There has been no shortage of LP allocations to the growth equity asset class over the last decade. The attractiveness of growth equity’s risk-return profile — occupying the space between VC and PE buyouts — and its exposure to investments in some of the fastest growing and most defensible private companies has attracted a range of investors, each with distinct philosophies.
Rising challenges of growth equity
Over the last decade, competition for the highest quality growth assets surged, driven by the attractiveness of the businesses seeking capital and by a favorable macroeconomic context in which dry powder far exceeded opportunities for deployment. Headline valuations continued to climb as a result. Combined with the growing number of investors willing to make large investments in later stage private companies entering the segment, downward pressure continued to be applied to the underwriting of return hurdles.
While the driving forces of growth equity’s success — companies delaying listing on public markets, the digitization of economies and lack of dependency on debt markets for funding, among others — ensure that this investment category is here to stay, it should come as no surprise that some of the deal terms that paid off during the longest bull market in history are now up for reconsideration as markets experience turbulence.
In the new macroeconomic environment characterized by a slump in public equities, rising interest rates, and high rates of inflation, we are seeing more pressure on (and disagreement over) exit projections and valuations. As a result, investors and founders are seeking to implement return and exit structures that simultaneously enable funds to meet valuation asks while preserving downside protection, and ultimately rewarding founders in the event that their original valuations and growth aspirations are realized.
Structuring in the new environment
In response to the current environment, we have observed increased use (or consideration) of the following investment terms, as market uncertainty takes hold and growth equity funds adjust their strategies:
1. Liquidation preferences. Growth investors are seeking a combination of higher priority payment rights compared to other preferred stockholders in the case of a liquidity event; higher minimum return multiples on their investments before distributions to other stakeholders; and the ability to share in any additional upside, either on a capped or unlimited basis (i.e., participating preferred shares).
2. Accruing dividends. While already common in middle market buyout deals, more growth investors are negotiating rights to cumulative dividends (typically calculated as a percentage of capital invested). This can act as a minimum return on investment at liquidation in a downside scenario, or as additional upside where returns are modest but often phasing out at a higher returns (e.g., 2x–3x return).
3. Valuation adjustment mechanisms. Growth investors are also favoring mechanisms that enable them to increase their ownership percentage in a company (through an upward adjustment to the conversion rate of preferred shares) if certain pre-agreed performance metrics are not met. This structure allows an investor to meet a company’s ask on initial valuation, but also provides protection to the investor in the event that performance does not play out as forecasted.
4. Redemption rights and forced sale provision. There is increasing demand for provisions that enable growth investors to require companies to repurchase their shares in the future or force a sale, if the investment is not growing at rates that generate sufficient returns or if exit timelines, and therefore liquidity, are delayed. Additional rights, such as an increase to the accruing dividend rate and/or rights that allow the investor to control the board in the event a sale or repurchase cannot be implemented, may also spring into effect.
5. Option for additional investment. The use of an additional investment option, which gives an investor a right to provide additional capital in the future (at a negotiated or fixed price) in addition to the investment at closing, has drawn less scrutiny from companies in this market and can become very valuable to a growth investor when markets stabilize or if the current outlook proves unduly pessimistic. This “wait-and-see” approach gives a growth investor time to understand and respond to how the market is evolving before providing additional capital, including the option to dollar-cost average down if the business outperforms relative to projections.
6. Inclusion of additional preferred stock protective provisions. While the use of preferred stockholder approval rights are quite common, some growth investors are looking to include preferred stockholder approval rights over more operational functions related to cash management, such as approval rights over annual budgets and capital expenditures in excess of the board approved budget.
As Goodwin continues to advise many different growth investors across the global growth equity market, we anticipate that those sponsors who transact on differentiated terms to create a win-win scenario for themselves and founders alike (while also protecting their downside risk) will be the ones most adept at navigating current market uncertainties fruitfully.