Adjusted growth equity

What Is Adjusted Growth Equity?

Adjusted Growth Equity refers to the valuation of investments made by growth equity firms, which often necessitates specific adjustments to account for the unique characteristics of these privately held companies. While growth equity itself is an investment strategy within the broader category of Private Equity, focusing on minority stakes in rapidly expanding, often profitable, businesses, the "adjusted" aspect highlights the critical process of modifying standard valuation metrics to reflect factors such as illiquidity and specific deal terms. These adjustments are crucial because, unlike publicly traded stocks, growth equity investments lack readily observable market prices and often involve complex Capital Structure elements and bespoke agreements.

History and Origin

Growth equity emerged as a distinct investment strategy, bridging the gap between early-stage Venture Capital and mature Leveraged Buyout funds. Pioneers such as General Atlantic, TA Associates, and Summit Partners are often credited with popularizing the term, identifying a need for expansion capital for companies that had proven business models but were not yet ready for a public offering or a full acquisition²³. This strategy formalized a segment of the private markets, providing capital to fuel substantial Revenue Growth and operational scaling. Over time, the investment landscape evolved, with growth equity becoming a recognized allocation for institutional investors²¹, ²². The "adjustment" component in valuing these investments became increasingly prominent as the market recognized the inherent challenges in assessing private company values and the need for rigorous fair value practices.

Key Takeaways

• Adjusted Growth Equity involves modifying standard valuation methodologies to account for the unique characteristics of private, growth-stage companies.
• Key adjustments often address the illiquidity of these investments, lack of comparable market data, and specific deal terms.
• The valuation process aims to determine a Fair Value that reflects the investment's true economic worth, often impacting reported Net Asset Value.
• Regulatory bodies, such as the SEC, have introduced rules to enhance transparency and investor protection in private fund valuations, underscoring the importance of these adjustments.
• Accurate Adjusted Growth Equity valuations are vital for investor reporting, fund performance assessment, and strategic decision-making.

Formula and Calculation

While there isn't a single universal "Adjusted Growth Equity" formula, the concept primarily involves applying adjustments to a baseline Valuation derived from common methodologies for private companies. The fundamental approach begins with standard valuation methods and then applies specific discounts or premiums.

For example, a common approach involves using a Discounted Cash Flow (DCF) model or comparable company analysis, and then applying an Illiquidity Discount. The formula for applying an illiquidity discount is generally:

Where:

• (\text{Adjusted Value}) represents the valuation of the growth equity investment after considering its lack of marketability.
• (\text{Unadjusted Value}) is the initial valuation derived from traditional methods (e.g., DCF, multiples of EBITDA or revenue).
• (\text{Illiquidity Discount Rate}) is a percentage reduction applied to account for the inability to easily sell the investment in an open market. This discount can range significantly depending on the asset and market conditions¹⁹, ²⁰.

Other potential adjustments, though not typically expressed in a simple formula, include:

• Control Premiums/Discounts: While growth equity often involves minority stakes, the extent of influence or protective rights can warrant adjustments.
• Performance-based Adjustments: Earn-outs or milestone-based payments can affect the final realized value and should be considered in forward-looking valuations.

Interpreting the Adjusted Growth Equity

Interpreting Adjusted Growth Equity involves understanding that the resulting value is an estimate, incorporating subjective judgments necessary for private, illiquid assets. A higher adjusted value suggests a more optimistic outlook on the company's growth prospects, its ability to achieve key milestones, and a lower perceived risk associated with its illiquidity. Conversely, a lower adjusted value indicates greater caution regarding these factors or a larger required illiquidity premium.

For investors, the adjusted value helps in assessing the true economic exposure and potential Risk-Adjusted Returns from their growth equity portfolios. It provides a more realistic basis for calculating fund performance and making capital allocation decisions. The magnitude of the illiquidity discount, for instance, reflects the market's perception of how easily or quickly the investment could be converted to cash without significant loss¹⁷, ¹⁸. A substantial discount signals a higher perception of liquidity risk, which can influence an investor's Investment Strategy.

Hypothetical Example

Imagine "TechGrow Inc.," a privately held software company. A growth equity firm, "Innovate Capital," invests $50 million for a minority stake. TechGrow Inc. has a proven business model and strong Revenue Growth, but it is not publicly traded, making its shares illiquid.

Innovate Capital's initial valuation, based on comparable private company transactions and TechGrow's projected future cash flows, calculates an unadjusted equity value for its stake at $70 million. However, recognizing the absence of a liquid market for these shares, Innovate Capital applies an illiquidity discount.

Step-by-step adjustment:

1. Baseline Valuation: Using a discounted cash flow (DCF) model and recent private market transactions for similar software companies, the team determines the unadjusted fair value of their stake in TechGrow Inc. to be $70,000,000.

2. Assess Illiquidity: Given that TechGrow Inc. is a private company with no immediate plans for an Initial Public Offering (IPO) or clear secondary market, the investment is highly illiquid.

3. Determine Discount Rate: Based on market studies of restricted stock and illiquid asset transactions, Innovate Capital's valuation policy dictates an illiquidity discount rate of 25% for companies of this stage and profile.

4. Calculate Adjusted Growth Equity:

   $$\text{Adjusted Value} = \$70,000,000 \times (1 - 0.25)$$ $$\text{Adjusted Value} = \$70,000,000 \times 0.75$$ $$\text{Adjusted Value} = \$52,500,000$$

Thus, while the unadjusted valuation indicated a $20 million gain, the Adjusted Growth Equity value of $52.5 million provides a more conservative and realistic estimate of the investment's current worth, accounting for the significant illiquidity inherent in the private market investment. This adjusted figure will be used in Innovate Capital's internal financial reporting and for reporting to its limited partners.

Practical Applications

Adjusted Growth Equity is a critical concept with several practical applications in the private markets:

• Fund Reporting and Performance: Private equity and growth equity funds use adjusted valuations to calculate their Net Asset Value (NAV) and report performance to limited partners. This ensures that investors receive a more accurate picture of their portfolio's value, considering the inherent illiquidity of the underlying assets.
• Investment Decision-Making: Fund managers incorporate these adjustments during their Due Diligence process to determine an appropriate entry price for new investments and to evaluate the ongoing attractiveness of existing portfolio companies. Understanding the potential impact of illiquidity allows for more informed capital allocation.
• Regulatory Compliance: Regulatory bodies, such as the U.S. Securities and Exchange Commission (SEC), have increasingly focused on valuation practices for private funds. Recent rules mandate that registered private fund advisers obtain a third-party valuation or fairness opinion for certain transactions, enhancing transparency and investor protection in these markets¹⁴, ¹⁵, ¹⁶. These regulations often require explicit consideration of factors like illiquidity.
• Exit Planning: When considering an exit strategy, such as a sale to another Private Equity firm or an Initial Public Offering (IPO), the adjusted valuation serves as a more realistic benchmark for expected proceeds.
• Balance Sheet Management: For the growth companies themselves, understanding how investors might adjust their equity valuation helps in strategic financial planning, including future fundraising rounds or potential mergers and acquisitions.

Limitations and Criticisms

While necessary for accurate reporting, the process of determining Adjusted Growth Equity, particularly the application of illiquidity discounts, faces several limitations and criticisms:

• Subjectivity: The size of the Illiquidity Discount is often subjective and can vary significantly depending on the valuation firm, market conditions, and specific asset characteristics¹², ¹³. There is no universally agreed-upon formula or standard for determining the precise discount rate, leading to potential inconsistencies. This subjectivity is a long-standing challenge in private equity¹⁰, ¹¹.
• Lack of Observable Data: Unlike public markets, private markets lack frequent, observable transaction data for identical assets, making it challenging to derive robust comparables for the "unadjusted" baseline value. This scarcity of data often forces reliance on assumptions and projections⁹.
• Conflicts of Interest: When a fund manager provides an internal valuation, there can be a perceived conflict of interest, as higher valuations can lead to higher management fees. While regulations aim to mitigate this by requiring independent opinions for certain transactions, it remains a point of scrutiny⁷, ⁸.
• Market Volatility Impact: Broader market downturns and increased public market volatility can indirectly impact private equity valuations, even though private assets are not traded daily. Public market sentiment and rising debt costs can create valuation gaps between buyers and sellers, affecting deal flow and exit opportunities⁵, ⁶. The Federal Reserve Bank of Chicago highlighted concerns about the overvaluation of portfolio companies and high expectations from limited partners in the private equity industry⁴.
• "Stale" Valuations: Traditionally, private equity valuations are updated quarterly or even annually, meaning the reported Adjusted Growth Equity might not immediately reflect rapid changes in market conditions or company performance. This can create a lag compared to real-time public market pricing.

Adjusted Growth Equity vs. Growth Equity

The distinction between "Adjusted Growth Equity" and "Growth Equity" lies primarily in scope and emphasis.

Growth Equity refers to an investment strategy where capital is provided to relatively mature, often profitable, private companies that are experiencing rapid growth. These investments typically involve taking a minority ownership stake, with the funds used to accelerate expansion, enter new markets, or finance acquisitions without a change in company control², ³. The core focus of growth equity is on companies that have a proven business model and seek capital to scale operations.

Adjusted Growth Equity, on the other hand, is not a distinct investment strategy but rather the valuation outcome for growth equity investments after applying specific modifications. It acknowledges that the simple, unadjusted fair value of a private company stake, derived from standard Valuation methodologies, must be "adjusted" to reflect the practical realities of owning an illiquid asset in a private market. These adjustments primarily account for factors like the Illiquidity Discount, the lack of a public trading market, and adherence to Fair Value accounting standards. Essentially, Adjusted Growth Equity is the refined, more realistic appraisal of a growth equity investment's worth, considering its unique characteristics within the broader private capital landscape.

FAQs

Why is an adjustment needed for Growth Equity?

An adjustment is needed for Growth Equity because these investments are typically in private companies, meaning their shares are not traded on public exchanges. This lack of marketability, or illiquidity, means they cannot be easily bought or sold, warranting a discount compared to similar publicly traded assets. Adjustments also account for specific deal terms and the unique risk profile of private investments.

What factors commonly lead to adjustments in Growth Equity valuations?

Common factors leading to adjustments in Growth Equity valuations include the illiquidity of the private shares, the absence of directly observable market prices, the specific rights and preferences negotiated in the investment agreement, and the need to comply with Fair Value accounting principles.

How do regulators view Adjusted Growth Equity?

Regulators, particularly the SEC, emphasize transparency and investor protection in the Private Equity sector. New rules require private fund advisers to provide investors with detailed statements and, for certain transactions, obtain independent valuation or fairness opinions to ensure accurate reporting of these illiquid assets¹. This regulatory oversight underscores the importance of properly "adjusting" growth equity valuations.

Does "Adjusted Growth Equity" imply a lower valuation?

Often, "Adjusted Growth Equity" will imply a lower valuation compared to an unadjusted intrinsic value, primarily due to the application of an Illiquidity Discount. This discount compensates investors for the inability to readily sell their investment. However, other adjustments could theoretically lead to premiums depending on specific, favorable deal terms or market conditions, though illiquidity discounts are more common.

Is Adjusted Growth Equity only relevant for private companies?

Yes, the concept of Adjusted Growth Equity is specifically relevant for investments in private companies because public company shares are liquid and have readily observable market prices. The "adjustments" are necessary to account for the fundamental differences in marketability and transparency between private and public securities.