Private equity vs growth equity: A comparative guide
Investment strategies continuously evolve to accommodate the diverse needs and aspirations of both investors and the businesses they support. A delicate balance has to be struck in that middle ground between maximizing returns and promoting sustainable growth.
Private and growth equity are two prominent approaches that target distinct stages of a company’s lifecycle, each with unique goals and expected outcomes. While private equity (PE) typically focuses on mature businesses, often through leveraged buyouts and operational improvements, growth equity (GE) concentrates on companies that are poised for rapid expansion and have the potential to disrupt their respective industries.
Both options offer unique opportunities for driving value creation, generating attractive returns and accelerating business growth. Software as a service (SaaS) startups and investors alike can benefit greatly from understanding the differences between private equity vs growth equity investments and how they align with their objectives.
To begin with, here’s a table that illustrates the key differences:
|Characteristic||Growth equity||Private equity|
|Investment focus||Companies with proven business models and strong growth potential||Mature, underperforming or undervalued companies|
|Control||Collaborative approach, minority stakes||Active involvement, majority stakes|
|Value creation||Support organic growth and provide expertise in sales, marketing and product development||Operational improvements, financial engineering and strategic realignment|
|Investment timelines||Longer horizon (5-10 years)||Shorter horizon (3-7 years)|
|Risk and return profile||Lower risk, lower return expectations||Higher risk, higher return expectations|
|Exit||Earlier exits, capitalize on favorable market conditions or strategic opportunities||Sale or public offering after value creation|
What is private equity?
Private equity refers to the direct investment in private companies, often with the intention to acquire a controlling stake, improve operational efficiency and create value.
These investments typically involve the acquisition of a private company, followed by strategic interventions to enhance profitability and growth before an eventual exit.
An asset class refers to categories of investments that exhibit similar financial characteristics and are governed by the same regulations. Cash, bond and public equity (investment in companies listed on the public stock exchanges) are the three main asset classes. Private equity is an “alternative” asset class and can be a way for investors to diversify their portfolios and potentially reduce exposure to market volatility.
Large private equity firms can be more accurately described as asset management companies, as they often specialize in a variety of alternative asset classes, including growth capital. According to McKinsey, total private assets under management (AUM) were worth $11.7 trillion as of June 2022, with growth capital making up 10%.
Private equity fund structure and lifecycle
Private equity funds are investment vehicles that pool capital from institutional and accredited investors and deploy it under the guidance of a private equity firm. These funds are typically structured as limited partnerships, where the firm is responsible for sourcing, executing and managing the investments, and the investors provide the capital and have limited liability.
The fund lifecycle follows a structured approach, each stage characterized by rigorous analysis, strategic decision-making and precise execution.
In this stage, the PE firm raises capital from investors, including institutional investors such as pension funds and insurance companies and high-net-worth individuals. The PE firm presents its investment strategy, target sectors and expected returns to potential investors, aiming to secure commitments for a specific amount of capital.
Once the fundraising target is met or the fundraising period ends, the fund is considered closed, and no additional capital can be added. According to Pitchbook, the average PE fund size for the U.S. was $1.5 billion in 2019.
Due diligence and investment
The second stage involves identifying and evaluating potential investment opportunities that align with the fund’s strategy. The private equity firm undertakes rigorous due diligence on prospective target companies, analyzing aspects such as financial performance, management capabilities, industry trends and potential risks. Upon selecting a suitable target, the firm negotiates deal terms and structures the transaction — often involving debt financing — to optimize returns and mitigate risks. The investment is then finalized, resulting in either a controlling stake or a significant minority interest in the target company.
Once the investment is made, the private equity firm collaborates with the portfolio company’s management team to drive value creation. This stage may involve operational improvements, financial engineering, strategic acquisitions or other initiatives to bolster the company’s profitability. The private equity firm also leverages its industry expertise and network to support the company and maximize shareholder value.
The success of the private equity fund lifecycle hinges on realizing returns through a carefully planned exit strategy. This exit typically occurs after a short predefined investment horizon. Common routes include initial public offerings (IPOs), sales to strategic buyers, secondary sales to other private equity firms or recapitalizations.
The private equity firm works diligently to identify the optimal exit strategy, considering factors such as market conditions, company performance and potential buyer interest. The successful execution of the exit strategy enables the private equity firm to return capital and profits to investors, thereby closing the fund’s lifecycle.
Types of private equity investment strategies
There are several types (asset classes) of private equity, including:
- Leveraged buyouts (LBOs): A private equity strategy in which investors acquire a controlling interest in a company using significant amounts of debt to finance the purchase. The acquired company’s assets and cash flows are used to service and repay the debt.
- In 2007, Blackstone Inc., an alternative investment management firm, purchased all outstanding common stock of the Hilton Hotels at a 40% premium in an all-cash LBO deal worth $26 billion. Most of the deal was financed through debt, and the firm later sold these shares in 2018 for a profit of $14 billion.
- Distressed investments: Investments in financially troubled companies or those undergoing bankruptcy or restructuring, with the objective of turning around their fortunes.
- Venture capital (VC): A subcategory of private equity that primarily invests in early to mid-stage, high-growth potential startups.
- Before WhatsApp became a verb, they were just another startup looking to secure funding for their early development stages. Sequoia Capital, one of the largest VC firms in the world, decided to invest $8 million in the young company’s series A round in 2011. When Facebook later bought WhatsApp for $19 billion, Sequoia realized a 50x return on investment.
- Secondary investments: Purchasing existing stakes in private equity funds or direct interests in private companies from other investors, often at a discount to net asset value (NAV). This type of investment provides liquidity to the sellers and offers the buyers access to mature assets with shorter holding periods. Industry Ventures estimated the total secondary market transaction volume (public and private) was $105 billion in 2021.
- Investment deals in secondary markets are often made in private boardrooms and kept out of the mainstream media. Large PE firms often have dedicated teams and funds for secondary investments, now considered a mature asset class.
Characteristics of private equity
Private equity investments are characterized by:
- High barriers to entry: PE firms often target businesses that exhibit strong competitive advantages, robust cash flows and market-leading positions.
- Control: PE firms typically seek a controlling interest, enabling them to implement operational and strategic changes.
- Value creation through operational improvements: PE firms rely on their expertise and operational excellence to unlock value in acquired companies. PEs typically comprise former operators with successful exits and proven business growth backgrounds.
- Exit focus: PE investments aim for a successful exit within a specified timeframe, usually through a sale or public offering, to generate attractive returns for investors.
What is growth equity?
Growth equity firms are focused on providing capital to established companies and helping them accelerate their growth trajectory in exchange for a minority stake. These companies have moved beyond the startup phase but often require an influx of capital to fuel their growth ambitions, seize market opportunities, and maintain a competitive edge.
Growth equity and private equity are often discussed in conjunction, which may create confusion for some investors and founders. Growth equity is, in fact, a subset of the broader private equity landscape. While private equity encompasses various investment strategies, including leveraged buyouts, distressed investments and mezzanine capital, growth equity focuses only on growth-stage companies.
Later in this article, we will explore the key differences between these two kinds of investments to better understand their relationship.
How do growth equity firms make money?
Data analysis from Bain and Company shows that global GE assets under management value showed a compound annual growth rate (CAGR) of 20% from 2012 to 2022, slightly behind venture capital and direct lending. Generating returns from GE investments involves the following steps:
Identifying growth opportunities
Growth equity firms begin by discovering promising businesses poised for rapid expansion. They rely on market research, data analysis and industry expertise to pinpoint companies with strong management teams, scalable business models and differentiated products or services.
This stage involves extensive networking, attending industry events and maintaining relationships with key industry players to ensure they have access to attractive investment opportunities.
Due diligence and risk assessment
Once a potential investment target is identified, growth equity firms conduct thorough due diligence to assess the company’s financial health, growth potential and the viability of its business model.
This process includes financial statement analysis, market assessment, management interviews and evaluation of competitive positioning. During due diligence, GE firms also identify potential risks and challenges, such as regulatory issues or economic downturns, and assess the company’s ability to navigate these obstacles.
If the due diligence process has a favorable outcome, growth equity firms collaborate with the target company to design the investment structure. This involves determining the appropriate level of capital infusion, negotiating valuation and establishing the terms and conditions of the investment.
In many cases, growth equity firms may negotiate for a significant minority stake, board representation or certain governance rights to protect their interests and influence strategic decision-making.
Post-investment support and growth acceleration
Following the investment, growth equity firms provide ongoing support to their portfolio companies. This support can take various forms, including strategic guidance, operational expertise and access to industry networks.
Growth equity firms may also assist in recruiting top talent, identifying potential strategic acquisitions and improving operational efficiencies — all for the sole purpose of accelerating growth. According to Cambridge Associates, companies with GE investments achieved an average annual revenue growth rate of 17.2% from 2008 to 2017, more than triple that of public companies.
The ultimate goal of a growth equity investment strategy is to generate a substantial return on investment through a successful exit. Exit strategies for growth equity firms may include an initial public offering (IPO), a merger or acquisition or a secondary sale to another investor.
Characteristics of growth equity investments
- Investment in companies with a high-growth potential: A defining characteristic of growth equity investments is the focus on companies that demonstrate potential for rapid growth. These businesses typically have a proven product or service, an established market presence and a clear path to scale.
- Collaborative value creation: GE investors work collaboratively with their portfolio companies to create value. By contributing to the growth and development of their portfolio companies, growth equity firms seek to maximize the value of their investments, ultimately leading to greater returns upon exit.
- Lower risk profile compared to venture capital: These investments typically involve a lower risk profile than venture capital investments. While venture capital investments often target early-stage companies with a limited operating history and unproven business models, growth equity investments focus on more mature businesses with established products, services and revenue streams.
Growth equity vs private equity: Understanding the differences
Let us now take a closer look at the key differences between growth vs private equity:
Growth equity strategies typically target established, high-growth companies with scalable business models, proven products or services and a clear path to expansion. These companies often operate in industries characterized by rapid growth and innovation, such as technology, healthcare or renewable energy. GE firms seek to capitalize on the disruptive potential of these industries, which can drive significant value creation as the target companies scale and capture market share.
Private equity investors encompass a broader range of targets, including mature, stable businesses experiencing stagnant growth and distressed companies needing financial or operational restructuring. Private equity firms may invest across various industries, including traditional sectors like manufacturing, retail or services. Their investment thesis typically focuses on identifying inefficiencies or underperforming assets that can be optimized to generate improved financial performance and increased enterprise value.
GE firms generally acquire minority stakes in their portfolio companies, allowing the existing management team to retain operational control. They usually assist the existing management team and board of directors and provide strategic guidance rather than direct intervention. Growth equity investors may have some veto rights or board seats, but they generally do not oversee the day-to-day operations of the company.
Private equity investors tend to have more control over their portfolio companies than growth equity investors. They often replace the existing management team and board of directors and implement significant changes in the strategy, structure and culture of the company. Using debt or leverage, these investors are able to buy a majority stake in the company, which increases their influence.
Value creation strategies
Growth equity investors aim to increase the revenue and market value of the company — so their value creation strategies are centered around providing capital, strategic guidance and other resources to support growth and expansion initiatives. They leverage their network, expertise and resources to help the company access new customers, partners, suppliers or markets. These investors also help the company optimize its pricing, marketing, sales and product development strategies.
In contrast, private equity firms may adopt a variety of value creation strategies, including operational improvements, cost optimizations, financial engineering or strategic acquisitions, to obtain better profitability and enterprise value. They also help the company restructure its balance sheet, divest non-core assets or merge with another business.
Growth equity investments often have a longer-term horizon, depending on the company’s growth stage and scaling potential. They are patient and flexible with their exit plans and wait for optimal market conditions or strategic opportunities to realize their returns.
Private equity investments typically have a shorter investment horizon, with firms generally seeking to exit within three to seven years after implementing their value creation strategies. PE firms are more disciplined and aggressive with their exit plans and seek to maximize their returns within a predefined time frame.
Risk and return profile
Growth equity investments focus on more businesses with established products, services and revenue streams, which generally reduces the risk involved. They also expect to earn moderate returns per year on their investments.
Private equity investments generally have a higher risk and return profile than growth equity. They invest in companies on the brink of failure; many do not recover. Using debt to raise investment capital could lead to costly interest payments. However, for investors with enough patience and risk tolerance, the high returns can also make PE a lucrative endeavor.
Growth equity investors typically exit their investments through an initial public offering (IPO) or a strategic sale to another company. In some cases, growth equity firms may hold a stake in the company post-IPO, allowing them to participate further as it grows in the public markets.
Private equity firms may employ a wider range of exit strategies, including divestitures, recapitalizations or management buyouts, in addition to IPOs and mergers or acquisitions. These diverse exit options allow them to monetize their turnaround efforts and optimize their returns.
Difference between growth equity and private equity asset classes
Continuing our discussion, it may also be helpful to compare growth equity with two other private equity subcategories:
Growth equity vs venture capital
Venture capital is the most common form of financing for startups and early-stage companies. Like GE, VC firms also typically invest in exchange for a minority equity stake in the company and provide operational and strategic guidance. There are, however, some distinctions to be made.
Venture capital investments typically occur during the seed, Series A or Series B rounds, while GE investments are usually made during the later series rounds (Series C and beyond). The primary difference between the two investment strategies is the stage of development that they focus on. VC primarily invests in early-stage startups with innovative ideas and high growth potential. In contrast, GE focuses on companies with more stable business models demonstrating excellent growth potential and a track record of revenue generation.
As a result, VC investments carry higher risks as they invest in unproven businesses with uncertain futures. Many startups may fail or underperform, but the potential for high returns from successful ventures compensates for this risk. GE does not use leverage or debt to finance a deal and carries a moderate risk and return profile, as it balances the growth potential of VC with long-term stability.
Leveraged buyout vs growth equity
Leveraged buyouts (LBOs) involve the acquisition of a controlling stake in mature, cash-generating companies using a combination of equity and a significant amount of debt. The acquired company’s assets and cash flows are collateral for the debt, typically repaid using the company’s future cash flows. The primary motivation behind LBO investments is to generate high returns through financial engineering, operational improvements and strategic planning.
LBOs can offer substantial returns, driven by leverage, which magnifies gains and losses. However, the high debt levels can also pose considerable risks, including financial distress or default, if the acquired company fails to generate sufficient cash flows to service its debt obligations.
Both leveraged buyouts and growth equity investments play essential roles in the private equity landscape and require careful due diligence and exit planning to achieve optimal results.
Choosing the right equity investment strategy for SaaS
Private equity vs growth equity is not a binary choice but a continuum of options that vary depending on the characteristics and objectives of both the company and the investor. Here are several tips and pointers for founders and investors to help navigate the decision-making process.
- Assess the business stage and growth prospects: Are you ready for serious growth and market disruption and just need a leg up? Or are you running a mature SaaS business that isn’t generating enough cash? If you’re the former, growth equity firms have the skills and experience you need, but if you’re the latter, private equity firms are better suited to help improve operations and finances.
- Evaluate ownership and control preferences: Consider your preferences regarding ownership and control. Growth equity investments often involve minority stakes, allowing founders to maintain operational control. In contrast, private equity investment strategies may involve majority or controlling stakes, with the investor exercising greater influence over strategic and operational decisions.
- Analyze investor expertise and resources: Assess the expertise and resources provided by potential investors, particularly within the software sector. Growth equity firms often offer specialized strategic guidance, market insights and connections to drive growth in startups with some previous traction.
- Ensure alignment of interests and long-term vision: Engage in open discussions regarding growth strategies, value creation and exit plans and establish a productive working relationship built on trust and mutual understanding. Remember that private equity investors may have different priorities or time horizons than you and may seek an early exit.
- Determine risk tolerance and investment objectives: The risk/return profile of growth equity is considered to be slightly lower (although this may vary) than that of private equity, as it does not use debt to magnify returns. With GE, you are also betting on a company’s growth potential that has yet to reach its peak and may have to wait longer for it to pay off than a private equity investment strategy.
- Evaluate diversification options: Growth equity firms focus on a particular industry. Firms can diversify their portfolio by investing in different stages, geographies or sub-sectors within their area of expertise. Private equity investors can diversify their portfolios by investing in different industries, sizes or types of companies within their private capital spectrum.
- Assess sourcing and due diligence capabilities: Growth and private equity investments both require rigorous due diligence processes to identify and assess attractive targets. You’ll need strong sourcing networks and relationships to access high-quality deal flow and compete with other investors for attractive opportunities. PE investors also need to have a broad knowledge of the fundamentals, financial metrics and valuation methods of the industries they are considering.
Both investment types require the assessment of key SaaS metrics, such as customer acquisition cost (CAC), lifetime value (LTV) and churn rate, to evaluate the health and potential of target companies.
- Develop management and value creation skills: Both investments require you to be well-versed in SaaS-specific value creation strategies, such as improving product offerings, expanding into new markets and optimizing sales and marketing efforts. Growth equity investors must excel in providing resources to support growth, such as introductions to potential customers and business partnerships. PE investors need management skills and expertise in operational improvements and financial optimizations.
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