Growth equity has become one of private equity’s fastest-growing segments in recent years, but today’s market uncertainty has slowed that momentum: 2022 was a year of disruption. Investors faced a multitude of downside risks, including geopolitical tension, energy and food scarcity, rising inflation and interest rates, stock market volatility, and supply challenges triggered by the war in Ukraine and the legacy of the COVID-19 pandemic. At the present point in the economic cycle, there is no clear-cut path to expansion, profitability, or resilience.
This period of change should encourage growth investors to rethink their models of engagement with portfolio companies. Such investors can coach them through the disruptions that lie ahead, mitigate the risks they face, and steer them toward long-term optimal growth. In short, they can educate and reinforce the founders and CEOs of these companies, many of whom have never led an organization through an economic downturn.
Especially now that there is some clarity around interest rates and other market dynamics, growth investors can help their portfolio companies survive the downturn in three ways. First, they can review the entire portfolio and divide its companies into different categories based on the degree to which market volatility has affected them. This classification will help identify the companies most in need of support. Second, investors can adopt a number of value creation levers to get these priority companies on the path of optimal growth. Third, they can invest time and resources to build the right talent and capabilities not only in their portfolio companies but also in their own companies.
From growth at all costs to optimal growth
Diverse institutional investors and multimanagers have been drawn to growth equity’s high growth and returns potential over the past few years because the investable universe of appropriate companies has expanded substantially, primarily as a result of substantial funding for venture capital. Thanks to this expansion of the investable universe and the increasing returns for growth equity, 2021 was a record year for the strategy: fundraising touched $132 billion globally—56.5 percent year-on-year growth. Across the United States and Europe, the deal count for growth equity and venture capital reached approximately 30,000, making 2021 the most active year on record.1“Q4 2022 PitchBook-NVCA Venture monitor,” January 11, 2023; 2022 European Venture Report, PitchBook, January 18, 2023.
Since then, the liquidity tailwinds powering growth equity’s fundraising and capital deployment spree have showed signs of waning. According to our 2023 Global Private Markets Review, fundraising for growth equity and venture capital dropped by 17 percent and 11 percent, respectively, year over year. Deal momentum dropped as well, especially in the second half of 2022. Growth activity fell by 18 percent, to $254 billion. VC deal volume fell even further, by 33 percent, to $498 billion. The decline in VC deal volume was more dramatic in the second half of 2022, when it fell by 55 percent from the second half of 2021. Meanwhile, PE returns disappointed across strategies. As a result of deteriorating technology valuations, VC and growth equity returns led the decline, in stark contrast with the past several years. The median VC and growth fund fell by 6.3 and 7.3 percent, respectively, through the first three quarters of 2022. The median buyout fund earned 0.9 percent.2McKinsey Global Private Markets Review, 2023.
Given the change in the macro environment and the metrics that drove valuations in the past, many portfolio companies across industries—especially in the later stages of investment—also expect “down rounds”3When a company raises equity capital at a lower valuation than it did earlier. in future. Because of reduced fundraising, the compression of multiples, and the overall market slowdown, fewer unicorns were created in 2022 than in the 2021 boom (exhibit).
It’s too soon to say how long this slowdown might continue. Public markets already face high levels of volatility: through the first three quarters of 2022, for example, the S&P 500 recorded its third-worst performance since the 1950s.4“September, Third Quarter 2022 Review and Outlook,” Nasdaq, October 3, 2022. In this period of uncertainty, growth investors have considered shifting from the growth-at-all-costs approach to optimal growth. As investors learn to operate in a world of higher interest rates and reduced access to capital, it is less realistic for them to expect hypergrowth across their entire portfolios. But if they shift focus to reducing risks and increasing the resiliency of their investments, they can pursue a path of optimal portfolio growth.
Investors typically execute this kind of strategy by finding faster routes to profitability, regularly reviewing the cost base, and developing healthier balance sheets to reduce risk and increase cash runways and the time between funding rounds. An optimal-growth model has worked well in previous downturns. In fact, some of today’s largest and most successful companies were born during the dot-com bubble, in the late 1990s, and survived the subsequent crash because of a well-positioned long-term growth strategy.
Playbook for long-term value creation
Growth equity investors can take three steps to create an optimal-growth model for their portfolio companies:
Fund managers tend to have limited resources for creating value, so it is essential to continuously determine which portfolio companies have priority. One option is to split the portfolio into different categories, depending on the downturn’s effect on each company. We believe that individual portfolio companies lie on a spectrum, with four distinct groups shaped by two key factors: first, their exposure to market conditions and to the macro environment and, second, their financial resiliency—for example, how much do rising interest rates or lower consumer spending affect a company.
After identifying priority companies, investors can take several approaches to get on a path of optimal growth. Some funds are by design more passive and less focused on building capabilities. Nonetheless, to unlock returns it’s critical for many operating teams to act as coaches for portfolio companies. Few high-growth companies employ executives who have lived through the type of economic slowdown occurring now. Industry experts who have experienced past crises can help today’s entrepreneurs understand how to approach this period of uncertainty.
A two-pronged strategy can help portfolio companies achieve optimal growth. The first is to stretch the runway:
The second strategy is growth-oriented cost optimization:
The choice of levers depends on the trajectory of the portfolio companies. Survivors and defenders, for example, can focus on sustained cash management and strategic pivots to align their business models and offerings with long-term trends. Investors ought to consider the appropriate returns on resource investments for such companies. Bloomers can focus on continuing to invest in their businesses for the long term to help them come out on top when economic growth resumes.
Once the appropriate levers have been identified, fund managers can adapt their operating models by engaging more with the portfolio companies and helping them with their strategic initiatives. By increasing the frequency and depth of discussions, investors can, for example, ensure that target initiatives get the most appropriate kind of support.
Focus remains a key unlock for value creation in high growth portfolio companies, hence initiatives with marginal or particularly long payoffs should be deprioritized in favor of doubling down on the core.
Investing in people
An optimal-growth strategy relies heavily on skills and competencies at the level of both the fund and the individual portfolio companies. Talent is a defining factor in the success of these companies across cycles. In a challenging market environment, building necessary skills and providing the right tools are even more make-or-break than usual. Investors seeking optimal growth shouldn’t hesitate to invest in developing human capital for their portfolio companies.
Historical study indicates that portfolio-value-creation teams help raise overall investment returns for funds. According to a McKinsey analysis, for example, PE firms with such teams outperformed their peers in the 2008 financial crisis. Of the 120 largest PE firms whose 2004–18 investment returns we analyzed, those with value creation teams or portfolio-operating groups achieved an internal rate of return (IRR) about five percentage points higher than the rest.
Resources can sometimes be scarce at the fund level, especially if the vehicle’s capital is invested in many companies. The solution is to have flexible resources so fund managers can give portfolio companies end-to-end on-the-ground support and bet on potential growth levers. Those managers should think carefully about the deployment of their operating partners’ resources to ensure that they are effectively allocated to portfolio companies that need support and have a high probability of providing strong returns on exit. As funds move into more active roles, they may need a different operating model, with more specialized talent and a stronger focus on partnerships than we have seen in the past few years.
This is a period of historic uncertainty, and unprecedented times often call for radical measures. Growth investors have long served as advocates for portfolio companies. Now these investors need to become coaches—scrutinizing the portfolio, categorizing companies by how they are likely to fare in the new environment, determining the best courses of action, and allocating resources to goals.
For many growth equity investors, this level of active engagement represents a fundamental shift from the way they have traditionally operated. If the downturn intensifies, they have only limited time to change their approach and take the steps required to unlock returns. The time to act is now.
This content was originally published here.