The growth of growth capital: how will the market develop?

The wall of money looking to invest in growth companies meant that, until relatively recently, high-quality companies with well-respected founders were able to command blockbuster valuations, negotiate more founder friendly terms and even reject investors that were not a good fit for their business.

But a challenging economic environment is shaking up the growth market, we expect that this will lead to the return of more investor friendly deal terms over the coming year.

Wall of money

In light of the impressive returns enjoyed by many growth capital investors in the years following the financial crisis, a new set of players sought opportunities to deploy capital in growth capital companies. This trend was accelerated by the pandemic, which saw technology sector valuations soar, further encouraging investment in this part of the market.

We have seen traditionally conservative corporates adjusting their risk criteria and establishing dedicated venture and growth investing arms, as well as private equity firms raising billions of dollars for stand-alone growth capital funds, while family offices and sovereign wealth funds have also increasingly started investing in growth companies. 

But many investors are anticipating a downturn in valuations of growth equity companies over the next year. Companies seeking growth capital typically make no or small profits, but tend to have a proven business concept and product, which with additional investment is likely to become cash-generative and profitable. With soaring inflation and a squeeze on incomes in many countries, a downturn could affect growth stage businesses disproportionately due to the often cash-hungry business models.

Adjustments to deal terms

Macroeconomic headwinds have already started to move the market back to more investor friendly deal terms, but the effect of the boom means that we still expect further adjustment over the coming twelve months.

As a reminder, the venture capital funds that traditionally dominate this sector have largely followed a relatively standardised set of terms, dominated by the NVCA form in the U.S. or BVCA in the UK. The focus for these investors tends to be on risk mitigation, more protective veto rights and speed of execution. Newer entrants, in particular private equity investors, are often more focused on the upside potential of their investments and ability to direct the destiny of the relevant asset.

Deal terms remain fluid and are worth close monitoring, but we have started to see a number of interesting trends that seem to be driven by the experience and preference of these new investors:

• Guaranteed returns – investors are arguing for more of a guaranteed return, not just the downside protection of the liquidation preference. This is manifesting itself in higher preference multiples in some regions or even a preferential payment or dividend, something which would be highly unusual in many markets only a few years ago.
• More majority transactions – we are seeing the ownership stakes creep up on many growth equity deals. Minority investment stakes tend to be common in this space, but many private equity firms are looking to take 55% stakes or even higher in growth companies. In such situations the traditional minority investment terms will often need to be re-evaluated.
• An extension of deal timelines – we are seeing that as more risk-wary investors enter the market, they require longer to assess targets and agree terms.
• Veto rights – where control is not sought, veto and consent rights are becoming more common. During the boom years, founders successfully resisted this trend but as investors perceive greater risk in the market, the demand for these sorts of protections has grown.

Winners and losers

We expect that a downturn will also lead to changes in the types of buyers and sellers operating in the growth capital market.

A downturn could be a boon for private equity investors, who will be keen to snap up growth stage companies at bargain prices. They may also be able to pursue more ‘buy and build’ strategies, where they merge a number of small companies into a sizeable business. Similarly, we expect that a bear market might push some more risk-averse investors to retreat from growth capital investing and instead focus on assets that are perceived as less risky.

We are also anticipating that growth companies that have already raised capital will likely shift to prolonging runway and considering opportunistic M&A. Competitors in less secure market positions may become tantalising targets for some growth capital companies in certain sectors.

The next 12 months brings many uncertainties but one thing is for sure: growth equity is here to stay and will remain a powerful feature of the private capital landscape for many years to come.