Investor Series: Selecting the Right Kind of PE Partner for your Life Science Firm – Part 2: Growth Capital

22 Jan

By Danielle Silva, Director of Research, LSN

Life science firms may often times find it difficult to select the right kind of private equity fund to partner with during their fundraising process. In order to pinpoint the right private equity group (PEG) to work with, the individuals tasked with fundraising at a life science firm must first gain an understanding of each private equity strategy. Last week, LSN offered an in-depth profile on buyout funds. This week, we shift the focus of our investor series, and take a deep dive into growth equity funds.

Growth equity funds, as their name suggests, supply an injection of capital into firms who are looking to expand or grow their businesses. Life science companies may be seeking this kind of capital in order to finance a major merger & acquisition, partner with a firm that has operational expertise, reduce personal guarantees on loans, or enter into new markets.

So why would a life sciences firm partner with a growth equity fund? Usually, because their business plans have been halted due to lack of available capital. As an added benefit, growth equity funds provide guidance at the board level. This means that one or more members of the private equity group will sit on the management board of their portfolio companies. Furthermore, growth capital funds usually take a non-controlling minority stake in firms, taking up to a 40% equity stake in a firm. This is because they prefer that the current management team continues to run the business.

Growth capital firms sometimes act like venture capital by providing companies with capital that helps them to accelerate the firm’s growth. However, unlike venture capital funds, growth equity funds only invest in established companies that have recurring, predictable revenue streams. For this reason, growth equity funds will not invest in an early stage, pre-revenue company. In the life sciences space, for example, a growth equity fund would invest in a medtech firm that already has one or more devices on the market. On the other hand, they would not invest in a medtech company, for instance, who has a prototype of their product, but does not have any products on the market.

Growth equity funds also vary greatly from buyout funds. Buyout PEGs typically generate revenue through restructuring a business, while growth capital investors hope to achieve returns by growing the business. Buyout funds also sometimes fully buyout a business owner, and thus do not prefer to keep the majority of the management team, whereas growth equity funds typically prefer that the current manager does stay with the firm and run the company.

Growth equity funds also have a much shorter-term holding period for their portfolio companies than both buyout and venture capital funds. Typically, growth equity funds will only hold a portfolio company long enough for their growth plans to be executed, and will then sell the business shortly after this expansion starts generating revenue.

Conversely, private equity funds typically hold businesses for longer time periods because it frequently takes longer for cost-cutting or restructuring measures to make firms increase their profitability. A venture capital fund typically has a longer time horizon than a growth fund because the firm is investing in an early stage company, and it tends to take a long period of time for these firms to become cash-flow positive, especially in the case of firms that are investing in pre-revenue companies.

Growth capital funds often focus due diligence efforts on forecasting the feasibility of the expansion that they are financing, rather than looking at the long-term attractiveness of the company as a whole. The expectation is that profits will be generated through the expansion of the company, and these profits will be used to return the capital that was provided by the fund.

When profits from the company’s expansion are not able to cover the capital that was provided by the growth equity fund, growth equity funds will employ an add-on strategy (similar to buyout funds) which will involve the acquisition of a smaller company, thus making the firm a larger player in their respective industry, with a larger market share. The cash flow that is generated from the company that is acquired can then either be used to increase the percentage of the fund’s equity stake in the parent company, or can be used to return capital to the fund.

Growth capital funds typically exit a company through a merger, or through an initial public offering (IPO). Therefore, because these funds seek to make exits through M&A or through an IPO, they typically work with larger and more established firms. Growth equity funds in the life science sector then, for example, would work with a biotech therapeutics company that currently has at least one product on the market, but would most likely not invest in a company that only has one product that is going through the clinical development process. Growth capital funds, consequently, can be very valuable partners for life science companies that are seeking to retain their current management team and are cash-flow-positive, providing these firms with the capital necessary to grow and expand their operations.

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