What is the difference between LMM and Growth Equity?

What's the difference between LMM and Growth Equity? I understand LMM is typical buyout but the check sizes are smaller. Is Growth Equity like LMM but just even smaller check sizes? Or are there nuances to it that make it more like venture? Is Growth equity the same as late stage venture like NEA or IVP?

 

LMM typically refers to buyout as you correctly stated - that means taking control and putting debt on the company’s BS.

Growth equity is more about injecting primary capital (or secondary purchase from owner? - not too sure which is more common). It is a minority position alongside the owner of the business and there is usually little or no debt put on the BS. Key point is that you are not in full control of the business (i.e. less than 50% ownership)

I have not spent a lot of time in either of those so happy to be corrected by someone more knowledgeble.

 

I would add that the types of companies smaller growth equity firms are looking for are much different than what NEA and such are looking for. NEA is looking to fund massive checks into companies that could be billion dollar outcomes. They will often fund pre revenue businesses or companies with big cash burns. Growth equity is more focused on companies with proven models and usually closer to break even. They aren't looking for the next Uber, moreso the next solid small company that could grow into a solid market company.

 

Growth equity is more similar to venture than traditional PE in my experience. We're a very small shop and typically do minority investments around 20% in convertible debt or preferred equity. I'd say the vast majority of our portfolio companies aren't turning a profit yet. We'll be the first institutional money a lot of them see, but they at the stage they've already established their business model and need to expand sales and marketing.

 

I will quote another comment I made:

APAE:

Growth equity has two definitions from two different sets of people.

One is 'growth capital for a proven business that wants to expand'. That is the private equity universe, and it tends to be capital for businesses that are targeting 15-30% annual growth. The hockeystick potential is either behind it or never existed because it wasn't that type of business to begin with.

The other is 'more fuel for a startup that is still early in its hockeystick'. That is the Series B, C, D for startups that have a massive addressable market and are starting to enjoy economies of scale (fixed development cost of the product, uncapped sales potential). That is the venture capital universe.

Lower middle market tends to refer to buyout. Growth equity refers to either of the two definitions above.

Lower middle market is a size definition. It refers to companies with $5-50m in annual revenue. Growth equity is a type of transaction definition. It refers to non-leverage transactions for businesses with a proven business model, regardless of profitability.

In summary, it's very often used interchangeably with 'late-stage venture'. One handy rule of thumb would be to look at the industry of the target company. If it's tech or tech-enabled (e-commerce, life sciences, etc.), it's venture-like. If it's not tech, it's private equity-like.

I am permanently behind on PMs, it's not personal.
 

I wrote a longer answer but it didn’t let me post this so to save time I make it a bit shorter and break it into three parts – if my post shows up multiple times, I am sorry.

Based on broad market understanding: LMM mostly refers to buyouts, growth equity to (most of the time) minority positions created via primary capital intake.

If we look at this more theoretically: In a nutshell growth investing refers to allocating capital into growing the business vs. immediate cash yield. Most often this means primary capital intake and minority positions but it does not have to take that form exclusively. Lets take nomenclature and transaction structure aside for a minute.

On this page it is often mentioned that growth is closer to VC than it is to LBO and I think the answer is more complicated than that. I would look at it in terms of risk you are underwriting and think in terms of the classic “value creation” bridge.

In very simplistic terms and based on the “traditional” view: VCs provide capital to a company for it to prove that a product works, a product market fit exists or a business model can disrupt existing operations. The returns are achieved if the business successfully proves that it has created a valuable business model. The risk is that no valuable business model is created.

Growth equity means providing capital to a company – post the product market fit stage – to permit it to scale operations. You want to be compensated for financing its expansion. Return stem from the achieved “growth” i.e. a more valuable business (sale of it, profits from it etc.). The risk you are underwriting is often operational and could mean that its more expensive to grow, there is no larger market after all, there is no exit etc.

In an LBO, you buy the Company and the returns are achieved by allocating capital towards paying down debt. In theory this could also be done without debt and just take the form of dividends but from the value bridge perspective, it’s the cash allocation of the existing business you are betting on. If anything dislocates (exit environment, business not stable enough, financing markets etc.), you take a hit.

 

The reason the risk / return thinking helps is because the transaction structure and nomenclature can mix: many buyouts have a growth element to it, i.e. the return bridge is quite growth oriented and primary capital is used to boost growth. So the returns and risks mentioned above mix. Another point to make things a bit more confusing, we also conduct growth deals without any primary capital but just permit the business to run EBIT breakeven and re-invest everything. Lastly, growth deals can happen as minority or majority. Ticket size does not really matter in that sense although we obviously expect to see growth investments much more in smaller companies where internal cash doesn’t permit re-investment at the required amounts. If a company is break-even, for them to hire 30 new sales people would take x years. We can fast track this by providing that cash up front – think international expansion of something that works or adding new verticals.

Another point regarding the company size: If I buy a dental practice where I have visibility on the cash flow since 10 years, this is most likely an LBO structure. Although the thing is small. However, if we aim at generating returns from growing this by buying new equipment or capitalising it to open a second and third practice, we are back in the growth equity space.

The terms late stage venture and growth are also a bit tricky. Worse even, many VCs have growth vehicles, too. When I hear late stage venture – and this is very arbitrary and my own view - I think much more about the investments that doesn’t fit the 5x VC target anymore but capital is still required to see it through. So for me that term is often much closer to momentum than it is to the “oldschool” growth nomenclature of taking something that was subscale before and has reached an inflection point / can accelerate with capital and expertise. Most growth deals as i think of them is first money in. Late stage venture is yet another round in a business model that has seen various funding rounds but needs some more capital (at a different risk / return profile though).

I copy an answer I wrote in response to a topic that was about giving the right answers in a growth interview below - not sure how helpful though.

 
Most Helpful

Here what i wrote in the past to some interview related topic about what makes a good growth invetment.

Key answer is you need an "engine" that is reasonably clean i.e. you know that every $ invested into growth gets you $*n revenue increase in X years. This together with the conviction that there is room for an asset of Xm revenue / size in the space and an exit environment supporting this, is at the core.

How do you know whether this is one of these assets that can become of the size you need it to be? In order to be able to do this you need to understand exactly the economics. Is this headcount driven? If so ramp up times, quotas and all of that needs to be assessed. If it is SaaS, the key drivers to assess for slightly change (churn, CAC, LTV etc.). The asset shouldn't be too hairy (non-core parts and other distractions). Unit economics and "fixed costs" need to be understood.

Obviously, what needs to be a given is an understanding of and a sizeable end-market (not just 10% of 10bn is our opportunity but a proper ASP x customer segments, ideally lists of customers etc). You will be surprised how detailed growth players audit customer lists (how much and on what do they spend their money exactly? What do they really use it for? What other solutions did they look at? What is your price / functionality compared to competition?) What needs to be achieved but by back solving is an entry valuation that allows you to make enough returns and an equity ticket that gets you to the exit (or factor in further rounds and at what valuation these need to be done...). Don't get the cash needs wrong because if you all of a sudden need 3x the assumed equity ticket to get to the target company size - you're returns have just disappeared. Yes you can throw in more money into the tank if you see great growth coming out of it and thus can get you faster to your target position (Accretive and return enhancing) but you cannot put in more money because your unit economics calculation is wrong and more $'s are required for the same outcome.

In a perfect world, you quantify exactly where this company can go over 3-5 years in terms of revenue, the funding required to get there and backsolve for what you can pay. You will see players like insight e.g. come in with valuations and ticket sizes that are extremely aggressive when looked at based on what stage the asset might be at. However if you have a high conviction that a e.g. 300-500m player can be created in this space, there is need for such a player, and you know exactly what you get for each $ invested, you can make great returns.

I sit in Europe so my example is European but if you look at insight investing $165m into tricentis this is a good case study. This business - when looked at in isolation (and i don't know it personally at all but for that I missed spotting it) - probably doesn't support this ticket or valuation but when your conviction is that there is room next to an IBM / HPE for a global automated testing business of scale (lets assume for the sake of the exercise 1bn revenue target) and you know exactly how the unit economics work and how the sales ramp up will work (adjust for SaaS metrics where required) then you have a great trade by selling / listing this with rev(1bn) @ a multiple of e.g. 5-10x. However, if you get the assumptions wrong and need more money to get there or don't get there at all because of slower roll out or less attractive market (exit, competition, size) you're screwed. Identify the market need, find the engine, add fuel, make money. Scale controlled into a market need (space might be empty or you offer feature parity at lower price etc. whatever your justification for the need of your player is).

Another point to add - which supplements - your answer above beyond the "growth engine part": ideally the asset is slightly overlooked in the market. There is a reason all growth shops prefer buying from management teams, outside of auctions and have cold calling teams to spot these assets. It is of course price but often it is also that these assets still have significantly more levers to pull in terms of growth vs. buying from another sponsor that has scaled this already. Growth can sell to LBO but growth buying from growth is difficult (unless fund time issues) because other people have already been investing behind the roll out and probably taking the returns and each $ you invest has not the same unit economics.

What needs to be in place is a governance / shareholder structure that allows you to execute on your trade even as minority but this is true for all investments hence not core to my answer. The structure needs to support the thesis in any investment unless your thesis itself is changing the structure e.g. forced sellers (funds at end of lifetime etc.), succession, de-listings etc. If you look at the teams at the leading growth players you will find that even the junior team members can speak very smartly about what end market and why and understand exactly the KPIs in this space and what to look for when calling companies / meeting companies at conferences.

 

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