In recent years, a new breed of investors has bounded into the private markets. As a result, private companies are raising larger amounts of capital and waiting longer than ever to go public. Here, PitchBook analysts Rebecca Springer and Kyle Stanford walk us through the blurring lines between VC and PE, as well as the growing prominence of new-school investment strategies.
The rise of the nontraditional investorIn the last ten years, the private markets have seen an explosion of increased participation from nontraditional investors . In fact, these investors participated in nearly $60 billion of venture capital allocations in 2020—accounting for a record 36% of total deal value. With more and more investors flooding the space, companies are now able to raise larger sums of capital from private investors and scale without having to turn to the public markets.
What is a nontraditional investor?A nontraditional investor is essentially any investor that operates outside of a traditional VC firm, including corporations, LPs, PE firms, sovereign wealth funds, hedge funds and investment banks. This group is proliferating as more new participants become involved in venture capital.
The growth of growth equityWith companies waiting longer to IPO, private market trends have continued to evolve in ways that increasingly blur the lines between venture capital and private equity. One investment strategy that exemplifies this growing ambiguity is growth equity—one of the fastest-growing segments in PE.
Growth equity investments target relatively mature, growth-oriented companies and typically take on a minority stake. Lying somewhere between PE and VC, growth equity incorporates aspects of both, providing an attractive risk-reward opportunity for limited partners.
To further explore growth equity, listen to our recent In Visible Capital podcast episode about the rise of New Jersey’s Edison Partners in the PE growth landscape. In the episode, PitchBook’s Adam Putz talks with the GP of Edison Partners Kelly Ford about how the firm has successfully transitioned from venture capital investing to growth equity.
Benefits and risks of growth equityLike any asset class, there are specific upsides to growth equity investing, including:
- Bypasses the high risk associated with early stage VC investing
- Unlike a buyout, growth equity deals typically do not use debt
- Growth equity often requires a smaller equity investment compared to what you’d see in a buyout for a similar sized company
- Upside potential of investing in high-growth companies
Growth equity as a standalone private market strategyBecause of the advantages presented above, growth equity has become a standalone private market strategy. According to PitchBook, growth equity funds raised twice as much capital from 2016-2020 than they did between 2011-2015. This roughly falls in line with the expansion of private equity as a whole, showing how growth equity has earned an established place in LP portfolios.
But what’s driving this growth?
“Venture has broadly outperformed other asset classes in recent years, and growth equity allows investors to get some increased exposure to that type of return while still mitigating the downside risk you’d have with pure venture,” says PitchBook Private Equity Analyst Rebecca Springer.
Another reason for growth equity’s rise is that private equity as a whole has become more oriented toward tech and tech-related sectors. As firms start to build expertise in looking at tech companies, emerging technologies and the like, we’re seeing more growth equity investments out of buyout funds, more growth equity funds being raised by generalist firms, and more awareness of and interest in the space as a whole.
Lastly, growth equity is highly flexible. “While the typical growth equity investment that you would think of might be a company that’s gone through a couple of venture rounds and now is bringing in PE growth investors, you can also see growth equity investments being made in much more mature companies,” Springer says. “Especially if they’re about to launch a new strategy or make an acquisition or IPO—so it can be used in a number of scenarios.”
Diving deep into venture debtVenture debt, or venture lending, is another trend gaining popularity. Venture debt is a type of short- to medium-term debt financing provided to venture-backed companies by specialized banks or nonbank lenders to fund growth and capital expenses.
Over the past decade, venture debt has emerged as a major alternative source of financing for high-growth VC startups, growing at a faster pace than the broader venture capital market itself. According to PitchBook, more than $80 billion in loans and other debt products were created for VC-backed companies in the US between 2018 and 2020, compared to just over $47 billion in the three years prior.
Debt financing can be risky, potentially raising red flags for investors. But in recent years, that risk has lessened as the benefits of venture debt have begun to outweigh the negative perceptions of yesteryear.
The benefits of venture debtLike other asset classes, including growth equity, there are unique upsides to venture debt that are worth considering:
- Venture debt is a great source for non-dilutive capital for companies that allows founders and their employees to continue holding a stake in the company
- Venture debt can be used as a supplement to equity raises
- Venture debt can be relatively cheap—with today’s low interest rates, companies can raise capital and pay back the loan in a few years, bypassing the need to sell a potentially lucrative stake in their company to investors
Venture debt as a standalone market strategyThe growth of venture debt has largely coincided with the growth of the private markets overall. More companies receiving VC funding means more potential borrowers for lenders. According to PitchBook, the number of venture debt loans more than tripled over the last decade—from 940 loans in 2010 to 2,900 in 2020. In addition to an increase in the number of venture loans, large, late-stage venture loans have heavily contributed to a surge in loan value. From 2009 to 2020, late-stage venture loans grew more than 2.5x and exploded over that time by nearly $17 billion in annual value, per PitchBook.
“Just as we're seeing megadeals in the VC equity market boost overall deal values, several large, outsized loans are really going have a major impact on the loan value that we're seeing in the market today,” PitchBook Analyst Kyle Stanford said. “That said, there has been huge growth in the number of loan financings that we're seeing taken out by VC-backed companies.”
This is, in part, due to the increased understanding of the benefits of venture debt for VC-backed companies, as well as because more lenders are stepping into the market to provide loans. Additionally, the growth of VC late stage is providing more opportunities for lenders to lend to companies with lower risk profiles AKA strong investor backing. The growth of SaaS and other recurring revenue business models has been a boost to lenders, too, making it easier for them to estimate and model payback schedules of their loans and further decreasing risk.
How will high-growth segments like growth equity and venture debt fare in the long run?
The future of growth equityPitchBook analysts believe growth equity will continue to grow in popularity, driven by the broader growth of the private markets, expanding allocations to PE and the growth of the venture ecosystem—which already produces a steady stream of companies that are good candidates for growth equity investments.
“The strength of the public markets right now are going to be a driver of growth in the space as it presents just another favorable exit opportunity for growth-stage companies,” Springer says. “We're also expecting to continue to see larger private equity firms, generalist firms, established firms launching specific growth equity strategies, whether that's in biotech, cleantech, software or another high-growth area.” She adds that we are likely to continue to see new firms entering the market and raising their first funds focused on these areas.
The future of venture debtAt PitchBook, our analysts think the venture lending market will see considerable growth in the coming years, likely mirroring the overall growth of the VC market in the US. Venture lending returns have remained strong and characterized by low loss rates, which isn’t what you’d typically expect from lending to these VC companies.
“Venture lending loss rates have been so low, which is going to bring more exposure to venture lending overall,” Stanford says. “There’s potential for interest rates to rise, though we don’t believe a small increase will have a material impact on the venture lending market.” He adds that overall, VC has a lot of capital ready for deployment and that many companies are moving through the venture lifecycle—both of which point to an increase in venture lending by way of more opportunities for lenders to get exposure to the VC asset class.
More on growth equity and venture debtWhy are nontraditional investors expected to continue their push into venture?
Download PitchBook’s Analyst Note: High Valuations, Higher Returns
Nontraditional investors in VC are here to stay
Learn more about their presence and impact in this PitchBook Analyst Note
Venture loans surpassed $20 billion three years in a row in 2020
Download PitchBook’s Analyst Note: Venture Debt a Maturing Market in VC
Venture debt is becoming a fundraising alternative in Europe, too
Read our news article about European startups’ embrace of venture debt
Mega-deals are underscoring PE’s growing embrace of VC deals in tech
Learn more about PE’s push into late-stage deals