Private equity growth investors are becoming more selective amid a tough economic environment as they focus on increasing profit margins over multiple expansion.

Rising interest rates have impacted the appetite for leveraged buyouts, although PE growth equity funds have also been affected. Higher rates impact portfolio valuations amid declining investor sentiment, making exits even harder.

As a result, fund managers such as Ash Puri, a partner at UK firm Lightrock, are considering how they can add value to their portfolio companies while at the same time becoming very selective about which companies they back.

Puri noted that before the current downturn, 85% of companies seeking a minority investment from PE would get backing. Now the same percentage of companies is more likely to struggle.

"With rising interest rates, you need metrics to show that the business can survive without endless money," he said. "That's been the biggest change in the growth segment of the market."

Sectors favored by PE growth investors include healthcare, business services, and software, which typically accounts for the largest share of deals. In the case of software, investors use "the rule of 40," where combined revenue growth rate and profit margin should exceed or equal 40%. This means that if revenue growth is strong enough, thin profit margins are less of a concern.

Allan Bertie, head of European investment banking at Raymond James, said while this rule is still applied, there is much more of a focus on the EBITDA margin becoming positive. In the current market, cash burning businesses are having a more challenging time.

Similarly, Yalin Karadogan, a London-based partner at emerging markets investor Leapfrog Investments, stressed the importance of organic growth over leverage. However, he warned that the focus on margin expansion can be difficult due to rising costs.

Rising interest rates brought about to combat rising inflation puts pressure on both the entry and exit multiples a growth equity investment must achieve.

"If exit values decline, then entry values have to decline as well. We don't get impacted by higher interest rates as directly as buyout funds, but we do get impacted due to secondary considerations such as entry and exit valuations," said Puri.

On the other hand, Raymond James' Bertie said that PE still has the ability to outperform even in a tough economic environment.

"[PE firms] are not insulated, but what they have is the flexibility to say, 'I've been tasked by my LPs to deliver a 2x to 3x money multiple over the life of the fund. In the good times, I could generate that in two or three years. In tougher times, it may take me four, five or six years,' " he said.

Growth equity struggles on

According to PitchBook’s Q1 2023 European PE Breakdown, only 17.2% of European PE deals were growth equity in Q1. But even in a tough fundraising environment, some notable funds have closed this year. Summit Partners closed its fourth growth equity fund on €1.4 billion (about $1.5 billion) in February, and Andera Partners raised €600 million for its midcap-focused fund in January.

Lightrock's Puri said there's still enough growth capital sitting on the balance sheets of firms waiting to be deployed. He said from 2019 to 2021, every business was raising money and getting progressively higher valuations.

"Sometimes I'd think, 'What am I missing?' It created a lot of froth in the market. It became very confusing, so this economic change is actually good," he said.

Founders are also increasingly looking to PE firms, even as minority investors, to leverage their industry expertise to advise strategic decisions such as international expansion.

Leapfrog's Karadogan noted the importance of having a relationship that is the right fit. "[Investors and founders are] going to live with these people for the next five years. They need to know that they can work together and they can actually create value."

He added that investors need to be selective about sectors and disciplined on valuation. This applies even in high-growth emerging markets such as India, where Leapfrog invests.

Lightrock's Puri noted that while his firm still backs companies that are yet to make money, it's not in the business of moonshots or taking unnecessary risks.

In Lightrock's case, the focus is on sustainability and targeting companies engaged in real-world solutions. One example is its investment in African electric vehicle startup Max, which aims to cut carbon emissions. Puri said that any technology he backs should be a solution to a real problem, not a solution looking for a problem.

"There's been a shift in attitude. People are not investing in 'nice-to-haves'—they're investing in 'must-haves' because the value of must-haves is much quicker to realize than nice-to-haves," said Puri.

Related read: PitchBook’s Q1 2023 European PE Breakdown

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