stake of the financial investor will be relevant in this context.
• Preferential rights: Many investors will request preferential rights in liquidations and exits.
• Dilution protection: The investor will be looking at dilution protection if there is a subsequent down round (either full ratchet or weighted average protection). However, dilution protection may not be as important as in VC cases, since the growth equity capital often should be sufficient to take the target to a full exit without further equity rounds.
• Valuation: Pricing is of course always a core item. In this "in between" VC and PE asset class, agreeing on the valuation may be particularly difficult. The target is often past the phase where the technology and the team will have to be valued on a fully discretionary basis. There may be some cash flow to form the basis for a cash flow based valuation model. At the same time, given that the growth plans are ambitious and the EBITDA projections used in DCF models will affect the net present value to a significant extent, the negotiations should therefore focus on agreeing on the appropriate growth rates to be able to reach a common valuation basis.
• Warranty protection: As growth equity investments are normally made as subscription for new shares and not by acquiring shares, a discussion point will often be whether - and to what extent - existing shareholders (not receiving cash in the deal) are willing to provide reps and warranties, even if they do not receive any proceeds. The available remedies for warranty breaches are thus negotiated to decide if the investor can receive cash, new shares or a combination thereof. W&I insurance may sometimes prove to be a useful tool in these discussions.
• Partial exit: It can be a driver for the deal that the management gets a partial exit. Many investors will be willing to discuss this, however all financial investors will expect an incentive structure where they can rely on the management being 100 % on board, with sufficient skin in the game to realize the ambitious growth plan.

From our point of view, the willingness to do significant investments by taking minority positions in growth companies creates interesting deal dynamics. PE funds often will often want to invest larger amounts in the most attractive targets, rather than doing a number of smaller deals. Precisely for this reason, it makes good sense to make quite significant minority investments in growth companies and thereby expanding the deal universe. As discussed above, the challenge is to strike the balance between the customary VC and the PE approaches in such negotiations.