Growth equity deal flow defies slowdown in PE dealmaking

Growth equity investment activity has remained relatively resilient even as poor market conditions dampen US PE dealmaking across the board.

In Q2 2023, there were 336 growth equity transactions in the US, up just slightly from Q1, while PE buyouts—which include big-ticket LBOs and smaller add-ons—recorded a nearly 20% decline quarter-over-quarter, according to PitchBook’s Q2 2023 US PE Breakdown.

Growth equity now also makes up a larger share of PE dealmaking. In the first half of the year, growth equity transactions accounted for 22.2% of total US PE deals, nearing the previous record of 22.7% set in 2013.

If PE managers keep striking deals at this pace, growth equity deal count this year will likely outnumber LBOs for the first time, PitchBook analysts estimate.

Growth equity’s stability is due in part to US PE firms turning to investment strategies that require smaller check sizes and less leverage as they confront the dearth of cheap debt financing.

“Growth equity is striding ahead on the deal front as it avoids the costly financing on which buyout strategies often rely,” said Garrett Hinds, a senior PE analyst at PitchBook and co-author of the report.

These deals also often involve less pricing tension than buyouts, an important factor at a time when softened public market valuations have made it difficult for buyers and sellers to agree on a price.

In these transactions, valuation is just one among many variables at play, said Brian McPeake, co-chair of the PE group at law firm Goodwin.

Negotiators will also weigh other factors such as the projected positive outcomes of collaboration between the management team and a growth equity firm that stands to bring in its skillset and other institutional resources to expand the business.

During the bargaining, growth equity firms and their target companies may focus more on the future upside of the business. As a result, while growth equity investors are still rigorous on price and can ask for protective rights to safeguard their investments, they are more likely to find common ground with owners of the target company.

“At times, the valuation discussion for a growth equity investment is more fluid than an outright acquisition because the investment is more of a partnership with multiple variables at play as compared to an outright acquisition,” McPeake added.

Increased borrowing cost has also driven up companies’ demand for equity financing—another factor propping up deal activity, according to Dwayne Hyzak, CEO of Main Street Capital, which provides debt and equity to lower- and middle-market companies.

The cost of equity had historically been significantly higher than the cost of debt, but that gap has narrowed since the Federal Reserve raised interest rates, making an equity raise more attractive for a growing business.

Today, a middle-market company will likely access leverage with interest rates in the low-to-mid teens, which is a significant financing cost for the borrower, according to Hyzak.

More companies daunted by elevated borrowing costs are seeking expansion capital and keeping their eyes off debt financing, because equity financing—albeit dilutive—does not require any immediate payouts.

“That could be a motivating factor for a company to seek growth equity, as opposed to debt capital,” Hyzak added.

Despite all the upsides, growth equity has its own drawbacks. Investment managers find exits more challenging due to rising interest rates, pressure on portfolio valuations and weakened investor demand. As a result, they are becoming more selective on deals and shifting their focus to help portfolio companies to grow profit margins, rather than pursuing multiple arbitrage.

In recent months, a number of investment firms have closed funds targeting growth equity opportunities. This includes Goldman Sachs Asset Management, which raised $5.2 billion to invest in high-growth companies, and JP Morgan, which wrapped up its debut fund targeting Series B to pre-IPO companies.

In February, Summit Partners closed a €1.4 billion vehicle targeting minority and majority equity investments in European companies.