THE VITAL ROLE GROWTH EQUITY IMPACT INVESTORS PLAY AND THE CASE TO BACK THEM

IE Case Study

By: Ander Iruretagoyena and Priya Parrish

In many ways growth equity is the middle child of the private markets spectrum. "Middle-child syndrome" is the idea that if you're neither the oldest child nor the youngest, you get less attention from your parents and feel “caught in the middle.” Similarly, at times, it feels like the market forgets about growth stage companies and instead focuses all of its attention on when companies are ideas with the potential to change the world or when they are proven leaders. There is a lot of space between early venture and exits, and without the right backers companies may become yet another statistic. Of all companies, only about 60% of start-ups survive to age three and roughly 35% survive to age 10. In the case of impactful ventures, the perceived challenges to make it out of this valley alive may even be greater as companies are not only fighting traditional hurdles, but oftentimes have the added burden of convincing mainstream investors and the broader market that their inherently impactful business model is actually scalable and profitable. Investing in impactful companies at every stage is important; that is why we manage a platform that has the flexibility to back impactful funds and companies at all stages through a number of different investment strategies. 

Many people think that impact investors are most needed at the early stage, as this is when impact gets “baked in.” However, in reality impact is solidified over a much longer time period before it becomes embedded into  a company’s business model and value proposition. As a company matures it needs different kinds of support, and the role of the impact investor shifts as well. We at Impact Engine believe that the growth equity impact space represents an interesting spot in the risk return spectrum, while also being a critical financing juncture to create scaled businesses driving impact.  Before diving into this topic, it is a helpful exercise to establish some common vernacular to frame the conversation.

Even though the growth equity investment strategy lies in the middle of a theoretical company lifecycle, it should not be confused with the strategy PE/Buyout firms utilize when acquiring mid-market companies. The investment strategy utilized for these lower middle market companies often relies on garnering outright control of relatively stable, cash flow positive business through leverage, and optimizing operations to increase margins, pay down debt, and create a compelling narrative to exit at a higher multiple than the one used to purchase the business.  The upside potential to these investments is much lower than what most venture funds aim for, but buyout strategies also see few, if any, write-offs, leading to a consistent risk-return profile.

In early venture, GPs (General Partners) are often securing single to mid-teen % ownership stakes in a much greater number of companies via a combination of small initial checks, followed by additional participation in subsequent rounds to prevent dilution and increase exposure. The investments made typically have the potential for a 10x+ return, but in reality most will fail and the fund returns will be driven by a small number of companies. These funds thus have the potential for much higher returns than buyout funds, but also a higher probability of a lower return.

The # and AUM in growth equity is dwarfed in comparison to PE & VC

Currently in the Pitchbook platform there are a total of 5,635 primarily PE-VC managers with traditional market structures (commingled LPs, primary funds w/. 10 year life, and raising more than $50M). Of those, 2,974 are venture (53%), 2,240 (40%) are buyout, and 421 (7%) are growth equity. Collectively these managers oversee 14,309 funds for a total of $7.29 Trillion.
  • Buyout- 5,367 funds (38%) managing $4.66 T (64%)
  • Growth- 1,615 funds (11%) managing $0.89 T (12%)
  • Venture- 7,327 funds (51%) managing $1.74 T (24%)

Growth equity investing typically focuses on companies with established product market fit, a proven revenue model (often translating to $10M+ in revenues) and who have attractive unit economics making them either EBITDA profitable or in a position to achieve this milestone within 2 years of the current funding round. In other words, these companies are at an inflection point and need capital to scale an already proven business model that is well beyond the typical venture risks of product/business model development and product market fit; rather, they are mainly facing scaling and execution risk. Companies begin to professionalize, start meaningful collaborations, and come into their own by learning from their BODs (Board of Directors) who might include sophisticated institutional investors for the first time. From a risk/return profile, growth equity is therefore rightfully less risky than venture while offering buyout-like consistent performance without the need for heavy leverage to magnify returns. GPs deploying this strategy often have a relatively concentrated portfolio (high single to low double digits) of significant minority positions with each of them being underwritten to base cases in the 3-4x range while expecting low single digit write-offs.

The difference continues in the world of impact

Of those same 5,635 managers and 14,309 funds there are 257 managers who self-report that they seek ESG/Impact Investments. Of those, 127 are venture (49%), 107 (42%) are buyout, and 23 (9%) are growth equity Collectively these managers oversee 378 funds for a total of $137B.
  • Buyout- 121 funds (32%) managing $80.7 B (59%)
  • Growth- 75 funds (20%) managing $23.6 B (17%)
  • Venture- 182 funds (48%) managing $32.7 B (24%)

Buyout, early venture, and growth GPs not only differ in investment strategies and the underlying stage of the companies but they also have some important differences in how they support the companies they invest in. This is especially true for impact investors relative to mainstream investors. These differences are summarized in the table below. Of course there are going to be some similarities across the stages, given that a good GP is often doing a wide variety of activities to add value and help the underlying portco grow, but there is definitely a palpable shift in emphasis depending on which stage the company is in.

 
 

Despite the difference, AUM growth in GE is quickly on the rise driven by technology…

Digital technology has forced growth equity and late-stage venture capital to the forefront over the past few years, and fast-moving investors with innovative new business models have joined the battle to control this burgeoning market under the belief that the digital disruption is still in its early stages. The numbers are shocking.

Growth and venture assets under management have expanded at about twice the rate of traditional buyout AUM over the past 10 years. Since 2014, $367 billion has been raised globally for growth equity.

Global Buyout, Growth Equity, and Venture Capital AUM ($T) | Preqin as of 06/30/21

… and that same pattern is observed in capital deployed

Growth equity and late-stage venture capital deployment has grown at 1.5 times the pace of buyout funding and now represents 61% of its levels.

Within growth equity, the SaaS vertical accounted for around 30% of total deal value in 2021.

Global Buyout, Growth Equity, and Venture Capital Deal Value ($B) | Preqin as of 06/30/21

To further illustrate the highlighted blue square and its underlying investment strategy, let's spotlight the work of one of our impact growth equity investees, Lumos Capital Group.

  • Overview: Lumos invests in high growth private companies developing innovative technologies and platforms in education technology, knowledge services and human capital development.

  • History: The firm was established in 2019 by Victor Hu and James Tieng  who were longtime friends and worked together at Exceed Capital Partners (a single LP fund with the vision of democratizing education by unlocking how technology can be used to provide greater access to learners of all ages). Together James and Victor have over 30 years of combined experience in the education sector. Victor was responsible for establishing  the education practice at Goldman Sachs, which he led for close to a decade, and James has invested over $1.5B in education and tech through his roles in Quad Partners, Apax Partners, and Irving Place Capital. This powerful combination of backgrounds (transaction advisory in M&A, strategy, corporate finance + principal investing) is exactly the type of backgrounds we like to see and the ideal one to source, secure, and support winning investments.

  • Investment Strategy / Portfolio Construction / Impact Thesis & Fund Cycle: In July 2021 Lumos held its final close for Fund I and currently has ~$200M AUM (assets under management). With it Lumos has executed several growth equity investments where they saw room for value creation and potential for global scale. Transaction structures are typically Series B+ with Lumos as the lead investor. Initial equity checks have generally fallen in the $10-20M range with up to 30% of the fund reserved for additional follow on opportunities. The fund expects to allocate 75% of the investments in North America and 25% globally. Some of the guardrails the GP has put in place include setting minimum revenue hurdles of $10m, targeting EBITDA profitability in at-most a 18-24 month window, and detailed investment screens for strong unit economics. Furthermore Lumos invests with structural protection in terms of preference shares and enhanced governance rights, and typically secures other protective provisions such as exit rights (ie. early-exit protection, lock-up periods, drags with return thresholds, and tag rights). Lumos has made 7 investments to date with the following characteristics and impact theses.

    • Ellevation – Led a $15mm Series B-1 round in March 2020. Ellevation is a market-leading software-as-a-service (SaaS) business for K-12 school districts in the US, serving English Language Learners (ELLs). ELLs experience outsized achievement gaps relative to non ELL students (41% of ELL fourth graders score below basic in math and 69% score below basic in reading) and there is a tremendous shortage in administrator and teacher capacity across the education system to support them (only 24% of teacher training programs train teacher candidates in strategies to support ELLs specifically).  Ellevation’s Platform product allows schools and administrators to comply with the requirements of federal law and other regulations surrounding ELLs. Ellevation also helps to close achievement gaps through both their Strategies product, which provides teachers with instructional support to help them differentiate instruction, and Ellevation Math, which is an academic language product used directly by students.

      • In June 2021, Ellevation announced the closing of an acquisition by Curriculum Associates. Lumos exited the investment as a result and served on the Transaction Committee, working to ensure that the company’s impact mission would be maintained through any strategic sale by the counterparty.

    • Ironhack – Led a $20mm Series B-1 round in December 2020. Ironhack offers technology-oriented programs for adult learners in areas such as web development, UX/UI design, data analytics, cybersecurity, and JavaScript. Adults without a postsecondary degree who hold a certificate or certification have higher full time employment rates than their peers with no credentials, as well as higher salaries ($45K versus $30K). Ironhack provides a quality education and relevant job skills to students and employees for a fraction of the time and money that traditional postsecondary education requires (typically 4 years and $100K+). By providing high quality technology skills training, Ironhack helps students start careers in high demand technology fields, improving their economic mobility by achieving high post program salaries. The company recently submitted their B-Corp Certification application with Lumos’ active support. 

    • OnlineMedEd – Led a $20mm Series A growth round in March 2021. OnlineMedEd (“OME”) is a digital healthcare learning platform primarily serving medical students globally. Healthcare education remains expensive and inaccessible in many parts of the world. Much of this is attributable to a traditional pedagogical approach that has yet to embrace innovation. In addition, people of color continue to be underrepresented in the healthcare community and inequity in health outcomes persists among these underrepresented demographics (people of color fare worse across a range of health measures including lower life expectancy). With over 80% of medical students in the US using OME and users in over 190 countries, OME can potentially improve outcomes by offering inclusive educational content and helping improve diversity of medical practitioners in the US, which in turn may contribute to closing health outcome disparities. For its part, Lumos has worked closely with the company to, among other things, recruit mission-aligned executives.

    • Openclassrooms – Led a $80mm Series C round in April 2021. OpenClassrooms (“OC”) is a leading global digital education-to-employment, reskilling and upskilling platform headquartered in Paris. OC provides a product suite of both free and paid online programs that trains a diverse global workforce for the future. An estimated 1B jobs will disappear worldwide between 2020-2030 while 300M people are estimated to enter the workforce during that same timeframe. Even for people with existing competencies, additional training/ reskilling will be necessary to keep up with the rapidly evolving world of work. The company intentionally provides access for the underserved  to participate in the digital economy through apprenticeships and a robust job placement support system. Additionally, to make its products more financially accessible, OC helps students unlock 3rd party funding; today a majority of its students are able to access its products such as technology apprenticeships with no out-of-pocket costs. The company tracks its impact goals and reports on them through an annual impact report which measures its success in job placements. Lumos has worked actively with the company’s executives on global expansion initiatives, both organic and inorganic, to help OC reach more learners and underserved populations.

    • Podium – Led a $20mm Series B round in December 2021. Podium is a high-growth digital learning company that provides credit-bearing, turnkey online courses for in-demand skills, delivered in partnership with universities to undergraduate students. In a recent survey run by Gallup, Strada, and McGraw-Hill, 86% of students said gaining skills to be successful in work was very important in deciding to pursue college. However only 36% of them believe they will graduate with the skills they need to be successful in the workplace. Podium’s offering combines high quality asynchronous content, real-world case studies, live interactions across schools, on-demand support, and seamless integrations to make for a student experience that stands on its own compared to traditional courses. In its most recent semester, Podium’s courses achieved a +68 NPS with completion rates at ~95% ( vs. ~50% for traditional undergraduate compsci courses for non-majors). Importantly, all courses can access federal financial aid and in some cases (e.g. Arizona State University) the university charges no incremental tuition for a Podium class.

    • BookNook – Led a $25mm Series B round in January 2022. BookNook provides a digital education platform that allows schools and districts to deliver high quality ELA (reading and literacy) supplemental support for K-8 students, both remotely and in-person. Today, the K-8 workforce is in ‘crisis’ mode due to staffing challenges, high student:teacher ratios and limited budgets; many of these existing difficulties were significantly exacerbated by the global pandemic As a result, the education system is struggling to provide personalized learning to students. BookNook has the ability to help readers achieve foundational skills more quickly and is able to reach a broader base of students than traditional in-person tutoring services. BookNook can leverage tutors anywhere in the world to provide access to students in both rural and urban settings that may not have otherwise had access to an in-person tutor. The company’s offering is differentiated given the use of real tutors and synchronous teaching in a small group setting, which is unique compared to the increasingly common asynchronous and gamified delivery methods. Most importantly, the solution democratizes tutoring by shifting the cost from individual families to the school district, enabling a service that previously was affordable to only a minority of families to become accessible to all.

    • TRANSFR – Led a $33mm Series B round in February 2022. Transfr is an emerging leader in the field of immersive learning (virtual reality simulations) for workforce development and training, particularly in the skilled trades. While graduating college does not necessarily have to be the ultimate goal, it is a pretty telling sign that the US higher education is deficient when approximately 2/3rds of US adults never see that system to completion and do not earn a college degree. As if this wasn’t enough, even the ones that do are often overburdened with debt, carrying an average student loan balance of $29,800, and only half say that the lifetime financial benefits of their degree outweigh the cost. TRANSFR’s career exploration modules expose students to a wider variety of jobs and immerses them in hands-on practice / training which are accessible, cost-effective, low-stakes, and effective ways to gain skills required for in demand jobs. TRANSFR also has strong relationships with local employers to complete the bridge to employment. Some of the delivered outcomes include 50% improvement in troubleshooting time; 93% retention of employees in the job at 6 months vs. 30% from employees sourced from temp agencies and 90%+ learner preference for VR training relative to traditional methods. The learners who utilize the solution are generally underserved by traditional higher education and include high school students, adults seeking to re-enter the workforce without a degree, students or job seekers with disabilities, and those formerly incarcerated. Lumos has worked with the company in its financing strategy, introducing its network of commercial partners, and has assisted in various other strategic growth initiatives.

2-3 more investments will round out the portfolio before a larger Fund II is raised in the first half of 2023.

Impact + Portfolio Support: As a co-investor in two of these transactions and as Chair of  Lumos’ Impact Advisory Board, Impact Engine has collaborated with and witnessed first hand how Lumos has embedded impact into every stage of their investment processes and how they have stayed true to the highlighted cell above. Leveraging its sector focus, relevant experience (operators, IPOs, M&As, principal investing) and networks & partnerships, Lumos’ portfolio support centers on helping their investments execute on (i) global growth (ii) follow-on M&A and (iii) capital financings and exits. 

  • Global Growth: James & Victor have worked in the global education and human capital development industry for years, and bring their network and knowledge of international markets to bear on the Fund’s investments with value-added introductions to commercial partners, referred to by Lumos as Ecosystem Partners, as well as an extensive Advisory Board with significant networks in various global markets. Domestically, the Investment Team is also uniquely knowledgeable of the tailored go-to-market strategies required to be successful across different market segments (with both B2B and B2C models), having invested or advised in many such situations over the past decade.

  • Follow-on M&A: A key strategy that Lumos has employed in past successful investments is to assist a portfolio company in consolidating a fragmented product category or extending its platform through accretive M&A. Lumos brings specific expertise in acquisition processes, as well as in-depth knowledge of the competitive landscape to be able to help companies execute on this strategy.

  • Expertise in Financings, Exits and Growth Strategy: The Lumos Investment Team has worked with numerous human capital development companies in growth strategy and positioning for follow-on financings and exits, and brings a differentiated value-add in these areas to assist portfolio companies post-investment. For example, James and Victor personally know key decision-makers at strategic acquirers throughout the industry, have advised numerous companies in minority financing and sale processes, and have also guided many companies in the sector to successful initial public offerings.

Lumos’ impact processes and philosophy centers on an overarching theory of change which recognizes that for numerous reasons the global status quo is unsustainable (most of the global workforce has less than a college degree, annual earnings of <USD20K, and is in danger of being left behind due to accelerating automation), that education is THE crucial lever for systemic change, and that purposefully investing in impactful private sector innovation will drive a more prosperous and inclusive future for everyone. Utilizing various frameworks and tools they embed impact into their investment processes in the following ways:

  • Sourcing – Multiple approaches, including thematic (e.g. education to employment outcomes) particularly in the wake of COVID-19, with a focus on proprietary opportunities aligned with broader impact theses and market trends; tracks deals with founders from marginalized backgrounds.

  • Diligence – Their diligence process is designed to deepen their understanding of the prospective company’s thesis to improve outcomes for students and educators, especially marginalized communities, and to uncover opportunities to more deeply embed accessibility and outcomes into the product or service. The team thoroughly reviews any research studies or academic papers the company has produced.

  • Investment – Formalize accountability with investee through explicit conversations with CEOs and impact side letters / legal documentation. Often ideate with CEOs as Lumos may be the first investor to ask for this thoughtfulness around impact.

  • Portfolio Support – Seen as a partner to portfolio management teams and engage in regular dialogue on impact priorities and positive social returns as the business scales. Develop, monitor, and continuously report on impact KPIs. Active voice on the board in regards to impact priorities.

  • Exit – Build relationships with impact aligned strategic and financial partners, and serve as a point of accountability at the board level in considering potential exit opportunities. Consistent dialogue and strategy planning with company on future plans.

As an example of how they used the Impact Management Framework and its 5 dimensions in the previously discussed first investment (and successful exit) please see the table below:

Lumos demonstrates that it takes a specific skill set to manage with success and impact at this stage.

Venture funds extending into later stages via opportunity funds or buyout funds being forced earlier due to competitive pressures need to understand that finding success at this stage requires much more than insider or sector knowledge. Take for instance the example of LendUp, a fintech company that had the mission to provide everyone with a path to better financial health. Through its proprietary software, it supposedly designed safe, transparent products that expanded access, lowered costs, and provided credit-building opportunities for the population of Americans who had limited options within the traditional banking system because of low credit scores and income volatility. Well after 9 years of operations and $366M in funding (including some of the most famous names in VC ie. Andreessen Horowitz, Google Ventures, Y Combinator, PayPal Ventures etc.) the US CFPB “shuttered the lending operations of this fintech for repeatedly lying and illegally cheating its customers,” causing the company to officially declare itself out of business on March 1st 2022.

The sector’s promise has inspired a number of the top buyout firms to launch large growth funds

Examples include: Bain Capital, TPG, and KKR. Blackstone, which manages $881 billion in assets across a diverse set of funds, is one of them. In March of 2021 it raised $4.5 billion for Blackstone Growth, its first-ever fund devoted to growth equity, and built a team of growth specialists led by Jon Korngold, an 18-year growth equity veteran from General Atlantic. Now it is supposedly already raising the 2nd vintage with over $3B secured in the first close.

Having said that, long standing growth equity players like Insight Partners are doubling down and protecting their lead by successfully raising its 12th flagship fund with over $20 billion in commitments.

As deal sizes increase growing companies can stay private longer

While in the past most growth companies eventually turned to the public markets to finance their expansion via IPOs, many today are delaying it and instead are tapping the ever deeper pools of private capital. IPOs are not going away, in fact they had a record year in 2021, but companies are reaching a relatively more mature stage of growth before subjecting themselves to the notoriously distracting and expensive IPO process. This trend has steadily increased the average deal size in the growth equity and late-stage venture markets, bringing (at least the $ figure) much closer to the range historically attractive to PE investors.

Average US Late-stage Venture & Growth Equity Deal Value ($M) | Pitchbook as of 06/30/21

As evidenced by the various callouts throughout the article, the rise of growth equity is evident but it is still in its early stages. Elevated valuations and general euphoria are certainly producing questionable transactions (not exclusive to growth), making it hard to assess which strategy will be the most lucrative over the long term. Nonetheless, the current investment wave driven by technology innovation seems to have stronger fundamentals than previous investment cycles like the dot.com era. In the approximately 1,700 calls/meetings Impact Engine has had with funds in the last three years, we have seen a variety of approaches, and we believe there are multiple ways to win. A wise person once said, “There are many ways to make money and there are many ways to lose money.” However, beyond financial outcomes, as this article has argued, we believe that supporting impactful growth investors is critical to the health and success of the broader impact investment ecosystem; as such impact growth equity holds a special place in our hearts and minds.

Pooled Horizon Net IRR for Global Funds | Cambridge Associates as of 06/30/21

Performance of Impact Growth Equity vs. Growth Equity (2006-2018) | Pitchbook

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