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How to Get Smart on New Themes as a Growth Equity Investor

As a growth equity investor, constructing an actionable investment theme is key.

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May 13, 2019

As a growth equity investor, constructing an actionable investment theme is the backbone of a successful strategy. A lucrative thesis starts at the micro level and necessitates alignment with the macro environment. Accurate data can uncover the answers to critical questions, including:

  • Does a company have high returns on capital?
  • Does it reside in a growing industry?
  • Are the company's margins high relative to those of competitors?
  • Is good management in place; what is happening on the industry and national levels?

These are just a few of the questions at the heart of developing a good thesis that investors use to avoid purchasing a "good house in a bad neighborhood."

In the past, uncovering the answers to these questions was time-consuming and difficult, as investors leveraged deal origination resources that were fragmented and inefficient. Fortunately, investors no longer need to rely on traditional methods for developing a thesis and sourcing leads. With the right tools in place, it's easier than ever for investors to develop themes that result in the most profitable niche opportunities.

Understanding & Pursuing the Right Niche

Conducting effective research into industry verticals is key to identifying the right niche to pursue. To develop a strong theme, define specific niches and expand them to include relevant verticals. These areas of specialization will help shape themes and more effectively target prospect companies.

An investment firm, for example, might be an expert on sales horizontally across a few different industries, or they might have expertise in companies at a specific stage of growth. Maybe they're skilled at taking a company from $5 million to $50 million; whatever the case may be, firms need to define their specific niche so they can effectively leverage origination data to design themes that capitalize on those points of strength.

Effectively Approaching Target Companies

Once you identify and develop a target theme, it's crucial to consider the right company data to generate a list of optimal targets.

Look at details such as company employee count and past and current growth trends to determine the best opportunities. Once you've identified your targets, leverage this information to help you develop the right strategy when approaching your target company.

For example, some companies are ready for growth capital but don't think they need it. When approaching these companies, reframe how you're thinking about their needs. Start with understanding why they don't need the capital to better conceptualize where they're coming from.

Maybe they have enough cash from internal funding, or perhaps they're getting a large amount of deferred revenue. Alternatively, they might have some non-equity form of financing. In this case, one carrot that investors can dangle is liquidity in the early stage. Approach investors and founders from the angle of helping to reduce their risk portfolio with additional capital.

Another approach is to explain to key decision-makers why the window of opportunity is closing. Creating a sense of urgency about receiving additional capital can assist with creating greater appeal when considering all relevant factors.

Understanding Critical Red Flags

A company might appear to be the perfect fit for growth equity, but there may be some red flags beneath the surface that could impact the business in the future. These are crucial to consider in advance to ensure the effectiveness of your deal flow. Here are a few important red flags to watch for:

Customer retention and churn. A company might be stuck in its current stage of growth due to customers churning too fast. Investors can do an in-depth churn retention analysis to understand 1) the profitability of each customer, 2) when the customer returns the acquisition costs, and 3) the lifetime value of that customer.

Customer concentration. Another critical piece of data is customer concentration. Does one customer make up over 50% of revenue? If so, is this one customer subsidizing other customers who are not profitable? These are two factors to examine closely.

Customer-level economics. How well is the company's sales engine working, and how efficient is that sales engine? If sales are soft, it's important to figure out why. If you're going to invest money in a growth-stage company, the goal is to triple or quadruple the sales, so customer-level economics become critical.

Alignment with investor strategy. Investors are always analyzing how they will earn their return on investment. Some earn return from being active investors and changing management teams. If you find that a company has a poor management team, do you have the expertise to put the right one in place? At this juncture, it could be that vertical expertise becomes important. However, if this company is not a fit with your vertical, it's important to steer clear and explore other options.

Moving into the Future with Greater Success

Investors can effectively build themes and reduce risk of red flags by utilizing data to their advantage, particularly with Sourcescrub. Sourcescrub can help growth equity investors understand relevant company data as well as the key players in a potential transaction with the following tools.

Pre-Scrubbed Lists: Investors can utilize lists from industry conferences, buyer's guides, member associations and more. Armed with this information, you can quickly understand which companies qualify for your firm's parameters with easy-to-use filters on details such as ownership, location and size.

Market Landscaping: Investors can develop more strategic themes by utilizing details from well-known companies in a given sector, and then finding other top-performing, relevant or undiscovered businesses in the same space.

Deal origination platforms such as Sourcescrub are fundamental for growth equity investors in today's ultracompetitive environment. While building relationships is a big part of the process for investors in private companies, that does take time, and the right technology can help speed up that process.

Quickly keying in on good prospects and receiving a list of companies to target at upcoming conferences brings a new level of efficiency to deal sourcing. Having the right data at your fingertips will allow you to rapidly filter out the companies that have minimal funding or target companies of relevance. As a result, you will spend far less time in the search to identify the right companies and will reach more profitable results faster.