FundFire: Cambridge, Others See Growth in Growth Equity

Growth equity, a private equity asset class traditionally categorized alongside venture capital, has matured into a distinct alternative for investors, according to a new report by Cambridge Associates.

Cambridge and fellow investment consultancy Segal Rogerscasey have both seen an increase among clients across institutions interested in growth equity investments over the past few years. “We’ve been recommending growth equity as a further build-out of the private equity portfolio, and clients are embracing it,” says Alan Kosan, senior v.p. and head of alpha investment research at Segal Rogerscasey.

Growth equity is similar to late stage venture capital and buyouts, with managers targeting portfolio companies that do not require capital, investing in growing companies to accelerate growth. Typically the companies are owned by their founders and fall most often into the technology or healthcare sectors.

Figures on the growth of the market are scant. Data provider eVestment, for instance, does not provide specific information on the asset class. But Cambridge’s private investments database, which holds information until 2011 inclusive, shows an uptick in interest. The sum raised by growth equity funds – defined as those companies that invested more than half of investment commitments in growth equity – was still only around $8 billion in 2011, but this marked a considerable increase on the figure of roughly $4 billion seen in 2008. That said, the growth equity market has been slow to recover after the market drop and is still nowhere near generating the $25 billion inflows seen in 2007.

“There has been a relatively modest amount of total alternative capital going into growth equity, [but] it has been increasing pretty dramatically over the past few years,” says Brian Rich, managing partner and co-founder at growth equity specialist Catalyst Investors. Anecdotally, and over a longer period, Bruce Evans, managing director at growth equity shop Summit Partners, says he has also seen the strong growth Cambridge is touting. In 1999 the firm had $2.8 billion in fee-paying assets under management, which has now risen to $10 billion, despite the financial crisis and the technology crash in 2000.

The wider industry appears to have picked up on this trend. Cambridge Associates plans to publish quarterly global growth equity performance benchmarks, which will help it gain prominence among investors. In January this year, the National Venture Capital Association (NVCA) formed a growth equity sub-group, which Evans chairs. “In response to the increase of growth equity investing, NVCA recently created a new member peer group to collect and disseminate relevant information and shared practices to its members who are active in this stage of investment,” the NVCA stated.

The asset class is not yet big enough for institutions to invest in it using standalone allocations, but they are still managing to allocate to it as a subset of private equity and venture capital. “[Institutions] are allocating first at a top tier to alternatives, then sub dividing to hedge funds and private equity, and within the private equity sub-divide venture capital, buyouts and geographies… [and] within that budget are the growth equity components,” says Rich.

“I don’t think many institutional investors have an allocation specifically for growth equity…some put it under the venture capital umbrella, some under the private equity or buyout umbrella.”

Investors seeking to enter growth equity investments should have at least $50 million in assets under management where direct or primary strategies make up the bulk of the portfolio strategy, says Kosan.

“For clients getting into this asset class for the first time, we would look at growth equity within the broader model,” Kosan says. Clients with an already established private equity investment could benefit more from further delineation into growth equity as its own asset class, he says.

“Growth equity is suitable for all investors,” says Kosan. “It’s another expansion of the venture model and is less debt-dependent.”

Institutional investors, managers say, are better suited to the time horizons of growth equity investing, especially when compared with retail clients. Typically the investing period is 10-15 years, with firms typically taking around five years to invest the money and another five or longer to get the money back.

While growth equity is a newer asset class for the U.S., the market is more developed elsewhere, with Asian institutions in particular using growth equity as a more prominent part of their alternatives allocations. “Internationally it is well recognized as a strategy,” says Evans. “Here [in the U.S.] there are more alternatives and more strategies…so [growth equity] has been slower to emerge from the noise.”

If more money flows to the asset class, existing growth equity managers may see more competition. Managers have witnessed a certain amount of competition already, says Rich, with those in late stage venture capital and in the buyout space moving into growth equity territory.

“I have no doubt that others will now [move into the asset class]. People follow the money. They will look at the Cambridge report and other facts and want to go out and raise more capital, so they will rebrand themselves as growth equity managers,” he says.

But regulation may stop some managers from moving into the space, says Evans. The Securities and Exchange Committee has classified growth equity as distinct from venture capital, with those firms offering growth equity having to become a registered investment advisor. “If [a firm] runs afoul of the definition in any funds the entire firm has to be a registered investment advisor,” Evans says, which places limits on the deployment of leverage and capital.

For institutional investors and consultants selecting growth equity managers, the characteristics to look out for are not too dissimilar from other areas of private equity, says Kosan. Investment firms should have the ability to recognize trends, take risks and exploit positive disruptions in technology and commerce, he says.

In addition, growth equity managers target portfolio companies that do not require capital, which makes it a competitive area to enter. Institutional investors looking for managers should target ones who have strong cold calling efforts and the ability to convince entrepreneurs to take on capital, even if they have no absolute need for it. When they realize their investments, growth equity managers typically target gross returns of three to five times, falling between the buyouts and venture capital range, according to the Cambridge report.

A final feature of the asset class that may prove attractive to institutions, particularly compared with Silicon Valley-style funds, is its greater regional diversity. Unlike venture capital, where most companies are concentrated in specific geographic areas, growth equity investments are more widely spread throughout the U.S., says Peter Mooradian, managing director of private growth research at Cambridge.

“You have to find partners who are willing to go on planes and attend off-the-beaten-path trade shows,” Mooradian says. “It’s really about that hustle.”

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