Is It Now Growth at Any Price?
In private investing, it appears that way, but a deeper look suggests there could be a method to the valuation madness.
First, let’s review how we got to this new era in private investing, one characterized by an emphasis on growth. Remember, the institutional private investment industry is relatively young (about 40 years young) and small compared to public equity markets. In its initial era, known for its namesake strategy, the leveraged buyout, the return driver was typically the application of a lot of leverage. All else being equal, adding leverage to the balance sheet and paying it down over time builds the equity value. That source of returns, also known as “financial engineering,” has long been commoditized.
The second era brought an emphasis on profitability, which remains a focus for today’s sponsors. The era was largely announced by the use of the now ubiquitous “100-day plan” developed at the outset of an investment. The goal was, and is, to improve operations to meet competitive standards by applying known techniques investors could underwrite with a high degree of confidence. All else being equal, growing profitability directly increases equity value. Profitability gains are largely a one-time boost to earnings, and therefore investment values, which could leave potential buyers thinking, “What have you done for me lately?” This era is far from over. Sponsors continue to experiment with types of operating capabilities in an effort to programmatically deliver operating improvements.
In today’s era, the focus has shifted to revenue growth —it can be organic or inorganic; revenue just has to grow, preferably consistently, and by a lot. A portfolio company exhibiting better revenue growth characteristics than its peers is good; if it’s in a sector growing faster than other sectors, it’s even better. The quality and type of the revenue are also important. For example, recurring revenue is more valuable than revenue that has to be built from scratch every year. The focus on growth is understandable —so far, managers have been rewarded. Our recent analyses of private equity return drivers point clearly to revenue growth as a success factor. Nearly half of private equity–owned companies exhibiting 20% or better revenue growth delivered at least a 3.0x multiple on the invested capital —top quartile territory. Looking at this from the reverse angle, nearly 40% of private equity–owned companies experiencing just one year of revenue decline were realized at a loss. The median revenue growth rate for successfully exited companies has been at least 10% per annum. Buyers want growth, and general partner (GP) activity indicates, “Message received.”
Back to our original question, GPs sure seem to be acquiring growth at any price based on headline valuations today. So, we seek to quantify what sponsors are paying per unit of growth by examining growth-adjusted revenue multiples, calculated by dividing the revenue purchase price by (projected or actual) revenue growth rates. These analyses indicate most sponsors are maintaining a degree of discipline, with the best-performing companies having a lower ratio (getting more growth per valuation dollar, essentially) even as growth rates (and valuations) climb. Growth rates of companies today range far and above the growth rates of the leveraged buyout era, which required portfolio companies to grow steadily but not significantly. Of course, there are other vectors fueling increasing valuations, such as the availability and persistence of low-cost leverage, the concentration of capital in technology-based businesses relative to previous eras, and the ever increasing supply of capital aimed at the private markets. Nothing can be distilled down to just one variable.
How can sponsors deliver growth to investors? Identifying sectors with strong growth characteristics and investing in growing companies in those sectors has been productive. Private equity investment in technology has nearly tripled by capital since 2001. Investment in healthcare, another sector exhibiting strong secular growth trends, nearly doubled. Investors can also ladder in degrees of growth by investing across private investment strategies that pursue various growth targets.
GPs also actively work with their portfolio companies to increase organic or inorganic revenue growth. Underwriting organic revenue growth is typically not as certain, or as clear cut, as underwriting profitability improvements, so it adds additional risk to an investment. Inorganic growth, namely the acquisition of another business or businesses and their associated revenue, can be familiar territory for some GPs and is increasingly pursued, although the financing and supporting of add-on acquisitions can impact outcomes as well.
Growth is not as simple as adding water and sunlight; it requires focus, skillsets, and capabilities to be expressed to its full potential and in a sustainable and repeatable way. Private market investors can layer in various degrees of growth across their programs and, with a view to acceptable risk, should assess their options and act accordingly.
