The glory days for growth equity are just getting started

Former hedge fund manager Andy Kessler recently published an obituary for private equity in the Wall Street Journal’s opinion pages. This piece not only mischaracterizes the private equity business model but also unfairly paints the industry with a very broad brush. Kessler’s example of private equity is limited to Wall Street-centric “mega buyouts” focused on driving returns through leverage and cost cutting. While this sector of private equity may be headed for more challenging times, there are many other flavors of private equity with a favorable outlook. Growth equity is one these lesser known strategies growing in popularity, and for good reason.

As the name implies, growth equity is a private equity business model focused on growth, not leverage. Firms in this sector don’t invest in billion-dollar startups or mega deals underwritten with leverage. A June 2013 report by Cambridge Associates, “Growth Equity Is All Grown Up” describes this strategy as, “somewhere between late-stage venture and leveraged buyouts – investing in established companies that can benefit from additional capital to accelerate growth.”

Growth stage companies typically operate in sectors growing faster than the overall economy. These businesses have proven business models, attractive revenue growth and are modestly profitable due to heavy investments supporting growth. Companies typically seeking growth capital are founder-owned with no prior institutional capital. There are several positive trends currently underway in growth equity.

1. Talent, Technology, and “TCO”: The talent available for these companies has never been stronger. Growth companies are not typically founded by whiz kids right out of college but by seasoned CEOs and executives with a bootstrap mentality. Many growth companies are technology-related and quality technical talent is increasingly available outside of the major technology centers. In addition, the cost of purchasing off the shelf technology, which is typically leveraged to deliver solutions growth companies provide to their customers, continues to decline while improving in both performance and capability. Finally, large enterprises are playing close attention to the total cost of ownership and the benefits of outsourcing or cloud-based software. These large companies are also increasingly comfortable purchasing from smaller best-of-breed vendors, which largely benefits growth-stage companies.

2. Attractive Risk Return Profile: Institutional investors are starting to pay more attention to this sector of private equity and commit more capital due to its attractive risk return characteristics. Growth equity offers similar returns to leveraged buyouts – but without the leverage. In fact, according to Cambridge, over three-, five-and 10-year periods, growth equity end-to-end net returns outperformed venture capital and has been competitive with leveraged buyouts.

3. Large and Diverse Market of Opportunities: Unlike the limited number of targets for mega buyouts mentioned in Kessler’s article, there is a huge range of companies at the growth stage in the lower middle market – 32,000 according to S&P Capital IQ research data from 2013. In many cases, they aren’t in Silicon Valley, where capital readily flows, but in high-growth/lower-hype markets such as Dallas, Denver, Atlanta, Salt Lake City, or Chicago.

There’s no need to start building the casket for private equity, especially once you look beyond the stereotypical mega deal. Growth equity is much more about the basics of helping talented teams grow great companies, and this flavor of PE has a very bright future.

Richard Maclean is the managing partner of Frontier Capital, a private equity firm investing in lower middle market software and technology-enabled business services companies. A cofounder of the 16-year-old firm, Maclean focuses primarily on the firm’s managed IT and HCM software and services investment activities. He currently serves on the board of three portfolio companies: talentReef, Healthx, and Celergo.