Navigating The Macro Environment

Why acceleration capital is well-positioned on the private equity spectrum

  The economic cycle is turning and investors of all stripes are reassessing which asset classes they are exposed to.

While private equity is sometimes regarded as a single asset class, in reality it is an umbrella term. At the “top” end, at least in terms of volumes of assets and size of deals, buyout funds may look vulnerable to rising interest rates and looming recession. With the end of “free cash”, the heavy leverage loads carried by buyout companies will raise their costs. Declining economic activity will apply further pressure, holding back the organic growth of mature companies.

At the other end of the size spectrum are VC-sponsored companies. To build out their businesses, they are dependent on raising debt and equity, both of which are in shorter supply in the current environment. “Lower-quality VC-backed companies will undoubtedly see a higher death rate than in the past,” says Marc Romano, head of Mirova impact private equity funds.

What then of growth funds?

The outlook for growth capital

Along the private equity spectrum, growth funds – or acceleration capital – sit between VC and buyout funds, and are the missing piece of the funding puzzle.

“Our view is that the growth stage will be less impacted, since growth companies have lower levels of debt and higher growth rates,” says Romano. “Even if their growth rate is reduced, they are dynamic companies and their growth will still be significant.”

Mirova, an affiliate of Natixis Investment Managers, specifically provides acceleration capital to companies that are able to make a positive impact on environmental sustainability. This makes its portfolio companies more resilient to cyclical headwinds, Romano believes. “Because the type of company we invest in innovates to create positive impact, they surf strong trends that supersede cyclical trends,” he says. “Our portfolio companies are not green for the sake of being green, but to solve the economic pain-points of their customers.”

These pain-points include the need for more plentiful supplies of clean energy, more efficient water consumption on farms, agricultural innovation and buildings which are built with sustainable materials that are cheaper to maintain and heat.


New fundraising to become scarcer

As cash becomes more expensive and economies contract, greater diligence is needed in the way portfolio companies are selected and managed.

Amid a more challenging fundraising environment in which retained profits are more likely to drive expansion than follow-on fundraising rounds, companies must have robust business models for both the short and long terms.

This favours companies with little or no leverage and those which do not have significant capex requirements. The business plan must also be more conservative given increases in the costs of operating – notably higher salaries and more expensive raw materials.

“Portfolio managers should challenge companies’ expected growth rates and incorporate contingencies, especially for companies directly exposed to economic cycles,” adds Romano.

Mirova’s acceleration capital approach, which dates from before the current crisis, is to map a clear route to profitability for each portfolio company within the typical holding period of five years.

If there has been a change in Mirova’s approach since the current crisis erupted, it is in communicating to companies and advisers the critical importance of the operating model. Romano says: “We need to make sure our message is taken seriously by management and their financial advisers.”

The key message is that new fundraising rounds will be harder to achieve and that emphasizes the need for managements to finetune their strategies for sourcing materials and managing labour costs.


Impact expertise as a differentiator

Dealflow in private equity is still strong, but less fluid than before. This inevitably leads to greater competition for well-run companies, with weaker companies left behind. In this environment, Mirova’s focus on companies which have a positive impact on sustainability issues has enabled it to get access to better deals.

Romano says: “The fact that we are different and can bring a strong value added in terms of our knowledge of impact investing and ability to engage with the issues, is allowing us to win deals without having to resort to unrealistic offers. We tend not to win on pricing alone but, as a proven impact player, on what we can add to each company.”


No change in return outlook

Despite changes in the operating environment, Mirova feels no need to change its outlook for its impact acceleration capital portfolio. Its aim has been to search for ideas that have the potential for generate 3x returns and this is still the case.

One of its advantages is that it is in the early stage of its drawdown phase and is fare to have deployed all of its capital. “For teams in the exit phase, reduced pricing across the board is not great news. But for us, it means we can buy good companies at cheaper entry multiples,” says Romano.

There is sufficient time for companies to weather the current downcycle, grow and then be divested when the cycle is more favourable, leading to good exit multiples.

Despite the positives, Mirova’s overall approach is tinged with caution, given current conditions. “We are more conservative about exits right now,” says Romano. “So we naturally have to be more conservative about the entry point.”

Published in July 2022.