Growth Equity: Not Venture, Not Control
Entrepreneur’s Dilemma: Growth or Control
Source: Wikipedia, Bloomberg, Forbes
There are many ways to build a $1 trillion company, but one common question which arises in the mind of an entrepreneur is, “How much control and ownership should I sacrifice so my company has the funding to grow?” Control is very important for an entrepreneur, not purely from a proper management perspective, but in order to stay true to his or her vision and to successfully build wealth. For example, after Apple’s IPO in 1985, Steve Jobs only owned 10% of Apple after several dilutive capital increases, and a year later, he was kicked out of the company. At the time of his death, Jobs’ net worth was estimated to be approximately $10.3 billion, but most of his wealth came from his shares in Disney, which he received when Pixar acquired Disney (according to Investopedia). On the other end of the spectrum, Jeff Bezos, the world’s wealthiest individual with $140.2 billion as of December 7, 2018, retained 48% of Amazon’s shares after their IPO in 1997, since Amazon had raised only $8 million prior to the IPO. Today, Bezos is still CEO and owns 16% of the company. Granted that Amazon is not a typical case, but the question of how much control an entrepreneur should relinquish to grow the company remains important.
A Solution for Rapidly Growing Companies
Growth equity is an investment strategy focusing on investing in growing businesses whose founders do not want to give up their control. After 2-3 years of rapid growth, many growing businesses experience a rather strange situation: the revenue is growing, but the cash flow is not. Many businesses receive customer payments after a lag of 30-90 days, yet the payments to their suppliers for materials or labor are often due much earlier, thus creating a cash shortage. (A cash positive surplus between receipts and payments, called “working capital” in financial accounting, may occur for more mature businesses.) However, banks are reluctant to lend money due to such negative or nascent cash flow, and the lack of funding can crimp their expansion and overall growth. For alternate source of funding, there is the venture capital but they may not be interested because the business may have already passed the rapid growth phase to produce the kind of exponential return that venture capitals seek, and the owners may want to hold on to the control to keep the significant upside in the future. So, who is going to fill the gap? Growth equity provides a solution.
Growth equity managers focus on businesses with established business models and rapidly growing revenue. Those businesses are often founder-owned, have no prior institutional investment other than venture capital funds, and have a proven business model (established product and/or technology and existing customers).
Growth equity is a relatively new concept within private equity. Until the late 2000s, it was categorized as a sub-sector of venture capital or buyouts. However, as more private equity managers focused on this segment of the market, it became a distinct investment strategy. In 2013, Cambridge Associates announced that it would create the first benchmark for growth equity strategies by separating them from venture capital funds and buyout funds.
In 2017, the assets under management for growth equity managers were estimated to be $385 billion. Due to its relatively short history, growth equity asset sizes are only 23% of buyout and 62% of venture capital assets, of which Asia—especially China—represents, not surprisingly almost 50% of the growth equity’s market share. In fact, buyout as a private equity strategy is almost nonexistent in China because the business owners do not want to give up their control in the growing businesses.
Source: Cambridge Associates
Over the last 25 years (since 1993), growth equity has generated strong and consistent returns, while other strategies have experienced high volatility. Unlike venture capital, growth equity invests in maturing businesses with lower business continuity risk, and distinct from buyout strategies, growth equity invests in businesses with no or very little debt.
Source: Cambridge Associates
Chuck Feeney, The Billionaire Who Wasn’t
Charles “Chuck” Feeney is a co-founder of Duty Free Shoppers Group (“DFS”) and the founder of The Atlantic Philanthropies. Through his work, he pioneered the modern-day philanthropic approach and launched of The Giving Pledge with Bill Gates and Warren Buffett. In 1988, an article in The Forbes 400 issue featured the success of DFS and the vast wealth of its 4 owners. The world’s largest duty-free business generated annual sales of roughly $1.6 billion with a 20% margin, thanks to affluent Japanese tourists visiting Europe and the United States. Forbes ranked Feeney as the 31st-richest person in America, worth estimated $1.3 billion. In the same year, Forbes ranked Sam Walton, founder of Walmart, as the richest American with $6.7 billion and Bill Gates No. 36 with $1.1 billion. However, Forbes made two mistakes: first, the fortune was worth substantially more; second, Feeney was already laying plans to give it all away. Over the following decades, Feeney gave away more than $8 billion. He completed his mission with a $7 million gift to Cornell, his alma mater, in late 2016. Feeney currently lives in a rented apartment in San Francisco and travels in economy class. We previously wrote about Feeney’s philosophy in our March 15, 2018 article, ‘Should Philanthropy Be Sustainable? Chuck Feeney Says “No”’.
General Atlantic, a Pioneer of Growth Equity
General Atlantic (“GA”) was founded in 1980 as the captive investment team for Atlantic Philanthropies and Feeney. To recycle the excess capital from DFS, Feeney hired former McKinsey & Company partner, Ed Cohen, and former U.S. Navy officer and McKinsey & Company executive, Steve Denning, to explore investment opportunities in early stage businesses globally. The first successful investment was a $3 million investment in Morino Associates, a computer software firm later renamed Legent, in 1983, and in 5 years, GA’s investment was valued at $52 million.
Today, GA focuses on 4 sectors (technology, financial services, healthcare, and retail & consumer) and 6 geographic regions (US, Europe, Latin America, India, China and Southeast Asia). Since 1981, GA has invested approximately $29.5 billion in nearly 300 companies, which have returned $38.7 billion in realizations, with a remaining value of $20.4 billion. Their track record has generated an aggregate gross multiple on invested capital of 2.0x (since inception). One of GA’s notable growth equity investments is called TriNet.
Case Study: TriNet
Founded by Martin Babinec in 1988, TriNet is a US-based service provider that frees small and mid-sized businesses from the complexities of human resource management. GA first invested in TriNet in 2005 to expand the business through acquisitions. The company’s revenue was only $50 million. During the following ten-plus years, GA helped TriNet to acquire 10 companies, including Gevity for $98 million in 2009. From GA’s initial investment to TriNet’s IPO in 2015, TriNet’s revenue grew 40x to $2 billion. By the time of GA’s full exit, revenue had increased 60x to $3 billion. After 20 years of service, GA helped Babinec to recruit his successor, Burton Goldfield, to become the CEO. At IPO, Babinec was able to maintain 7.9% ownership in TriNet, and his stake is now valued at $250 million (as of November 16, 2018).
GA identified a hidden issue in the highly fragmented HR service outsourcing industry, which was ripe for consolidation and it provided expansion capital to TriNet for conducting the transformational acquisitions. In total, GA held its investment in TriNet for over 12 years.
Source: General Atlantic, TriNet, babinec.com
Growth Equity For Long-Term Entrepreneur and Allocators
Growth equity is an investment strategy focusing on the gap between venture and buyouts—providing capital to growing businesses whose founders do not want to relinquish control. Over the last 25 years (since 1993), growth equity has generated strong and consistent returns, while other strategies experienced high volatility. Despite the success, growth equity has remained a small portion of private equity; nevertheless, the strategy is now growing rapidly, especially in Asia. We believe high-quality growth equity managers will offer patient allocators like us attractive investment opportunities while providing the companies with the necessary capital to sustain growth and satisfying entrepreneurs' desire to control their own destiny.